The new role of finance and banking

India's Economy in the New Millennium: Selected Essays by Bimal Jalan, VBS Publishers' Distributors Pvt Ltd., New Delhi, 2002; pages 239, Rs.395.

THE author of this book is the Governor of the Reserve Bank of India. Bimal Jalan earlier held other key posts such as those of the chairman of the Economic Advisory Council to the Prime Minister, member-secretary of the Planning Commission and Finance Secretary to the Government of India. He had, for a term, also served as the executive director representing India on the boards of the International Monetary Fund and the World Bank. The book consists of seven essays and six short comments, all based on public addresses delivered on different occasions in recent years after the author became Governor of the RBI. About the collection the author says that though dealing with a variety of themes they are all concerned with the past record and present policies and raise some issues for the future.

Among the different themes discussed in the book, this review concentrates on those that deal with finance and banking. But first some preliminary observations. The thrust of all the pieces in the volume is on the new global and national economic environment of the 1990s and the early part of the present decade and changes in policy necessitated by it. But Jalan as an economist does not take the position that economic policies in the country during the first four decades since Independence were wrong or that after the economic reforms initiated in the early 1990s everything is right. Similarly in the state vs market and the related public vs private sector debates he does not take a dogmatic position. A balanced evaluation of the past and a cautionary approach to the future can be seen in the first essay titled, "India's Economy in the Twenty-first Century: A New Beginning or a False Dawn?" Another significant contribution is the seventh essay, "Science, Technology and Development".

The decision to concentrate on finance and banking in this review is based partly on the fact that these are the areas over which the author as the Governor of the RBI has special insights and responsibility, and also on the fact that they are among the sectors most affected by the reforms against the backdrop of the new thrust of globalisation. As the author points out, the significance of the financial system for an economy arises from at least three major sources. "First, it performs various transformation functions relating to intermediation of funds in the economy. Secondly, it provides the mirror image of the underlying real economy and the basic macroeconomic balances. Thirdly, it is one industry whose basis of operation is underpinned in public trust" (page 91).

Major changes came about in the financial sector as the economy grew and matured during the decades since Independence. The opening up of the economy in the early 1990s, the increased flow of capital, especially private capital, into the country resulting from it, the diversification of agencies and instruments, the increased international competition and the revolution in the information and communication technology have all brought about unprecedented changes in the sector.

A four-fold attempt has been made in India in response to these changes. First, financial reforms have attempted to set the policy conditions right and remove the operational constraints of the financial system. Secondly, directional changes to create a more competitive environment have been effected. Thirdly, financial intermediaries have been given greater freedom. Fourthly, in order to provide greater safety, certain structural changes have been initiated and some prudential standards have been prescribed.

In this process of the reorientation of the financial system, changes had to be brought about in the exchange rate policy, capital transactions and convertibility, interest rate policy and in other related areas. As one of the chief institutions dealing with credit and finance, the banking system in the country too has had to undergo major changes. Although India's banking system was the product of a long period of natural evolution and hence shows some peculiarities of its own, since the nationalisation of the major banks in 1969, it had come to be dominated by the public sector regime. It is readily conceded that the rapid growth of banks and banking in the country and their significant penetration into the rural areas was a direct result of nationalisation. Similarly, the availability of credit to the weaker sections would have been terribly slow and extremely limited but for that major action. A policy change in this sphere also has become necessary in the new context where competition - national and international - is the order of the day.

On this Jalan says: "A sensitive and controversial question which would need to be faced, sooner, or later, is whether the 'public sector character' of our banks and other institutions is consistent with their being able to play a globally competitive role in the future" (page 134). Among the advantages of the public sector character of the banking system the most important that the author lists is the fact that it considerably reduced the 'vulnerability' of the system as a whole. This was clearly demonstrated by the manner in which India escaped the financial crisis that rocked Thailand, Indonesia, South Korea, Malaysia and many other Asian countries in 1997-98.

A second advantage is the availability of an established institutional infrastructure. As against these, the important disadvantages are "the relative insensitivity of the system to its cost structure, inability to respond quickly to the changing market trends and the greater rigidities in the management decision-making processes because of what may be described as 'non-commercial' considerations" (page 134). Referring to the failure of the private banking systems in many countries, including Japan, the author points out that privatisation per se is not the answer. This non-dogmatic approach of the author is accompanied by his repeated emphasis on the need for transparency and accountability.

In respect of a vast, complex and rapidly changing segment such as finance, it is not fair to expect a full and comprehensive treatment. But two crucial issues do not appear to have received the author's attention. As noted already, a major (and ideal) function of finance is to provide a mirror image of the "real economy". But it is in the very nature of finance to lose this feature and to become a mere reflection of global capital. Indeed, the evidence that one has is that what is frequently being referred to as "globalisation" is neither a new international division of the real economy of the world nor an increased interaction of real economies through trade with finance playing a facilitating role for these desirable purposes. Rather, it is a process whereby finance is increasingly delinked from real economies everywhere, and emerging as a manifestation of capital with an autonomous momentum of its own. To the extent this is true, finance, instead of mirroring the real economy, may distort it. This danger is particularly prominent in countries such as India where close to 90 per cent of the real economy is characterised by a variety of informal arrangements. To the extent that finance is attempted to be aligned solely to macroeconomic balances, it may play havoc with the microeconomic processes of the real economy. Is this happening in India and is that why with all the achievements in the financial and external sectors, the real economy has been remaining stagnant?

The second issue has to do with the high cost of banking in India. Jalan points out that "a comparative analysis indicates that while the average operating cost of banks as a percentage of assets was about 2.7 per cent in India during 1991 to 1999, it was much lower at 1.8 per cent for the East Asian economies and 1.7 per cent for the three large industrial economies of USA, Germany and Japan" (page 96).

There need be no doubt that the high Indian cost is partly a reflection of operational inefficiencies. But is it also the result of the large number of small accounts that banks in India operate? More important, is it also because Indian banks are multi-purpose agencies - they disburse pensions, collect a wide variety of taxes and perform functions that banks in other parts of the world may not be engaged in? If these are relevant factors, more than an attempt to tune the country's banking system to international norms and procedures is necessary.