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Challenges in financial intermediation

The most important issue for policy-makers would be to clear the obstacles in the path of efficient financial intermediation from the wholesale to the retail markets.

IT IS one of the anomalies on the modern Indian economic scene that has not yet found a solution. At one end, the Reserve Bank of India issues securities to absorb the "excess" rupee liquidity created by its purchase of dollars in the foreign exchange market. The "excess" rupee resources, ostensibly, do not find prudential and profitable deployment.

Therefore, instead of allowing them to slosh around in the wholesale financial markets with the potential for causing systemic problems such as inflation or an asset bubble, the RBI, under the new Market Stabilisation Scheme (MSS), has stepped in to impound the rupee liquidity with itself.

At another end, there are local governments in the country negotiating with overseas aid agencies for financial assistance. For what? To fund public administration projects such as in health, rural sanitation, highways development or for replenishing the fleet of a State Transport Corporation.

Inadequacies of system

This disconnect between crying investment needs of the economy and the wholesale financial markets has been a characteristic feature of the Indian financial system for a long time.

Only, it has become prominent in recent times with the surge of dollars into the Indian markets.

This disconnect is a clear pointer to the fact that the wholesale financial markets have not found a way of intermediating the "surpluses" created by the RBI's dollar-buying intervention in the foreign exchange market to segments in the economy requiring those resources. There is no bridge between savers and borrowers.

In fact, going further, one can even say that the RBI could have saved itself the trouble of devising an MSS. For, given the "efficiency" with which the Indian financial system has worked historically — broadly indicated by the ratio of overall money supply to base money remaining in a fairly narrow 2.25 to 4.25 range in the past 30 years — there was no way the rupee liquidity created by the RBI's dollar purchases was going to result in a overheating of the economy (overheating marked by excess credit creation).

Structural impediments

The RBI's own monetary policy stance may have inhibited credit expansion during different periods in the past. But, it is also a fact that structural impediments have played a major part in rendering the financial intermediation process inefficient.

Therefore, while the wholesale financial markets talk of an ultra-comfortable liquidity situation (that has been prevailing for quite some time now), there are large segments in the overall economy to which the benefits of such ultra-comfortable liquidity (timeliness and adequacy of credit and its lower cost) have not percolated down. The "trickle-down" theory, like elsewhere in macroeconomics, has not been in operation.

Arguably the most important issue for policy-makers from now on would be to clear the obstacles in the path of efficient financial intermediation from the wholesale to the retail markets.

This task may have acquired added urgency in the prevailing borderless global market system. And more so, as a fundamental re-appraisal (upward valuation) of the investment prospects of major developing economies such as India seems under way. In such a scenario, if the RBI were to continue its policy of active foreign exchange market intervention to build up the country's forex reserves, the "problem" of excess wholesale market rupee liquidity may persist.

Market stabilisation schemes such as the one recently devised could be only a temporary palliative (if it can be called a palliative at all). A more enduring and economically more optimal solution would seem to lie in intermediating these surpluses on to sectors in the economy starved of capital.

Avenues for intervention

This is certainly a situation where path-breaking and direction-giving intervention from the Government may be required. A few showcase projects in infrastructure — drinking water schemes, communications, ports and power projects, road and rail transport networks — which can absorb the huge resources coming into India, on commercial and mutually beneficial terms (both for lender and borrower), may well be an answer.

China shows the way

For a lead, India just needs to look at China. Massive debt issuance by government / state-owned enterprises — averaging $100 billion per annum in the past three years — has been the policy approach to absorbing in an economically useful way the local currency resources released by the Chinese central bank's dollar-supportive forex market intervention. (China has the second largest forex reserves in the world — in excess of $350 billion). These debt programmes have gone on to fund some of the biggest infrastructure projects.

It is no wonder that on the back of such massive spending, Chinese industrial and overall economic growth is rocketing ahead (at 13/14 per cent). Admittedly, there are also excesses in the China story.

There are likely to be infrastructure projects coming up just for the sake of it.

There may also be a lot of resources leakage and wastage. Serious as these lacunae are, they still do not detract from the underlying principle — an attempt to utilise excess liquidity arising from forex inflows in a productive way.

There is an interesting sidelight from the China experience. Despite the huge public deficits, the consequential large bond issuances and the outsized growth of the economy, benchmark bond yields are still ruling well below 5 per cent. Is there a message here for the Indian bond markets?

The author is Associate Vice President (Treasury), ING Vysya Bank Ltd. These are purely his personal views and do not represent those of his employer.

T. B. Kapali

The author is Associate Vice President (Treasury), ING Vysya Bank Ltd. These are purely his personal views and do not represent those of his employer.

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