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How practical are Raghuram Rajan's radicalideas?Anand Adhikari March 4, 2014

If we are to achieve results never accomplished before, we must expect to employ methods

never before attempted," said the 16th century author and statesman Sir Francis Bacon.

Raghuram Rajan, the 23rd Governor of the Reserve Bank of India (RBI), may well have

been inspired by Bacon. RBI under Rajan is talking of a radically new approach to achieving

financial inclusion and creating a financial infrastructure for the new millennium.

In his five months at the RBI's Mumbai headquarters, the central bank has come up with

ideas that were never considered before. Consider, for example, the move to have bank

accounts for all citizens by 2016. Or the initiative to raise over $5 billion in September,

without having a sovereign bond issue, to combat the rupee depreciation. This was achieved

through a swap facility to attract NRI funds. The masterstroke was Rajans decision to go

after black money and fake currency by simply withdrawing currency issued before 2005.

Many of the existing banking practices and regulations were given shape several decades

ago. The RBI Act itself was drafted in the pre-Independence era, Winds of change have been

blowing globally for some time and the RBI needs to respond to them. The emergence of

electronic payments is transforming a poverty-stricken continent like Africa. "The

technological revolution bodes well for India. It can leverage payment technologies to bring

about financial inclusion," says Raj Jain, Chairman and Managing Director at RS Software

(India) Ltd, a technology company.

3/9/14 How practical are Raghuram Rajan's radical ideas? : Business Today

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...Not everybody needs credit and not everyone who asks for

credit should get it: Nachiket Mor, Central Board Member, RBI

Photo: Rachit Goswami

Click here to Enlarge

Financial Inclusion

Today, 60 per cent of Indias population does not have a bank account. In addition, about 90

per cent of small businesses have no links with formal lending institutions. Efforts to achieve

financial inclusion have failed to deliver adequate results. Rajan sounded out his Indian

Institute of Management (IIM) Ahmedabad classmate Nachiket Mor, now a member of the

RBIs central board within days of taking over, for ways to cover small businesses and low

income households. By January, the Mor committee had come up with the concept of

"payment banks" with initial capital of Rs 50 crore, one-tenth of what a full-service bank

requires. These banks could be set up by existing banks as subsidiaries or by consumer

goods dealers and mobile phone companies, non-banking finance companies (NBFCs) and

the post office system. Payment banks will only accept deposits and not do any lending.

But some question the need to create another structure in addition to the existing banking

network. "The infrastructure of mobile phone outlets and kirana stores already exists," says

Mor. This obviates the need to set up more new branches and payment banks can begin

offering basic banking services on getting a licence, he adds. Mor has also recommended

allowing NBFCs to set up wholesale banks which will accept wholesale deposits (not retail)

and engage in lending activity too. Mor reasons that the best incentive for financial inclusion

is to create competitive pressure in the system.

The second important

recommendation of the Mor

committee is to have bank accounts

for all by 2016 by linking them to the

Aadhaar numbers of citizens. But

not many are convinced. They say

the larger issue is of simultaneously

strengthening the banking

infrastructure and raising standards

of living. "Financial inclusion

definitely cannot mean just the

opening of a bank account. It also

cannot be done only by the banks.

You have to have financial viability,

telecommunications, power, water, roads and then banks can follow," said Aditya Puri,

Managing Director of HDFC Bank at a recent Indian Bank Association function.

Two of the Mor committee members - Shikha Sharma, Managing Director and CEO, Axis

Bank, and S.S. Mundra, Chairman, Bank of Baroda - have stressed the need for providing

the complete bouquet of financial services which wont be achieved through payment banks.

"But not everybody needs credit and not everyone who asks for credit should get it. Credit

has to be given much more carefully," says Mor.

Rajan is yet to take a call on the Mor committee report.

Monetary Policy Reforms

On his very first day, Rajan also talked about a new approach to formulating monetary policy.

Rajan picked Deputy Governor Urjit Patel to take a look at what more needed to be done to

strengthen the monetary policy framework. The Patel committees report talks of inflation

targeting as the sole objective of the monetary policy and has insisted on using the

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Financial inclusion definitely cannot mean just the

opening of a bank account: Aditya Puri, MD, HDFC

Bank Photo: Nishikant Gamre

consumer price index (CPI) instead of the wholesale price index (WPI) for determining

interest rates. The CPI itself is a very new series with no long history. The share of food

component is very high in the CPI, almost half, which limits the impact of the monetary policy

on the index, say analysts.

"There is nothing wrong, theoretically or

conceptually, in using CPI as a nominal

anchor, but I dont think it will work as

monetary policy cannot influence any

significant component of the CPI," says

Madan Sabnavis, Chief Economist at Care

Ltd. In the third quarter review of the

monetary policy in January, Rajan has

made a reference to CPI, which shows he

obviously sees merit in using it as an

inflation anchor. Patel committee has also

suggested forming a five-member monetary

policy committee (MPC) to decide policy

action.

These two radical ideas are in direct conflict

with the recommendations of the

government-appointed Srikrishna panel on

Financial Sector Legislative Reforms.

Srikrishna report, submitted a year ago, has

clearly spelt out the governments role in

giving quantitative monitorable objectives to

RBI for monetary policy formulation. The

mandate of the RBI spelt out in the Act is to

support growth, financial stability (of the banking system) and price (inflation) stability. "The

objective that the RBI must pursue would be defined by a central government and could

potentially change over the years," added the Srikrishna report.

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The composition of the MPC suggested by the Patel committee - with RBI Governor as

Chairman, a deputy governor, executive director and two external members - is also in

contrast to the Srikrishna committee recommendations. Srikrishna has suggested a seven-

member MPC, which includes the RBI Governor, one executive director from the RBI and

five external members. Out of the five external members, two will be appointed by the

Governor and three will be by the government. Clearly, the government wants to have a say

in the monetary policy decision-making whereas Rajan appointed committee is tilted in

favour of the RBIs independence.

Internationalisation of the Rupee

Many were surprised when on the very first day of assuming office in September last year,

Rajan talked about internationalisation of rupee. "This might be a strange time to talk about it,

but we have to think beyond the next few months," said Rajan. It actually means acceptability

of the Indian rupee for settlement of cross border transactions globally like the dollar. Rajan

spoke about internationalisation when he was actually expected to do some fire fighting to

save the rupee from depreciating against the US dollar. The rupee breached the 68 mark last

August against the dollar. "That may be his long term plan," says Rohit Wahi, CEO and

Country Head, FirstRand Bank India. Internationalisation is a sensitive issue as it first

involves capital account convertibility. This might make the rupee volatile and it might

3/9/14 How practical are Raghuram Rajan's radical ideas? : Business Today

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India can leverage payment technologies to bring

about financial inclusion: Raj Jain, CMD, RS Software

(India) Ltd

eventually depreciate because of a large current account deficit. A report authored by two

RBI executives in May 2010 said: "It depends on market forces, i.e., how much faith the

market has in that currency, which in turn depends on various factors, such as size of the

economy, level of financial development, stability, etc."

Distressed Assets

Rajan is quick to spot the growing non performing asset (NPA) menace in the banking

sector. While his measures for early detection of bad debt are laudable, the second leg of

NPA resolution, which depends on the courts, requires an overhaul of the legal system. The

RBI plans to take up with the government concrete suggestions on reining in NPAs. These

include creation of additional debt recovery tribunals, creating special cadre of officers and a

separate bench for speedy disposal of NPA-related cases. Recommendations may also be

made to the government to expedite setting up of special benches in every high court for

corporate cases. "But these things will take years," says an official of an asset

reconstruction company.

The governor wants to reduce the SLR

(statutory liquidity ratio), which requires

banks to invest 23 per cent of the deposits

in government securities. "This (reduction)

cannot be done overnight, of course. As

government finances improve, the scope of

such reduction will increase," said Rajan in

his very first media interaction. The banks

today hold 28 per cent SLR, more than the

stipulated amount, because of shrinking

lending opportunities in an economic

slowdown. "Commercially speaking, banks

are finding it more comfortable to hold risk

free G-Sec," says Sabnavis.

Separately, Rajans idea of allowing fund

transfers by way of an SMS system also

looks ambitious. "It actually requires

installation of encrypted software in every

handset," says Uttam Nayak, Country Head

at Visa India. And thats a challenging task to

have such an encryption with handset

manufactures spread over different

geographies.

Clearly, Rajan is not looking at band-aid

solutions to fix the larger structural issues

and has set an ambitious agenda for the

central bank. Can he pull if off? For the moment, Rajan exudes confidence that he can ring in

far reaching reforms.

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