Indian Financial Economy - On a Structral Growth Path

The article tries to put my view on the events in India related to establishment of process enabling tremendous growth in credit in coming years. Hence, the article deals with structural changes and at last ends with my conclusion.

Let me start with the speech of Deputy Governor - RBI recently.

My thoughts on the same in black. The red bold font is directly taken from his speech.

Reflections on Regulatory Challenges and Dilemmas

(Address by Anand Sinha, Deputy Governor, Reserve Bank of India, at FICCI-IBA Conference on “Global Banking: Paradigm Shift” at Mumbai on August 24, 2011)

Mr Sinha starts by putting a context --- how the financial crisis has changed the very nature of the pre crisis period regulations. Thus he may mean - These regulations will either need a change or we need more regulations.

1. "There are many reasons attributed to the outbreak of crisis and the most notable ones are: inadequate quantity and quality of capital, insufficient liquidity buffers, excessively leveraged financial institutions, inadequate coverage of certain risks, absence of a regulatory framework for addressing systemic risks, proliferation of opaque and poorly understood financial products in search of yields in the backdrop of an era of ‘great moderation’, perverse incentive structure in securitisation process, lack of transparency in OTC markets particularly the CDS, inadequate regulation and supervision, and a burgeoning under/unregulated shadow banking system." I dont entirely agree to the reasons he cites for the Crisis of 2008. Like the liquidity part. I think role of Fed Reserve should be brought into the picture...Also the crisis developed over long term hence issues like bailout of LTCM and Tech Bubble bust should be looked and the Fed response should be looked into to understand how and why the crisis has developed.
2. He then cites that Basel 3 has been brought in to cater to the shortcomings earlier regulations had. 
3. " As regards India, our estimate is that transition at system level would not be much of an issue as all capital ratios currently are above the minimum requirement of Basel III though a few banks may come under pressure.  Moreover, the capital requirement on account of increased coverage of risks would not be so material for Indian banks as either those activities are not allowed (i.e. resecuritisation), or their magnitude is quite small (i.e. trading book).  The stress point, however, would be that banks will be required to adjust the unamortised portion of Pension and Gratuity liabilities in the opening balance sheet on April 1, 2013 on transition to IFRS.  However, going forward, the capital requirements including equity are likely to be substantial for supporting the high GDP growth and the fact that Credit to GDP ratio, which is currently quite modest at about 55 per cent, is bound to increase substantially on account of structural changes in the economy i.e., Financial Inclusion program, increase in loan requirements from more credit intensive sectors such as manufacturing and infrastructure, etc." Look for in the next few years banks shoring up their equity capital - for state owned fresh infusions from the government will be done. For private banks they will have to dilute their equity or shore up their balance sheets by internal cash generation through selling some assets or taking out the cash from the profits. There must be other ways as well, which i would have to look into.
4. "While the objective of the countercyclical policies is to increase the resilience of the system by building buffers to withstand shocks during downturns, the broader objective is to lean against the wind during the boom phase to dampen the credit and asset price boom.  A more ambitious objective would be to ensure stable credit supply through the cycle- through booms and busts. However, our limited experience shows that the countercyclical measures appear to be more effective in moderating the credit supply during the upturn than in increasing the credit supply during the downturn.  During the upturn in the economy, the countercyclically raising of capital and/or provisioning for standard assets would moderate the flow of credit by raising the cost and thereby impacting the demand.  However, during the downturn, the increase in credit supply on release of buffers does not seem as plausible.    The economic agents whose balance sheets are affected due to the downturn would be risk averse as would be the banks who would be excessively cautious thus restricting credit supply.  The behaviour of economic agents during both booms and busts seems to be a case of “disaster myopia”.  The likely asymmetric impact of countercyclical measures is another challenge for regulators to revive the economy during downturns." Mr. Sinha in a manner admits the limited powers of a central bank (RBI) to control the credit flow in booms and busts cycles. 
5. "The BCBS framework uses the metric 'Credit to GDP ratio' and its upward deviation from the long term trend to signal the need to build up countercyclical capital buffer.  This metric is not suitable for Indian economy and other EMEs, as was also pointed out in the Financial Stability Report (FSR) of June 2011, due to structural changes taking place in the economy on account of high growth rate and financial inclusion etc.  We have been using sectoral approach to deal with systemic risk on account of procyclicality which we may have to continue with.  The BCBS framework is a ‘comply or explain’ framework.  While this framework gives us the freedom to deviate from the BCBS methodology, the dilemma is whether the explanation provided for deviation from the BCBS framework would be perceived in proper light by the markets or whether it will be interpreted as non-compliance with the international standards, in which case, it will be disadvantageous to Indian banks.  In any case, the macro prudential authorities will have to make determined efforts at communicating the rationale of their policies and actions taken thereunder much as Central Banks have sharpened the art of communication of monetary policy.  Focussed communication may improve the understanding of these policies by markets and thus make the actions taken more effective.  Such a communication may also help in making the effect of macroprudential policy more symmetric in booms and busts." Mr. Sinha makes the case that Credit to GDP ration may not be a suitable parameter to judge the risk of booms and busts occuring because of the inherent nature of structural changes happening in the Indian Economy. He also refers to the sharpened art of communicating the monetary policy (by Central banks)!. In my opinion here he is making a case that the credit growth for India has to happen at a much higher pace compared to the rest of the world. Hence, needs to be viewed and measured in different light.
6. Further he analyses the basel 2 implementation in Indian Banks and expresses - theres lot more to be done since the banks have neither done enough on hiring the required talent nor the systems and technology has been geared up.
7. "It is now accepted that it is difficult to accurately model the financial markets, as against modelling the physical world as done by physicists.  This is because models are an abstraction from reality and the reality in finance is far more complex and unpredictable.  The statistical relationships of the past do not necessarily extrapolate to the future, essentially, due to the actions of the human mind which shape the results in the financial markets. I would like to quote Emanuel Derman, a leading quant in this context- “It’s not that physics is better, but rather that finance is harder.  In physics you are playing against the God, and he doesn’t change His laws very often.  In finance, you are playing against God’s creatures, agents who value assets based on their ephemeral opinions”."
8. Convergence with IFRS for Indian Banking system was mentioned.
9. "During the last few years the share of infrastructure finance in the total credit portfolio of banks has risen significantly posing challenges for management of asset liability mismatches. Bank financed infrastructure already enjoys considerable amount of regulatory dispensation.  This makes the issue, of finding alternative sources of finance for infrastructure projects, critical.  RBI has already taken a number of measures in this regard including permitting higher exposure limits for infrastructure, introducing repos in corporate bonds, permitting CDS for corporate bonds, creating a separate category of NBFCs (NBFC-IFCs), etc.  The Government has recently come out with a broad structure of Infrastructure Debt Funds (IDFs) which, when set up, might also provide an alternate source of financing." Given the recent slowdown in the implementation of infrastructure projects in India - one of the reasons being slow pace of reforms of Government of India, infrastructure giants in India have been badly beaten down in Stock Markets - with market indicating they are not happy with the capital generation and ROCE. This puts additional pressure on the banks books which are heavy lenders to the sector and hence have possible NPA sitting if the pace of reforms, pace of execution of projects and returns dont pan out as per the plan. That India needs infrastructure is nobody's guess.
10. "One of the causes behind the global crisis was the rapid growth of the shadow banking system which also undertakes credit intermediation function involving liquidity and maturity transformation and often with some degree of leverage. Its rapid growth was due to regulatory arbitrage as the sector was un/under regulated. In many cases banks had parked their riskier activities in vehicles or structures that were not consolidated with them but when the crunch came, banks had to take these risks on their balance sheets. As the height of the credit boom, the size of the shadow banking system in USA was roughly twice as large as the banking sector and is still 25 per cent larger. In several other advanced countries including Canada, the sector is at least as large as the banking sector. Therefore, the oversight and regulation of this segment has acquired urgency and currently is an important international agenda. The basic tenet is that no systemically important entity should escape regulation or oversight. While in US, under the Dodd-Frank Act, all systemically important financial institutions would come under the purview of Fed, this is not necessarily the position in other jurisdictions. The regulatory challenge would be to devise a framework for identifying systemically important non-banking financial institutions, markets and products, and evolve a framework, for the oversight and, if need be, prudential regulation. While this issue is important for regulated financial groups, it is of greater significance where such entities are not part of regulated financial groups." Recent actions involving the formation of new banks licenses given to NBFC's and regulation of Micro Finance Institutions are a part of larger direction to regulate the Non Banking Instituations or the Shadow Banking System as it is know in West.
11. To bring NBFC - Non Banking Financial Company under the regulatory purview of RBI, to also enable more capital to be infused into the veins of the economy and also let foreign capital participate in the process - RBI has just few days before come up with the Guidelines for NBFC if they are eligible to apply for a banking license.
12. Lets look at some of the recent reports that came out - India to emerge as third largest banking hub by 2040: PwC.
13. Essentially - the point that Indian Economy would need the support of banking system to grow is a no brainer and the systems and process are being put in place to let that happen. This will cause the selective rise in asset prices in the Indian Subcontinent. Specifically the Financial Inclusion aspect being the focus of Government of India will keep the Food Inflation component on a structural growth path. Added with the credit surplus, there will be few sectors NBFC, companies with technologies enabling financial inclusion will be benefitting immensely and multibaggers to boost. Due to high inflation - Gold as usual would be the prefered choice of asset for an Indian housewife.