Banking Renaissance: Inclusion, Innovation & Implementation - S. S. Mundra

Shri Arun Tiwari, Chairman, Union Bank of India; Dr. Rajan Saxena, Vice-Chancellor, Narsee Monjee Institute of Management Studies (NMIMS); Dr. Shamsuddin Ahmed, Dean; Dr. Vrinda Kamat, Professor and Programme Chairperson (MBA Banking); Shri. C. B. Ramamurthy; faculty and students of the School of Business Management, NMIMS University; distinguished invitees, members of the print and electronic media, ladies and gentlemen! At the outset, let me commend the NMIMS for imparting excellent education and practical knowhow to its students thereby equipping them to take on leadership roles in various organisations. Institutions such as the NMIMS are playing a key role in developing skilled and capable manpower and are, consequently, serving the nation. 2. It is, therefore, a pleasure for me to be amidst these budding management professionals this morning to deliver the opening address at the seventh Annual Banking Conference “Bank on it, 2014” organised by the NMIMS University. I observe that the Conference has hosted some illustrious speakers in the past and deliberated upon various pertinent issues impacting the banking system. 3. Before I get down to the theme of the Conference, let me begin by quoting two famous Americans. “It is well enough that people of the nation do not understand our banking and money system, for if they did, I believe there would be a revolution before tomorrow morning.” - Henry Ford, founder of the Ford Motor Company “I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.” – Thomas Jefferson, the principal author of the Declaration of Independence (1776), and the third President of the United States Now that you know what some of the leading statesmen of the world have to say about banks and the banking system, I am not sure whether we should attempt to spread greater awareness about them and risk a revolution! Also imagine these comments came at a time when the credit card, mortgage loan and other personal loans were not even known. However, as a career banker with over thirty five years of experience in banking, I would like to comfort you that the bankers and the banking profession is not as iniquitous, as these two gentlemen would like the world to believe. Why the call for Banking Renaissance? 4. On a more serious note, let me now turn to the theme for the Conference, which is “Banking Renaissance: Inclusion, Innovation & Implementation”. As you might know, the word ‘Renaissance’ has a French origin meaning re- 'back, again' + naissance 'birth' (from Latin nascentia, from nasci 'be born'). Renaissance refers to a period which witnessed a revival of European art and literature under the influence of classical models in the 14th–16th centuries. Another dictionary meaning of renaissance is ‘a revival of or renewed interest in something’. 5. I am not too sure in what context has the word ‘Renaissance’ been referred to in the theme of this Conference. Obviously, you could not be talking of revival of interest in classical mould of banking and about innovation in the same breath. Likewise, I am not too sure whether it has something to do with a revival of or a renewed interest in banking, as I don’t think the interest of the society in banking, more so, in a developing economy like ours, has ever waned. My understanding of the theme for the Conference is that we probably need to deliberate about the innovative measures needed in our banking sector which would render it more inclusive, vibrant, productive, efficient and above all, customer-centric. Therefore, in my address today, I would speak with this basic presumption and I do hope that I am not veering away from the theme. Evolution of banking 6. But before I get into the subject proper, just to set the context, I would like to briefly highlight how the modern day banking has evolved. Banking, in the form that we know today, might have evolved during the 17th century. However, even in ancient Mesopotamia, all the modern banking practices such as deposits, interest, loans and letters of credit seem to have existed. The practice of safe-keeping and savings also seem to have been in existence in the temple of Babylon as early as 2000 B.C. Closer home, Kautilya, in his Arthashastra written in about 300 B.C., has also mentioned about the existence of powerful guilds of merchant bankers who received deposits, and advanced loans and issued hundis (letters of transfer). In the modern times, an experienced Scottish goldsmith, William Paterson, is credited with the idea of setting up a national bank in Britain in 1688, which gave birth to the Bank of England. The modern day banking, in its simplest form, is meant to facilitate financial intermediation between the savers and the borrowers. It also seeks to act as a safe place to store money and earn some return in the process, as also a place to seek simple financial solutions to individual problems. The advent of technology in modern times has heralded three distinct phases in banking: a) Computerisation of back office processes during the 1980s, b) Facilitating higher customer convenience during the 1990s and c) Enabling lifestyle/life stage banking during the 2000s. Thus, over time, the banks have witnessed significant changes in their outlook and have emerged as financial supermarkets offering a range of complex financial products and services on a round the clock basis, duly customised to the needs of their customers through multiple delivery channels. 7. RBI, as the regulator of banks in India, has increasingly deregulated the sector and has allowed the market players to develop products and services best suited to their customers. As a result, both in terms of products & services and delivery channels, there has not been any dearth of innovations. On the product front, the innovations have led to emergence of complex offerings like swaps, derivatives and securitisation, while on the other hand, the delivery channel is no more limited to brick and mortar branches, but has spread to modern, technology-driven channels like ATMs, mobile, internet and the social media, besides the Business Correspondent model. Thus, over the years, there has been tremendous amount of progress and innovations in the sector. However, these developments have, simultaneously, raised certain pertinent questions: Whom have these innovations benefited? Are these product offerings demand driven? Have the banks addressed the ‘suitability and appropriateness’ question? Have the charges for various services been made transparent and non-discriminatory? Why banks are still a place where ordinary mortals fear to tread? Why has a large section of the society remained financially excluded despite sincere efforts of the regulator as well as the policy makers? 8. Having an insider’s view of India’s financial system, first as a commercial banker and now as a central banker, I intend to use this opportunity today to share my perspectives on the approach adopted by RBI as the regulator of Indian banks for making the Indian banking sector more inclusive and relevant to a large cross-section of the Indian economy and society. I shall also delve on the challenges which the banking system is encountering in realising the goal of universal financial inclusion and the innovation and reforms that may be necessary to overcome some of these challenges. I also wish to emphasize that having bright and innovative ideas do not have any meaning until and unless they are acted upon. I, therefore, compliment the organisers for including ‘implementation’ as an element of the theme for the conference, as I believe that rigor in implementation is extremely important for realisation of the dream of universal access to financial services and products. Why is Financial Inclusion necessary? 9. The ILO Declaration of Philadelphia in 1944 proclaimed that “Poverty anywhere is a threat to prosperity everywhere.” It is universally agreed now that Financial Inclusion helps build domestic savings, bolster household, domestic and financial sector resilience and stimulate business and entrepreneurial activity, while exclusion leads to increasing inequality, impediments to growth and development. Thus, financial inclusion is an important tool for poverty alleviation as it not only connects individuals to the formal financial system, but also inculcates savings habit among them. Hence, Financial Inclusion or inclusive banking is a precursor for inclusive and sustainable economic growth. Financial Exclusion: Dimension of the problem 10. An accusation that has come to be levied against the banking sector in the aftermath of the Financial Crisis is that it has failed to be ‘inclusive’. Let me tell you that the Indian banking system is not alone in failing the ‘inclusion’ test. It is only the degree of exclusion that varies between different jurisdictions. The Financial Inclusion Action Plan (FIAP) developed by the G20 Global Partnership for Financial Inclusion mentions that the universal financial inclusion initiative requires bringing the 2.5 billion people (or about half the working age population) currently excluded, into the formal financial system. 11. That brings us to the question how inclusive is the Indian financial system? Census 2011 gives us some answers. Out of 24.67 crore households in the country, only about 14.48 crore or 58.70 per cent households had access to banking services. Further, of the 16.78 crore rural households only about 9.14 crore or 54.46 per cent households were availing of banking services. But that is only one aspect of the financial exclusion story. The statistics on number of individuals or households that are credit-linked makes for an even more gloomy reading. The World Bank Findex Survey (2012) points out that only about 35 per cent of Indian adults had access to a formal bank account and a meager 8 per cent borrowed formally in the last 12 months. If we were to broaden the canvas and examine the exclusion in the other financial segments of insurance and securities market, the situation is far worse. Initial Efforts at Financial Inclusion 12. Having recognised early the social and economic imperatives of broader financial inclusion, both Government and the Reserve Bank have pursued this goal over the last several decades, but with limited success. Starting with the nationalisation of banks, priority sector lending requirements, launching of Lead Bank Scheme, establishment of Regional Rural Banks (RRBs), Service Area Approach, Self-Help Group-Bank Linkage Programme- all these innovative programmes were launched with the aim of taking banking services to the masses. Starting in 1990s, however, the focus shifted to strengthening financial institutions as part of financial sector reforms. Despite all the above efforts, the extent of financial exclusion has remained staggering. Why did these efforts fail? 13. The target driven approach to social banking could be counted as one of the main reasons for the failure of these efforts as these initiatives could never become part of the business strategies of banks. The banks were more interested in somehow trying to meet the lending targets, mostly at subsidised rates of interest, or with subsidy from the Government under various government directed schemes. The banks never treated social banking as a viable and profitable business proposition. They always worked under the presumption that the poor can neither pay normal interest rates nor could they earn enough without subsidies; while in reality the poor continued to pay exorbitant interest rates to informal sources of finance. For any activity to become sustainable and scalable it has to be viable. Regrettably, there has never been a concerted effort on the part of the banking system to identify specific business opportunities within these groups and to develop viable business models to realise them. I would like to reiterate our firm belief that banking for poor is viable and scalable only on commercial lines, of course, without an exploitative intent. Reform Era Setback 14. During the period starting mid 1980s and till about 2005, the regulatory focus shifted to consolidation and profitability of banks. Since social initiatives, as argued earlier, were not integrated with business plans and were thought of as non-viable, they were the first casualties. A number of rural branches were closed down or merged or were shifted to semi-urban areas as they were considered unviable. Excessive Reliance on Public Sector Banks 15. The thrust of social initiatives has always been on the public sector banks while the private sector banks and foreign banks have not been given adequate social obligations. Besides, too many authorities involved in pursuing financial inclusion also, at times, resulted in dissipation of structured and planned efforts. Absence of Technology 16. In the absence of appropriate enabling technology, reaching far flung areas of the country without a brick and mortar structure, proved to be a difficult and expensive ordeal. What has changed now? 17. In the last few years, it has been realised that for financial inclusion to become a reality, there has to be a sustainable business and delivery model. Further, availability of technology as an enabler has now created avenues for developing cost effective solutions for the mammoth task of providing banking services to six lakh plus villages in the country. The lessons learnt from the initial attempts at promoting financial inclusion have also proved to be vital inputs in recalibrating our financial inclusion strategy. The RBI's Approach to Financial Inclusion 18. The failure to achieve meaningful progress in financial inclusion forced the regulators and policy makers to have a rethink on the approach. It began with defining what Financial Inclusion actually meant and where should the energies be focused. RBI has defined Financial Inclusion as “the process of ensuring access to appropriate financial products and services needed by all sections of the society in general and vulnerable groups such as weaker sections and low income groups in particular, at an affordable cost in a fair and transparent manner by regulated, mainstream institutional players”. Thus, financial inclusion has two fold objectives: To connect the excluded with the formal banking system in order to help them gain an understanding of the financial services available and equipping them with the confidence to make informed financial decisions. Providing door step banking services to all the six lakh villages and meeting their life cycle financial needs through appropriate savings, credit, remittance and insurance products. Planned and Structured Approach 19. RBI has been following a planned and structured approach to address the twin issues of demand and supply of financial services. The efforts have been aimed at creating an enabling environment for the banks. Wide-ranging strategies from a relaxation of regulatory guidelines to provision of new products and supportive measures have been adopted to achieve sustainable and scalable Financial Inclusion. Bank- Led Model & Leveraging Technology 20. RBI has advocated a bank-led model for financial inclusion with thrust on leveraging technology. We firmly believe that the success of FI initiatives greatly depends on technology which would enable emergence of cost efficient delivery models. Though we have advocated the use of technology, we are agnostic to the platform to be used for pursuing financial inclusion objectives. Banks have been accorded the freedom to adopt solutions which can be easily scaled up and customised as per their requirements. Recent innovations under Financial Inclusion 21. RBI has not been found wanting insofar as experimenting with innovative solutions to further the cause of financial inclusion is concerned. However, we have always believed that innovation does not mean developing complex solutions to simple problems. Also, innovation need not always involve cutting edge technology. Hence, some of the innovative practices we have encouraged banks to follow, merely involves making small adaptations and a change in mindset. Let me explain some of these initiatives. a) Business Correspondent/ Business Facilitator Model 22. Beginning January 2006, Reserve Bank has permitted banks to utilise the services of non-governmental organisations (NGOs), micro-finance institutions (other than Non-Banking Financial Companies) and other civil society organisations as intermediaries in providing financial and banking services through the use of Business Facilitator and Business Correspondent (BC) models with an objective of solving the list mile connectivity issue. Banks were encouraged to connect the BC network with their Core Banking Solutions (CBS) and also to develop offline solutions to overcome the network connectivity issues experienced in some areas. As the uptime of the equipments was of paramount importance, the banks were advised to ensure that equipment and technology used by BCs are of high standards. Interoperability of BCs at the retail outlets or sub agents of BCs has also been permitted, provided the transactions were carried out on-line, on CBS. The list of entities that can be appointed as BCs has also been expanded substantially over time. b) Simplified branch authorisation 23. RBI has considerably relaxed the branch opening norms for banks whereby they do not require prior RBI permission for opening branches in centres with population less than 1 lakh. To further step up the opening of branches in unbanked centres, banks were mandated to open at least 25 per cent of their new branches in unbanked rural centres. Banks have also been advised to consider frontloading (prioritising) the opening of branches in unbanked rural centres over a three year cycle co-terminus with their Financial Inclusion Plans. c) Combination of Branch and BC Structure to deliver Financial Inclusion- ICT Based Accounts - through BCs 24. RBI has been advocating a combination of Brick and Mortar structure and the BC network to extend financial inclusion, especially in geographically dispersed areas. In order to provide efficient and cost-effective banking services in the unbanked and remote corners of the country, RBI directed commercial banks to provide ICT based banking services – through BCs. These ICT enabled banking services have CBS connectivity to provide all banking services including deposit and withdrawal of money in the financially excluded regions. The use of smart cards, hand held devices / POS machines along with bio-metric authentication facilitates digitisation of Financial Inclusion process. d) Opening of Basic Saving Bank Deposit Accounts (No-frills accounts) 25. On the products side, banks were directed to make available Basic Savings Bank Deposit Accounts (BSBDAs) for all individuals with zero minimum balance and facility of ATM card/Debit card, effectively making opening of a basic savings account a fundamental right for every eligible Indian citizen. Further, banks were also advised to provide in-built overdrafts in such basic savings accounts so as to meet the emergency credit needs of the customer and prevent them from having to approach money lenders in distress situations. The provision for entrepreneurial credit has also been simplified in the form of KCC for farm sector households and GCC for non-farm sector households. e) Relaxed KYC norms 26. One of the major constraints faced by the people in getting linked to the formal financial system was the strict Know Your Customer (KYC) norms prescribed for opening bank accounts. To facilitate easy opening of accounts, especially for small customers, the KYC guidelines have been simplified to the extent that these accounts can be opened by way of a self-certification in the presence of bank officials. Further, to leverage upon the UIDAI initiative, RBI has allowed ‘Aadhaar’, to be used as one of the eligible documents for meeting the KYC requirements for opening a bank account. Very recently, the RBI has also allowed banks to use the E-Aadhaar facility provided by UIDAI for KYC purposes. f) Pricing of advances freed 27. Banks have been provided the freedom to decide the pricing of loans given to customers with a view to ensuring the economic viability of banks’ Financial Inclusion initiatives. Financial Literacy as a facilitator of Financial Inclusion 28. As financial markets are becoming increasingly complex with serious problems of information asymmetry, the need for financial literacy and education has become even more acute. Besides, there is a general lack of awareness among the financially excluded population about the benefits of being connected to the formal financial system. This highlights the importance of the task of promoting financial literacy, which faces numerous challenges in a country like India, on account of wide disparities in literacy levels, social/ economic development, widespread use of regional languages, etc. Recognising the importance of financial literacy as the stepping stone towards financial inclusion, Reserve Bank has taken several steps in recent times for promoting financial literacy. ‘Project Financial Literacy’ aims at disseminating information regarding the central bank and general banking concepts to various target groups (which includes school and college-going children and the rural/urban poor). Implementation: Issues and Challenges 29. Let me now dwell upon some implementation challenges that need to be overcome if the goal of attaining universal financial inclusion has to be achieved. a) Believing in Financial Inclusion as a viable business 30. There is still a widespread belief that if the poor have to be provided financial services, it must be done in a subsidised manner or as an act of charity. And this belief has kept the poor bereft of these services while keeping the regime of rationing, queuing and patronage alive. Contrary to common perception, financial inclusion is a potentially viable business proposition because of the huge untapped market that it seeks to bring into the fold of banking services. Financial Inclusion, prima facie, needs to be viewed as “money at the bottom of the pyramid” and in order to tap this opportunity, banks would need to have in place an appropriate business and delivery model in line with their business strategy and comparative advantage. If the banks start believing in this business, they would be able to innovate and, in the process, start reaping the benefits of economies of scale. This will ultimately create an environment of competitiveness amongst banks which will benefit the unbanked population. b) Monitoring performance 31. Along with the implementation efforts, the monitoring of the performance to access the impact is also very crucial. The impact assessment helps in initiating policies and removing barriers to Financial Inclusion. We have encouraged banks to adopt a structured and planned approach to financial inclusion with commitment at the highest levels, through preparation of Board approved Financial Inclusion Plans (FIPs). A structured and comprehensive monitoring mechanism for evaluating banks’ performance vis-à-vis their targets has also been put in place. c) Leveraging the banking network for extending social benefits: Direct Benefit Transfer 32. The introduction of direct benefit transfer by validating the identity of the beneficiary through Aadhaar will help facilitate delivery of social welfare benefits by direct credit to the bank accounts of beneficiaries. The government, in future, has plans of routing all social security payments through the banking network using the Aadhaar based platform as a unique financial address for transferring financial benefits to the accounts of beneficiaries. Besides providing timely delivery of benefits at the door step of beneficiaries, it would save Government the administrative cost involved in delivering cash to the intended beneficiaries and help minimise the chances of leakages in the system. Banks must initiate steps to proactively open bank accounts for all eligible individuals and seed these accounts with Aadhaar numbers for ensuring smooth flow of the social security benefits through the banking channel. Pradhan Mantri Jan Dhan Yojana (PMJDY) 33. Pradhan Mantri Jan Dhan Yojana has been announced recently to give a further push to Financial Inclusion initiatives in India. The scheme has been launched with the objectives of providing universal access to banking facilities, providing basic banking accounts with overdraft facility and RuPay Debit card to all households, conducting financial literacy programs, creation of credit guarantee fund, micro-insurance and unorganised sector pension schemes. The objectives are expected to be achieved in two phases over a period of four years up to August 2018. Under the scheme, technological innovations like RuPay card and mobile banking are also being made use of. Banks are also permitted to avail of RBI’s scheme for subsidy on rural ATMs and UIDAI's scheme for subsidy on micro ATMs to augment their resources at the village level. Way forward 34. Banks’ business models for financial inclusion should be designed to be at least self-supporting in the initial phase and profit-making in the long run, with an unwavering focus on affordability. The banks need to think and act differently and make themselves more flexible so as to meet even the smallest requirements of the rural population. Banks need to move from a cost centric model to a revenue generating model by offering a bouquet of deposit, credit and other products and services. The products and services should be designed in such a way that it suits the needs of people in unbanked rural areas. i) BC Model 35. There are multiple challenges being faced while implementing BC model. Sustainability and scalability of the BC model is essential. There are issues around BCs’ cash management services and remuneration to be paid to them. There is a need to have a close look at the problems constraining the model and to develop practical solutions that help in realising the full potential of this channel. More and more innovative products will have to be introduced which would benefit both banks as well as the rural people and at the same time make the BC model more viable. ii) Differentiated banking 36. RBI is set to create a framework for licensing small banks and payments banks. These differentiated banks would be expected to serve niche interests and to meet credit and remittance needs of small businesses, unorganised sector, low income households, farmers and migrant work force. This aims at allowing a wider pool of entrants into banking to further Financial Inclusion. iii) PMJDY 37. The objective of Financial Inclusion as defined by us is very much in sync with the objectives sought to be achieved under the PMJDY. We are fully committed to the implementation of the scheme and are trying to ensure that the efforts of RBI converge with the work under the PMJDY so that the common objective of financial inclusion is achieved. Further, the idea is to enable more transactions in these accounts and providing more credit products, which will not only help rural people to avail of credit at comparatively lower rates of interest but, at the same time, also make the financial inclusion process viable for banks. With implementation of PMJDY, it is expected that the beneficiaries of social security will get the direct credit of their entitlements without any leakage. However, for successful achievement of the same, it is to be ensured that there is timely and accurate listing of beneficiaries. Message for students 38. Before I conclude my address, let me leave you with a couple of thoughts. Very shortly you would be venturing into the job market and start working. My advice to you is that you should choose your profession/vocation carefully and work hard in whichever field you opt for. But I would also advise you to work smart. Working smart, among others, also involves need for networking. You must choose your associates wisely and cultivate that association. My second thought is around what I call the theory of ‘1-2-3’ being practiced in the professional job market. These days, the organisations seek to hire one person, pay him/her the salary of two persons and expect him/her to work equivalent to three persons. If you do not guard against that, you would end up burning out very early in your professional lives. My advice to you would be to develop the spirit of a marathon runner and not that of a sprinter. Only then would you be able to fully realise the potential imbibed by you through the quality education received from this esteemed institution. Conclusion 39. Financial Inclusion cannot be achieved without the active and collaborative involvement of all stakeholders like RBI, other financial regulators, banks, governments, NGOs, civil societies, media, etc. Good intentions always need to be supported by concerted action for achieving goals. The support of policymakers, regulators, governments, IT solution providers and public at large would be essential to bring about a decisive metamorphosis in Indian banking and making it inclusive. 40. Finally, though Innovation is desirable, excess of the same could also mean higher cost and time overruns. It is important to strike a balance between no innovation and excess innovation. Innovation need not always be revolutionary. Enough on the financial inclusion front could be achieved even by thinking ‘inside the box’, that is, by focusing on doing the basics right. I would like to conclude by quoting Gene Roddenberry, “It isn't all over; everything has not been invented; the human adventure is just beginning.” 41. I once again thank Narsee Monjee Institute of Management Studies University and the faculty and students of the School of Business Management for inviting me to this Conference for sharing my thoughts on a topical subject. I am sure that you would now have a better understanding of the issues involved and you would reflect on the challenges at hand in making banking inclusive. I am also confident that some of the students present here would join the banking sector and serve as torch bearers for “inclusive banking and inclusive growth” in the days ahead. I hope the deliberations during the day would also pick up some issues that I have laid down on the table. We have a lot of expectations from our youth and I do hope some of you could take up research in this area and come up with actionable solutions for financial inclusion. 42. I wish you a successful conference today as well as success in all your future endeavors. Thank You. * Chief Guest Address by Shri S. S. Mundra, Deputy Governor, Reserve Bank of India on “Banking Renaissance: Inclusion, Innovation & Implementation” at the seventh Annual Banking Conference “Bank on it , 2014” organised by the Narsee Monjee Institute of Management Studies in Mumbai on October 11, 2014.

Problem Loan Management and MSME Financing R. Gandhi

I am very glad to be talking to you on a subject which is very contemporary and very critical for the economy. Both the Government of India and the Reserve Bank have long been convinced of the contribution, and of the enormous potential, of the SME sector to the economic growth, employment and income generation for vast masses of the country. Recent Government pronouncements about “Make in India” are fundamentally based on these convictions. Therefore, detailed discussions and debate on the ways, procedure, precautions and follow-up on SME financing are very apt and timely. I appreciate the efforts of CRISIL and others in this regard. I understand that in this workshop you all had discussed about SME Loan Life Cycle Management, Credit Scoring as a technique for credit appraisal, strategies and tools to monitor SME loans and handle problem SME loans, including building early warning systems, etc. I am sure all of you have been benefited by these discussions. Let me dwell a bit more on the problem loan management, as currently it is a serious issue for the banking sector. Asset Quality 2. Asset quality is an important parameter to measure the health of the banks. In the last twenty years or so, the Gross Non-Performing Asset Ratio as well Net Non- Performing Asset Ratio of Indian banks have been showing a declining trend due to many factors, and very significantly due to the sustained improvements in the credit risk management practices adopted by the banks. The gross non-performing assets (NPAs), in percentage terms, have declined steadily from 15.70 per cent at end March 1997 to 2.35 per cent at end March 2011. However, asset quality of the banking system has suffered significant deterioration in the recent years. NPAs expressed in terms of Gross NPA Ratio increased to 4.11 per cent at the end of March 2014. During the period, the ‘restructured but standard loans’ (restructured in terms of regulatory dispensation provided to banks for supporting viable accounts facing temporary difficulties and in line with public policy imperatives) as a per cent of gross advances increased considerably from 1.14 per cent in March 2008 to 5.87 per cent in March 2014. There has been further deterioration in asset quality during March to September 2014 and the GNPA ratio and restructured advances ratio increased to 4.54 per cent and 6.13 per cent respectively at the end of September 2014. As such, the overall stressed advances (NPAs + Restructured advances) remained high with considerable increase in the recent period working out to 10.67 per cent for the banking system as at the end of September 2014. In terms of value, with Gross NPAs at `2,798 billion and Restructured standard advances at `3,780 billion, the total stressed advances amounted to `6,578 billion at the end of September 2014. Stressed Sectors 3. Based on the levels of stress in different subsectors, it was observed that (i) ‘infrastructure’ (ii) ‘Iron and Steel’ (iii) Textiles (iv) Mining (including Coal) and (v) Aviation services had significantly higher level of stress and thus these sub-sectors/segments could be taken as ‘stressed’ sectors in the current scenario. Macro-Stress tests 4. Macro-stress tests are conducted by the Reserve Bank of India to ascertain the resilience of banks against macroeconomic shocks. The results of this analysis presented in the Financial Stability Report-December 2014, suggest that under the baseline scenario, the GNPA ratio is expected to be around 4.0 per cent of total advances as at the end of March 2016. However, if the macroeconomic conditions deteriorate, the GNPA ratio may increase to 6.3 per cent under severe stress scenario by March 2016. Drivers for deterioration in Asset Quality 5. Theoretically speaking, there could be various factors which may cause a good loan to turn into a problem loan. Some of the external reasons could be economic recession, non-payment in other countries, inputs/power shortage, price escalation, accidents/ natural calamities, and changes in government policies in excise/import duties, pollution control norms, delay in disbursal of loans by lenders, etc. Internal reasons for loan accounts becoming problem loans could be diversion of funds for expansion/diversification/ modernisation/for taking up new projects, for helping/ promoting associate concerns, time/cost overrun during the project implementation stage, business (product, marketing, etc.) failure, inefficient management, strained labour relations, inappropriate technology/ technical problems, and product obsolescence, etc. 6. The current deterioration in the asset quality of Indian banks could mainly be attributed to domestic and global economic slowdown, delays in statutory and other approvals, especially for projects under implementation, relatively aggressive lending practices during upturn (2003-08), as evidenced from high corporate leverage, risk concentration, especially to large greenfield projects, and of course, lax risk management systems of banks, etc. NPA Management 7. Managing NPAs has a lot to do with managing productive assets and ensuring effective corporate governance. Management of NPAs begins with the realisation of benefits that accrue in running a quality advances portfolio and warrants a better understanding of risks in lending. The Board of Directors has to decide a strategy on NPA management keeping in view the regulatory norms, the business environment, the asset profile, the available resources, etc. The strategy should be reflected in Board approved policies and procedures to monitor implementation. 8. The essential components of sound NPA management are: Prevention of NPAs through prudent underwriting Effective early alert system Quick and effective remedial measures to prevent slippage Faster resolution of post slippage 9. A multi-pronged strategy of preventing slippage of standard assets into NPA category and reducing NPAs through cash recovery, up gradation, compromise, legal means etc., is called for. Restructuring 10. Generally, stress in borrowal accounts is more likely to be resolved in terms of recovery if the company is in operation. For this to be effective there must be a system of identifying the weakness in accounts at an early stage. Banks should put in place an ‘Early Alert’ system that captures early warning signals in respect of accounts showing first signs of weakness. This would help the banks to take remedial measures and prevent the account from becoming NPA. Banks may restructure / reschedule the accounts of viable entities and assist the entity to tide over the temporary difficulties faced by them. 11. Once a weak account is identified, the bank needs to consider various corrective actions. One of the corrective options is restructuring. In spite of their best efforts and intentions, sometimes borrowers find themselves in financial difficulty because of factors beyond their control and also due to certain internal reasons. For the revival of the viable entities as well as for the safety of the money lent by the banks, timely support through restructuring in genuine cases is called for. The objective of restructuring is to preserve the value of viable entities that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders. We already have a detailed regulatory prescription, separately for Corporate Debt Restructuring mechanism for consortium advances and standalone restructuring by individual banks. 12. The objective of the Corporate Debt Restructuring (CDR) framework is to ensure timely and transparent mechanism for restructuring the corporate debts of viable entities facing problems, outside the purview of BIFR, DRT and other legal proceedings, for the benefit of all concerned. In particular, the framework aims at preserving viable corporates that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders through an orderly and coordinated restructuring programme. The CDR Mechanism has been designed to facilitate restructuring of advances of borrowers enjoying credit facilities from more than one bank / Financial Institution (FI) in a coordinated manner. Framework for Revitalising Distressed Assets 13. The Reserve Bank of India has released in early 2014 a Framework for Revitalising Distressed Assets in the Economy. The Framework outlines a corrective action plan that will incentivise early identification of problem cases, timely restructuring of accounts which are considered to be viable, and taking prompt steps by banks for recovery or sale of unviable accounts. The main features of the Framework are: i) Central Repository of Information on Large Credits (CRILC) has been set up by RBI to collect, store and disseminate credit information with the reporting entities in respect of borrowers enjoying aggregate exposure (funded + non funded) of `50 million and above. ii) Early formation of a lenders’ committee (Joint Lenders Forum) with timelines to agree to a plan for resolution; mandatory beyond the exposure of `1000 million and above. The Corrective Action Plan may include any one of the following: Rectification Restructuring Recovery iii) Incentive and disincentive structure for lenders to take corrective actions in a timely manner iv) Incentives for lenders to agree collectively and quickly to a plan: better regulatory treatment of stressed assets if a resolution plan is underway, accelerated provisioning if no agreement can be reached. v) Improvement in current restructuring process: Independent evaluation of large value restructurings mandated, with a focus on viable plans and a fair sharing of losses (and future possible upside) between promoters and creditors. vi) More expensive future borrowing for borrowers who do not co-operate with lenders in resolution. Support to viable but stressed Accounts 14. Despite the best efforts by banks, slippages do occur. Once an account slips into NPA category, then the focus should shift to upgradation. At this juncture, it is important to understand that the Reserve Bank has not barred banks from sanctioning need based additional finance to borrowers whose accounts are classified as NPAs. On the contrary, Reserve Bank’s extant guidelines envisage a situation where banks may need to sanction additional finance to borrowers under stress to revive / rehabilitate the borrower and to preserve the economic value of the asset. Mere classification of an account as NPA need not result in withdrawal of support to viable borrowal accounts. However, while considering their support to accounts under stress, banks should make proper distinction between wilful-defaulters / non-cooperative / unscrupulous borrowers on the one hand, and, on the other hand, borrowers defaulting on their debt obligations due to circumstances beyond their control. Sale of NPAs 15. In the event of failure of the above mentioned measures, banks could resort to filing suits with Debt Recovery Tribunals or invoke the provisions of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Banks may also sell their NPAs to asset reconstruction companies. The RBI has granted Certificate of Registration (CoR) to 14 ARCs so far. In addition to asset reconstruction companies, banks may also explore selling the NPAs to other banks, non-banking finance companies or other financial institutions, who have the requisite skills to resolve the NPAs efficiently. In February 2014, regulations on sale of stressed accounts have been amended to facilitate emergence of a market for distressed assets. Recovery Channels 16. Despite various corrective measures, if upgradation is not proving to be possible due to unviable nature of the borrowers’ business, the bank should take steps to recover the loans through any of the recovery options available to them. Among the various channels, the amount of NPAs recovered under the SARFAESI Act, 2002 formed almost 80 per cent of the total amount of NPAs recovered in 2013-14. The SARFAESI Act has, thus, been the most important means of recovery of NPAs. NPAs of SCBs Recovered through Various Channels (Amount in ` Billion) Year No. Particulars Recovery Channel Total Lok Adalats DRTs SARFAESI Act 2012 -13 1 No. of cases referred 8,40,691 13,408 1,90,537 10,44,636 2 Amount involved 66 310 681 1,058 3 Amount recovered* 4 44 185 232 4 3 as per cent of 2 6.1 14.1 27.1 21.9 2013 -14 1 No. of cases referred 16,36,957 28,258 1,94,707 18,59,922 2 Amount involved 232 553 946 1,731 3 Amount recovered* 14 53 244 311 4 3 as per cent of 2 6.2 9.5 25.8 18 Notes : 1.* : Refers to amount recovered during the given year, which could be with reference to cases referred during the given year as well as during the earlier years. 2. DRTs: Debt Recovery Tribunals. 17. However, the present legal system is unable to cope with the mammoth task, considering the ever increasing number of suits and the limited infrastructure available at DRTs / courts. Further, there are various issues relating to DRT and SARFAESI, which needs to be strengthened to make these channels more efficient and effective. They are being examined at various levels. 18. Banks also explore entering into a compromise settlement / one time settlement with the borrower to optimise its recovery in present value term. MSME Financing 19. As this workshop was meant to specifically discuss SME financing, let me share a few thoughts on this matter. 20. As I mentioned in the beginning, Micro, Small and Medium Enterprises (MSMEs) play a major role in economic development, particularly in emerging countries. There is heightened attention by the international community on MSME sector. This is primarily because of the critical importance of job creation in the recovery cycle following the recent financial crisis, and the MSME’s potentials in that respect. 21. Yet, lack of access to finance is a major obstacle to their growth. Although the situation can differ among countries and individual businesses, the financing gap for SMEs in the developing country has a few well-accepted causes. These include Information asymmetries, higher risks, Sizeable transaction costs and a lack of adequate collateral. These factors can be exacerbated by institutional factors within a country. Finally, there are a number of "demand side" considerations that deserve more attention. 22. The following three factors play a considerable role in perpetuating the MSME financing gap - The poor quality of projects seeking funding, the inability of MSMEs to make the best possible use of available resources of funding and the negative attitude displayed by MSMEs towards equity financing. 23. Unfortunately, there is no authentic data available about the SME financing gaps. The informal segment within the SME sector is so vast and, by definition, no authentic information about them is available. However, various data sources and studies indicate that most of the small firms rely on internal financing and informal sources. 24. A study by the IFC and McKinsey and Company (McKinsey) suggests that there are close to 365-445 million micro, small, and medium enterprises in emerging markets of which 25-30 million are formal SMEs and 55-70 million are formal micro enterprises, while the rest (285-345 million) are informal enterprises. According to the same study, close to 45 to 55 per cent of the formal SMEs (11-17 million) in the emerging markets do not have access to formal institutional loans or overdrafts despite a need for one. The finance gap is far bigger when considering the micro and informal enterprises; 65-72 per cent of all MSMEs (240-315 million) in emerging markets lack access to credit. The size of the finance gap varies widely across regions and is particularly daunting in Asia and Africa. Some studies about SMEs in India have reported that as high as 93 per cent of their financing needs are met by internal and informal sources. 25. In order to scale up the best practices in SME Finance, the G-20 SME Finance Sub-Group executed a global SME Finance stocktaking exercise with various SME finance models. This exercise entailed the collection of 164 SME finance models spanning across a broad spectrum of interventions, including: (i) legal and regulatory framework; (ii) financial information infrastructure; (iii) public support schemes; and (iv) private sector initiatives. The stocktaking exercise confirms the rise in various parts of the world of specific business models aimed at providing financial services to SMEs in a cost-effective manner. From microfinance up-scaling to bank down-scaling, including community banks, these models share common characteristics: they reduce cost to serve through intensive use of technology and/or the adoption of cost-effective clientrelationship models; they combine offering of savings, transactional, and credit products, with a view to increase generated income; they use advanced risk management technology to maximise the risk/reward balance; and, they achieve strong focus on the small and/or medium enterprise segment, to help implement excellent execution capabilities in the above areas. 26. Hence, the key challenge is to support banks in extending credit facilities to SMEs. It will be a greater challenge to reach informal SMEs. This is due to SME intrinsic weaknesses, flaws in delivery models and, most importantly, lingering deficiencies in the enabling environment for financial services: i.e. the financial infra-structure covering accounting and auditing standards, credit reporting systems, and collateral and insolvency regimes. Some other ideas 27. In this workshop, you all had detailed deliberations on how to assess credit needs of an SME, how to monitor the relationship and what new techniques you can adopt for this. Let me give you a flavour of ideas beyond this: Reaching informal businesses will have to be built on microfinance approaches. It all has to start with account relationship. The financial inclusion programmes like PMJDY will facilitate key information inputs to banks about the existence of the MSMEs, whether in formal and in informal segments. Banks should leverage these data and information feeds to identify potential MSMEs for suitable financing opportunities. Banks will also need to develop ingenious and innovative products suitable for the MSMEs. I strongly believe that this aspect needs to be grounded more at the grass root level. Based on broad parameters given by their central / head offices, the actual packaging of the products and services will have to happen closer to the field. Key elements of such packaging will have to include Risk-sharing facilities. Banks will also have to play a much larger role than being the financiers. MSMEs often lack management skills, tools, governance and financial planning expertise. Banks will have to help these entrepreneurs leverage the RSETI like institutions to fill the gaps. Another major weakness that inhibits the growth of this sector is the lack of good records management by the MSMEs; this often results in poor credit ratings and a perception of risky business. Some innovative solutions using cloud computing have been tried successfully in some countries like Ghana. Perhaps this can be studied and adapted for Indian environment. 28. These interventions need to be accompanied by enhancements to the enabling environment for MSME lending, such as improved credit bureaus, and collateral and insolvency regimes. For the success of effective SME financing models, it is imperative that suitable supporting environment for the financial sector is in place. In particular, financial information and the ability to enforce collateral are seen as critical necessities. Weaknesses in these areas appear to impede more aggressive financial services growth in developing markets. 29. We are very aware of these requirements and have taken several measures in that direction. Our recent guidelines, based on Aditya Puri Committee recommendations, envisage that credit information now will flow to all credit bureaus simultaneously and therefore the financial entities can have a holistic view about any prospective borrower at one go. As regards collateral registry, steps have been initiated in this direction. The Central Registry of Securitisations, Asset Reconstruction and Security Interest of India (CERSAI) has come on the scene for registering security interests over property. Other types of registry and inter-linking registries are also being debated. As regards insolvency, especially for MSMEs, as announced in the last Budget, a Committee is working out an insolvency framework. 30. Public support schemes (funded facilities, guarantee schemes, and state banks) represent the large majority of the collected models. India has also adopted these strategies. CGTSME, MSME lending as a priority sector lending for banks etc measures have been in line with this thought. 31. Although MSME financing and microfinance models have started yielding desired results, equity financing remains a challenge. Given that banking and lending services represent the bulk of SME financing in the developing world, especially for small firms, equity financing presents an opportunity for the development of a complementary financial product. Conclusion 32. To conclude, let me emphasize that increasing access to finance can only be successful if qualitative aspects are taken into account. Adhering to principles of responsible finance and the G-20 principles on innovative financial inclusion can serve this purpose. It should also be noted that although financial access is critical for MSME growth, expansion of financial access should not be achieved at the cost of financial stability. Appropriate prudential measures need to be exercised while offering finance to MSMEs, in order to avoid the potential pitfalls stemming from excessive credit. * Valedictory Speech delivered by Shri R. Gandhi, Deputy Governor, Reserve Bank of India on January 30, 2015 at a Workshop organised by CRISIL on “Credit Risk and Problem Loan Management” at Goa. Assistance provided by Shri A. K. Choudhary and Shri Nethaji B. is gratefully acknowledged.

Make in India, Largely for India Raghuram G. Rajan

The global economy is still weak, despite a strengthening recovery in the United States. The Euro area is veering close to recession, Japan has already experienced two quarters of negative growth after a tax hike, and many emerging markets are rethinking their export-led growth models as the industrial world stagnates. In the last couple of years, the IMF has repeatedly reduced its growth forecasts. After 6 years of a tepid post-crisis recovery, the IMF titled its most recent World Economic Outlook “Legacies, Clouds, Uncertainties”.

The conventional diagnosis and remedy

Why is the world finding it so hard to resume pre-Great Recession growth rates, let alone restore the levels of GDP that would have been attained if the Great Recession had not happened? The obvious answer is that the legacy of the financial boom that preceded the Great Recession is debt, and the overhang of debt, whether on governments, households, or banks, is holding back growth. In the colourful words of the IMF’s Managing Director, we are experiencing “the New Mediocre”. The implication is that growth is unacceptably low relative to potential, and more can be done to lift it, especially given that a number of economies are flirting with deflation. Hence the conventional policy advice urges yet more innovative monetary interventions with an ever expanding set of acronyms, even while governments are urged to spend on “obvious” needs such as infrastructure. While the need for structural reforms is acknowledged, they are typically deemed painful, and possibly growth-reducing in the short run. Hence the accent is on monetary and fiscal stimulus, and as much of it as possible given the deadening effects of debt overhang.

The efficacy of such policy advice remains to be seen. But the Japanese checked each of these boxes over the last two decades, including interest rates held low for long, quantitative easing, and massive debt-financed spending on infrastructure. Few would argue that Japan has shed its seeming malaise.

A different diagnosis

A different narrative of the pre-crisis period is now emerging that may explain why the efforts at stimulating economies back to the pre-crisis growth paths have not been successful, even six years after the crisis.1 The term “secular stagnation” used by Larry Summers to describe the current persistent economic malaise, echoing Alvin Hansen’s speech in 1938 in the midst of the Great Depression, has caught on.2 But different economists focus on different aspects and causes of the stagnation. Summers emphasises the inadequacy of aggregate demand, and the fact that the zero lower bound as well as the potential for financial instability prevents monetary policy from being more active. The reasons for weak aggregate demand include ageing populations that want to consume less and the increasing income share of the very rich, whose marginal propensity to consume is small.

Tyler Cowen and Robert Gordon on the other hand, emphasise a weak supply potential.3 They argue that the post-World War II years were an aberration because growth was helped in industrial countries by reconstruction, the spread of technologies such as electricity, telephones, and automobiles, rising educational attainment, higher labour participation rates as women entered the work force, a restoration of global trade, and increasing investments of capital. However, post-war total factor productivity growth – the part of growth stemming from new ideas and methods of production – fell from its 1920-50 high. More recently, not only has productivity growth fallen further, but growth has been held back by the headwinds of plateauing education levels and labour participation rates, as well as a shrinking labour force in some countries because of population ageing.

It is obvious from these lists of factors that it is hard to disentangle the effects of weak aggregate demand from slow growth in potential supply. Population ageing contributes to both. Indeed, one may cause the other. For example, anticipating a slowdown in growth potential, households, worried about impending retirement in the face of promised social security entitlements that are unlikely to be delivered upon, may try and build savings. This will depress demand further. Conversely, anticipated weak demand may reduce incentives for corporations to invest, causing supply potential to grow more slowly.

Whatever the reasons for slow underlying growth starting in the 1970s, the traditional adverse consequences such as the growing unemployment of the system’s outsiders such as immigrants and the youth was compounded by the growing realisation that economies could also not deliver on social security promises without growth. These promises, as sociologist Wolfgang Streeck writes, were made to the wider public during the growth years of the 1960s when visions of a “Great Society” seemed attainable.4 Promises have been augmented since then by increases in pension and old age healthcare commitments to public sector workers. These have been made to avert budget-breaking wage increases, but they have created huge liabilities for the future, which is approaching fast.

Growth therefore became an imperative, and with underlying growth slow from the 1970s on, governments began to spend more to stimulate the economy. With supply potential also stagnant, the spending translated into inflation, which spiralled upwards. Streeck argues that industrial country successes in curbing inflation in the 1980s meant something else had to take the place of the inflation tax in financing spending. And that was debt, first public debt, then as governments narrowed fiscal deficits, an encouragement to the private sector to take on debt. Growing leverage of all kinds, whether on banks, corporates, households, or governments, led to the financial crisis of 2008-11. Some of the private debt has morphed into government liabilities, but the overall level of debt in industrial countries as a fraction of GDP is still growing.5

Governments that are not forced by market pressures to undertake productivity-enhancing reforms prefer to delay them. As a result, overall debt is still growing because the policies of “reaching for growth” through monetary and fiscal stimulus have not abated. Further complicating all this is a growing sense amongst the middle class that they need quality higher education and training to not slip back into the ranks of the poor, but the poor quality early education they have received, as well as the prohibitive cost of quality higher education, puts better livelihoods out of reach. Populist middle class movements, as epitomised by the Tea Party in the United States or UKIP in the United Kingdom, reflect these worries. The possibility of a backlash against technology, global finance, and foreign immigration and trade, which the middle class is led to believe are responsible for its plight, is very real.

The mediocre economic outlook might change. Strong US growth could pull the world out its funk, while low oil prices could also give a substantial boost to aggregate demand. The industrial world may well muddle through for a while before it figures how to harness and monetize (as well as measure) new technologies. New well-paying middle class jobs that we cannot imagine today may emerge once again, as they always have. But overall, there is a palpable sense of gloom in the industrial world, a belief that growth is unlikely to be strong enough to satisfy for the foreseeable future.

If secular stagnation persists, industrial countries will have to figure out how to restructure their promises, whether debt, social security, or low taxes, and how to distribute the burden. After filing for bankruptcy, the city of Detroit in the United States has already had to make tough choices, between servicing its pensioners or its debt, keeping its museums open or its police force intact. More such difficult decisions will have to be made.

What about emerging markets?

Slow industrial country growth has made more difficult a traditional development path for emerging markets – export-led growth. Indeed, in the last decade, even as China developed on the back of its exports to industrial countries, other emerging markets flourished as they exported to China. Emerging markets now have to rely once again on domestic demand, always a difficult task because of the temptation to overstimulate. That task has become more difficult because of the abundance of liquidity sloshing around the world as a result of ultra-accommodative monetary policies in industrial countries. Any signs of growth can attract foreign capital, and if not properly managed, these flows can precipitate a credit and asset price boom and exchange rate overvaluation. When industrial country monetary policies are eventually tightened, some of the capital is likely to depart emerging market shores. Emerging markets have to take extreme care to ensure they are not vulnerable at that point.

What implications should an emerging economy like India, which has weathered the initial squalls of the “taper tantrums” of the summer of 2013, take away for its policies over the medium term? I would focus on four: 1) Make in India; 2) Make for India; 3) Ensure transparency and stability of the economy; and 4) Work towards a more open and fair global system.

Lessons for India

1) Make in India

The government has the commendable aim of making more in India. This means improving the efficiency of producing in India, whether of agricultural commodities, mining, manufacturing, or services.

To achieve this goal, it has to implement its ambitious plans on building out infrastructure. This includes

• Physically linking every corner of the country to domestic and international markets through roads, railways, ports and airports. The kind of economic activity that is generated when a pukka all-weather road is built into a village – the explosion of horticulture, poultry, and dairy farming, the opening of clothing and assorted goods shops, the increasing use of powered vehicles – is extraordinary, as is the kind of activity that emerges around national highways.
• Ensuring the availability of inputs such as power, minerals, and water at competitive prices.
• Linking everyone electronically and financially to the broader system through mobiles, broadband, and intermediaries such as business correspondents.
• Encouraging the development of public institutions such as markets, warehouses, regulators, information aggregators and disseminators, etc.
• Making possible affordable and safe homes and workplaces.

A second necessity for increasing productivity in India is to improve human capital. This requires enhancing the quality and spread of health care, nutrition, and sanitation to start with so that people are healthy and able. People also need better and more appropriate education, skills that are valued in the labour markets, and jobs where firms have the incentive to invest more in their learning.

The government is examining the cost of doing business in India with a view to bring it down. The woes of the small entrepreneur, as she confronts the myriad mysterious regulations that govern her, and the numerous inspectors who have the power of closing her down, are well known. The petty bureaucrat, empowered by these regulations, can become a tyrant. It is appropriate that the government intends to make him help business rather than hinder it. As regulators, we too have to continuously examine the costs and benefits of the regulations we impose.

Finally, we need make access to finance easier. I have spoken about that in other contexts, and will not dwell on it here. Before I move on, let me add some caveats.

There is a danger when we discuss “Make in India” of assuming it means a focus on manufacturing, an attempt to follow the export-led growth path that China followed. I don’t think such a specific focus is intended.

First, as I have just argued, slow growing industrial countries will be much less likely to be able to absorb a substantial additional amount of imports in the foreseeable future. Other emerging markets certainly could absorb more, and a regional focus for exports will pay off. But the world as a whole is unlikely to be able to accommodate another export-led China.

Second, industrial countries themselves have been improving capital-intensive flexible manufacturing, so much so that some manufacturing activity is being “re-shored”. Any emerging market wanting to export manufacturing goods will have to contend with this new phenomenon. Third, when India pushes into manufacturing exports, it will have China, which still has some surplus agricultural labour to draw on, to contend with. Export-led growth will not be as easy as it was for the Asian economies who took that path before us.

I am not advocating export pessimism here – India has been extremely successful at carving out its own areas of comparative advantage, and will continue to do so. Instead, I am counselling against an export led strategy that involves subsidising exporters with cheap inputs as well as an undervalued exchange rate, simply because it is unlikely to be as effective at this juncture. I am also cautioning against picking a particular sector such as manufacturing for encouragement, simply because it has worked well for China. India is different, and developing at a different time, and we should be agnostic about what will work.

More broadly, such agnosticism means creating an environment where all sorts of enterprise can flourish, and then leaving entrepreneurs, of whom we have plenty, to choose what they want to do. Instead of subsidising inputs to specific industries because they are deemed important or labour intensive, a strategy that has not really paid off for us over the years, let us figure out the public goods each sector needs, and strive to provide them. For instance, SMEs might benefit much more from an agency that can certify product quality, or a platform to help them sell receivables, or a state portal that will create marketing web sites for them, than from subsidised credit. The tourist industry will probably benefit more from visa on arrival and a strong transportation network than from the tax sops they usually demand.

A second possible misunderstanding is to see “Make in India” as a strategy of import substitution through tariff barriers. This strategy has been tried and it has not worked because it ended up reducing domestic competition, making producers inefficient, and increasing costs to consumers. Instead, “Make in India” will typically mean more openness, as we create an environment that makes our firms able to compete with the rest of the world, and encourages foreign producers to come take advantage of our environment to create jobs in India.

2) Make for India

If external demand growth is likely to be muted, we have to produce for the internal market. This means we have to work on creating the strongest sustainable unified market we can, which requires a reduction in the transactions costs of buying and selling throughout the country. Improvements in the physical transportation network I discussed earlier will help, but so will fewer, but more efficient and competitive intermediaries in the supply chain from producer to the consumer. A well designed GST bill, by reducing state border taxes, will have the important consequence of creating a truly national market for goods and services, which will be critical for our growth in years to come.

Domestic demand has to be financed responsibly, as far as possible through domestic savings. Our banking system is undergoing some stress. Our banks have to learn from past mistakes in project evaluation and structuring as they finance the immense needs of the economy. They will also have to improve their efficiency as they compete with new players such as the recently licensed universal banks as well as the soon-to-be licensed payment banks and small finance banks. At the same time, we should not make their task harder by creating impediments in the process of turning around, or recovering, stressed assets. The RBI, the government, as well as the courts have considerable work to do here.

We also have to work on spreading financial services to the excluded, for once they learn how to manage finances and save they can be relied on to borrow responsibly. New institutions and new products to seek out financial savings in every corner of the country will also help halt the erosion in household savings rates, as will a low and stable inflation rate. The income tax benefits for an individual to save have been largely fixed in nominal terms till the recent budget, which means the real value of the benefits have eroded. Some budgetary incentives for household savings could help ensure that the country’s investment is largely financed from domestic savings.

3) Ensure transparency and stability of the economy

As I argued earlier in the speech, even developed countries like Portugal and Spain have been singularly unable to manage domestic demand. Countries tend to overstimulate, with large fiscal deficits, large current account deficits, high credit and asset price growth, only to see growth collapse as money gets tight. The few countries that have avoided such booms and busts typically have done so with sound policy frameworks.

As a country that does not belong to any power blocks, we do not ever want to be in a position where we need multilateral support. It will be all the more important to get our policy frameworks right.

Clearly, a sound fiscal framework around a clear fiscal consolidation path is critical. The Dr. Bimal Jalan Committee’s report will provide a game plan for the former, while the government has clearly indicated its intent to stick to the fiscal consolidation path that has been laid out. Whether we need more institutions to ensure deficits stay within control and the quality of budgets is high, is something worth debating. A number of countries have independent budget offices/committees that opine on budgets. These offices are especially important in scoring budgetary estimates, including unfunded long term liabilities that the industrial countries have shown are so easy to contract in times of growth and so hard to actually deliver.

On the monetary side, a central bank focused primarily on keeping inflation low and stable will ensure the best conditions for growth. In reacting to developments, however, the central bank has to recognise that emerging markets are not as resilient as industrial economies. So the path of disinflation cannot be as steep as in an industrial economy because an emerging market is more fragile, and people’s buffers and safety nets are thinner. A “Volker” like disinflation was never on the cards in India, but an Urjit Patel glide path fits us very well, ensuring moderate growth even while we disinflate. Going forward, we will discuss an appropriate timeline with the government in which the economy should move to the centre of the medium term inflation band of 2-6 per cent..

In addition to inflation, however, a central bank has to pay attention to financial stability. This is a secondary objective, but it may become central if the economy enters a low-inflation credit and asset price boom. Financial stability sometimes means regulators, including the central bank, have to go against popular sentiment. The role of regulators is not to boost the Sensex but to ensure that the underlying fundamentals of the economy and its financial system are sound enough for sustainable growth. Any positive consequences to the Sensex are welcome but are only a collateral benefit, not the objective.

Finally, India will, for the foreseeable future, run a current account deficit, which means we will need net foreign financing. The best form of financing is long term equity, that is, Foreign Direct Investment (FDI), which has the additional benefit of bringing in new technologies and methods. While we should not be railroaded into compromising India’s interest to attract FDI – for example, the requirements to patent a medicine in India are perfectly reasonable, no matter what the international drug companies say – we should ensure policies are transparent and redress quick. If we make it easier for young Indian companies to do business, we will also make it easier for foreign companies to invest, for after all both are outsiders to the system. This means a transparent and quick legal process to deal with contractual disputes, and a proper system of bankruptcy to deal with distress. Both are issues the government has taken on.

Let me turn finally to the international framework.

4) Work towards a more open and fair global system

As a country that does not belong to any power block, and that does not export vital natural resources but is dependent on substantial commodity imports, India needs an open, competitive and vibrant system of international trade and finance. Our energy security, for example, lies not in owning oil assets in remote fragile countries but in ensuring the global oil market works well and is not disrupted. We need strong independent multilateral institutions that can play the role of impartial arbiter in facilitating international economic transactions.

Unfortunately, the international monetary system is still dominated by the frameworks put in place in the past by industrial countries, and its governance is still dominated by their citizens. To be fair, it is changing, albeit slowly. But there is a more immediate reason for faster change. With slow growth, as well as the need to finance large debt loads, the interest of industrial countries in an open global system cannot be taken for granted. For instance, regulations that have the appearance of shoring up safety and soundness of the industrial country financial system may have the collateral effect of discouraging investment in emerging market assets. We have to recognise that slow growth may direct industrial economy policymakers’ attention inwards, even while politics turns protectionist. The multilateral governance system, still dominated by industrial countries, may not provide a sufficient defence of openness.

Emerging markets may therefore have the responsibility of keeping the global economy open. For this, not only do emerging markets have to work on quota and management reforms in the multilateral institutions, but they also have to work on injecting new agendas, new ideas, and new thinking into the global arena. No longer will it suffice for India to simply object to industrial country proposals, it will have to put some of its own on the table. And this means that our research departments, universities, and think tanks have to develop ideas that they can feed to India’s representatives in international meetings.

Conclusion

Let me conclude. We are more dependent on the global economy than we think. That it is growing more slowly, and is more inward looking, than in the past means that we have to look to regional and domestic demand for our growth – to make in India primarily for India. Domestic-demand-led growth is notoriously difficult to manage, and typically leads to excess. This is why we need to strengthen domestic macroeconomic institutions, so that we can foster sustainable and stable growth. At the same time, we cannot let foreign markets shrink further, and we have to take up the fight for an open global system. Rather than being reactive, we have to be active in setting the agenda. That requires investment in our idea-producing institutions – research departments of official bodies, think tanks, as well as universities. In sum, the diminished expectations in the world at large should not be a reason for us to lower our sights.

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* Talk delivered by Dr. Raghuram Rajan, Governor Reserve Bank of India at the Bharat Ram Memorial Lecture at FICCI on December 12, 2014 in New Delhi.

1 See, for example, “The Crises of Democratic Capitalism”, Wolfgang Streeck, New Left Review 71, Sept/Oct 2011 or “The True Lessons of the Recession: The West Can’t Borrow and Spend its Way to Recovery”, Raghuram Rajan, Foreign Affairs, Volume 91, no 3, May/June 2012 .

2 Summers, L. (2014), “U.S. Economic Prospects: Secular Stagnation, Hysterisis and Zero Lower Bound”, speech delivered to the National Association for Business Economics, Economic Policy Conference, February 24, 2014.

3 Tyler Cowen (2013), The Great Stagnation, Ebook, Gordon, R. (2012), “Is US Economic Growth Over? Faltering Innovation Confronts Six Headwinds”, NBER Working Paper 18315.

4 Cited in footnote 1.

5 Luigi Buttiglione, Philip Lane, Lucrezia Reichlin and Vincent Reinhart, Deleveraging? What Deleveraging?, 2014, Geneva Reports on the World Economy.