India's banking and financial sector plays an enabling role in the country's growth outcomes. Amidst the current economic backdrop of moderating growth; the financial system's ability to effectively incentivise, mobilise, and allocate domestic savings and foreign capital to stimulate growth, assumes even greater importance. To meet the demands of India's huge potential, significant infrastructure investment requirements, and the need based commitments for financial inclusion, the banking sector faces a challenging task, which if handled astutely, would convert them into significant opportunities for growth. The time has perhaps come to make a more concerted push towards the next generation of financial sector reforms, accompanying the turn of the political and economic cycle in the country. I elaborate six priority areas that the new government must focus on.
I. Reviving infrastructure growth and providing impetus for investments
While the CCI has been clearing stalled projects in the infrastructure domain, there is an urgent need to establish systems which promote early collaboration among agencies in a transparent and time bound manner. The new government must encourage consultative process between the Centre and state to align all requisite approvals for infrastructure projects, akin to a hub and spoke arrangement, to create a seamless mechanism for project clearances.
In the interim, the new government needs to nurture investor confidence through specific, targeted, and temporary measures to kick start the capex cycle.
One-time restructuring with no provisioning impact, could be considered for stalled projects that have faced cost over-runs due to delay in necessary approvals.
Instruments like Credit Enhancements and a broader application of Priority Sector Lending guidelines for the infrastructure sector including agri infrastructure (most important) should be conceived.
As the tide turns, the government needs to ensure availability of long-term finance for India's infrastructure requirement. In this context, focus needs to be squarely upon:
Development of the corporate bond market to provide an alternative to bank finance and foreign currency borrowing. In a developed bond market, banks, which would require long-term funds in the context of Basel III requirements, would also be able to raise resources easily.
Create a framework for development of the Municipal Bond Market in India that has advantages in terms of the size of borrowing and the maturity period, both of which are considered to be ideal for urban infrastructure financing.
Tax-free infrastructure bonds have created a distortion in the corporate bond/bank lending market due to the implicit floor provided by such rates. As such, a gradual phasing out of these bonds should be considered to ensure a level playing field.
'Takeout financing' for infrastructure projects could be incentivized by reasonably compensating banks that have provided finance during the implementation stage with a higher risk need when they give up a good asset after the project is completed.
II. Incentivise financial inclusion
India is home to the largest unbanked population in the world, with as many as 65% of adults lying outside the purview of formal banking network. The solution to moving towards greater financial inclusion lies in fostering more competition. While banks have leveraged technology to further financial inclusion, there is indeed a lot of ground left to cover. The new government can consider setting up incentives for banks to make loans to priority sectors such as agriculture, which could enhance credit flowing to these sectors and in a more efficient way. Towards this, two recommendations of the Mor Committee must be actively discussed and put into practice:
Government subvention on bad loans to be directly transferred to beneficiaries than through banks
Allowing banks to assign a higher weightage to such lending while computing the adjusted priority sector lending target.
Mandatory linking of Aadhaar enrollments to banking accounts could also prove to be a game changer.
III. Incentivise financial savings
India's savings rate has deteriorated in the post crisis period to a level of 30.1% of GDP in FY13 (down from its all time high of 36.8% in FY08). One of the key reasons behind this has been a decline in household financial savings, primarily owing to negative returns on bank deposits after adjusting for structurally high retail inflation since 2011.
While the RBI has displayed its commitment, in consonance with Dr. Urjit Patel Committee recommendation, of bringing down CPI inflation to 6% by January 2016, the new government needs to act in tandem.
Enhancing agriculture supply chains, encouraging investment in warehousing and storage infrastructure, setting up new institutional structures, abolishing APMC act for perishables, among others must be on priority focus of the new government.
IV. Widening Equity (domestic & foreign) Markets – Attracting capital into Indian Banks.
In order to create wider equity access, reduce volatility (presently directly proportional to FII behavior) and to enable more promoter dilution access, higher participation of "true FDI" PE investors, we recommend the following :
1. FII / FDI limit should be fungible upto 74% and GDRs / ADRs should not be classified as FDI when they are substantially in the nature of FII. Correcting this anomaly, will significantly increase pools of capital without banks having to go through cumbersome / high cost/ illiquid ADR's / GDR's in order to overcome the 49% FII restriction by simply "swapping" into a different investment product offering" (QIP's are the same).
2. Private Equity (PE) duly registered with SEBI / RBI should be permitted to invest upto 15% singly, instead of only 5% with prior RBI approval (their voting rights can be restricted to 10% or even 5% as deemed appropriate). Long term PE capital with lock in of MIN 3 years will enable fresh, new capital to enter Indian Banks, reduce FII dependence and augment the highly limited domestic QIB / retail equity markets.
3. LIC as the bastion of domestic QIB investors is allowed (with prior Board/ RBI / IRDA approval) to invest upto 10% in Indian Banks. This limit should be increased to 20%, given that LIC has proven expertise, their investment funds represent highly granular long term "savings pools of funds", and since they actively review investment / board performance etc. This is required for building equity markets risks stability in order to reduce the high "beta factor" in domestic India banking, given that banking is a cyclical business and requires specialized understanding of Indian Banking conditions.
V. Gradually move towards FSLRC
Financial Sector Legislative Reforms Commission calls for a unified regulator for the financial services sector which will regulate insurance, capital market, pension funds and commodities derivatives market (the RBI should continue to exist outside the unified regulator although with modified functions of setting monetary policy, regulating banks and payment systems). Although a move to a single regulator may be premature in India's context, the new government within the present framework can improve coordination and clearly delineate responsibilities among existing regulatory agencies. Government and financial sector regulators must adopt a principles-based regulation mechanism which will be more conducive to rapidly evolving financial markets and is also more adaptable by market players.
VI. Ensure fiscal prudence
Last but not the least, persistently high fiscal deficits results in diversion of national savings for non-productive purposes and creates internal and external structural imbalances. A high fiscal burden also obstructs any efficient financial intermediation process and the reforms in the financial sector. As such, adherence to FRBM defined fiscal deficit target of 3% by FY17 by the new government is critical to create space for private investments. This will also be in sync with the recommendations from RBI's Urjit Patel Committee Report on strengthening the monetary policy framework.
As the political and economic cycle turns, the new government must focus on a comprehensive review of the banking sector's needs and institutional infrastructure for meeting them. Towards this end, banking and financial sector reforms at the current juncture can add significantly not only to India's current economic growth but also make a major contribution to the sustainability of this growth.
(Rana Kapoor, President, ASSOCHAM)
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