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Viral Acharya made a “famous" speech last year that a government that does not respect institutional autonomy would incur the wrath of financial markets. With some of the proposals presented in the Union budget for 2019-20 on 5 July, the government may have unwittingly rendered itself potentially vulnerable to incurring the wrath of the bond market down the road.
In addition to the proposed borrowing by the sovereign state in foreign currency, India has also liberalized foreign financial flows. Since capital and current accounts have to balance, the materialization of huge capital inflows will feature a concomitant large current account deficit. So, to cap that, pre-emptively, India has resorted to higher import duties (and, maybe, to curbing consumption demand through higher taxes on high income earners). In other words, India has resorted to financial liberalization and trade restrictions. This is the opposite of what a country with weak export potential and performance, and with vulnerability to swings in external capital flows, should do. It must also be noted that issuing sovereign masala bonds to foreign lenders is not a better answer at all.
The second proposal in the budget with potentially far-reaching consequences is the proposal to fund infrastructure through deepening of the corporate bond market, including the market for credit default swaps. At one level, measures to deepen the bond markets, especially on infrastructure financing, are steps in the right direction. The book Economics Of Derivatives, written by T.V. Somanathan and yours truly, has captured the perils of encouraging credit default swaps. It is not a swap. It is an insurance contract. The word “swap" was used to keep the product out of regulatory scrutiny. It played a big role in precipitating and deepening the crisis of 2008. The alternative is the revival of term-lending financial institutions. The excess reserves held by the Reserve Bank of India that the government is seeking could be deployed as capital in new term-lending financial institutions. Armed with the government’s credit guarantee, they can then borrow in capital markets and also seek refinancing from multilateral financial institutions.
India should be more open to foreign trade than foreign finance. As the North East Asian economies have shown, export discipline and export competition are the way to enhance resilience on the capital account. Further, the bitter experience of the South East Asian economies in 1997-98 is that illiberal trade practices and liberal finance will expose the country to the excesses of financialization, and to the whims of international financial flows. Taking on additional external liabilities amid shrinking global trade volumes and an inadequate export capability is to invite danger. Fixing the latter must come first. Finally, with financial liberalization, India will be exposing itself more than before to the dangers of spillovers from the ill-conceived monetary policies of advanced nations even if India’s economic fundamentals are solid.
The government’s rationale is easy to understand. In the context of an impaired domestic credit (banking and non-banking) market and stagnant domestic savings, the government has thought it fit to tap foreign savings to provide growth finance. However, India’s financial market challenges are different. On one hand, a significant share of its citizens is financially excluded, and its bank-dominated credit markets suffer from several deficiencies. On the other, pockets of the economy involving asset prices, the attendant leverage, and cross-border capital flows are experiencing an increasing trend of financialization. The measures announced in the budget will exacerbate this trend.
In the past, India has avoided the excesses of financialization because it has been a bank-dominated rather than a capital-market dominated economy. Instead, India’s problem has been the politicization of finance, reflected in the periodic occurrence of bad debts in the banking system, just as the global crisis of 2008 reflected the consequences of the Anglo-Saxon economies’ financialization. Public ownership of Indian banks facilitated their politicization and limited their operational autonomy. Combined with financial repression, it made it difficult to fix accountability on either banks or the regulator. That ought to be the focus of the executive.
Demonetization may have accelerated digital and banking transactions, thereby formalizing transactions and increasing banking penetration. The goods and services tax promotes formal recording of commercial transactions, recourse to banking systems for payments for transactions, etc., and hence, more liquidity with banks. If the insolvency and bankruptcy code improves recovery of defaulting loans, and discourages wilful defaults, bank credit will grow faster and its proportion as a share of gross domestic product will rise.
Financial sector growth must be concomitant with the evolution of institutions of economic governance and resilience. So, “making haste slowly" and “crossing the river by feeling the stones" have not only kept India in good stead, but can continue to do so.