It is only recently that banks have become objects of hate or loathing and are supposed to carry WMDS – weapons of mass destruction! I am alluding to the trillions of CDOs, swaps, derivatives, etc which threaten the real economy with resultant mass unemployment, poverty and deprivation. This was not the vision which bankers like Velayudham had in their days.
In their days, as several economists like Paul Krugman or Venugopala Reddy say, “banking was a boring business” of taking deposits and prudently lending to business, trade, etc thereby promoting economic growth. It is the endeavour of many governments and regulators to restore them back to their older boring role. Unfortunately, Wall Street and global bankers resist such reforms and there is as yet no global consensus.
Though idealists like Joseph Stiglitz may regret the lack of global cooperation or consensus, as far as developing countries are concerned, it may be a welcome development. The ongoing financial crisis has chastened the advanced economies and robbed them of the pretension of having the best banking system – the Anglo Saxon model. They may not be as eager to impose them, as in the past, on emerging economies. In any case, the emerging countries are wiser.
Earlier it was an integral part of the structural adjustment programs (SAPs) put through by the International Monetary Fund (IMF) and the World Bank. It was grandiosely called the Washington Consensus. I do not wish to flog the dead horse.
The Consensus is dead and the Twins are in retreat. Unfortunately, we have to live with the collateral damage inflicted by them on the banking sector of countries like India which adopted those reforms. This comes out starkly when we compare the banking experience of China with India, especially on the financing of infrastructure. Financing of infrastructure is truly a proxy for economic growth.
This takes us on to the broader issues of the relationship between financing, including bank credit, and economic growth. For more than two decades there has been an exponential growth of literature on the relationship between finance and growth.
One of the earliest studies was done by King and Levine (1993). They used different measures of bank development for several countries and found that banking sector development can spur economic growth in the long run. In a later article Levine (2002) emphasized the critical importance of banking system in economic growth and highlighted the circumstances when banks can actively spur innovation and future growth by funding productive investments.
Some other economists like Loayza and Ranciere (2006) and Saci et al (2009) provide evidence of a negative impact of financial sector activity (banking activity) upon economic growth by using data for sample years, countries and techniques. Some other studies showed how the relationship has not been linear and impacted by credits ‘surges’ or volatilities.
Overall, a survey of extant literature does not suggest a robust or ‘one-to-one’ relationship between finance (bank credit) and economic growth. At best, the relationship is moot or tenuous and probably depends on other factors.
In a pioneering study, Rousseau and Wachtel (2005) went into the accepted wisdom on finance-growth nexus. Surprisingly, they found that the finance-growth relationship is not as strong with more recent data as it was in the original studies with data for the period from 1960 to 1989. The picture gets distorted. “The finance-growth relationship that seemed so robust in studies using data from the 1960s to the 1980s simply does not carry over to data from the past fifteen years!”
They adduce two reasons for this: One was the then prevailing greater financial depth which absorbed the shocks; and the other, the spread of financial liberalization in the 1980s increased financial depth in countries that lacked the legal or regulatory infrastructure to successfully exploit financial development. The Asian crisis of 1997 is traced to this premature liberalization. However, they do not rule out the importance of financial factor for economic development. They wisely conclude: “The correlations between finance and growth found in cross-country data may well reflect differences in country characteristics rather than any dynamic cause-effect relationship from finance to growth.”
This takes us on to the next issue of financial institutions and deepening. Banks were the earliest credit institutions extending loans (credit) to customers. It was their job to transform short-term liquid deposits into long-term illiquid financial assets that can fund long gestation activities and enhance economic growth. Banks are said to have financed the Industrial Revolution in the U.K. They financed the wars of Kings and Cardinals in Europe in the medieval ages! For that they needed strong sinews or liquidity to build maturity structures. With sound maturity structures, banks are able to extend more long-term credits. In modern times, this credit maturity depends on a number of institutional and economic factors or support structures such as the legal system, information availability, etc. The support structures are the stock market, bond market, insurance companies, etc. Both in the U.S. and in the U.K. it was possible for banks to operate under the umbrella of these structures which synergized and supplemented each other. It even nurtured the ‘shadow banking’ with hedge funds and other non-banking institutions and gave the impression that their liquidity pockets were deep! That was until the crisis struck in August 2007. This apparent depth of the market was the pride of regulators in the U.S. and EU. It is another story that, over time, it proved to be fragile with the spread of the so-called financial innovations, that is spreading of risk to others through derivatives, etc, and the inability of the insurer (AIG) to underwrite and bear the risk (or backstop credit collapses).
It is recognized now that these structures were country specific or centric and could not be exported or replanted in other countries, especially emerging economies. Sadly, financial reforms which meant the adoption of the Anglo-Saxon model became the centre piece of SAP. India, under financial stress in 1991, succumbed to the Fund/Bank pressure. China which had adopted the policy of modernization and global integration was not dependent on them and had the freedom to set the pace and the contents of financial reform.
When financial reforms were introduced in India in 1993, banks were turned into ‘universal’ banks. Formally, they had the freedom to engage in any activity, including long-term lending. Development or term institutions like the IDBI, IFC and similar other state funded long term institutions were abolished. Private Banks were allowed to provide competition to state-owned banks. Foreign banks were also expected to join the fray and take the country to higher levels of development. Unfortunately, the Reserve Bank proved to be the kill joy and restricted their entry and power.
Only a few critics like the Economic & Political Weekly and Professor Chadrasekar bemoaned the destruction of development banks. Banks were also given the freedom to fix lending rates. The hope was that infrastructure expenditure could be financed in part by banks, in part by multilateral agencies and in part by private investment, both domestic and foreign. Due to the obligations imposed to maintain fiscal deficits at stipulated levels, government was hamstrung. It lost or forswore its developmental roles it had adopted since Independence. Dependence on foreign funding agencies and private sector, domestic or foreign, was total. Unfortunately, all hopes were belied.
Banks have not proved to be a source of funding for capital projects. Due to the institutional weaknesses and the economic climate in which they operate, they have become “narrow banks” and have not performed a noticeable developmental role.
Under competitive conditions when their margins are low, they take recourse to easier options like money market operations or retail lending. In a report issued in August 2008, CRISIL expressed concern over the delinquencies in the retail advances made by Indian banks. It estimated the outstanding retail lending at around Rs.5,50,000 crore for banks and estimated that the proportion of non-performing assets (NPAs) to retail advances would rise to 4 percent in March 2009, from 2.7 percent in March 2007. ICICI alone had a retail loan portfolio of 65 percent which was expected to come down to 50 percent soon. Its corporate lending was yet to look up. Further, SOBs tend to keep their money in government securities over and above SLR limits or in repos. Moreover, banks tend to have “sliding door” relations with mutual funds and NBFCs for greater freedom for tax free investment and profitability. This bizarre alliance came to the fore in September 2008 after the fall of Lehman Brothers and the RBI had to bail out the MFs by pumping in extra liquidity of around Rs.80,000.00 crores. Indeed, the RBI has issued guidelines seeking to restrict the relations between MFs and NBFCs with scheduled banks. However, the dalliance continues.
With constant pressure on the reduction of NPAs, they are risk averse and seek easy options. Infrastructure advances are risky and least attractive. It appears that there was great reliance that private sector participation would come through Public Private Partnership (PPP). The record on date has been dismal.
After destroying specialized term lending institutions, government has been in search of financing mechanisms to fund infrastructure. Their attempt to draw on a part of forex reserves of the country met with stern resistance from the RBI and for the right reasons. There is now reliance on the India Infrastructure Finance Company (IIFCL). It is a 100% government owned company and issues bonds and probably 70% of these bonds are subscribed by public sector banks. The same banks will get refinance from IIFCL for their lending to infrastructure projects with the attendant risks remaining with them. As Dr. Venugopala Reddy has narrated (2010), there is no evidence of additionality of funds, but there could be transaction costs for issue and trading of bonds. The same banks give guarantees for foreign commercial borrowings for the same project/s. This scenario could impact the systemic stability of banks.
Road projects which are arranged through private participation models have created a logjam or what an economist has called “Contractor Raj” which has replaced the much maligned ‘licence permit raj.” Only 30 percent of the target has been achieved till date. Extent of PPP, except in airports, is negligible. Even the extent of FDI investments in infrastructure is negligible. As Sharma and Bhanumurthy (2010) explain, “There is a need for structural reforms in the domestic financial markets that helps in mobilizing long term finance for infrastructure and in achieving double-digit targets. One the foreign investments front also, although many of the infrastructure sectors are allowed up to 100% through automatic route, there appears to be many more bottlenecks that hinder FDI flows.” These authors suggest that to achieve projected investments government “encourage the use of derivatives, liberalizing investment guidelines for debt instruments, IPO for infrastructure companies, develop bond market in the country, allow NBFCs to access infrastructure fund, funding from multilateral agencies, encourage ECB for investment in infrastructure sector and boost PPPs modes of financing.” The same old litany and waiting for the crumbs to drop from the table.
The World Bank went over drive in the late nineties to involve private sector in infrastructure. It took some years for the Bank to realize that infrastructure is long gestation and low yielding and thus unattractive for private investors. It was in the mid 1990s that the Bank realized its mistake and regretted that its efforts had delayed development of infrastructure development in developing countries by a decade. Sadly, the legacy still haunts the reformers in countries like India.
In the recent meeting of the Planning Commission’s Mid-term Review, the Prime Minister indicated the total capital to finance infrastructure at Rs.60,000 crores. Given the past performance and the fiscal constraints of the government, it is unclear from where this large volume of capital will flow. Meanwhile, there is deep regret that lack infrastructure is a drag on our growth and investment. Our banks are unable to meet the demand for credit for long term projects. As earlier explained, they find their balance sheets to be unequal to the job what with provisioning requirements of the RBI (which has been reduced to 15 percent in the latest Monetary Policy Review) and the rising volume of NPAs. Under our conditions and, in the absence of a well functioning bond market, banks will not be able to raise funds for long term projects. Even in the U.S. and Europe, the happy days when high value projects, mergers and acquisitions (M&AS) could be funded through banks initially and recouped through bond issues are over. The high tide of private equity is unlikely to revive even if the banking system turns normal.
China story has been different. The political leaders in China looked upon economic growth, infrastructure and job creation as an integrated process. Indeed, infrastructure was the main driver and they were obsessed with it. It was evident to them that for a poor and backward country like China it was necessary to promote infrastructure to promote trade and investment. One may add that they had even over done it. The other driver was the state-owned-enterprise (SOE). China’s economic growth depended on two pillars, viz. SOEs and SOBs which funded SOEs. It may not be known to many in this audience that China’s banks were prohibited from lending to private companies. They relied mostly on internal resources and retained earnings. This ban has been lifted only in recent years. Another issue is, notwithstanding all efforts to modernize, open and to integrate the economy with the global economy, Chinese authorities did not give up state ownership of banks and SOEs.
China had witnessed the collapse of former Soviet countries (CIS) under “shock” therapy. It did not want to risk a similar fate. It was determined not to seek foreign assistance and decided to draw on its own national resources, savings. Banking itself was not much developed then and there was distrust dating back to the communist era. Premier Deng had to create trust in the bank and appeal to his people to keep their money with the bank without fear of appropriation. He allowed anonymous accounts and deposits swelled. In a few years, the trust would grow and citizens would open regular accounts in their own names.
The Chinese leaders were not worried about the so-called “efficient market” theories and the abhorrence with which western economists, especially monetarists, looked upon “directed credit.” When there was a shortfall in government revenues, they encouraged the banks to fill the gap by lending to companies which had no capital and to SOEs. Zhou Xiachuan, the Governor of the Peoples’ Bank of China, defended this policy in a major conference in the World Bank. He told the audience of senior officials of the World Bank, “We were advised that this was wrong. But we decided to go ahead.” As he explained, directed lending was necessary “for them to survive in production, to maintain employment, for them to renew technology and to import new equipment, for them to slow-down lay offs, for them to train new skilled workers.” The banks were asked to support the Government’s fiscal over-drawings and, indeed, played a significant role in supporting project programs. The reform of the financial system, in particular, banks was gradual, pragmatic and adaptive. India’s decision to abolish term institutions and entrust term lending to commercial banks was unrealistic and unworkable. Perhaps, India had no choice and had to conform to the IMF stipulated norms. It created a vacuum in development finance.
China’s economy, like India’s, is bank dominated. In the course of its reform over thirty years, China maintained the umbilical connection between banks and economic growth. As explained earlier, India snapped the relationship abruptly on the expectation that the links would be forged through market forces. China was pragmatic and maintained a dualist approach. At one level they opened up market opportunities for economic players and, at another, they did not give up control of the state owned banks and enterprises. For instance, to relieve pressure on commercial banks to lend loans to enterprises, they created four policy banks. These are: The Bank of China; the Industrial and Commercial Bank of China (ICBC); the China Construction Bank (CCB); and the Agricultural Bank of China (ABC).
The policy banks were enjoined to lend to SOEs to finance projects. Their lending itself was subject to an elaborate procedure which was dovetailed into Five Year Plans. Unlike in western countries, there are non-market components governing lending.
Deposits of citizens in banks are the major sources of funding. These are channeled through policy (development) banks. The disbursements are vetted by the National Development Reform Commission which is comparable to our Planning Commission. There are administrative procedures to evaluate the cost effectiveness and sustainability of loans/projects. The Communist Party of China (CPC) and the government also keep pressure on SOEs, etc to fund or open operations in newer areas. The central bank – Peoples’ Bank of China – is also a part of this public-investment funding system. Credit plans are drawn in accordance with Plan priorities and become the basis for bank lending. In earlier years, this control was somewhat rigid. Over years, these have turned into “window guidance.” Counties and Town and Village Enterprises (TVEs) are also associated in the process. There are accounts of intense competition (corruption!) to access loans from banks.
Policy banks extend loans and also subscribe to bonds issued by enterprises. The loans and bonds are guaranteed by government and there is no risk of default. Loans are also given on very low rates of interest depending on their priority, etc. Indeed, there are problems of non-performing loans and China’s banks are not unduly concerned about them like Indian banks. The loans in any case are backed by assets in the shape of infrastructure though, for various reasons, they have turned unviable. The Chinese government cleaned up the NPAs by drawing on its forex reserves.
In the decade after China commenced its financial reforms, there used to be global concern over the weakness of its banking system, especially their NPAs. The authorities in China, mostly the PbOC, took several measures to improve their functioning. They held discussions with the Bank for International Settlements (BIS) and introduced the best practices. The process is continuing and it may not be said that China has the best system. But, China can truly claim that it has a system which has been adaptive and has best served its interests, in particular, economic growth and poverty reduction. It has also been highly adaptive.
In a recent interview, Prof. Wendy Dobson, one of Canada’s leading economists, compared India’s experience with China’s. He said, “India has all the institutions that China does not. But they don’t work. India is a sort of gridlock. At the very top, India has absolutely first-rate managers. But in China, there is a very clear set of objectives. They ask what are the binding constraints on our growth? And focus on them.” (DNA, March 22, 2010.)
China could not have maintained its record of growth over two decades at near double digits without the funding provided by its banking system. World Bank documents and studies record the achievements of China and it is acknowledged that the high rate of growth had come through investments in infrastructure. Conventional wisdom relates finance (bank credit) with economic growth. In the case of China, as some economists point out, it is economic growth that strengthens finance or bank credit.
It is not only in economic growth that the banks have played a dominant role. Since 2004, the endeavour of the Chinese authorities has been to rebalance its economy. There are major programs to reduce reliance on exports and increase domestic consumption/demand. There are programs to redress backwardness in the western region. Here again banks have been playing a leading role as instruments of change.
When the global economic crisis erupted, China was hard hit, particularly because of its export dependence. There were doomsayers predicting that China would sink under such a global scenario. As in 1997 when it had to face the Asian crisis, China could announce a stimulus program of $570 billion through its banks. Not many believed that its program would work. But China surprised the world as the first country to come of the crisis. In fact, other countries, mostly in Asia, began to look upon China to lift them out of the crisis. As Time described, “On top of government outlays for new infrastructure and tax breaks, Beijing most significantly counted on massive credit growth to spur the economy. The amount of new loans made in 2009 nearly doubled from the year before to $1.4 trillion – representing almost 30% of GDP. The stimulus plan worked wonders, holding up growth even as China exports dropped 16% in 2009.”
China’s banks are globally respected and, before the financial crisis, major American banks were keen to take them over or hold big chunks of equity in them. China has resisted such pressures as their leaders are aware of the central role played by banks in maintaining growth and employment. In his book – On the Brink – Henry Paulson, former Treasury Secretary, refers to the debates he had with top Chinese leadership and how he failed to convince them to approve foreign holding in China’s banks. Apart from concerns over growth and stability, there is the utmost concern over protection of employment.
The financial crisis has led to many revisions and reviews of past theories and shibboleths. It has convincingly lain to rest the “efficient market” theory and the ability of a free market system to allocate credit. Lord Turner has argued this dramatically in his report. If a study of China’s banking development in recent years has any lesson it is that there are other ways or allocating credit.
There is a seminal analysis of China’s banking evolution and its adaptability done by Prof. Jean-Claude Maswana of Kyoto University, Japan. (2008). After a close study he takes the view that in a rapidly changing economic environment as in China, the co-evolving financial system is in no way limited to primarily attaining market efficiency. “Rather, the workability of the financial system depends on its different element fitting together: the system can be considered consistent insofar as its complementary elements take on values that lead to an optimum, even though such an optimum need not be most efficient. Had the Chinese authorities privileged financial return (allocative efficiency) from the start, as did their Russian counterparts, for instance, the macroeconomic system would have collapsed with incalculable economic and socio-political consequences.”
In the Indian situation, the adoption of the market based model has weakened the links of banks to economic growth. It is unclear from where the extra-ordinary push for promoting economic growth will come. Till then we have to live years of low growth and lamentation.
(The writer, Mr K.subramanian, is a Former Joint Secretary, Ministry of Finance, Government of India. He is associated with the Chennai centre for China Studies. This formed the basis of his talk at Dr T.K.Velayudham Endowment Lecture, organised at Chennai on 27 april 2010)
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2. Levine, R., (2002). “Bank Based or Market-Based Financial Systems: Which is better?” Journal of Financial Intermediation, 11:398-428.
3. Loayza, N. & Ranciere, R. (2006) “Financial Development, Financial Fragility, and Growth”. Journal of Money Credit and Banking, 38, 1051-1076.
4. Saci, K., Giorgioni, G. & Holden, K. (2009) “Does financial Development affect growth?”, Applied Economics.
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6. Business Line, 10/08/2008, “Retail loan quality under a cloud.” And the Wall Street Journal, WSJ Com, March 23, 2010, “ICICI Bank Cuts Back on Retail Lending.”
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8. Chandan, Sharma and Bhanumurthy, N.R., (2010) “Estimating Infrastructural Investment Needs for India”, MPRA Paper No.22188.
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10. TIME. (2010), “India vs. China: Whose Economy Is Better?” January 28, 2010.
11. Maswana, Jean-Claude, (2008), “China’s Financial Development and Economic Growth: Exploring the Contradictions”, International Research Journal of Finance and Economics, Issue 19, 89-101. ————-