Publications

3.47 Sterilisation through open market operations is the most popular policy response and has been used by several countries facing capital surges during the 1990s (RBI, 2003). Such operations leave domestic money supply unaffected and avoid the burden of higher reserve requirements on the banking system. Moreover, by limiting the role of the banking system in intermediating the flows, sterilisation operations reduce banks’ vulnerability to sudden reversal of flows (Lopez-Mejia, 1999). Empirical evidence, however, suggests that the effectiveness of sterilisation over time is limited by its implications for domestic interest rates as well as quasi-fiscal costs (Lee,1996). Furthermore, intensification of sterilisation operations could be counter-productive

Box III.3

Macroeconomic Policy Trilemma

IV. FINANCIAL SECTOR OPENNESS

3.56 The financial sector of an economy, comprising institutions, markets and instruments, is multi-dimensional in nature with both domestic and external facets. At the risk of generalisation, one can discern the following broad contours of financial liberalisation, viz., (i) withdrawal of credit controls and excessively high reserve requirements; (ii) interest rate deregulation; (iii) privatisation; (iv) deregulation and development of markets; (v) lowering of entry barriers, limits on participation of foreign banks, and restrictions on specialisation or diversification of banks; and (vi) easing of restrictions on international financial transactions, such as on current and capital account convertibility, and the use of multiple exchange rates. It is interesting to note that out of the six broad attributes, only the last two are related to financial openness. In other words, financial openness is merely a subset, albeit an important one, of features characterising financial liberalisation. Financial Openness

3.57 Three decades have lapsed since Mckinnon (1973) and Shaw (1973) had indicated the prevalence of financial repression in developing countries. Theories and cross-country evidence have shown that financial repression is harmful for economic growth. Worldwide, financial reforms mainly involved elimination of financial repression with steps to contain the vulnerability of the financial system. It has been observed that trade openness is correlated with financial market development, especially when cross-border capital flows are free, and that changes in openness are correlated with changes in the size of financial markets (Rajan and Zingales, 2001).

3.58 While it is widely accepted that reduction or removal of financial repression and financial openness enhances efficiency and potential growth of an economy, there is no such unanimity regarding the pace and sequence of reforms. The initial condition of the economy undoubtedly would influence the pace and sequence of desirable policy changes or reforms. This calls for a detailed discussion of the benefits and cost of reforms in charting out the optimal pace and roadmap (Box III.4).

Evolution of Financial Openness in India

3.59 In India, unlike in most other countries, liberalisation of the financial sector was initiated simultaneously with liberalisation of the real sector and led the latter in terms of the extent of reforms undertaken. Opening up of the financial sector in terms of entry of foreign entities and easing of restrictions on international transactions took place within the broader process of reforms. The constant policy concern in this respect has been that of preparing the financial sector for global competition and taking preventive measures for the potential vulnerabilities that it might engender. Notwithstanding their extensive branch network, the biggest banks in India are miniscule compared to most multi-national banks, in terms of standard parameters like assets or deposits. Illustratively, India accounted for only 1.1 per cent of world’s bank deposits in 2000. Hence, the initial focus of reforms in the financial sector has been to strengthen the domestic financial infrastructure, make it more competitive and to provide banks greater freedom in their foreign operations. While there has been a significant progress towards globalisation in the recent past in India, the extent to which India is globalised is considerably low as compared with other emerging economies. This indicates not only the existence of enormous opportunities but also challenges in terms of transition from a low base. More importantly, the issue of financial integration and in particular the integration of banking sector has to be considered in terms of overall sequencing in the process of integration with the rest of the world.

Box III.4

Cost-Benefit Analysis of Financial Sector Openness: Theory and Evidence

The benefits of opening up of the economy are varied. Financial openness permits domestic firms to finance investment projects with rates of return greater than the costs of borrowing, and makes higher yielding assets accessible to savers. As long as the marginal return on investments is at least equal to the cost of capital, net resource inflows can supplement the domestic saving, a binding constraint to higher growth in developing countries. Openness also provides to the residents the gains of greater portfolio diversification. This would increase levels of physical capital per worker. The potential benefits are particularly large for certain types of capital inflows like FDI. By facilitating the transfer of managerial and technological know-how, and by improving the skills composition of the labour force, FDI may have significant positive long-run effects on growth. World capital markets play a counter-cyclical role as a country can borrow from abroad in bad times and lend at good times. Opening up would thus permit an improved inter-temporal allocation of consumption. This counter-cyclical role is justified if shocks are temporary in nature. By increasing the rewards of good policies and the penalties for bad policies, financial openness may induce countries to follow more disciplined macro policies and reduce the frequency of policy mistakes. To the extent that greater policy discipline translates into greater macro-stability, it may also facilitate higher rates of growth.

On the impact on banks, it has been observed that opening of the economy, among others, results in more competition and greater banking efficiency and stability. It enables the banks to reap economies of scale and scope. It helps in diversification of risks. Foreign bank penetration improves the quality and availability of domestic financial services by increasing competition and enabling the application of more sophisticated banking techniques and technology. The risk management capabilities are upgraded. It serves to stimulate the development of the domestic bank supervisory and legal framework. It enhances a country’s access to international capital, either directly or through their parent banks. It contributes to the stability of the domestic financial system, if, for example, during turbulent times depositors shift their funds to foreign institutions that are perceived to be stronger than local banks, instead of transferring their assets abroad. Empirical evidences in Asia support the view that presence of foreign financial intermediaries leads to decline in cost of financial intermediation and improvement in quality of financial services.

The capital flows can be harmful also. The ability to monitor the financial system gets eroded with increasing capital flows. Large capital inflows can lead to rapid monetary expansion, inflationary pressures, and real exchange rate appreciation. Under a fixed exchange rate regime loss in competitiveness and external imbalances may eventually lead to currency crisis. Many countries can borrow in world capital markets in good times, whereas in unfavourable times, they face credit constraints. Procyclicality, particularly of short-term flows, as well as herding, contagion and volatility of capital flows expose the economy to greater instability. The capital inflows may finance low quality investments, such as speculation in the real estate sector, which would have limited impact on growth and may increase instability. Low-productivity investments in the non-tradable sector may reduce over time the economy’s capacity to export and lead to growing external imbalances.

Entry of foreign banks may lead to relatively greater flow of resources to large firms while the flow of resources to small firms may be rationed. This would have adverse impact on output and employment. The foreign banks may enjoy regulatory advantages and the possibility of domestic savings fleeing the economy also increases. Mergers, resulting from increased competitiveness, may create banks that are too big to fail and lead to greater moral hazard. Opening up of the economy and greater competition also impel domestic banks and firms to take on greater foreign exchange risks and riskier projects than domestic financial liberalisation. By calling loans and drying up credit lines, foreign banks may aggravate a shock. They can also propagate the crisis by calling loans elsewhere.

Based on cross country experience in 1980s and 1990s, it has been observed that instability of banking systems distinguishes economic crises from ordinary recessions. Some of the suspected reasons for banking crises were found to be lending booms, exchange rate regime, destabilising external factors, rapid financial liberalisation, inadequate prudential supervision and weakness in the legal and institutional framework. Robust causes of banking crises have been found to be rapid domestic credit growth, large bank liabilities relative to the reserves, and deposit rate control. There is little evidence of any particular relationship between the exchange rate regime and banking crises. The relationship that weak institutional environment causes greater risks of financial liberalisation was empirically found to be weak. The relationship between deposit insurance and crisis risks in emerging markets was also not well established (Eichengreen and Arteta, 2002). On implications for global stability, it has been argued that financial events, such as devaluation or defaults, trigger adverse chain reactions in other countries in the presence of 'the unholy trinity': (i) these events follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. Similar events, however, have little international repercussions when they are widely anticipated or take place at a time when capital flows are already subsided (Kaminsky et al., 2003).

Policies towards Developing and Strengthening Financial Infrastructure

3.60 Given that inherent soundness of bank balance sheets, presence of well-established institutions, presence of adequate safety nets and vigilant supervision are the pre-requisites for successful financial liberalisation, the reform process in India within the banking system sought to strengthen the balance sheets of individual banks, empower banks to respond in the most optimal manner to market stimuli and to establish institutions to ensure a level playing field for all market participants and provide a back-up system for contingencies.

3.61 Measures to strengthen the financial sector include capital adequacy requirements, prudential norms and means to enhance transparency in the balance sheets of banks and financial institutions by appropriate disclosures. With greater integration of financial markets and institutions, steps have been taken towards consolidated accounting and supervision and standardisation of accounting norms. Prudential norms have progressively been brought closer to international best practices and the process of convergence continues. Higher provisioning norms, tighter asset classification norms, dispensing with the concept of ‘past due’ for recognition of NPAs, guidelines in respect of debt restructuring/rescheduling/renegotiating, and lowering of ceiling on exposure to a single borrower are among the important measures in this area.

3.62 Measures to enable banks to operate freely in a commercially justifiable manner and competitive environment include the reduction of statutory pre-emptions, deregulation of interest rates and giving banks greater autonomy and flexibility in day to day operations. Other measures in this direction include greater streamlining of the operations of development financial institutions and deregulation of the capital market. Competition has been infused into the financial system by licensing new private banks since 1993. Foreign banks have also been given more liberal entry. The Union Budget 2002-03 announced the intention to permit foreign banks, depending on their size, strategies and objectives, to operate either as branches of their overseas parent, or, as subsidiaries in India. The latter would impart greater flexibility to their operations and provide them with a level-playing field vis-à-vis their domestic counterparts. Progress has also been generated through demonstration and spread effects of advanced technology and risk management practices accompanying new private banks and foreign banks. Given the fiscal constraint being faced by the Government and in keeping with the evolving principles of corporate governance, the Government permitted public sector banks to raise fresh equity from markets to meet their capital shortfalls or to expand their lending. Several public and private sector banks have accessed the domestic equity market. Public sector banks have also raised capital through GDR/ADRs while many banks have raised subordinated debt through the private placement route for inclusion under tier-II capital.

3.63 The quality of financial regulation and supervision as well as of information and the legal system are important for reaping the benefits of globalisation. Hence, enactment of enabling legislation has been a priority area of the reforms. With the switchover to international best practices on income recognition, asset classification and provisioning, the problem of non-performing loans (NPL) assumed critical importance. It was widely perceived that the level of NPLs in India was high by international standards. The problem needed to be tackled urgently and from different fronts. A menu approach has been adopted to tackle this major constraint confronting the banking sector. These policy measures have resulted in reduction in gross NPAs in the banking system from about 15 per cent of gross advances at end-March 1999 to 8.8 per cent at end-March 2003.

3.64 The need for monitoring and supervising becomes even more important systemically with the opening up of the economy. Thus, the prudential regulations were fortified by reorientation of ‘on-site inspections’ and introduction of ‘off-site surveillance’. The focus of inspection has shifted from ensuring appropriate credit planning and credit allocation under a closed economy framework to assessment of the bank’s safety and soundness and to identify areas where corrective action is needed to strengthen the institution and improve its performance. The Board for Financial Supervision (BFS) was constituted in 1994, with the mandate to exercise the powers of supervision and inspection in relation to the banking companies, financial institutions and non-banking financial companies.

Financial Openness in Indian Banking

3.65 An analysis of the financial openness of the Indian banking sector in the broader context of reforms discussed above reveals that the presence of foreign entities within the Indian banking sector has increased and international transactions of Indian banks have increased substantially.

Liberalisation of Operation of Domestic Banks

3.66 The process of opening up is reflected in the foreign exchange related operations of the domestic banks. Authorised dealers (ADs)3 have been given substantial autonomy to conduct foreign currency business by augmenting the delegated powers vested with them.

3.67 Between 1998-99 and 2002-03, turnover in foreign exchange business of banks has increased at nearly five per cent per annum in US dollar terms. It is important to note that merchant banking business of the ADs has grown much faster than inter-bank transactions (Table 3.5).

V. SYNCHRONICITY OF BUSINESS CYCLES

3.76 The globalisation process has been strengthened and reinforced in the 1990s and beyond under a confluence of forces, embracing trade, technology, and investment flows. The impact of globalisation on the degree of synchronicity of business cycles, however, remains unsettled in practice. Co-movement of business cycles across countries can arise mainly in two ways. First, countries may be hit by common shocks, which cause them to experience similar cyclical chacteristics irrespective of the degree of integration. Second, the cross-country transmission channels may intensify by way of increasing international trade - corporate connection ( e.g., FDI route), and financial linkages. Thus, co-movements could increase as a result of globalisation. Trade linkages lead to demand linkages across countries which could then lead to closely synchronised business cycles. On the other hand, financial linkages could generate or reinforce the demand side effects, leading to contagion effects, which could have quick cross-country ramifications through financial linkages. For instance, a dampened international stock market could have adverse implications for demand in the investor countries. While there are a number of studies that explore synchronisation of business cycles among OECD economies, the literature is not so rich in the context of other countries.

3.77 The Indian annual growth cycle during 1950 to 1975 indicated a close temporal relation with the growth cycles in GDP and industrial production of the market economies, in general, and, industrial production of North America, in particular (Chitre, 1982). While external demand has traditionally played a relatively limited role in the course of business cycles in India, the patterns of exports and industrial production have since started exhibiting co-movement with the global business cycle (RBI, 2001). Similarly, cyclical exports and cyclical output in India were found intertwined in a bi-directional causality. On the other hand, cyclical output of advanced countries had unidirectional causal effects on cyclical output in India. This clearly brings out the impact of business cycles of advanced countries on India’s industrial sector (Chitre, 2003). Mall (2001) finds that the Indian output cycles have positive relationship with the UK as also with the US output cycles, especially during the post-1980s with a stronger relation with the former.

3.78 The business cycle literature on India has so far examined the cyclical trends in relation to a block of countries - the developed or the Association of South East Asian Nations (ASEAN) economies. An attempt has been made to test for synchronicity of the Indian business cycle with those of its major trading partners from the developed world and the emerging economies, as also the world output for the period 1972 to 2000. The analysis focused on ascertaining whether the opening up of the economy in the 1990s has increased the synchronicity of the Indian business cycles with those of her major trading partners. The Indian business cycle was represented by non-agricultural GDP as also by industrial GDP instead of aggregate GDP.5

3.79 An exercise undertaken to analyse correlation of business cycles of India with her trading partners indicates that the synchronicity with the developed world has been relatively strong during 1972-2000 with the UK and Canada, and weak with Japan, Belgium and Germany, both in terms of non-agricultural as well as industrial GDP. On the other hand, relatively strong synchronicity was observed in the developing world with Philippines and Thailand, while the relation turned out to be weak in respect of China and Middle East. A comparative analysis of the periods before and after opening-up of the economy indicates that the cyclical synchronicity of India with the UK, Canada, Australia, New Zealand and the US has strengthened in the latter phase in terms of both non-agricultural GDP as well as industrial GDP. On the other hand, the relation has weakened in respect of Japan and Germany. Simultaneously, within the developing world, the relation has become stronger with the Philippines, Brazil, China and Hong Kong in the post-opening up phase. The exercise throws up divergent signals in terms of non-agricultural GDP as against industrial GDP in respect of the remaining developing countries like Singapore and Malaysia. The improved cyclical synchronicity with Singapore, Malaysia and Indonesia in terms of non-agricultural as against industrial GDP possibly testifies to the emergence of a new relationship based on services and information technology. On the whole, the cyclical correlation between India and the world turned out stronger in the post opening up phase both in terms of industrial and non-agricultural GDP (Table 3.8).

⁵ This is because agricultural developments are largely weather-driven and market forces do not affect the sector much.

3.80 In order to ascertain the role of trade and capital account linkages as also of the structural features in the observed cross-country business cycle correlations, the cyclical correlations of India’s non-agricultural GDP growth with her 16 major trading partners (excluding Brazil and Middle East) were regressed on the degree of trade openness and structural features in line with Cosby and Voss (2002).6 The similarity of structures across countries is sought to be represented by differential in short-term real interest rates and standard deviation of bilateral exchange rate in respect of monetary policy, and differential in the manufacturing shares in GDP in respect of other structural features. It is generally perceived that large variation in exchange rates and manufacturing share should lead to a lower degree of synchronisation of cycles. The results indicate that the

VI. CONCLUDING OBSERVATIONS

3.82 A large increase in cross-border trade and investment in recent years has brought about a growing integration of commodity and financial markets across the world. This has highlighted increasing interdependence among economies and the growing need for a new approach to public policy. The forces of change can only accelerate in the near future and this requires policymakers to proactively explore new instruments, targets and leading indicators for policy purposes.

3.83 Several initiatives have been taken in the Indian fiscal policy in line with the greater openness of the economy. The fiscal deficit, however, has proved to be largely intransigent. In this respect the intermediate targets of the FRBM Act will have to be achieved if fiscal policy in India is to play its fitting role in the economy’s growth process. Fiscal reforms at the State levels will assume greater importance in this context in consolidation of the variables at the margin.