Ten months ahead of schedule, he is joining North Block as secretary, department of economic affairs, on Monday. Given a choice, he would have loved to finish his term at the RBI, Mohan said in a free-wheeling interview with Tamal Bandyopadhyay. Excerpts:
In December 2002, you spoke about lazy banking...
Let's take a longer term view and look at the subscription to government bonds by the banks. At one point of time the SLR requirement was 38.5 per cent. Over time, the statutory minimum requirement has been brought down to 25 per cent.
What is striking is despite the fact that the requirement went down, the actual subscription by banks to SLR remained very high -- between 38 and 40 per cent. This is, however, not the case with the new private banks. So, I wondered why the banks have not taken advantage of the reduction in statutory minimum subscription to SLR.
One can't ignore the macro side of this phenomenon. We have a high fiscal deficit and the share of market borrowing in financing fiscal borrowing is going up. So, banks had to subscribe to the government bonds. Recently, non-banks have actually increased their subscription (to gilts) and banks have reduced their subscription.
Now, take a look at the way the banking sector has evolved. First of all, we used to have all kinds of credit allocation, administered interest rates, etc. In some sense, given that experience over a long period of time, banks have lost their ability to do risk assessment of borrowers.
This is not their fault but that's how the system has been. I spoke about lazy banking at the bank economists' conference in December 2002. I wanted to draw their attention to the fact that times are different and they do need to strengthen their ability of risk assessment of their borrowers. Banks must find good borrowers on that basis and do the lending.
Have you changed your view on Indian bankers since then?
In the scenario of falling interest, one could also argue that the banks were doing appropriate profit maximisation. It was a strategy of buying government securities and booking treasury profits which subsequently used to reduce the net non-performing assets. In a sense, it's an appropriate, well thought out strategy for cleaning up the balance sheets.
The industrial growth was slow as industry was restructuring and therefore credit demand was also low. With the restructuring of firms, the debt equity ratio was changing with the share of debt coming down and therefore the demand for credit was going down.
Since the third quarter of 2002 we are seeing a consistent recovery of the industry. This is evident in exports data. There is resurgence of Indian manufacturing competitiveness.
We are observing that through higher exports, higher growth in capital goods industry and import of capital goods. So, very clearly, credit demand is growing, particularly from the last half of 2003-04. The incremental credit deposit ratio is 96 per cent in the first six months of the current financial year.
The market interest rates have gone up. Therefore, banks are adopting an appropriate strategy -- investing less in government securities and lending to corporates.
As a matter of policy, should the SLR level be brought down from 25 per cent?
Within the context of the Fiscal Responsibility and Budget Management Act, we have targets for fiscal deficit and a number of state governments are also trying to enact the Act. If that works out and we see a reduction in fiscal deficit over the next five years, then obviously something has to be done to reduce the SLR requirement.
Can the Indian banking system absorb the shock of rate hike?
We have stated that the system is resilient and the banks are in the process of learning to live with environmental changes where inflation and rates can go up and down. They need to improve their risk management practices. In a rising interest scenario, they have a greater incentive to lend and the interest income compensate the treasury losses. We don't see it as a serious threat.
What's the greatest concern for the Indian Banking industry?
There is not one concern. We have had a constant and gradual movement in financial sector reforms and seen encouraging results. Particularly in the last two years we have seen consistent improvement in most of the parameters -- be it NPAs or profit ratios. The commercial banks today are much stronger than what they were ten years ago. That's something unique in emerging markets -- something we can be justifiably proud of in terms of macro management.
Developments in debt market and foreign exchange market are also remarkable. India has probably exhibited the highest level of financial stability in the emerging markets.
Way forward, we have to continue this movement. Banks will have to improve the credit delivery system. In the context of Basel II, they have to particularly concentrate on risk management improvement as the emphasis will shift from micro management to systems management. That's a key challenge ahead of us -- both for the regulatory system as well as for the commercial banks.
As banks improve their risk management systems, the intermediation cost as well as potential NPAs will come down.
The debt market will have screen-based trading soon. If we succeed in the FRBM Act over the next five years, the government debt issuance in proportion basis will come down but if you consider the growth in the country on a nominal basis, it will roughly remain the same level.
As the credit demand grows, non-banks will play a greater role in the government securities market. The challenge is to make the debt market transparent and activation of trading on stock exchanges. We need this as the debt market becomes more broad based and more non-banks pick up gilts.
Another challenge is the issue of derivatives. We must bring in more participants in the derivatives market and we also need to make sure that it should not result in greater risk rather than reduction of risk.
As the state government market borrowings increase, we will have to make the state government papers more liquid. Most state government instruments are not very liquid now.
Have we reached a situation where hike in interest rates has started hurting growth?
We have stated in the monetary policy clearly that the objective is to provide "appropriate" liquidity for growth. Very clearly, that's what we want to do.
What interest cycle we are in?
That's a difficult thing to say. Internationally, many central banks have increased their policy rates but some have not. As of now, indications that rates are not going downward. In our case, the rates did not go down as fast as it happened globally...
Do we see a US like situation where the central bank ups rates in small doses at regular intervals?
The monetary policy statement has been very clear that has that been the case it would have stated that. Since this is not the case, it has not stated that. I really cannot add to that.
Is the Indian economy getting over heated?
It's very clear that since the third quarter of 2002, there has been a sustained industrial revival. In terms of numbers and data, what is very interesting is that the first five months' industrial growth estimate is 7.4 per cent. The April-August manufacturing growth has been 8 per cent.
Neither manufacturing growth of 8 per cent nor industrial growth of 7.4 per cent has taken place over the last so many year. The last time it happened was in 1995-96. At the same time, we will have to remember that for 15 years from late '70s and early '80s to mid-'90s we had an average industrial growth of 7-8 per cent. Incidentally, this was also the average in 1950s and 1965. So, this is nothing unusual. The economy is not overheated.
Why do we need so much of foreign exchange reserves?
Well, I think we had a pretty consistent policy on forex management. There is no change in that policy. The working group report on sterilisation also highlights the issues facing us in forex management.
There seems to be a difference of opinion between the finance ministry and the RBI on private bank ownership issue?
I don't think this perception is correct. Post nationalisation of the banking system until the early '90s you basically had public sector banks and foreign banks and some small private banks. There was no issue either on ownership or on governance. Now, with the entry and expansion of private sector banks we need to be more careful on governance and ownership.
Therefore, we need to have strategy because banks are special as they are trustees of public money and they have very high gearing ratio. It is very important to supervise these institutions carefully. We must ensure their ownership and governance.
We need to have the ownership diversified so that the dominant owner does not have the opportunity of playing with public deposit. The general view across the world is that the ownership should be diversified.
But even if you have a diversified ownership, corporate governance is not automatic. In fact, it's the other way round. When you have a diversified ownership, we need to have a sharper focus on corporate governance. We must ensure the fit and proper nature of both the owners as well as the managers of a bank.
The finance minister said the foreign banks will be allowed to take over private banks but RBI has a different view on that..
I think that the finance minister spoke about foreign banks. We had not made any comment on that.
We get a feeling that finance ministry and RBI do not agree on certain issues..
No, there is nothing of that sort
But there is a lack of consistency in RBI's policy vis-a-vis foreign banks...
Again, I don't see any lack of consistency. The finance minister wanted more competition among banks and all banks should get the same treatment. We also want that.
Does RBI have freedom? Doesn't the finance ministry decide on the interest rate movement?
You are contradicting yourself. Earlier you had said there are differences of opinion between the ministry and the RBI. If that's true, how can you say we don't have freedom?
How do you look back your stint at RBI?
I enjoyed it very much. I never made it a secret that monetary economist is not my forte and I had to learn a get a deal. One of the biggest joys in RBI is working with a very professional staff. They are disciplined and dedicated. We have a healthy practice of open discussions. I would have liked to complete my three year stint year.