[Dec 2007, Volume 4 Quarterly Issue] Pdf File size - The IIPM Think ...

REIMAGINING INDIA
can subsequently cause what can be
termed a “policy reversal” by government.
Such policy reversals can arise
under several conditions some of which
are:
• Suppose government is running high
deficits and implements a tight monetary
policy by increasing interest
rates. Due to the inflexibility of the
banking sector in passing on interest
higher incidence of NPA in balance
sheets. This may force the government
to revive the banking sector
through measures like recapitalization
which will be a direct burden on
government budget. As discussed
earlier, the cost of reviving banks is
very high in the case of India. The
government indeed began a partial
privatization of banks as part of its
economic reform process initially
providing Rs.40 billion from 1991-92
to 1992-93 to 19 nationalized banks.
Subsequently, the government has
spent around Rs.164.5 billion at a
rate of between 0.02 and 0.7 percent
of GDP each year from 1993-99.
Though there was a decline in NPA
from 17.8 percent in 1997 to 11.4 percent
in 2002 they are still very high.
• A second reason for policy reversal is
the existence of weak regulatory and
supervisory framework in the Indian
Banking sector. The UTI mutual
funds crisis is an example of this (See
Appendix A.1).
The government began a partial privatization of banks,
initially providing Rs.40 billion from 1991-92 to 1992-93
to 19 nationalized banks. Subsequently, ithas spent
around Rs.164.5 billion at a rate of between 0.02 and 0.7
percent of GDP each year from 1993-99
on the state of the financial system.
Standard and Poor’s (Polackova, 1999)
estimate the fiscal cost of a future
banking crisis in India will be around
15 percent of GDP. This is so high because
of the persistent inefficiencies in
the banking system even after a decade
of financial reform (Bhattacharya and
Patel, 2003). Bhattacharya and Patel
(2003) put the estimate of government
guarantees in India as around 12 percent
of GDP. Hence government guarantees
are a crucial part of analysis of
a financial sector especially in developing
economies.
The overview of the reform process
brings up the question of policy reversal
which is covered in the next section.
5. Policy Reversal
Most of the financial reforms in the Indian
economy were guided by “.... objectives
of increasing operational efficacy
of monetary policy....” (RBI, 1997,
page I-9). It is argued that under current
inefficiencies (especially high NPA
and the large share of government ownership)
in the banking sector, any efforts
by government to ensure macroeconomic
stabilization (say reduction
in fiscal deficit) or restructuring will
involve an offsetting effect, adversely
affecting the initial policy objectives,
which will transmit mainly through the
financial sector. This offsetting effect
rates rise this will lead to banking
stress. This inflexibility arises mainly
because of the government’s policy
of directed and concessional lending
to priority sectors. Because of a regulated
interest rate regime, the banks
cannot adjust their deposit rates
much, say in the, area of savings deposits.
Thus stress in the banking
sector will be directly reflected in a
6. Conclusion
The present paper has reviewed the financial
sector reform process in India
focussing on the banking sector. It can
be safely concluded that financial sector
reform in India is incomplete. The
banking sector remains inefficient because
of several factors viz. high reserves
and liquidity requirements, a
poor regulatory and supervisory framework,
the presence of implicit government
guarantees, high transaction costs
etc. These inefficiencies can adversely
affect the long-term policy objectives
of a sound fiscal system and can even
lead to policy reversals.
128 THE IIPM THINK TANK