Financing Growth, India Style
While most of Asia grew through financial repression, New Delhi is bucking the trend.
In the standard Asian growth playbook, governments stimulate exports, hold down the value of their currencies and repress the financial industry. East Asian tigers like Taiwan and Korea ensured that domestic savings were captive and then funneled them, at low interest rates, to export industries. Today China is doing much the same.
India is going its own way. Alone among Asian powerhouses, New Delhi often runs trade deficits, meaning it is developing a strong domestic market. In the last two years, the Reserve Bank of India hasn't targeted the exchange rate, so exporters must fend for themselves when the rupee rises. And far from keeping savings bottled up in low-yielding bank deposits, the central bank is trying to help domestic financial markets mature.
Earlier this month, the RBI changed how it conducts daily operations. Until recently, commercial banks could borrow easily from the central bank, as well as park their excess funds at it. This meant that banks could easily manage their liquidity troubles without going to the market. Now the RBI only allows banks to borrow from it, and only through a restricted facility, forcing money markets to develop.
Because these markets, which borrow and lend at short maturities, were barely needed, India lacks a full yield curve, the mainstay of developed-economy credit markets. Changes in overnight rates are an important indicator of credit conditions, especially when compared with long-term bonds. Similarly, the RBI last year introduced a market-oriented method for commercial banks to price loans.
These moves deserve praise, but there is a ways to go before Indian finance is truly market-driven. State-owned banks still make up 70% of the banking sector, while all banks are forced to hold 24% of their assets in government bonds. But instead of financing exports, as in East Asia, these forced savings go toward welfare spending.
As the main financial regulator, the RBI was slow to increase private competition and allow innovation over the last decade. On the brighter side, in the past two years the central bank has continued to liberalize India's capital account to allow savings to flow across borders, broken some ground in the corporate bond market, and battled to deregulate the interest rate on savings accounts that the government stubbornly keeps fixed.
Seen together, these developments put India in a different corner in the Asian macroeconomic field. In the East Asian policy reckoning, what matters most is mobilizing financial resources to push growth, and cost is no object. Yet the costs materialize sooner or later, for example, in high-speed train projects that get derailed or in property booms that go bust.
In contrast, India's regulators are paying more attention to the price of financial resources and the process of marshaling them. That leaves India less vulnerable to the risks of malinvestment and on sounder footing for a long boom.
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