How right is criticizing India’s financial sector policies?

There are two flavors of the season people are writing on:

1) India’s financial sector policies and
2) Financial Innovation.

The majority of the articles says Indian policy framework is poor and financial innovation is useful.

I don’t know the reason why our financial sector policymakers are criticised. Experts say they have curbed our financial system, made it antediluvian, have limited variety of financial products.

Most criticism (perhaps entirely) is directed towards the Central Bank. The reasons are:

  • Managing the impossible trinity – Some even say if RBI has to manage the exchange rate it should give up monetary policy!. I have looked at the problem here and have shown it is not really RBI’s fault. It is sticking on the mandate given to it by the government. So, it is not right to criticise RBI but instead ask government to change RBI’s mandate. All Central Banks work as per the mandate given to them by their respective governments.
  • Inflation Management:  The analysts didn’t like RBI not cutting the rates in the January Monetary Policy meeting. RBI maintained its inflation stance and as current inflation numbers show, it former seemed to be right. The same analysts criticised RBI earlier in 2007 saying inflation is very high if we look at the CPI numbers and RBI is not tightening enough. RBI didn’t raise the rates as it expected inflation to come down (which it did) and didn’t cut rates as it expected inflation again to surge (which it did again).
  • Not allowing capital account convertibility- Well the experts hold empirical research close to their heart on first point which shows in an open economy central banks should only manage inflation and let exchange rates float. But on this topic they seem to ignore the research. The most comprehensive research from Rogoff et al shows benefits from capital inflows are at best limited.
  • For not allowing exchange traded derivatives in exchange rate products, interest rate etc: This is perhaps one of the most funny things I have heard. The experts have now started blaming the RBI for the recent exchange rate derivative mess. Just because the Banks and corporates got greedy and took bets on the currency doesn’t mean exchange rate derivatives would have helped. These derivatives essentially trade on an OTC market as they are designed on the basis of the client . Introducing exchange traded derivatives would have hardly helped.

    And then most experts criticising RBI have been on committees that looked at developing these derivative markets. The markets didn’t take off and then it took sometime to launch them again.

The idea behind this post is not to defend the Central Bank but to point it is not really its fault. No one disputes the benefits of the reforms in the financial sector but it has to move ahead with real sector.

The monetary transmission in India is still not as robust as developed economies and things work with a bigger lag. So we have to wait. The main issue is we need reforms in real sector to let things become better. The Doing Business report shows it is becoming more difficult to do business in India. Finance and its policies only work if we have things moving in real sector. Most analysts assume it to be an assumption which we all know is just that- an assumption.

However, one area where the Central Bank can surely do better is to communicate. The markets need more cues from the Central Bank especially in India where we have very little data coming and enormous focus on Indian markets.

I will write on the financial innovation debate later. I have actually expressed my initial views here


8 Responses to “How right is criticizing India’s financial sector policies?”

  1. HmmBut Says:

    Great post! Couldn’t agree more. I think the RBI has done a good job considering the circumstances.

    Your last point about derivatives makes me suspect the motives of these critics. Call me a conspiracy theorist but I think many financial firms around the world want to open up new markets to sell their financial products (which has led to a situation where the subprime crisis in the US infecting financial institutions around the world, what with small banks in Norway going bust).

    PS: Please don’t mind this comment but I have bring up something I have noticed about the usage of the word ‘corporate’ in the Indian media and by people there. Corporate is an adjective. Usages will be ‘Corporate finance’, ‘corporate governance’ etc. The noun is ‘Corporation’. I think the blame falls on that hindi film ‘Corporate’. Again I mean no offence.

  2. Amol Agrawal Says:

    Hi HmmBut,

    It is great to get your regular comments. Thanks for the same. I would be glad if you could sign by your real name. Hmmbut sounds a bit weird.

    Well it is obvious that western world wants the other markets to open up to their services sector. They don’t want to open their agricultural sector but want others to open up. It is an age old issue which has led to collapse of WTO (if you remember there was a lot of focus on WTO around 2000-03. It has become a defunct organisation now. Financial globalisation has expanded beyond imagination and real globalisation has sulked. The Western people again say globalisation has also expanded and give examples of various services being traded worldwide. That is precisely the point- services sector is the one west has a comparative advantage. We need much more in industrial and agriculture.

    I agree to the usage of word corporate. Frankly, it didn’t strike me. It has got little to do with the movie but is a part of the lexicon now.

  3. HmmBut Says:

    I will try to change my nick. Hope that will be ok. I really don’t want to post under my real name and have my personal views get queried by a simple google search. Call me a coward but people do get into trouble.

    I don’t mind the western world wanting to take advantage of the situation. I simply don’t understand why there are some Indians who support this agenda wholeheartedly. I question their motives.

    lol! If its part of the Indian English lexicon, all I can do is make this face 😦

  4. What do you exactly mean by Modern Finance? « Mostly Economics Says:

    […] for the crisis. The article further goes on to criticise RBI and its policies (I have my comments here) […]

  5. Syed Zahid Ahmad Says:

    Muslims clogging Inclusive Growth of India

    Muslims and Indian Civil Society:
    The Economic development of the nation needs strategic utilization of natural, physical, human, financial and social resources. Unless we establish socio-economic justice through resource allocation among religious communities, it is meaningless to talk about civil society development and inclusive growth. Abandoned Indian Muslims (as 15% Indian population) definitely need more focused plans and strategies for inclusive growth of India.

    Our Strength – Unity in Diversity:
    The Sachar Committee Report revealed the facts that Muslims are not far better than Scheduled Castes and Scheduled Tribes of India and thus needs special attention in our national plans and policies framed for inclusive growth. We need to believe that the strength of India is ‘Unity in Diversity’. The religious communities may have diversity in believes and approaches, but are united for the nation. Indian Muslims are instinct part of the nation with diversified approach in believes and approach to practice.

    Interest Free Banking for Inclusive Growth of India:
    The Sachar Committee did not consider the constraint of ‘Interest’; the most important reason for financial exclusion of Indian Muslims, rather advocated financial inclusion of Indian Muslims through participation in Scheduled banks. Since majority of Indian Muslims are poor and orthodox, their financial exclusion is mainly due to prohibition of interest in Islam. We must not forget that Indian Muslims shares 18.35% Indian population living below poverty line. So unless Indian Muslims is allowed transacting interest free banking, their financial inclusion is not possible. Without financial inclusion of Indian Muslims, their economic development is not possible. And without economic development of Indian Muslims, it is not possible for India to achieve the much desired real inclusive growth of the nation.

    Sachar Committee Report – Half work done!
    The Sachar Committee Report reflects that Muslims are under financial loss over Rs. 23,766 crores per annum in terms of credit through Scheduled Commercial Banks; as their share in outstanding loans under PSA is just 4.7% compared to 12% share in PSA accounts. A community with more than 31% population living below poverty line and 39.4% as self employed workers, such credit loss pushes it towards more backwardness; ultimately making inclusive growth more difficult. The Sachar Committee not only denied the requirement of Interest free banking for Muslims; but also failed to suggest any suitable measure to make our financial system more interactive and attractive for Muslims.

    Recommendations of Sachar Committee – Imperfect measures
    After Sachar Committee Report, the government took some initiatives to follow the suggestions made by the committee, but none of the initiatives is ensuring financial inclusion of Indian Muslims. The Sachar Committee has reported that participation of Muslims in Micro Finance is very low and share of Muslims in credit through SIDBI and NABARD are also very low. Instead of analyzing the causes of financial exclusion of Muslims, the committee just advocated to increase number of Scheduled Banks in Muslim areas, promotion of Micro Finance and deployment of more funds to NMDFC, SIDBI and NABARD. This approach is irrational because the measures suggested by the Committee are against the orthodox approach and financial requirements of Indian Muslims.

    Approach of RBI toward Indian Muslims:
    RBI is not paying due attention on financial exclusion of Indian Muslims. It should have studied the impact of ‘Interest’ on Indian Muslim’s financial inclusion and suggested some measures to comply with religious and financial need of Indian Muslims. But RBI (might be with intention to avoid any additional procedural changes) has already declined the feasibility of interest free banking in India. RBI should have considered why Muslims are just 0.78% in its working force. Similarly it was not discussed about reasons that why Muslim’s share in credit through SIDBI is just 0.48% and through NABARD is under 4%.

    Dr. C. Rangarajan Committee Report ignored Muslims:
    Under such extreme financial exclusions, it was supposed that the high level committee for financial inclusion would focus on Muslims. It was not a surprise to see that there was no Muslim member in that committee, but unfortunately the committee did not pen a single word about financial exclusion of Indian Muslims. Generally it is not expected that such committees would make community wise study; but since the report worth mentioned specific plans for 100% financial inclusions of SCs and STs, it was duly expected to have some comments on Indian Muslims which is not far better than SCs and STs of India.

    While the Terms of Reference assigned to the Committee on Financial Inclusion contained the task ‘to identify the barriers confronted by vulnerable groups in accessing credit and financial services, including supply, demand and institutional constraints’ The report submitted by Dr. C. Rangarajan Committee did not carry any personal intervention report with vulnerable group. Moreover it did not study the financial exclusion in urban areas. Thus the report did not serve the designated purpose. So it is not justify for the government implementing the suggestions of the report with no study of minority community and with any case of committee’s interference with vulnerable group. If this would be the approach of our high level committees, how financial inclusion mission could be a success?

    Dr. Raghuram Rajan Committee Report – Missing Inclusive Growth potentials:
    The Planning Commission of India set another high level committee to prepare a report on financial sector reforms. This committee is also 0% representation of Muslims. The committee prepared a draft report after interference with more than 82 persons. Unfortunately there was no Muslim among those 82 persons. Neither the committee considered the issue of financial exclusion of Indian Muslims, nor suggested any proposal to ensure financial inclusion of Muslims. How could we set financial sector reform, unless we consider factors responsible for financial exclusion of minorities? With such abandoned financial exclusion of Indian Muslims by committees after committees, we may not be able to develop a civil society nor succeed to achieve the desired real inclusive growth.

    Government Schemes for Minorities:
    In Muslim concentrated areas, the physical infrastructure is always found lacking behind the actual requirements; and the community based institutions constrained by regulations and closed after no support from government schemes. Moreover the schemes announced by government to empower Minorities are also not inclined with Muslim NGOs which could have utilized and help to develop the social resources of Muslims. Such practices of dethroning Muslim social and institutional resources will certainly snag development of civil society and inclusive growth process.

    Policy initiatives are required for real inclusive growth:
    In the interest of the nation it is wise to take due initiatives instigate Indian Muslims into mainstream section to help India realize the desired inclusive growth.

    1. There should be a parliamentary committee to study abandoned financial exclusion of Indian Muslims and recommend measures to ensure financial inclusions of Muslims.
    2. At least one Muslim should be incorporated as member of any committee constituted for study and analysis of national level issue, because it is not justify ignoring minority community while doing strategic study for the nation as a whole.
    3. If any committee has no Muslim member, the committee must have physical interaction with Muslim NGOs or institutions to ensure inclusion of the Muslims in that study, recommendations and schemes framed after that.
    4. Minority related schemes should ensure participation of Muslim NGOs so that Muslim social resources could grow in civil society manner otherwise the process of isolation may threat wastage of Muslim social resources or it may go against national interest.
    5. RBI must consider ways and means to include Muslims as working staff and find means to attract Muslims involvement in monetary and financial service businesses. It may need to incorporate products suitable to shariah compliant.
    6. There should be at least 12% working staff in special financial institutions like NMDFC, SIDBI and NABARD. Moreover such institutions should introduce interest free credit schemes for Muslims because interest is most important hurdle in financial inclusion of Indian Muslims.
    7. Interest Free credit schemes is not only required by Indian Muslims but also by our vulnerable section associated to agriculture, rural, small and micro industries where due to financial sickness entrepreneurs are unable to take financial risk, thus need risk free credit scheme. It is possible that credit on profit loss sharing basis may be provided to these groups through inducing shariah bound investors to interact with these groups.
    8. To allow inflow of capital on profit loss sharing basis for our vulnerable enterprises associated with unorganized sector, it is necessary that such investments should be exempted from all taxes and free from undue formalities.
    9. If we succeed to mobilize capital on profit loss sharing basis (for unorganized sector) from Islamic countries, it may along with capital investment, generate resources for allied industries and also boost export potentials.
    10. The introduction of Islamic Banking for unorganized sector may help our economy in dual manner. At one end it will boost capital investment in unorganized sector without cutting resources of organized sector; on the other end it will generate new sources of employment and income opportunities to shift load of labour from organized sector to unorganized sector.

    Our policy makers and administrative forces need to study the prospects and feasibility of interest free banking and finance for unorganized sector to avoid possible need to loan waiving schemes in future. It depends on our own wisdom whether we take challenges as opportunities or threats. The issue of Interest free or Islamic Banking must be addressed before we frame our financial sector reform and it must be tackled with thorough and sincere study by our financial experts.

    Hope the leader will use their wisdom to study and analyze the issue of Indian Muslim financial resources and adopt suitable policies. This sincere attention and due efforts in this regard will surely ameliorate India develop a true civil society and achieve the much desired real inclusive growth.

    Syed Zahid Ahmad
    Mobile – (091) 9869814113
    E Mail –

  6. Literature survey on Central Bank communication « Mostly Economics Says:

    […] managing the impossible trinity and commmunication. I have critiqued the developments on first here. Though, I did make a case for better communication I have never been sure what it […]

  7. Syed Zahid Ahamd Says:

    RBI may just ruin the Indian economy
    Syed Zahid Ahmad

    The present trend of recession in US and prevailed uncertainty in petroleum nations had provided an opportunity for India to pull capital resources from US and Gulf countries, but the practical approach of RBI has converted the opportunities into challenges as the liquidity and inflation is certainly not under control of the RBI who is attempting to freeze the liquidity by increasing the interest rate and cost of credits. Interest is a factor for liquidity and credit, but all cares should be taken up while we handle this instrument because if liquidity and credits influences inflation, are also necessary for growth and development. Increased cost of credits not only increases the cost of output, but also creates shortage of supply. This increases the prices levels further up. However the depositor gets higher rate of interest over their deposits and this inflates their purchasing power, thus boosts inflation. FICCI and the corporate sector have already disagreed with RBI recent announcement to increase the rate of interest.

    With recent trend of increased capital inflow into India the aggregate deposits by Scheduled Commercial Banks (SCBs) has increased from 80.7% in 2005-06 (Rs. 21,09,049 crores) to 102% (Rs. 31,96,939 crores) of GDP at factor cost by 2007-08. With increased deposits, the bank credits has also increased from Rs. 15,07,077 crores in 2005-06 to Rs. 23,61,914 crores by 2007-08 reflecting 75.6% of GDP at factor cost in 2007-08 as credit against 57.7% in 2005-06. This indeed is a situation, where our economists, financial sector regulators and bankers need to review the policy and practices adopted by RBI as we take interest as a major tool to control liquidity but we hardly evaluate the far reaching consequences of interest in our economic process.

    Our real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. The liquidity theory of J. M. Keynes is failed here to guide RBI optimize these opportunities. The practical approach of RBI to curb the rate of inflation by increasing the rate of interest may not control inflation and might lead towards stagflation as the prices are continue to increase along with purchasing power of the depositors, but the expenditure, investment and net GDP growth rate is falling due to costlier credit and interest based deposit schemes.

    By increasing the rate of interest, liquidity might be controlled for shorter period, but with increased cost of credit, the GDP value will increase that leads to inflation. Interestingly the interest income to SCBs was Rs. 1,85,384.9 crores in 2005-06 which increased to Rs. 2,37,271.14 crores by 2006-07. It means by 2006-07 total interest income to SCBs was 7.1% of GDP at factor cost. It simply means that the interest income to SCBs has inflated the value of GDP at factor cost by 7.1%.

    With increase in rate of interest, the aggregate deposits might increase and SCBs may need to pays more interest over increased deposits. Total Interest expended by SCBs over deposits was Rs. 89,742 crores in 2005-06 which increased to Rs. 1,20,261.08 crores by 2006-07 showing a net annual increase of 34%. This growth is inflationary as it increases the buying capacity of the depositors. By 2006-07, the interest expended over deposits was around 4.20% of GDP at factor cost.

    If we add the interest income of SCBs to interest expended over deposits, it stands for around 12.5% of GDP at factor cost and 8.6% of GDP at market prices in 2006-07. Considering the impact of interest on inflation, we may need to add interest income of SCBs through investments / commercial credits with interest expended by SCBs over deposits. This amounts to approximately 9% of GDP at factor cost and 5% of GDP at market prices in the year 2006-07 while annual rate of inflation was 6.7%. It reflects that basically inflation is a result of interest charged on credits expanded by SCBs and interest expended over deposits. The interest charged by SCBs increases the cost of GDP and the price levels, while the interest paid by SCBs over deposits increases the purchasing power of the depositors. Both ways the interest is increasing the price level and causing inflation. Since RBI regulates the banking business in India, by increasing rate of interest it is increasing the inflation and decreasing the real term growth rates.

    Further to note that RBI is increasing the rate of interest for over one year to control the inflation which ultimately increasing the cost of GDP showing higher GDP value and increasing inflation instead of controlling it. Our total final consumption expenditure as % of GDP at market prices is already declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. This economic tendency may leads to stagflation which is more dangerous for economic stability and growth. The unemployment rates in increasing, the investment rate is also declining; so RBI should review its policies and practices to monitor liquidity, credit and inflation, if we have to combat inflation and attain desirable growth rate.

    Islamic economic ethics suggests mechanisms for stable and anti inflationary monetary system which should be adopted by RBI to make our monetary system more stable and anti inflationary. Hope the RBI will consider these ethics as measure to combat inflation and stagflation. Islamic Banking principles and practices will not only increase the equity deposits and finances but also promote capitalization and investments. It will help increase employment and business opportunities which are must for inclusive and foster growth of India at a time where world is eying upon Indian economy for making more investments. Otherwise consistent approach of RBI to control inflation through interest rate may let the UPA government face cruel failures in capitalizing the investment and growth opportunities with worst off inflation and stagflation.

    Wish all the best for Indian economy, the general Indians, RBI and the UPA government.

  8. Syed Zahid Ahmad Says:

    The follwoing matters has been deleted from the original article, thus readers kindly do not consider the follwoing texts as part of the article.

    “Our real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. “

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