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India cannot afford to delay bank reforms

By James Lamont
October 10, 2008 15:23 IST
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The first signs that India was victim to the global credit crunch came not in the teeming financial centre of Mumbai but in the cities of Karnataka and Andhra Pradesh. Depositors queued up at branches and ATMs of ICICI Bank, the country's second largest bank, and simply withdrew their cash. It was the beginning of an old-fashioned bank run.

Rescuing ICICI fell to D Subbarao, the new governor of the Reserve Bank of India. The RBI issued a short statement saying depositors' money was safe and offering liquidity support if necessary. The private sector bank's management was more voluble. It indignantly complained the bank was prey to 'baseless and malicious' rumours, exploiting an earlier admission of exposure to $ 81 million (46 million pounds, 59 million euros) in Lehman Brothers' senior debt, and stock market manipulation.

The loss of confidence in India's banking system was short-lived. After a tumultuous slide in its share price, ICICI bounced back before being knocked again by emerging market turbulence. The scare was enough to put paid to long-awaited banking and pension reform.

The global financial crisis has given the anti-reform lobby in the Indian government the upper hand over Manmohan Singh, prime minister, and his finance minister, Palaniappan Chidambaram. No one is advocating opening up the banking sector any further to what is seen as a toxic, profligate western financial system.

Only two months ago, it was another story. Buoyed by winning a confidence vote in parliament over the US-India civil nuclear deal, the Congress party-led government was suddenly free of the deadweight of leftwing allies who had blocked not only advancing a relationship with the US, but also market reforms. Expectations were raised that the government could at last achieve some reforms before a general election by next May.

In Mr Subbarao's in-tray lie recommendations on reforms intended to transform India's small banking system, which leaves access to bank capital limited. McKinsey, the consultants, estimates that loosening the state's grip could release as much as $ 48 billion of capital a year for investment. But any enthusiasm for allowing more foreign investment in domestic banking, paring down state ownership and modernising the payments system this side of an election is all but snuffed out.

"Nobody is making a case for liberalising the Indian financial markets any more. The liberalised financial markets (elsewhere in the world) are going back to... getting nationalised," says Anand Tankon, director of equities at Brics Securities, a Mumbai-based stockbroker.

Mr Subbarao will find it difficult to step out of his risk-averse predecessor's shadow. Plaudits have been pouring in for Y.V. Reddy. Once criticised for his aversion to big-bang financial reforms and for his anxieties that the Indian economy was overheating, the retired central banker is now credited for keeping the crisis at bay. Comparisons are being made with the Asian crisis of 1997 when an underdeveloped banking industry and capital controls again insulated India from the perils of 'casino capitalism.'

The ICICI panic pricked the invulnerability of India to the global liquidity chill. Lulled by ambitions of reaching double-digit economic growth, Indians awoke to the prospect that they might have their own banking crisis. Regulators have loosened rather than tightened policy to overcome the effects of the credit squeeze. The RBI has lowered its cash reserve ratio for the first time in five years. Meanwhile, the Securities and Exchange Board of India has scrapped curbs on offshore derivative instruments.

Mr Chidambaram continues to beam out of the nation's television sets, reassuring that there is nothing to fear from the meltdown in the US and Europe. He forecasts 8 per cent economic growth for this fiscal year, rising to an optimistic 9 per cent next year. But more recently he has been forced to stress 'vigilance' as the rupee and Bombay Stock Exchange tumble. "There is a storm blowing across the world," Mr Chidambaram said this week. "India will be affected to some extent, although indirectly." The depositors in Karnataka and Andhra Pradesh, along with the hundreds of millions without bank accounts, will find they are affected a little more directly than the finance minister is letting on.

The Indian government can ill afford to set aside reforms. The banking system is not up to the task of providing financial support to the development of India. Some of the most productive areas of the economy are starved of capital. Tempting though it might be to lock down the financial system, India must allow private sector banking -- currently only about 10 per cent of market share -- to grow.

India's financial depth is low for an economy that promises much. Financial assets represent 160 per cent of gross domestic product. This puts India on a par with Indonesia, but way behind China's 220 per cent. An impaired financial system may help weather a global financial crisis in the short term, but it will not help India reach the higher growth levels to which it aspires.

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James Lamont
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