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Privatisation may make banks more efficient, but will compromise on social objectives, says former RBI governor D Subbarao

The cost-benefit calculation of privatisation is net- positive because India should not be using the banking system to drive social objectives and turn instead to other instruments of policy, Subbarao says.

August 31, 2022 / 07:05 AM IST
Former RBI governor Duvvuri Subbarao.

Former RBI governor Duvvuri Subbarao.

Economists and bureaucrats have differed on an article published in the Reserve Bank of India (RBI) bulletin this month suggesting that a big bang approach to privatisation of government-owned banks may do more harm than good. Public sector banks have better than private sector counterparts on counts such as financial inclusion and have in place a sounder credit system, the article said. RBI governor Shaktikanta Das said the central bank was ownership-neutral.

In an exclusive interview with Moneycontrol, former RBI governor Duvvuri Subbarao spoke about the impact bank privatization would have on the Indian economy, and other contemporary issues. Edited excerpts:

There has been a lot of talk about privatization in recent times. What do you think could be the impact of bank privatization on Indian economy?

One broad trend of our mix of public and private banking structure has been that while private banks have focussed almost exclusively on profit maximization, public sector banks (PSBs) have had to compromise on profits to drive social objectives such as, for example, financial inclusion and lending to microenterprises. If that be the case, the impact of privatization will manifest in two ways. First, overall efficiency of the banking system will go up since PSBs will also become profit oriented; second, some social objectives maybe compromised.

I believe the net cost benefit calculus of privatization will be positive. PSBs have done a great job in meeting social objectives. But it’s time to move on. At our current stage of development, we should be using other instruments to pursue those objectives rather than continue to place the burden on bank depositors and borrowers. A big bang privatization is not advisable; but that does not mean the issue remains on the backburner forever. Ideally, we should have a roadmap, maybe over a 10 year timeframe, to privatize all PSBs. That will give much needed predictability to all stakeholders. Meanwhile, the government should also be thinking about corporatization of public sector banks so that they come within the umbrella of uniform RBI regulation.

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Can privatization cause an asset-liability mismatch for the banks?

I saw that Dr. Pronob Sen raised this issue of asset liability mismatch in a recent speech. I gather the average maturity of a deposit (liability) is about two and a half years whereas the average term of a loan (asset) is about nine years. This asset liability mismatch (ALM) has come about because of two reasons. First, Indian banks are dependent almost exclusively on retail deposits of relatively shorter duration for their funding because unlike their western counterparts, they are not allowed to tap capital markets for deposits. Second, earlier banks used to specialize in financing working capital of shorter maturity. But since becoming universal banks after reforms, the proportion of term loans of longer duration in theor loan portfolios has gone up lengthening the average maturity of a loan.

But it’s unlikely that this ALM will result in an explosion if PSBs are privatized. We must understand that maturity transformation has historically been one of the underlying drivers of banking. The RBI, as the regulator, keeps a watch to ensure that this transformation does not go overboard. Besides, the Basel III norms which are ownership neutral ensure that banks are adequately capitalized to withstand shocks of this nature.

What could however be a concern when PSBs are privatized is a possible sudden flight of deposits. PSBs enjoy a ‘perception advantage’ because depositors believe that these banks will be bailed out by the government if they come under pressure and therefore their deposits will always remain safe. That perception advantage will be gone with privatization and depositors might flee to what they see as stronger banks.

What this implies is that there is a lot of learning to be done by doing. The government should move forward adopting ‘cross the river by feeling the stones’ approach. In particular,  the first set of banks for privatization should not be the weakest banks. That might wrongfoot the whole process. Instead, the government should choose one reasonably strong bank and one reasonably weak bank to test the waters, learn the lessons and then move forward.

Since you mentioned that corporatization of the existing banking sector can happen, in that matter do you think more NBFCs will be turned to private banks?

I believe the RBI licencing policy allows a route for NBFCs to become banks. NBFCs also have the opportunity to establish a track record in the finance space as compared to non-NBFC applicants for bank licences. But it’s not as if every NBFC should aspire to become a bank. In fact, many NBFCs might want to stay as NBFCs because of the flexibility in operation it allows them even if the cost of funding is higher. Also, in operating its licencing policy, the RBI should avoid giving the impression that becoming an NBFC is a necessary entry point for a bank licence.

Apart from bank privatization, dealing with inflation has been a major area of focus in recent times. RBI Governor Shaktikanta Das mentioned in the interview that inflation might come down to 4 per cent in the next two years. Do you think it will be possible within this short target, and even if it's possible, what will be ways to achieve it?

I think bringing inflation down to 4 percent over the next two years is possible. This will come about both because of RBI’s monetary policy action as well as possible base effect.

Monetary policy action will involve raising interest rates and withdrawing liquidity. RBI has already started on the job by raising the repo rate by 140 basis points. There is a case for further tightening although I cannot speculate on how much. The trend inflation of 6% suggests that the repo rate should be 7% so that it is positive in real terms. It’s possible that RBI might not be so aggressive given global slowdown.

On the liquidity front, the net absorption under the SDF window has come down substantially from about 4 trillion rupees to about 1 trillion. But there is need for further tightening on this front as well.

But tightening monetary policy is just the first line of defence against inflation. Fiscal and exchange rate policies have to complement that effort. In choosing the appropriate policy mix, the government and the RBI will have to navigate several dilemmas.

The first balance is between fighting inflation while supporting recovery. Even as we are the ‘fastest growing large economy in the world’, we should note that our output (GDP) remains below trend which is to say that it is still lower than what it would have been in the absence of the pandemic. In that sense, there has been a permanent loss of output. The RBI will have to calibrate its financial tightening to manage this tension, according priority though to price stability which is its primary responsibility.

The second dilemma pertains to the exchange rate which has been under downward pressure. The question is to what extent should the exchange rate be used as a shock absorber. In the face of significant trade imbalance and high current account deficit, a weaker rupee can help restore balance. But a weaker rupee will also be inflationary.

The third dilemma pertains to fiscal policy. It’s important that the government deliver on the budgeted fiscal deficit of 6.4% of GDP notwithstanding higher than budgeted expenditure commitments on food and fertilizer subsidies. Any additional borrowing, apart from eroding fiscal credibility, will also put upward pressure on inflation.

This year’s fiscal performance will also set the stage for the government’s glide path to the FRBM fiscal deficit target of 3% of GDP. If the government borrows and spends the money on capital expenditure which lays the base for future growth, I believe the market will tolerate  even a slower fiscal consolidation path.

These are the three dilemmas the government and the RBI will have to manage to achieve the 4% inflation target over the next two years.

Do you think there is further room for depreciation for the rupee?

The rupee depreciated by about 7% against USD on account of capital outflows and a rising current account deficit. Even so, the rupee has been more resilient compared to other emerging market currencies as reflected in the broader 40 currency real effective exchange rate (REER) which is still over 100.

Rupee movement going forward will largely depend on commodity prices and financial conditions in the global economy, in particular the monetary policy stance of the US Federal Reserve.

I believe the RBI has sold I believe about $50 billion of reserves so far to defend the rupee. The question is, to what extent can the RBI sustain this? No doubt we have a fairly comfortable level of reserves. Even so, market confidence can be dented by rapid drop in that level. It’s best if the exchange rate is allowed to track fundamentals which means that the RBI should intervene in the market not to prevent the deprecation of the rupee but only to engineer the trajectory of that fall.
Pushpita Dey is a banking and finance correspondent.
first published: Aug 30, 2022 06:33 pm
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