Project on Indian Financial Market - Module: 4
Stability of Financial Sector
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Legal Infrastructure

Since 1993, efforts have been made to improve debt recovery by setting up special debt recovery tribunals. However, tribunals remain insufficient in number, in staffing and in other infrastructure. Progress in implementing debt recovery has also been constrained by several institutional impediments, especially the inadeqate legal system in place. The efforts to reduce NPAs would, to a large extent, depend on improving the legal infrastructure. The Expert Committee for Recommending Changes in the Legal Framework Concerning Banking System (Chairman: Shri T.R. Andhyarujina) had submitted its report to the Government in February 2000. The Committee had recommended, inter alia, the institution of a new law granting statutory power of possession and sale of security directly to banks and financial institutions and adoption of the draft Securitisation Bill. Efforts to improve debt recovery would need to be supplemented by efforts for improving credit assessment so that incremental NPAs are kept low. The proposed plan to set up Credit Information Bureau is, therefore, an important step in the efforts to reduce the sticky portfolios of financial institutions.

India is among the few countries, which has a long standing tradition of bank deposit insurance as a safety net. About 97 per cent of the deposits of scheduled commercial banks are fully protected, with the coverage amounting to over 70 per cent of the deposit amount. The extent of coverage under deposit insurance is seen to have remained more or less stable in terms of number of accounts. The insurance coverage, nevertheless, has registered some rise during the second half of the 1990s, albeit with some year-to-year fluctuations. Deposit insurance has a well-found rationale in economic theory and is viewed as a means to prevent banking panics in a financial market characterised by multiple equilibria. However, mere provision of deposit insurance is neither a necessary, nor a sufficient condition for ensuring financial stability. Deposit insurance poses moral hazard risks that could invite imprudent behaviour by bank managements or poor choices by depositors. Therefore, what is of greater importance is to ensure that deposit insurance is provided on efficient lines and does not guarantee complete insurance. Despite the low probability of banking failure in the Indian financial system with predominant presence of state-owned banks, the issue of reforming the deposit insurance system has been accorded importance. There is a certain amount of consensus that the principal objective of a deposit insurance system is to protect small depositors and to contribute to the stability of the financial system. The Reserve Bank constituted a Working Group (Chairman: Shri Jagdish Capoor) to examine the issue of deposit insurance which submitted its report in October 1999. Some of the major recommendations of the Group are:

1. fixing the capital of DICGC at Rs.500 crore, contributed fully by the Reserve Bank;

2. withdrawing the function of credit guarantee on loans from DICGC; and

3. risk-based pricing of the deposit insurance premium in lieu of the present flat rate system.

A new law in supersession of the existing enactment is required to be passed in order to implement the new recommendations. The task of preparing the new draft law has been taken up. The relevant proposals would be forwarded to the Government for consideration.

Macroeconomic stability and financial stability reinforce each other. Therefore, macroeconomic co-ordination that ensures macroeconomic and financial stability is an important consideration in framing monetary and fiscal policies. This has become even more important with the fiscal reforms and emergence of a more liberalised financial system. There are several possible dimensions for co-ordinated response. At core of this is the persistence of fiscal imbalances that have placed burden on fiscal sustainability, with implications for financial stability.

The Government budget and the way it is financed impacts interest rates as well as inflation in the economy. Fiscal discipline is, therefore, important for financial market stability. The general trend observed in the budgetary performance of the Central Government is that, final account data, by and large, do not adhere to their original targets. Consequently, the fiscal deficit, more often than not, turns out to be far higher than the anticipated level. For instance, during 1992-99, on an average, the gross fiscal deficit in the final account, turned out to be higher by 22.4 per cent than the original budget estimates. On the receipt side, both tax revenue and total revenue receipts experienced shortfalls in the final accounts as compared to the budget estimates. This shortfall ranged between 2.1-12.6 per cent in respect of total revenue and 2.5-10.7 per cent in the case of tax revenue. As regards expenditure, the trend observed was that both revenue expenditure and aggregate expenditure exceeded the budget targets; the rise was to the extent of 2.6 to 6.2 per cent for revenue expenditure and 3.0 per cent to 8.0 per cent in respect of aggregate expenditure. While the magnitude of the impact of fiscal deficit on interest rates and inflation depends upon the size of the fiscal deficit, overruns in government deficits have adverse macroeconomic impacts. A high and growing stock of public debt, which has implications for the sustainability of the fiscal situation, puts pressure on the absorptive capacity of the market and, thus, fuels interest rate expectations. In the Indian case, it is empirically found that despite the stability in the market debt, the overall fiscal situation is precarious because of potential instability in the non-market debt and due to large unfunded liabilities of the Central and State governments.

A readjustment in the maturity structure of Government debt has taken place after reforms. The share of short-term maturity bonds (i.e., under five years) in total outstanding dated securities has recorded a sharp increase from 8.6 per cent to 41.0 per cent between 1991 and 1998. On the contrary, share of long-term bonds (i.e.,over ten years) declined rapidly to 18.2 per cent in 1998 from 85.8 per cent in 1991. Shortening of maturities, however, led to some bunching of redemption of securities and the need for frequent rollovers from the market. The repayment profile witnessed steep humps in the medium-term on account of shortening of the average maturity of fresh issues of dated securities to 5.5 years in 1996-97 from 18.6 years in 1991-92. In order to impart stability to the maturity profile of internal debt, debt management operations were re-oriented towards transforming the maturity structure to longer-term. As a result, the average maturity of dated securities steadily rose to 12.6 years in 1999-2000.

The fluctuations in maturity profiles and the yield curve have attracted attention for improving treasury management skills to cope with interest rate risks. Until recently, investors in the securities market were willing to take interest rate risks by locking themselves into long maturities, on the ground that their incomes would be higher if they invested at the longer end of the spectrum without giving due cognisance to risks of depreciation4 . With the market orientation of interest rates, investors are required to make provisions for depreciation in their portfolio. Increased focus on asset-liability management, therefore, assumes importance. The Reserve Bank has taken several steps and provided guidelines to help market participants to initiate prudent trading activities that add to the strength and stability of the financial system.

Apart from debt accumulation, the growing size of guarantees extended by the Government affects public sector balance sheets and impacts the fiscal position. In the case of State governments, under a market-oriented borrowing system, the higher amount of guarantees without proper risk assessment has the potential of raising the risk premium on their bonds. As part of the effort for improved fiscal discipline, the outstanding guarantees for the Central Government has been brought down from 7.8 per cent of GDP as at end-March 1993 to 4.2 per cent as at end-March 1999. Such guarantees for the Centre and States (combined) also declined from 13.9 per cent as at end-March 1992 to 8.9 per cent of GDP as at end-March 1999. The reduction of such contingent liabilities has been lower in case of State governments.

In view of the budgetary imbalances, the imbalances on account of quasi-fiscal activities and the need to contain explicit and implicit Government guarantees, an institutional mechanism to support fiscal restraint would be useful. The Central Government and the Reserve Bank have been closely co-ordinating in this respect. In the Union Budget for 2000-01, the Government announced its intent to bring about Fiscal Responsibility Legislation (Box VI.6).

The Fiscal Responsibility and Budget Management Bill, 2000 was introduced in Parliament in December 2000. The Bill provides for the responsibility of the Central Government to ensure inter-generational equity in fiscal management and long-term macro-economic stability by achieving sufficient revenue surplus, eliminating fiscal deficit and removing fiscal impediments in the effective conduct of monetary policy. It also provides for prudential debt management consistent with fiscal sustainability through limits on the Central Government borrowings, debt and deficits, greater transparency in fiscal operations of the Central Government and conducting fiscal policy in a medium-term framework and for matters connected therewith or incidental thereto. The salient features of the Bill, inter alia, include laying the Medium-term Fiscal Policy Statement, Fiscal Policy Strategy Statement and Macroeconomic Framework Statement by the Central Government before the Parliament, along with the annual budget; elimination of the revenue deficit by March 31, 2006 and bringing down the fiscal deficit to 2 per cent of GDP in the same period; and prohibition of direct borrowings by the Central Government from the Reserve Bank after three years except by way of advances to meet temporary cash needs in certain circumstances.

Developing countries typically run current account deficits (CAD) to supplement their domestic savings to achieve higher levels of investment and growth without cutting their current consumption. In the borrowing countries, the accumulated current account deficits result in external debt and other liabilities that need to be serviced out of the country's current earnings. This raises the question of a sustainable level of external debt. India is classified as a less indebted country by the present value-GNP criterion and a moderately indebted country by the present value-exports criterion by the Global Development Finance.

Measured in terms of conventional indicators of external debt sustainability, India's external debt position has undergone significant consolidation during the 'nineties as a part of the overall approach to external sector management. First, the current account deficit has been kept within sustainable limits, with the CAD/ GDP ratio averaging at around 1 per cent since 1991-92 in contrast to an average of 2 per cent during the 'eighties. Secondly, as a result of a distinct shift in the policy framework in favour of equity as against debt in capital inflows, non-debt creating inflows have increased from a mere 1 per cent of total capital flows in 1990-91 to more than 50 per cent of the capital inflows. Thirdly, a transparent policy on external commercial borrowings with the stated objectives of prudent debt management has helped to consolidate India's external debt. The policy aims at lengthening of maturity while keeping a ceiling on approvals. Restrictions on end-use in the form of investments in stock markets/real estate have helped to avoid the pitfalls associated with unbridled external flows. Fourthly, in the case of non-resident deposits, withdrawal of exchange guarantees, alignment of interest rates with international rates, a minimum maturity prescription of 12 months in the case of foreign currency denominated deposits and promotion of non-repatriable deposits helped in consolidating non-resident deposits and making them a stable source of external funding. Fifthly, short-term debt flows have been tightly monitored and are permitted only for trade related purposes given their volatility and the possibility of their non-renewal in times of crisis. Sixthly, the exchange rate policy, which has been market determined, helped in avoiding the excessive risk-taking that occurred in some of the South-East Asian countries that followed a policy of either a fixed exchange rate or a predictable exchange rate regime. Finally, since debt servicing has ultimately to be funded out of current earnings, the policy efforts have been aimed at achieving a commensurate growth in current receipts. It may be noted that in line with the current trend in the liability management, the Central Government has set up a high level steering committee and a technical group to work out the modalities for more active sovereign external liability management in India. The Group in collaboration with the World Bank is developing a risk management model for sovereign external liability management in India.