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Keeping the financial doors half open

June 09, 2009 11:58 IST

The clarion calls for the opening up of the financial system have resumed and predictably so. The trigger this time appears to be President Pratibha Patil's June 4 speech to the joint session of Parliament, the contents of which reflect a fair, if not considerable, share of inputs from Prime Minister Manmohan Singh.

The speech comes on the back of the 'we've-cracked-it-this-time' euphoria that has accompanied the electoral results and added to the buoyancy in the stock markets. And thus merited, I thought, a closer look. Not because her words are cast in stone but because a rising Sensex, to put it bluntly, causes unbridled optimism, a letting down of guard and leads to positive spins on things either said or unsaid.

To be fair, the President's speech does separate the mention of large foreign investment flows (particularly foreign direct investment) from 'the need to augment resources in the banking and insurance sectors,' in turn 'to serve the needs of society better.' But the sentences follow each other -- the kind of wording which permits either forward movement or backtracking, depending on how matters develop.

I thought this was a good moment to rewind to two interesting observations made by outgoing Reserve Bank of India Deputy Governor Rakesh Mohan in recent speeches. Both broadly concerned external capital flows into the country.

The first dwelt on the danger of foreign banks having a greater than desirable presence in an economy, notably India. The second, a study into whether there was a link between financial liberalisation and a nation's economic growth.

In hindsight, both thought processes made their way into policy pronouncements and action, both pro-active and defensive. Pro-active by defining the limits, for instance, of the extent of foreign bank presence in India. And defensive, by resisting the various forces that lobbied directly or via the government in recent years to change the status quo.

Let me first pick up the argument on foreign banks because that is representative of a larger stance on external inflows. Why do Rakesh Mohan and the RBI argue against foreign banks' having a greater share in the domestic banking universe?

In one sentence, it's the apprehension that foreign banks could yank out capital if they were faced with destabilising developments elsewhere in the world, typically on home turf.

This has happened earlier, in eastern Europe and the Baltics. Also in the early 1990s, Japanese banks pulled back from foreign markets -- including the US -- to reduce their liabilities on their balance sheets and thereby meet capital adequacy ratio requirements. For a central bank with financial stability as a defined and accepted objective, this is at all times a potential area of concern.

Does Dr Mohan suggest that foreign banks be kept out? Not quite.

Instead, he argues for a reasonable presence because the banks, as is well-acknowledged, tend to bring the latest technology and practices. And change or create new competitive standards, for example, the creation of a strong forex trading market which is also beneficial for the economy.

Let's focus on capital flows. This is perhaps a less contentious issue but interesting nevertheless. More so, because there is little or no debate, and this is a good time to ignite one.

On linking capital market liberalisation with economic growth, Dr Mohan points to Stanford professor Peter Blair Henry's work, 'Capital Account Liberalisation: Theory, Evidence, and Speculation.'

More on Henry's work as I understand it better. But Dr Mohan points out, in synthesis, that there is strikingly little convincing documentation of the direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries. At the same time, interestingly enough, opening the financial account does appear to raise the frequency and severity of the economic crisis.

In hindsight, the RBI's conservatism won out. That point has been effectively documented now. What has not been effectively documented is the careful study that created the policies that prevented greater financial integration with the rest of the world.

I would argue that it is imperative to re-visit the academics and thinking behind the policy. And it's not that difficult to start either -- both former Governor Dr Y V Reddy and Deputy Governor Rakesh Mohan have released books of their speeches.

The author is editor of UTVi Business News. He is struggling to decipher the algebraic formulae that look at capital flows and economic growth. The English is pretty clear though.

Govindraj Ethiraj
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