The Hindu : Business : Gradualism over foreign equity in banks

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Monday, Apr 04, 2005

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Gradualism over foreign equity in banks

As the RBI Governor explained, financial integration should be approached cautiously in a country-specific context, saysK. Subramanian

TWIN MOVES OPPOSED: Bank employees in Mumbai protesting against the proposal to encourage mergers and acquisitions among public sector banks and the Government's move to allow 74 per cent foreign equity participation in private sector banks. — AFP

IN RECENT months, especially after the UPA Government came to power last year, no issue has led to more public debate or acrimony than the one on foreign equity in Indian banks. The zeal of the reform warriors to allow a free hand for foreign capital has been duly matched by the ideological antipathy of Left parties to any such freedom. Financial journalists titillated public opinion with leakages of differences between the Finance Ministry and the Reserve Bank of India. Strangely, the issue had been settled well before the present regime took over.

The BJP government had decided to raise the FDI limit in private banks from 49 to 74 per cent and a Press Note was issued on March 5, 2004. Thus, when the present government took charge, the decision was already there. What was needed was implementation.

Indeed, it was not a decision that could have been done under a fiat. The Left parties whose support was vital to the continuance of the UPA government began to voice serious misgivings over the issue and quoted the Common Minimum Programme in support. More importantly, the RBI had to work out the modalities to administer the new regime. This took a very long time. It was this interregnum which added grist to the rumour mills.

Row over guidelines

What disturbed the dovecotes was the issue of draft guidelines by the RBI on July 2, 2004 on ownership and governance in private banks. Either they misunderstood the intention behind the guidelines or misread them. They began to attack the RBI for "putting the clock back.'' The Banker of London reported how the RBI ruling `dismayed bankers and investors.'

These apprehensions lacked evidence about the divergence of views between the Government and the RBI.

Within a fortnight after the issue of the draft guidelines, Y. V. Reddy, RBI Governor, elaborated the strategy. This was in a seminal lecture on "India and the global economy" delivered at the Lal Bahadur Shastri National Academy of Administration, Mussorie, on the July 17, 2004.

He referred specifically to Press Note No. 2 of March 2004 and explained how the RBI included it in the guidelines. Further, he added, "the Reserve Bank is currently examining various options for strengthening the financial sector, in general, and the banking sector, in particular, concurrent with the well-calibrated deregulation process already set in motion.''

Apart from emphasising the appropriate timing for a significant entry of foreign banks, he explained the need "to examine several issues relating to the implementation of the Press Note No. 2 not in isolation but as a part of overall reform paradigm in the banking sector." A few weeks later, at a CII Meeting on September 9, 2004, while elaborating the intention and scope of the draft guidelines, Rakesh Mohan, Deputy Governor, RBI, clarified that the central bank's instructions would provide for the equity level decided by the Government. In short, though the RBI might have had differences with the Government over minutiae such as caps on voting rights, at no point did it question the decision of the government. Rather, it was engaged in a long and serious dialogue to work out the ground conditions for the new regime of `gradualism.'

During this period, the Finance Minister had to assure repeatedly that the Government stood by the March 2004 notification. He hoped to complete the discussions with the RBI by December 2004. Even by mid January 2005, he had to confess that he was holding further discussions "to dot the i's and cross the t's.'' By then, he had to meet the wrath from the Left.

Left parties' opposition

The Left parties were opposed to the proposal to raise the FDI limit to 74 per cent and to the removal of caps on voting rights. They said they would oppose any amendment to the Banking Regulation Act to lift the caps. These could have led to further discussions within the Government, within the UPA and with other groups. The air was perhaps cleared by February 2005 when it was decided to include it in the Budget. Surprisingly, the budget speech of the Finance Minister did not deal with it in detail. It referred briefly to the banking sector and said that the RBI would unveil the road map it was working on. The RBI issued two sets of guidelines the same evening, that is, on February 28.

The reaction of the left thus far has been muted. It is likely that they are reconciled to a policy that does not provide an open door for FDI in banking. Moreover, the RBI in operating the scheme of "gradualism" in the sector would apply elaborate criteria such as "fit and proper'' tests and would not permit predators.

The other end is the comment of the Economist (March 10, 2005), "New rules announced by the Reserve Bank of India (RBI) at the end of last month have dashed foreign banks' hopes of being allowed to grow unfettered.'' On the whole there is disenchantment in foreign financial circles over the new policy. They have been waiting for long to enter the Indian market. The Indian market is more attractive than China as it is also endowed with established legal systems, stock and security markets and other infrastructure. They were waiting for months and readying for the `pickings.' HSBC had done it in advance by acquiring a 14 per cent stake in UTI Bank through a deal with a Mauritius-based company owned by the DFI of the U.K. Government. Many other FIIs have also acquired shareholdings in Indian banks. No wonder they are unhappy with the setback to their hopes. Whatever may be their perception, what is the rationale behind the new process initiated by the RBI?

RBI's rationale

In the lecture referred to earlier, the Governor elaborated it at length. There is great reliance on current research on financial integration and its impact on developing countries. Much of the earlier research on FDI in banking was done with reference to developed countries. There is the standard cliché that FDI in banking generates FDI in industrial sectors. This is not so. Much of the FDI in banking in the post war years was in the nature of "follow the leader'' and to cater to the credit needs of their big clients and to service their FDI abroad. Such ethnic or clientele (crony!) relationships were observed in the U.S. and the EU. The larger question is whether these banks would meet the credit needs of domestic investors. There is evidence that foreign banks engage in "cherry picking'' and leave out high risk creditors/projects to domestic banks and weaken them. This was observed in Latin American countries and Africa and, surprisingly, even in South Korea.

Moreover, there are concerns about the operations of foreign banks and their impact on the macro-economic stability of the host economy. FDI in banking in emerging economies or what is described as the "third wave" came about in the late 1990s, especially after the Asian crisis. Banks were acquired by foreigners as "fire sales'' and their later record suggests the ebbs and flows of capital. These flows are pro-cyclical and tend to leave the country whenever the country faces a downturn. They cause `contagion' and transmit crisis across the countries. Japanese banks transmitted home country `recession' to the U.S.!

The economists are now more chastened about financial integration vis-a-vis developing countries. In a study on "Financial Globalization, Growth and Volatility in Developing Countries,'' by Easwar et al (NBER Working Paper No.10942, December 2004), the authors take the view; "The empirical evidence has not established a definite proof that financial integration has enhanced growth for developing countries. Furthermore, it may be associated with higher consumption volatility. Therefore, there may be value for developing countries to experiment with different paces and strategies in pursuing financial integration.''

In an earlier version of this paper, they suggested that benefits could be derived by those with a "threshold'' or an absorptive capacity.

The RBI Governor has taken the cue from such research work. In his lecture at the National Academy, he was explicit when saying, "A judgemental view needs to be taken whether and when a country has reached the `threshold' and the financial integration should be approached cautiously with a plausible road map by answering questions in a country-specific context and institutional features.'' From a larger vision, he looks upon bank reform with the same caution and calibration with which one approaches economic reforms and the measures towards capital convertibility.

The road map is unique in that it deals with banks, domestic or foreign, with the same criteria and is WTO compliant. While the reformists of the fundamentalist variety may be unhappy with the `gradualism' envisioned, the Chinese authorities may learn a lesson or two in handling their bank restructuring issues.

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