Measuring the exact value of money

Often it is said that money value is declining, but we have yet to find any statistical report over it. The Reserve Bank of India (RBI) as monetary regulator in India monitors different monetary ratios like 1) GDP/Broad Money, 2) GDP/Narrow Money and 3) GDP/Currency with public etc. to evaluate the impact of money on income velocity. But still after 75 years of monetary regulations, RBI is not in a position to tell us exact figure of decline in money value because its approach misses some important factors like growth of credit and accrued interest etc. in broad and narrow money. Actually RBI does not use the concept of gross and net liquidity to measure the value of money at a given point of time.  

 

The value of all commodities and services could be measured in terms of money, but money cannot be measured through itself. Since money is used to measure and exchange the goods and services produced in any economy, it is better to evaluate money value in proportion of Gross Domestic Products (GDP). The value of GDP at Market Prices in proportion of Broad Money may reveal lowest value of Money whereas Value of GDP at Market Prices in proportion to currency with the public reveals the highest money value. It would be confusing to denote different money value at a time, so it is desirable to find actual money value at a given point of time.  

 

Considerably it is the liquid of money which allows economic transaction in any economy. Since the actual liquidity in the market differs from Narrow Money (M₁) and Broad Money (M₃), we need to evaluate actual liquidity in the market which enables sale of GDP at market prices. So, it is better to compare the components of M₁ and M₃ with respect to actual liquidity. Only then we would be able to understand what RBI is missing to evaluate the actual money value.

 

The Narrow Money (M₁) constitutes of three factors a) Currency with the public, b) Deposits (other than Banker’s deposits) with RBI and c) Demand Deposits; whereas the Broad Money (M₃) is equal to Narrow money plus Time Deposits. Since Time deposits pull liquidity from the market and discourages economic transactions, RBI in general considers Narrow Money as total liquidity in the market.

But there are other factors considerably increasing the liquidity in the market which are not considered by RBI in calculating Narrow or Broad Money. The first is Bank Credits which as proportion to Narrow Money has increased by 194.41% during 59 years (from 27.07% in 1950-51 to 221.48% in 2008-09). Similarly bank credit as percentage of GDP at Market Prices has increased by 46.73% during this period, as it was just 5.42% in 1950-51 which increased to 52.15% in 2008-09.

The second factor is the accrued interest over Time Deposits which may be used by the depositors periodically or after maturity. Considerably annual interest on Time deposits as percentage of Narrow Money was just 0.98% in 1950-51 which was found 22.41% in 2008-09. This as percentage of GDP at Market Prices has also increased by 5.08% during 59 years (from 0.20% in 1950-51 to 5.28% in 2008-09). Thus bank credits and interest on time deposits when added to narrow money increases gross and net liquidity above and above the narrow and broad money in the economy.

So if we really want to evaluate actual liquidity in the market, we need to add these two components into the narrow money. To know about net liquidity in the market we have to add Bank Credits into Narrow Money and to get gross liquidity, we have to add accrued interest on time deposits into net liquidity.

The amount of Gross and Net liquidity reflects the gross and net purchasing capacity of consumers. So, to evaluate the exact money value at a given point of time, we need to divide the value of GDP at Market Prices with Gross Liquidity or Net liquidity. The outcome will be actual value of money. After analyzing the available data for last 59 years (1950-51 to 2008-09), we have found that the value of money declines considerably if we divide GDP at Market Prices with Gross Liquidity, or Net Liquidity or even with Broad Money. This decline moderates if we divide GDP at Market Prices with Narrow money. Contrary to these evaluations, if we divide GDP at Market with Currency with public, the value of money is found to be increasing. Who will accept this analysis that value of money has increased during 1950-51 to 2008-09? Better we should consider the value derived by dividing GDP at Market Prices with Gross Liquidity as real value of money which has considerably declined by 2.66 points (from 3.9 points in 1950-51 to 1.2 points in 2008-09).

 

If we use this mechanism of evaluating the currency value, we may go on evaluating currencies of different countries. The respective points of currencies in different countries may allow us fix actual rate of currency exchange instead of taking purchasing power parity, SDR or US Dollars as base to calculate currency exchange rates. The value of currency in different countries by dividing their GDP with their gross liquidity may help us evaluate exact currency value of different countries, which may be compared among nations to fix exchange rate of currencies at international level. Let’s hope the monetary regulators at international level will start behaving rationally and do justice in protecting values of their currencies and adopt fair currency exchange rates for different countries.

Interest, Inflation and Money Value

The approach of Reserve Bank of India (RBI) to use ‘interest rate’ as tool to keep inflation under control should be reviewed because interest has not only helped regulating liquidity, but has considerably accumulated Time Deposits and Broad Money in proportion to Gross Domestic Products (GDP) during last 59 years which ultimately cost for sheer loss in money value. The coins of 1 to 20 paise and notes of 1 and 2 rupee are out of circulation in the market. Today 5 rupees coin is used for a purchase which was possible for 50 paise earlier (say in 1970s). So, we may need to use coin of 50 rupees to get a product in 2010’s we had been purchasing for 50 paise in 1970s. How long we will keep minting coins of high denomination to counter the inflation and loss in money value? A day will come when people will not keep hundred rupee notes in their purses and we have to mint currencies in denominations of millions only.

Since inflation is blamed for loss in purchasing power of money it is important to understand how inflation deteriorates the purchasing power of money? Inflation is simply meant for increase in prices of goods and services without any improvement in their quality. Prices of goods and services increases either due to increased money supply without any addition in stocks of goods and services; or due to short of supply (goods and services) as compared to demand. In both cases, the buyers intend to pay more for same grade of goods and services, thus money loss its purchasing power.

Since money is not a sellable commodity but a source to measure prices of all goods and services, it is easy to find inflation rate but difficult to measure fall in money value. Though money is considered as capital, there is no system of calculating depreciation of money like other capitals. Considering the fact that the purchasing power of money deteriorates if proportion of total money stock with that of GDP increases, we can measure the decline in money value if we calculate the difference in proportion of money to that of GDP at Market prices. Thus we may say that money value in India has fallen by 3.17 points (from 3.29 points in 1950-51 to 0.12 points in 2008-09) in 59 years.

Data Source: – Handbook of Statistics on the Indian Economy 2008-09 by RBI

RBI failed to protect the money value. The broad money as percentage to GDP at market prices has increased multifold (from 23.32% in year 1950-51 to 89.52% in 2008-09). This increase in broad money in proportion to GDP is due to increase in share of time deposits in Broad Money from 14.07% in 1950-51 to 73.69% in 2008-09. Considerably almost half (47%) of Time deposits (Rs. 35,10,385 Crores) in 2008-09 is equal to total paid interest (Rs. 16,48,822 Crores) over time deposits during 1950-51 to 2008-09. Once interest is accrued into time deposit, it cannot be separated from broad money which ultimately increases. People hold and spend more money to buy same goods and services if GDP increases lesser than the ratio interest is accrued into the monetary system. It leads to sheer devaluation of money.

Data Source: – Handbook of Statistics on the Indian Economy 2008-09 by RBI

While it is argued that interest compensates the loss in money value due to inflation; it is prudent that interest further inflates the economy by deteriorating the money value instead of compensating loss in money value. Considering the minimum rate of interest payable in different years, at least Rs. 16,48,822 crores has been paid as interest over Time Deposits during 1950-51 to 2008-09. This amounts about half (47%) of outstanding Total Time Deposits in 2008-09. Similarly the interest received against bank credits during this period was Rs. 18,43,154 which is 38.69% of Broad money in 2008-09. The total interest paid on Time Deposits and interest received against Bank Credits is about 73.30% of Broad Money in 2008-09. Since accrued interest on deposits increases the stock of money in the economy, the broad money in proportion to GDP increases and the difference in GDP and Broad money as percentage to broad money declines. It leads to cause inflation and fall in purchasing power of money.

Data Source: – Handbook of Statistics on the Indian Economy 2008-09 by RBI

The percentage share of interest over time deposits to GDP has increased from 0.20% in 1950-51 to 5.00% in 2008-09. Only interest on time deposits has increased the market prices by 5% in 2008-09, whose impact was negligible in 1950-51. The total interest as percentage to GDP has increased from 0.58% to 10.75%. Similarly Total interest as percentage to broad money has increased from 2.47% in 1950-51 to 12.64% in 2008-09. Monetary policy to regulate money supply should be based on estimates of national income and expenditure. It is required that the RBI should regulate money supply according to growth in national income and expenditure instead of wish to keep inflation at desired rate and to achieve targeted saving and credit growth rates. Since major inflationary factors are disbursement of interest over deposits, rigid policies to regulate supply of commodities, fiscal deficits and debt finances we need sound monetary policy considering all these aspects while regulating money supply. Otherwise the actual rate of inflation may vary from the estimated rate of inflation based on projecting the growth in price indices in wholesale and retail markets.

While the rigid supply policies of agricultural produces create shortage of supply in the market, interest on deposits increases the supply of money, empowering the purchasing powers of potential buyers and ultimately increasing the price levels. Interest inflates the economy by two ways. Interest over credits is charged before the output is sold in the market, so the cost of credit increases the price of the output. On the other hand, since depositors get interest over deposits irrespective of sale of produced goods and services in the market, it inflates the price levels with empowered purchasing powers of potential buyers. So interest has both demand and supply side effect on inflation.

RBI can’t protect the economy from inflation as it failed to protect the value of currency minted by her? RBI can’t regulate supply policy of essential goods which is creating shortage of essential items in the market, thus inflating their prices. RBI is supposed to just regulate the banks according to the Banking Regulation Act 1949, which compels the banks to give interest on deposits and charge interest over credits. Since 1951 the value of interest money in India is more than 73.30% of Broad Money in 2008-09. Just to induce bank deposits or arranging debt finance, we are inviting inflation and losing the purchasing power of money. If no bank will offer interest on deposits, would all customers withdraw their deposits? Don’t people feel safety of funds in banks? Does interest is only means to induce depositors? There had been a time when there were hardly any avenues for non debt investments, but now after globalization and liberalization there are many other alternatives to induce potential depositors. Growing business of equity based investments may induce the banks to start small level equity based banking to finance small enterprises working in agriculture and industry sector.

If we want anti inflationary economic growth, besides adopting a banking mechanism where money can’t be accumulated unless the existing money stock acts to add value in output of goods and services, we have to review and change the regulatory policies on supply of essential commodities. All public finances should be made through either revenue receipts or by equity finances. Then we would be able to avert inflation, otherwise money will loose its purchasing power. RBI should not be just conscious about stability in the rate of inflation by adjusting the interest rate, but should aim to protect the money value by restricting the growth of money within GDP growth rate.

To get anti inflationary monetary system we may need to amend our Banking Regulation Act 1949 and stop making debt financing. RBI can’t allow interest-free banking unless the banking regulation act 1949 gets amended by the Parliament. Hope RBI will suggest the government that inflation is caused due to strict supply policies and interest based banking, and it can’t be restored through interest itself, therefore the Government besides relaxing regulatory policy on essential commodities should amend the banking regulation act 1949 to permit interest free (equity based) or participatory banking in India and issue non debt securities to meet deficit finance. It is just possible to do equity business of smaller level through banks and market equity based securities and corporate bonds through stock markets so that both the markets have their own set of clientele. Had India made the required changes earlier; we would have saved our economy from inflation and sheer loss in purchasing power of money.

Islamic Banking windows in India

Despite regulatory hurdles, it is very much possible for Indian banks dealing in para banking to run Islamic Banking Windows in India. Such windows may be just opened through adding any counter or specific desk to cater needs of customers seeking Shari’ah Complaint banking. Under present banking regulations, following may be found ready to cater as Shari’ah Compliant products and services at Islamic Banking windows. 

A. Deposit Side Products & Services

1. Current Account.
2. Internet Banking services for receiving, disbursing and transferring funds.
3. Online Trading Services
4. Safe Deposit Locker Services
5. Mutual Fund Deposits (With floating and fixed maturity).
6. Consultancy Services (On Commission basis) to customers seeking Shari’ah Complaint Investments in Mutual Funds.
7. Consultancy Services (On Commission basis) to customers seeking Shari’ah Complaint Investments in Equities / preferred Shares.
8. Resident Foreign Currency Account (For NRI’s returning home)
9. Foreign Currency Non Resident Deposits (For NRI’s)
10. Equity Deposits ( conditions prescribed in contract for bank as trustee of any company)  

B. Lending and Investment Side Products & Services

1. Leasing Finance business
2. Hire purchase business
3. Factoring services
4. Disbursement of corporate benefits services
5. FOREX Services
6. E-Freight Services
7. E Tax services
8. Retail Sale of Gold Coins
9. Foreign Inward Remittance Services
10. Gift Cheques Services
11. Gift Card Services
12. Pay Roll Card Services
13. Foreign Travel Card Services
14. Initial Public offer Services
15. Mutual Fund Business
16. Letter of Credits
17. ATM Services
18. Issuance of Bank drafts
19. Issuing bank guarantee in favour of customers
20. Broking services 

Though these products and services are already available with many banks, general public don’t have the understanding that these are Shari’ah Complaint. Thus ignorance prevails in the market both for the potential customers and the bankers. Any bank may just declare to open Islamic Banking window with such products and services and successfully catch attention of customers seeking Shari’ah Complaint banking in India. If any bank is having Islamic Banking windows in India and abroad, such bank will have edge over others to draw investment funds for India by assuring the investors that investment will be suitably placed in India through proper Shari’ah complaint linkages to the end level in India as well. 

The State Bank of India (SBI) with its widest network and largest asset base may take lead in attracting customers looking for Shari’ah based banking services. Even if other banks take due leads, the rich experiences of SBI in dealing with para banking activities will help optimizing the opportunity faster than other banks. For Islamic banking at international level, Indian banks may have stiff competitions from foreign banks, but in national market there is no competition as such because at present no bank is offering such services. The bank which makes first announcement may take the lead in accruing the untapped market of Islamic Finance in India and others would have to follow that bank. 

SBI is already having a subsidiary called SBICAP Trustee Company Ltd. (STCL) to work as a trustee for companies. It empowers SBI to raise deposits and deploy funds in prescribed trade / industry on specified conditions in accordance to customer’s need. So, it may not be difficult for SBI to cater the customer’s need looking for Shari’ah Complaint financial products and services. With long and varied expertise in commercial and investment banking, SBI is in a good position to innovate financial products to meet new challenges.   

It would be easy for the first bank to accrue the untapped market by making Islamic Cooperative Credit Societies and NBFCs as their Business Correspondents to promote such products in Indian market. Once a bank enrolls such Indian Islamic Financial institutions of India (IIFIs) as their Business Correspondent, it would be difficult for other banks to find customers for their Shari’ah Compliant products. Traditionally the customers seeking Shari’ah Compliant financial products and services have been served by these IIFIs only and it would not be easy for new banks to get new customers for Islamic banking windows unless it has any IIFI as its registered Banking Correspondent. 

To start any Islamic banking windows in India a bank just need to have services of Shari’ah Advisory Board who may take care of all needs related to opening up and development of Islamic banking windows in India. This board may finalize the products; identify the potential market and channels to promote this business. Banks just need to make an announcement of going for Islamic Banking windows in India, the due resources will follow on. 

Hope we will be soon observing some changes in nature and extent of Islamic financial business in India. Expectedly after launch of Islamic banking windows in India by any bank, there would be competition among other banks declaring their specific products as more Shari’ah complaint. The one who better care to handle their customers will be having better market share of Islamic banking windows in India. Besides SBI, the other runners in this course are Standard Chartered Bank, HSBC, and Development Credit Bank etc. Some more names may be counted soon after first official announcement by any bank. Though today, there is no declaration about Islamic banking windows in India; in near future we expect to see series of advertisements for Islamic Banking windows in Electronic and Print Media especially Urdu media catching our attentions.

Multi-Sectoral Development Plans And Indian Muslims

By 23^rd July 2009, the Ministry of Minority Affairs has received proposals from 73 Minority Concentration Districts (MCD) under the Multi Sectoral Development Programme (MsDP). The plans of 59 districts have been approved. Rs. 388.66 crore has been released for 44 districts to the States / Union Territory concerned for implementation of various proposals approved for these districts.  Considerably Indian Muslims are 69% of national minority population, but their share in selected 90 MCD for MsDP is just 30%. Is it anyway possible to achieve multi sectoral development unless we develop financial and social infrastructure for the community? 

As there is a perception that the MsDP is an outcome of the recommendations made by the Sachar Committee to reduce the infrastructure deficits in Muslim concentrated districts; and because the allotted budget for MsDP is more than 50% (Rs. 889.5 crores out of Rs. 1,756 crores) in Ministry of Minority Affair’s annual budget for 2009-10,  it is important to analyze the prospects of MsDP in improving the infrastructure facilities for minorities who constitute 19.47% of total population. 

After analyzing the set programme and guidelines for preparation of MsDP for Minority Concentration Districts it is observed that 15 states and UTs are completely excluded from the MsDP for minorities. 

The new list of selected 90 districts for MsDP covers just 37.90% Indian Muslims population. As much as 62.10% of Indian Muslims are completely deprived of MsDP because they don’t live in these districts. Only 29.25% Muslims living in rural areas of these districts are actually expected to get benefits of this MsDP because the plan aims to focus on rural and semi urban areas only. Though Indian Muslims share 69% in national minority population, they are just 30.38% of the total population in 90 districts selected for MsDP. 

The selection criteria of districts may not be justified as it just counts literacy rate and work population ratio as parameters for socio – economic indicators and does not cover the parameters like per capita income or expenditure. There is lack of any standard index to evaluate the socio – economic status of selected districts. While the focus is upon creating physical infrastructure to improve linkages for economic opportunities, the important concepts of social and financial infrastructures are completely missing in the whole plan document. The optimal utilization of physical infrastructure and human resources if created through MsDP could not be optimized unless we include programs for improving the social and financial infrastructure of these selected 90 districts. 

The Sachar Committee report has specifically made following recommendations about improving infrastructure in Muslim concentrated districts. 

“While the number of service providers from the non-governmental organizations is on the rise, public provision of infrastructure remains critical and desirable. Sensitivity to the issues of different SRCs is very important to the delivery of services such as primary education, health, etc. Service providers face a number of difficulties in reaching out to the Muslim community for various reasons, ranging from a sheer lack of understanding of issues particular to the Community to lack of Muslim presence in the organization and a sense of suspicion which the Community may have towards them. It is alleged that in many situations, the service providers have inherent biases and show resistance to reach out to the Community. To correct this situation the committee suggested following measures –  

• Credible NGOs, with necessary expertise, from the Muslim community are few and far between. These institutions, being closer to the community can indeed play an important role as intermediaries between policy programmes announced by the government and their beneficiaries within the Muslim community. Besides, there is need to encourage the setting up of civil society organizations from amongst the Muslim community as well. But once again, the reach of such organizations is going to be very limited and the responsibility of the State in providing basic health and other infrastructure facilities remains the main hope of all poor, including Muslims.
• Partnerships between the government, the community and the private sector may be quite useful to deal with problems faced by the Muslims. “ 

Though the set programme and guidelines for preparation of MsDP for Minority Concentration Districts has well mentioned that “the peoples’ participation and involvement of PRIs, NGOs and Self Help Groups should be ensured at every stage including plan formulation, implementation and monitoring”; there is no guidelines about empowering the NGOs through knowledge, training and capacity building. Without adequate investments in social resources to create better social infrastructure, the scope of utilizing physical infrastructure for betterment is not possible because unless social resources get refined, the human assets cannot capitalize the physical infrastructure. The role of NGOs and civil societies cannot be negated in socio – economic transition of any community. 

Banking facilities are inversely correlated to the proportion of the Muslim population. The Sachar Committee has emphatically mentioned that – 

“Lack of access to credit is a more serious problem for the Community as a significantly larger proportion of workers are engaged in self-employment, especially home-based work. Therefore, non availability of credit can have far-reaching implications for the socio-economic and educational status of the Community. “ 

Though the Sachar Committee had mentioned that Indian Muslims lack access to the credit system, it did not state that 29% credit loss to them is one of the main reasons for their economic backwardness. The high level committee as constituted by the Planning commission of India for Financial Sector Reforms under the chairmanship of Prof. Raghuram Rajan has in fact noticed that lack of financial infrastructure for interest free banking and finance is an important factor for financial inclusion of Indian Muslims and thus made following significant recommendation.   

“Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region.  

While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.”   

No one can assure any success in targeted economic growth if the economy lacks required financial infrastructure. For inclusive growth in India, there is an urgent need to arrest the financial exclusion of Indian Muslims by creating required financial infrastructure for interest free banking and finance. It would not only help us yield foster and inclusive growth, but also allow us mobilize huge investment funds for physical infrastructure without increasing the fiscal deficits. 

If we really wish to see the MsDP a successful plan to remove the infrastructure deficits for Indian Muslims in minority concentrated districts, we need to consider the following facts under the MsDP. 

1. The selection of the districts should be based on standard index for socio – economic indicators like Per capita income and per head asset or agricultural land per household etc.
2. Potential Muslim NGOs should be identified and empowered through knowledge, training and capacity building so as to enable them interact with district planning committees in formulizing and execution of the MsDP in selected 90 districts.
3. Creating financial infrastructure for interest free banking and finance so as to ensure financial inclusion of Indian Muslims for inclusive growth.  

The nation cannot attain sustainable inclusive growth unless the due regulatory and policy initiatives are taken to allow Indian minorities grow naturally, not artificially by means of subsidies, grants and reservation in almost every aspect of life. To allow natural growth it is more important to remove the regulatory hurdles for development instead of providing aids, grants and subsidies as supplements. After 62 years of Independence we should now phase out the practice of Subsidizing because it does not lead to natural growth rather paralyses the entrepreneurship spirits. 

It is expected that the Programme and guidelines for preparation of MsDP for the Minorities will be reviewed with an object to improve the potential of the programme in bridging the development deficits of Indian Muslims in Minority Concentrated Districts.

CDS Derivatives cannot mitigate financial risks

Systematic risks are associated with every financial transaction, whether it is debt based credits or equity based finances. The practice of covering such risks through Credit Default Swaps (CDS) derivatives failed to mitigate risks at a time when market collapsed due to large scale default swaps; rather it has intensified the financial crisis.

 

After global financial crisis the 55,000 billon $ CDS market has been found as completely unregulated and lacking in transparency. AIG the world’s biggest underwriter of credit protection failed to deliver protection in time. The settlement auction on Lehman CDS contracts was a bombshell. Creditors got just nine cents on a dollar from the Lehman wreckage. Perversely the insured volume is greater than the $150bn total of Lehman debt.

 

Risks cannot be covered by additional risks. If the bank needs protection to mitigate credit risk, it cannot be protected through CDS derivatives because there is a risk that the insurance company may also fail to protect the risks in case of a large scale defaults. It should be noted that even sometimes the credit rating agencies could also be interested in taking undue advantages of such default swaps. In fact the risks for defaults of credits are shifted upon insurance companies who also need protection through CDS derivatives and; when Swap starts from one point, it starts shifting to other points causing failure of all interlinked end points due to process of shifting the risks instead of sharing it.

 

The better way to mitigate financial risks is to share it instead of shifting it on others. Islamic banking and financial instruments tend to share risks instead of shifting it, thus the inter-connected chain reaction in case of huge defaults does not occur. Under Islamic banking and finance, the risks associated with products are shared by the investors and need not be shifted upon others. In case of any loss, that loss is meant for the investors and not for institutions or manager. It thus insulates the financial sector from multiplier effects of any financial loss if the systematic risks under equity finance were managed properly.

 

The working group’s report on ‘Introduction of Credit Derivatives in India’ was submitted to RBI by Shri B. Mahapatra in March 2003. By that time hardly anyone could have visualized that companies like AIG will ever fail. So, that report has not answered the question that what will happen if the Association of the Default Protection Sellers fails to stand as guarantor. Who can guarantee that the International Swaps and Derivatives Association, Inc. (ISDA) will never fail in providing security against any huge defaults by leading default protection sellers? If company like AIG could fail, who will provide security if the Default Protection Sellers in India fail to perform? RBI should think thrice before allowing CDS derivative business in India, because if US economy with a much larger market of CDS derivatives fell into one of its toughest financial crisis and witnessing negative growth rate, how could we feel India safer after growth of sophisticated CDS market.

 

After global financial crisis, the need of mitigating credit risks by the Indian banks and insurance companies has intensified. But since the system of shifting risks through CDS derivatives has failed, its time to adopt instruments for sharing financial risks instead of shifting the risks through CDS derivatives. Our banks have been so far safer from global financial crisis not only due nationalization, but also for avoiding CDS derivatives. In fact CDS derivatives are like paper umbrella that let the banks feel paper security, but fails when swaps start raining heavily.

Islamic Finance to Reduce Fiscal Deficit in India

At a time when economic recovery needs more stimuli by the Government of India (GoI), there is also an urgent need to safeguard the economy from the debt trap because the GDP growth rate fell to 6.7% in 2008-09 against 9% in 2007-08; the debt servicing reached to 58.83% of the total expenditure for the year 2008-09. It means maximum receipts are now spent for debt servicing which accounted to 15.87% of the Gross Domestic Product (GDP), while the debt receipts were 9.78% of the GDP in 2008-09. Even the interest payments were 21.39% of the total expenditures by GoI and 5.77% of the GDP in 2008-09. Notably the revenue deficit in 2008-09 is already 30% due to high debt serving ratio to total revenue expenditure.

In an attempt to find the actual reasons behind high fiscal deficit, it is observed that the increased debt receipts by GoI to finance revenue expenditures (especially high debt servicing); increased subsidies on food, fuel and fertilizer; and rural development through schemes like NREGS, farmer’s loan waiving scheme and Sarva Shiksha Abhiyan are the three most important factor of high fiscal deficit. Since there is need of more stimuli to counter recession in the economy, it is expected that the plan expenditures may further increase whereas due to recession, the revenue receipts may decline. This decrease in revenue receipts and increase in plan expenditure may increase the fiscal deficit to an unwanted level high. Working upon different options to reduce the fiscal deficit, it is found that Islamic finance can reduce the fiscal deficit even though if revenue receipts declines and plan expenditures increases.

Islamic financial products has a great role to play in reducing the fiscal deficit in emerging economies by replacing the debt based investments for infrastructure with funds mobilized through equity based Government Securities for infrastructure projects. Let’s see how Islamic finance may help us reduce our present fiscal deficit.

Revised Estimates as presented in Interim Budget for 2009-10

Income Expenditure Estimates for Union Budget	2008-09 R. E. (in Rs. Crores)
Gross Tax Revenue	627,949
Net Tax Revenue	465,970
Total Non-Tax Revenue	96,203
4.      Total Revenue Receipts	562,173
Non-debt Receipts	12,265
6.      Debt Receipts to finance Fiscal Deficit	326,515
Market Loans	261,972
Market loan as % of total debt receipt	80.23%
Debt receipts as % of total receipts	36.24%
Debt receipts as % of total capital receipts	96.38%
Total Capital Receipts	338,780
8.      Total Receipts	900,953
Total Revenue Non-Plan Expenditure	561,790
10. Total Capital Non-Plan Expenditure	56,206
11. Total Non-Plan Expenditure	617,996
12. Total-Revenue Plan Expenditure	241,656
13. Total Capital Plan Expenditure	41,301
14. Total – Plan Expenditure	282,957
Total Revenue Expenditures	803,446
Total Capital Expenditures	97,507
15. Total Budget Support for Central Plan	204,128
16. Total Central Assistance for State & UT Plans	78,829
17. Total Expenditure*	900,953
DEBT SERVICING
18. Repayment of debt**	337,316
19. Total Interest Payments	192,694
20. Total debt servicing (18+19)	530,010
21. Interest Payments as Percentage to Revenue Receipts	34.30%
22. Total Debt servicing as Percentage to Revenue Receipts	94.28%
23. Non Debt receipt as % of total receipts	1.36%
24. Debt receipts as % of total receipts	36.24%
Interest payment on debts as % of total Expenditure	21.39%
Debt Servicing as % of total Expenditure	58.83%
25. Interest Payments as Percentage to Total Receipts	21.39%
26. Repayment of Debts as Percentage to Total Receipts	37.44%
27. Repayment of Debt as % to GDP	10.10%
28. Interest payment as % to GDP	5.77%
29. Total Debt Servicing as % to GDP	15.87%

* Excludes expenditure matched by receipts (Details in Annex-2 to Expenditure Budget, Volume-1, 2009-2010)

** Excludes discharge of 91 days, 182 days & 14 days intermediate Treasury bills, discharge of Ways & Means  Advances including overdraft, income and expenditure of National Small Savings Fund (NSSF), investments of NSSF, Reserve Funds and Deposits not bearing interest and suspense transactions. Discharge under MSS met from the sequestered cash balances is not included.

Data source: http://indiabudget.nic.in/

Notably the total revenue expenditure is 142.92% of total revenue receipts reflecting 30.03% revenue deficits. Major cause of this high revenue deficit is high debt service ratio to total revenue expenditures. For a developing economy like India, in the proposed plan we project increasing capital expenditures, but in revised estimates of 2008-09 budget, the revenue expenditure is 89% and capital expenditure is just 11% of total expenditure; all due to high debt servicing ratio (66%) to total revenue expenditure. Notably the interest payment alone is 24% of total revenue expenditures. So, with capital expenditure being as low as just 11% of total expenditure and debt serving being as high as 59% of total expenditure, how can we go planning for foster inclusive growth?

Debt Finances crossed the Planned Estimates:

The debt based finances for investments under 11^th five year plan document was proposed to be 48.42% of total receipts for 2008-09, whereas the revised budget estimates reveals that the debt receipts were 96.38% of total capital receipts in 2008-09. This reflects our inability to mobilize targeted amount of non debt receipts, causing high fiscal deficit due to interest payments over borrowed debt receipts.

Source-wise Projected Investment for 11^th Plan

(Rs crore at 2006–07 prices)

Sources	2007–08	2008–09	2009–10	2010–11	2011–12	Total 11th Plan
1. Centre	112,608	128,305	148,545	172,123	204,041	765,622
Central Budget	29,416	33,517	38,804	44,963	53,301	200,000
Internal Generation (IEBR)	24,958	28,437	32,922	38,148	45,222	169,687
Borrowings (IEBR)	58,234	66,352	76,819	89,012	105,518	395,936
2. States	79,499	99,022	124,998	160,232	207,186	670,937
States Budgets	52,689	65,628	82,844	106,195	137,315	444,671
Internal Generation (IEBR)	8,043	10,018	12,646	16,211	20,961	67,880
Borrowings (IEBR)	18,767	23,376	29,508	37,826	48,910	158,386
3. Private	78,166	94,252	115,724	146,762	184,687	619,591
Internal Accruals/Equity	23,450	28,726	34,717	44,029	55,406	185,877
Borrowings	54,716	65,976	81,006	102,733	129,281	433,713
Borrowings as % to private	70.00%	70.00%	70.00%	70.00%	70.00%	70.00%
4. Total Projected Investment	270,273	321,579	389,266	479,117	595,913	2,056,150
Non-Debt	138,555	165,875	201,933	249,546	312,205	1,068,114
Debt	131,718	155,704	188,333	229,571	283,709	988,035
Non Debt as % of Total	51.26%	51.58%	51.88%	52.08%	52.39%	51.95%
Debt as % of Total	48.74%	48.42%	48.38%	47.92%	47.61%	48.05%

Data Source: http://planningcommission.nic.in/

According to 11^th plan documents, projected investments in 2008-09 should be of Rs. 321,579 crores while total plan capital expenditure in revised budget observed as just Rs. 41,301 crores. So the plan capital expenditure is just 12.84% of targeted investment in 2008-09. This shows our inefficiency to make budget development pro to ensure foster and inclusive growth. So, it is better that GoI reduce debt borrowings which ultimately increases revenue deficits; and shift the focus on infrastructure investments to stimulate the economy at a time when GDP growth rates and employment growth rates are falling.

Actual Debt Receipts is 210% to the planned Estimates:

Since the revised estimates on debt receipts (Rs. 326,515 Crores) is already 210% of estimated requirements of debts (Rs. 1,55,704 Crores) by year 2008-09 as projected in 11^th five year plan documents, the GoI should seriously think about this increased debt receipts. The funds utilized for debt servicing (Rs. 530,010 Crores) is already 162% of debt receipts to finance fiscal deficit (Rs. 3.26.515 Crores), the GoI should revisit its budgeting. How good is it to increase the debt receipts at a time when Indian industries are looking for more affordable credits from banks to meet the challenges after the global meltdown?

Likely Sources of Debt as projected by the Planning Commission

(Rs crore at 2006–07 prices)

Likely Sources of Debts	2007–08	2008–09	2009–10	2010–11	2011–12	Total Eleventh Plan
1 Domestic Bank Credit	49,848	63,207	80,147	101,626	128,862	423,691
As % of likely total debt resources	48.69%	49.99%	51.09%	52.00%	52.72%	51.32%
2 Non-Bank Finance Companies	23,852	31,485	41,560	54,859	72,415	224,171
3 Pension/Insurance Companies	9,077	9,984	10,983	12,081	13,289	55,414
4 External Commercial Borrowing (ECB)	19,593	21,768	24,184	26,868	29,851	122,263
5 Likely Total Debt Resources	102,370	126,444	156,874	195,435	244,416	825,539
6 Estimated Requirement of Debt	131,718	155,704	187,333	229,571	283,709	988,035
US$ Billion	32.93	38.93	46.83	57.39	70.93	247.01
7 Gap between Estimated Requirement and Likely Debt Resources (6–5)	29,348	29,260	30,460	34,136	39,292	162,496
US$ Billion	7.34	7.31	7.61	8.53	9.82	40.62

Data Source: http://planningcommission.nic.in/

In year 2008-09 the deficit budget cost an amount of Rs. 192,694 crores to GoI which was paid as interest over the debt receipts borrowed to finance the deficit budget. This may be called as loss to GoI because had there been equity based receipts against debt receipts, GoI would have saved this amount.

Financing Fiscal Deficit through subsidized bank loans is not good

In the 11^th five year plan document it was projected that by year 2008-09, to meet the proposed investment needs around 50% debt receipts worth Rs. 63,207 crores would be mobilized as domestic banks credit. However the figures of revised budget estimates for 2008-09 states that market loans (amounting Rs. 261,972 Crores) are over 80% of total debt receipt by the GoI. The increased flow of subsidized bank loans to GoI for financing fiscal deficit is in fact creating problems for economic growth of the economy because it is creating hurdles for banks to increase the supply of cheaper credit to the private sector at a time when they needs it to minimize their output cost and combat recession.  It is observed that beside fall in international demands, the availability of equity finance or cheaper credit sources have affected the business confidence. The equity financial sources are drying up after reversal of capital flows from stock markets due to global meltdown. External Commercial Borrowings (ECBs) and Export Credits have also declined.  This all had affected the growth rate for industries.

Industry wise GDP growth trend during recent years

Industry	2006-07	2007-08 (QE)	2008-09 (RE)	Percentage change over previous year
				2007-08	2008-09
1. Agriculture, forestry & fishing	531,315	557,122	566,045	4.9	1.6
2. Mining & quarrying	60,038	61,999	64,244	3.3	3.6
3. Manufacturing	440,193	476,303	487,739	8.2	2.4
4. Electricity, gas & water supply	60,544	63,730	65,899	5.3	3.4
5. Construction	205,543	226,325	242,577	10.1	7.2
6. Trade, hotels, transport and communication	778,896	875,398	954,589	12.4	9.0
7. Financing, insurance, real estate & business services	409,472	457,584	493,356	11.7	7.8
8. Community, social & personal services	385,118	411,256	464,926	6.8	13.1
9. GDP at factor cost	2,871,120	3,129,717	3,339,375	9.0	6.7

Source: – CSO press release dated 29^th May 2009.

Besides evaluating fall in annual growth rate of Gross Domestic Product (GDP) from 9.0% in 2007-08 to 6.7% in 2008-09, it would also be important to analyze the growth trend for different industries during last year. The Manufacturing industry employing majority of non agricultural workers observed deepest fall where annual growth rate fell to 2.4% in 2008-09 compared to 8.2% in 2007-08. Similarly the annual growth rate of agriculture, forestry and fishing fell to 1.6% in 2008-09 against 4.9% an year ago.

However the increase in annual growth rate for Community, Social and personal services has remarkably increased to 13.1% in 2008-09 as compared to 6.8% in 2007-08 reflecting the impact of increased expenditures by the Government by financing schemes like NREGS.  But it would be important to notice that such expenses have not only increased the fiscal deficit beyond estimated budget for 2009-10, only 9% Indian workforce engaged in Community, Social, and Personal services expected to be benefited through it. Thus the excess flow of subsidized bank credits to GoI for financing deficit budget is ultimately restraining the economic growth.

Fearing for even higher fiscal deficit?

To reduce the fiscal deficit, it is simple to either cut the expenses or increase the revenues. But under present conditions, it is not possible either to increase the revenue receipts or to cut the expenditures because any increase in taxation will be disastrous at a time when recession has hit the business community and are already demanding for more stimuli to recover. When there is mounting pressure to increase the stimuli, the expenditure is suppose to increase further. Moreover the political promises (to provide subsidized foods and increase flagship programme expenses) by the new Parliamentarians before the election would also increase the plan expenditures. It all increases the possibility of any further increase in the current fiscal deficit.

What the Government should do now?

Considering the constraints to increase the revenue receipts and cut the plan expenditures to control fiscal deficit, the GoI needs to innovate new products for public finance. As almost 60% of total expenditures are made for debt servicing, GoI needs to substitute the debt receipts with equity funds. Since SEBI failed to protect the stock markets and NBFCs dealing in MFs and VCs are not in a position to mobilize huge long term investment funds, GoI needs to innovate Sovereign equities to mobilize adequate amount of non debt receipts for consolidation of public finance.

Considering the available options of capital sources in international market, there are chances to get Islamic funds instead of mere equity funds from the Muslim countries. The equity funds are somehow different from Islamic Funds in the manner that when equity funds are mixed with debt funds, it doesn’t remain Islamic Funds.

Islamic Bond (Sukuk) for public finance in India:

Islamic economist Dr. Shariq Nisar in his paper ‘Islamic Bonds (Sukuk): Its Introduction and Application’ writes that the recent innovations in Islamic finance have changed the dynamics of the Islamic finance industry. Specially in the area of bonds and securities the use of Sukuk or Islamic securities have become increasingly popular in the last few years, both as a means of raising government finance through sovereign issues, and as a way of companies obtaining funding through the offer of corporate Sukuk. Beginning modestly in 2000 with total 3 Sukuk worth $336 millions the total number of Sukuk by the end of 2007 has reached to 244 with over US$ 75 billion funds under management. Dr. Shariq summarizes the growth of Sukuk in following table.

Year	Sukuk Size (USD million)	Number of Sukuk
1990	30.00	1
2000	336.30	3
2001	780.00	4
2002	985.83	9
2003	5717.06	36
2004	7209.53	67
2005	12033.76	89
2006	48114.82	225
2007	75538.70	244
2008	32242.16	156
Total	182988.16	834

Recent studies about Sukuk at http://online.wsj.com/ indicates that although by recently the Sukuk market has managed to come back modestly, but only for higher corporate issuers. IFIS data show that so far this year, more than $7.6 billion of Sukuk have been issued. Almost all this year’s fund-raisers have been governments or government-related, the overwhelming majority from Southeast Asian countries such as Indonesia. The Middle Eastern market that drove the pre-2007 boom has also sprung into life this month with a $500 million issue for the government of Bahrain, which was boosted to $750 million because of strong demand. Thus there is no harm if GoI study the feasibility of innovating Islamic products to consolidate public finance in India. 

Scope of Islamic Bond in India:

Since India houses second largest Muslim population of the world, it is expected that at least 20% Indian Muslims who are economically better off and desperately looking for real Islamic investments would grab it with enthusiasm. Unfortunately so far India has yet to launch any real Islamic bond or Mutual fund because somehow all the so called ethical mutual fund have been mixing equity funds with debts.

Moreover unofficial sources indicates that considering the higher growth rate of India, some larger Islamic banks and financial institutions like Islamic Development Bank, Dubai Islamic Bank and others desire to invest in Indian infrastructure but do not find suitable opportunities.   So, we find the scope to study the prospects of Islamic Bond (Sukuk) from GoI to finance infrastructures.   

Sector-wise Projected Investment for the Eleventh Plan

(Rs crore at 2006–07 prices)

Sectors	Projected investment for 11th five year Plan
	Rs. crore	Shares (%)
Electricity (incl. NCE)	666,525	32.42
Roads and Bridges	314,152	15.28
Telecommunication	258,439	12.57
Railways (incl. MRTS)	261,808	12.73
Irrigation (incl. Watershed)	253,301	12.32
Water Supply and Sanitation	143,730	6.99
Ports	87,995	4.28
Airports	30,968	1.51
Storage	22,378	1.09
10.  Gas	16,855	0.82
Total (Rs crore)	2,056,150	100

Data Source: http://planningcommission.nic.in/

Fiscal deficits can be reduced by the Sukuk funds:

Since returns to Sukuk holders comes from the actual returns from the project there is no chance of any interest burden on the economy. In case there is any loss in the specified project that will also be duly shared by the Sukuk holders. Thus Sukuk finance negates any possibility of interest burden on the economy and removes the chances of fiscal deficit due to interest payments on borrowed debts to finance infrastructural needs of the economy.

We have higher revenue expenditures due to higher debt servicing ratio total expenditure. The problem is also that capital expenditure is much behind the target and growth rate can’t be foster if we lack infrastructure. Thus while we need to stimulate the economy, it is better to introduce Sukuk by Indian Government as it would not only help building infrastructure, increase capital expenses and stimulate the economy, but also reduce the revenue deficits, debt servicing ratio and also revenue deficits.  

Financing the deficit through more of subsidized bank loans is creating problems for the banks to reduce lending rates for private sector; as a result the private sector are getting lower amount of credits at higher costs. Besides the recent global recession, this hardening credit supply is adversely affecting the growth rate of agriculture and manufacturing industry by witnessing negative growth rates in during last 6 months.  Thus deficit finance is not helping majority of Indian workforce as agriculture and manufacturing collectively provide livelihood to around 63% workers. So, to ensure foster and inclusive growth by way of providing sufficient and affordable credits to private sector, the increased flow of subsidized bank loans to GoI should be reduced otherwise private sector will continue to suffer and we may not be able to attain desirable growth rate even by increasing the fiscal deficits to stimulate the economy.

Since Sukuk is bounded with religious faith, the economic rationality is secondary aspect in decision making by the investors. The top priorities for Sukuk holders are to ensure that –

1. The returns are Halal (legal according to Islamic ethics) and investments will be used for building potential infrastructures for national development, thus the investments and returns may draw tax incentives as well which may stand as compensation against lower rate of returns. 
2. The investments are meant for legal share (proportionate ownership) in the infrastructure.
3. There would not be any fraud or cheating by the fund managers and the investments would not be spent for promoting unethical and unlawful activities (as prohibited by Islamic ethics). 
4. The investments will be in safe hands to carefully develop the assets and not manipulate it.
5. Even if the rate of returns are low as compared to market returns on other investments, the advantage of earning Halal income, tax incentives on investments upon national infrastructure would be some compensatory advantages to the Sukuk holders.

Since all sorts of returns on Sukuk are free from interest and does not exceed to the actual asset value, whatever is paid as returns to Sukuk holders is to pay from the actual earnings from the asset created by that particular investment. There is no need to borrow any debt to pay Sukuk returns or repay the whole Shukuk funds because all the Shukuk holders collectively own the asset. They will thus proportionately gain or loose according to appreciation or decline in the value of that particular asset.

Indian Institute of Islamic Infrastructure Funds (IIIIF):

It is desirable that the GoI set an autonomous financial corporation as ‘Indian Institute of Islamic Infrastructure Funds’ (IIIIF) to grab the national and international market of Shariah Funds and mobilize adequate funds for the infrastructural investments in India. If IIIIF succeeds soliciting cooperation with leading Islamic investment and development banks around the world, hopefully we may not need debt based receipts for deficit finance especially to meet the infrastructural requirements in India. The services of such banks may be solicited through GoI securities with assured lease rent after completion of particular infrastructure projects. Once India manages to mobilize project based Islamic Infrastructure funds, with such funds specific borrowed debts may be repaid to reduce the debt burdens.

Based on the projection by the Planning Commission of India, the estimated requirements of infrastructure investment is Rs. 20,56,150 crores. Considering the commercial aspects of different sectors, it is expected that IIIIF may help us arrange 93% of the total requirements amounting Rs. 19,12,420 crores for 11^th five year plan’s infrastructural needs. Only the investment need of water supply and sanitation amounting Rs. 1,43,730 may not be sellable otherwise infrastructure projects of all other sectors seems sellable through equity based Government securities by IIIIF upon which any specific amount as % of investment could be assured as returns in terms of lease rents after completion of the projects. IIIIF along with RBI and Ministry of Finance may design such equity based Government Securities (Sukuk). Further such securities may be traded in open market as RBI has recently framed policy for stripping and reconstitution of Government securities to enhance the trading scope of securities. However for Sukuk, there could be assured lease rent or dividend as rate of returns instead of interest.

Conclusion:

Islamic Finance in terms of Sukuk may help India raise required infrastructure investment funds for the Government and the corporate sector. It may solve the most threatening challenge of our economy by providing equity funds for infrastructure against Government Securities enabling GoI reduce its fiscal deficit after repaying borrowed debts for capital expenditures through equity funds; and also by arranging equities for the corporate sector. Wish the proposed IIIIF may reduce the fiscal deficit allowing India attain foster and inclusive growth as it carries following promising features –Reduce the fiscal deficit of India even if our revenue receipts declines and we need to increase the plan capital expenditures to stimulate the economy.

1. Help India save amount up to 6% of our GDP we pay as interest over debt receipts.
2. Enable GoI to repay debt receipts borrowed for financing the infrastructure investments.
3. Provide desirable equity fund for the corporate sector at a time when external financial resources are dried up and the cost of domestic bank credits are not affordable.
4. Once GoI succeeds arranging sufficient infrastructure funds through Sukuk and repays debts borrowed for capital expenditures, it would reduce the load of public finance on domestic banks thus enable them to reduce the cost on credits specified under PSA or for private sector enterprises.

There could be many more significances of IIIIF if we resolve it without any prejudice for the sake of national interest.

India may be on high growth trajectory again

 

With due respect to ministers and other managers of Indian economy, it really pinches to read statements where it is repeatedly said that the worst in yet not over; GDP growth rate may fall further; fiscal deficit may increase over the revised budget estimates; and Indian economy may not turn around unless the global economy recovers; however once the global economy shows the signs of recovery, India’s turn around will be sharper and swifter.

 

Challenges should be viewed as opportunities:

Gratitude to Dr. Reddy for his contributions enabling us to fight against financial crisis; and hats off to D. Subbaroa for his well acquaintance with political and economic scenario and timely taken monetary measures to boost enough confidence in the economy. Since chances of error and omissions might be there for everyone; just possible that we might be missing something in evaluation and analysis of data and plans. It is thus desirable that we should find and remove the regulatory hurdles for growth, adopt alternative measures after reviewing the strategic plans and impacts of adopted measures. Indian economy is facing hard time due to global recession, but as India is one of the top emerging economies with huge domestic consumerism, the challenges could also be viewed as opportunities for India to pick up higher growth rate again after adopting innovative measures. If India succeeds in doing so, many other nations may like to follow her. Thus, India has an opportunity here to become a global economic leader.  

 

Overweighing GDCF ratio to GDP:

It is rather unfortunate that the strategy for financing 11^th five year plan is not in accordance with the fundamental principles of economics of development and planning. How can we resolve a plan allowing continuous fall in the ratio of consumption expenditure to GDP? Somehow we have overemphasized Gross Domestic Capital Formation (GDCP) to boost GDP growth. No economy can achieve sustainable higher economic growth if consumption expenditure ratio to GDP falls below 70 percent.  Since 11^th five year plan was finalized, the economic environment in India and around the globe has drastically changed. The proposal to finance the plan was based on higher saving and investment growth rates which was going right according to the plan till capital inflow was increasing, but after reversal of capital account status, the falling consumption expenditure ratio to GDP along with falling international demand revealed that economy cannot grow at higher rate if consumption expenditure ratio to GDP keep on declining and the GDCF ratio to GDP keep on increasing.  

 

Continuous falling TCE ratio to GDP should be arrested:

After liberalization of capital account, our GDP growth rates in India have been more than impressive, but proportionate share of Total Consumption Expenditure (TCE) to GDP has declined from 73.2% in 2003-04 to 67.8% in 2007-08. Even with higher GDP growth, our consumption demand has weakened during this period. On the other side the GDCF ratio to GDP has increased from 27.7% in 2003-04 to 31.9% in 2007-08. There is a limit to stretch the GDCF ratio to GDP. At present India needs to increase consumption expenditure compared to investment expenditures which is possible if liquidity is allowed to flow towards unorganized sector where workers have higher Marginal Propensity to Consume (MPC) as compared to workers in organized sector. But after analyzing the scope of increase in consumption expenditure with increased liquidity through currently adopted monetary and fiscal measures, it may be found that funds are not really reaching to those who have higher MPC, rather financial adjustments are more composite in these measures.

 

Uneven distribution of financial resources:

The fall in consumption expenditure and increase in saving and investment do not indicate inclusive growth because data may prove that after liberalization of capital account, capital inflow through stock market or through External Commercial Borrowings (ECBs) has relatively benefited the corporate sector and the financial sector more than other sectors; but the domestic unorganized sector were somehow remained neglected and suffered due to insufficient financial resources for growth. The uneven distribution of financial resources within the economy has put the corporate sector on higher growth trajectory at the cost of unorganized sector. As a result the rich became richer and poor became poorer. 

 

Corporate Sector might have exploited financial regulations:

At this stage, one may advance the hypothesis that the corporate sector has exploited the financial regulations framed with regard to fuller convertibility of capital account. The recommendations made by the Tarapore Committee have been somehow overruled. Corporate sector have been investing locally raised equities into Mutual Funds, while enjoying ECBs to expand their businesses because ECBs have been cheaper than domestic credit sources. It has pulled the equity funds and ECBs to the corporate sector and the unorganized sector enterprises were left under mercy of local banks with higher interest rate which was enough to discourage the domestic small scale entrepreneurship.

 

Flow of Funds for inclusive growth:

Study might reveal that the financial sector enjoyed liberalization of capital account; thus the financial sector growth rate surpasses growth rate of GDP and many primary and secondary sector industries and trades. The data on growth rate for organized and unorganized sector during last five years and fund flow ratio to these sectors would reveal the script of high growth trajectory for India. It would help us assess the role of financial sector enterprises to help the economic enterprises grow. We may observe that financial intermediaries have more benefited with liberalization of capital account while domestic industries and trades with local base have missed the fruits. We need to assure that liquidity is genuinely guided to flow according to sustainable and real inclusive growth plan.

 

Appropriate flow of equity funds may reduce fiscal deficit:

As an emerging economy, India has high potential for investment expenditures, but when GDCF ratio to GDP crosses 25%, this potential is bound to moderate. The fall in TCE ratio to GDP for last ten years could not hold the high economic growth rate and it became faster when global recession further weakened the external demands. Since October 2008 after intensified global financial crisis, Indian authorities provided excess liquidity worth around 10% of GDP through various monetary and fiscal measures; but even 2% increase in domestic consumption expenditure ratio to GDP has not been achieved. It is critical to review whether the measures are appropriate enough to divert the liquidity to the group with higher Marginal Propensity to Consume (MPC). With the combined debt of Central and state government at more than 70% of GDP, it would be imprudent to increase the fiscal deficit any more. Domestic consumption expenditure could be increased at higher rate along with entrepreneurship development if equity funds are extended to the unorganized sector enterprises where workers have higher MPC compared to corporate sector where workers have higher Marginal Propensity to Save (MPS). If we genuinely priorities the flow of equity funds it may work more effectively to boost domestic demands compared to increasing public expenditures and making fiscal deficit beyond revised budget estimates.

 

Workers with higher MPC do not access Equity Funds:

A study may reveal that we need to track the fund flow guided through monetary and fiscal measures to boost domestic consumption. Around 79% poor and vulnerable workers engaged in the unorganized sector enterprises with higher MPC still find difficult to access equity funds while corporate sector with higher MPS enjoys all equity funds. Undoubtedly equity funds encourage entrepreneurial expenses whereas higher risk mitigating capacity and sound collateral base is required to afford debt based credits. Since poor entrepreneurs in unorganized sector do not have sound collateral base rather they have low risk mitigating capacity, thus debt based credit is unaffordable for them. They really deserve more of equity funds as compared to debt based credit to exploit the entrepreneurial skills. The working patterns of enterprises in unorganized sector are not suitable to avail equity funds from stock markets and it is not feasible for SEBI to help millions of smaller domestic enterprises where self employed workers do a lot, thus are deprived of equity funds.

 

Banks should be allowed to deal in small equity funds:

India needs to establish small banks dealing in small equity deposits and credits at local level so that the small domestic enterprises working in the unorganized sector could be provided with commercial credit that are otherwise beyond the reach of stock markets.  It might be reasonable to allow local banks dealing in equity funds to extend equity support up to a limit of Rs. 3,00,00,00 from their equity funds. This way banks may not overrule the market regulated by SEBI. This way RBI and SEBI may have separate equity market to regulate in their own way. Thus smaller equity funds may be maintained by banks which could be easily monitored at local levels through their own business managers.

 

Huge domestic consumerism is the main strength of Indian economy:

Such initiatives may increase flow of equity funds to the unorganized sector enterprises whose factor costs (especially wages and salaries) would certainly boost expenditure capacity of workers. Since such workers are around 93% of total Indian work force, it may increase the consumption expenditure to considerable level because their MPC is much higher compared to workers in the organized sector. It would really boost the demand forces enough to push India out of recession. The investment through equity funds in unorganized sector enterprises will raise output whose consumers may locally based, thus increased output is supposed to be consumed by huge domestic consumerism where MPC is much higher and is still unaffected by global recession.         

 

Equity Funds to the unorganized sector is the key:

If we succeed to provide equity funds to unorganized sector workers who have higher MPC, India may be on higher growth trajectory again with much inclusive and sustainable growth in nature because it would not depend on international demand or supply, but grow with domestic demand and supply which is much strong at present as indicative through the difference in wholesale and retail price indices. Equity funds to the unorganized sector will help 93% Indian workers make more expenditure on consumption and investment allowing India grow faster than ever before with really inclusive in nature.

 

Let’s guide the global economy:

Since recession is more acute in developed nations with uncertainty about recovery, it is insane to wait for their recovery. On the contrary with innovative measure of allowing equity funds to unorganized sector through local banks, if Indian economy comes out from recession, it will certainly guide other nations to follow this pattern. India will then certainly lead the international economic growth strategy.

Muslims don’t need any scheme but fair policies

Political parties are finalizing strategies to attract voters before general election. Before manipulating schemes for Indian Muslims, politicians would refer Sachar Committee report; but they also need to consider some problems of Indian Muslims which has not been covered by Sachar Committee. Study shows that Indian Muslims don’t need any special schemes but fair policies to ensure inclusive growth of India.  India cannot attain sustainable growth unless second largest community is brought into mainstream, whereas practically Indian Muslims are more worried about security compared to growth. Their plight in world’s greatest secular democratic economy reflects from following facts- 

 

1.      Indian Muslims are so marginalized that its share in national population is 13.47%, but they actually share 18.35% of Indian population living below poverty line. It shows that instead of sharing development, Indian Muslims really share national poverty.

2.      When 31% Muslims live below poverty line and 39.4% Muslim workers as self-employed in the unorganized sector, the huge credit loss to Indian Muslims due to regulatory hurdles is like economic assassination of Muslims by financial sector regulators.

3.      In Muslim concentrated areas, the physical infrastructure lacks behind the actual requirements; and the community based institutions are constrained by regulations.

4.      The schemes announced by government to empower Minorities are not linked to Muslim NGOs which could have effectively optimized the social resources of the community.

5.      To understand Muslims problems regarding economy and finance, there is no Muslim officer in grievances cell at Department of Economic Affairs. In fact we hardly find Muslim staff even in institutions like NMDFC which is supposed to focus on minorities.

 

Thanks to Dr. Manmohan Singh and his team for the Sachar Committee Report, but a lot more is desired for rescue of the Indian Muslims. The Sachar Committee Report has made recommendations about policies and schemes, and also well stated that the said objectives would only be achieved if both sort of recommendations are implemented simultaneously. The Governmnet has taken up some of the recommendations related to shcemes only. Following are some questions related to the intention of UPA Government related to the study made by Sachar Committee–

 

1.      Why Muslims status in capital market was not studied while net worth in capital market is more than all sorts of deposits in all Schedlued Commercial Banks (SCBs)?

2.      Why the committee did not suggested to link minority related shcemes to Muslim NGOs which would have not only reduced the cost of implementation but also ensured increased community participation in these schemes?

3.      While the issue of Muslims low participation in IAS or other higher level jobs were well mentioned in the report, why the committee did not made any suggestion to improve Muslims participation in RBI, where Muslims are just 0.78%?

4.      Why the committee did not pointed the figures reflecting net annual financial loss to Indian Muslims which is very huge and is hampering economic growth of Muslims.

5.      Why there is no suggestion about optimizing Muslim’s social and financial resources?

 

Considering the economic plight of Indian Muslims the variuos schemes announced by central Governmnet are not sufficient because major thrust is upon education only whereas severe economic backwardness and financial exclusion need immediate attention. Let’s see what Government offers to Indian Muslims under name of minorities’ schemes–

 

Schemes and institutions set for Minorities	Approx. Amount (in Rs. Crores)
1.      Annual Grant to Ministry of Minority Affairs for 2008-9	1,000
2.      Asset of Maulana Azad Education Foundation	250
3.      Asset of National Minority Development Finance Corporation	750
4.      Annaul grant for Multi Sectoral Development of 90 Minority districts	540
5.      Modernization of Madrasas	45
6.      Scholarship schemes through Minsitry of Minority Affairs	1,400
7.      Central Wakf Council, NCPUL and other instititions / schemes	785
8.      Total approximate amount spend on welfare of Minorities	4,770

Source – Central Governmnet Annual Budget statement 2008, PIB bulletins and GoI websites

Note – Even this total amount was half before March 2008.

 

This total amount is not even 10% of the amount Indian Muslims are annually loosing in terms of credit due to conflict between Islamic ethics and financial sector regulations. Due to interest based systems, since independence banking has been unfavourable sector for Indian Muslims. The Sachar Committee Report pointed that Muslims have 7.4% share in individual saving deposit amounts at SCBs in year 2005. But they had just 4.7% share in outstanding amounts under Priority Sector Advances (PSA). Considering the same ratios of deposits and credits for Muslims in all sort of aggregate deposits and credits at SCBs in 2008, Muslims would have following aggregate figures.

 

Deposits / Credits Ratios and Amounts for SCBs	Rs. Crores
Aggregate Deposits with all SCBs	31,96,939
Estimated Aggregate Deposits with SCBs made by Indian Muslims	2,36,573
Total Credit extended by all SCBs	23,61,914
Estimated Credits extended by SCBs to Indian Muslims	1,10,010
National average Credit-Deposit Ratio at SCBs for all communities.	73.88%
Desired extendable amount of Credit by SCBs to Indian Muslims.	1,74,780
Average Credit-Deposit Ratio by SCBs to Indian Muslim.	46.50%
Estimated Credit loss to Indian Muslim as % of their deposits.	27.38%
Estimated amount of Annual Credit loss to Muslim Community.	64,770

Source: – Data derived by analysing the RBI Annual Report 2008 and Sachar Committee Report.

 

Considering the economic plight of Indian Muslims and their annual financial loss in terms of credit, it was expected that Governmnet would amend banking regulaton act to allow Muslims practicing Interest free banking. Scholarship schemes cannot help 31% Muslims living below poverty line (BPL) who need child labour income for meeting daily expenses. They really deserves for subsidy to meet the opportunity cost of child labour income along with interest free credit for their betterment. At least the government should have guided RBI to counter this financial loss to Muslim community, but instaed of framing desired credit policy for Muslims, the Prime Minsiter 15 point programme advcates opening more interest based banks in Muslim concentrated areas. Interesting to see how the Government would stop this continuous credit loss to Indian Muslims, when Muslims are reluctant to deal with interest based banking activities and demanding for interest free banking.  Some sincere though process and policy initiative is required by our Government who allocate funds for culture; but has no Minister to improve livelihood of 22% Indians living below poverty line.       

 

Though the Raghuram Rajan Committee for Financial Sector Reforms has made following recommendation for interest free banking, still political will is required to accept and implement these recommendatuions –

 

“Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region.

 

While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.” 

 

We hope the secular parties would not only raise political will to accept and implement the above recommendations submitted to the Prime Minsiter on 12^th September 2008; but would also add following recommednation for overall economic welfare of Indian Muslims. 

 

1.      There should be at least one Muslim member in committees constituted for study and analysis of national level issues, because it is not justify ignoring second largest community of the nation while doing strategic study for the nation as a whole.

2.      There should be priority based initiatives to implement the recommendations made by Raghuram Rajan Committee to allow Interest-free banking.

3.      If any committee has no Muslim member, the committee should physically interact with Muslim NGOs or institutions to ensure inclusion of Muslims in that study, recommendations and schemes framed after that.

4.      Minority related schemes should be linked to Muslim NGOs so that Muslim social resources could be optimally utilized otherwise the process of isolation may lead wastage of Muslim social resources or it may go against national interest as well.

5.      RBI should find ways to increase Muslims working staff. It may need to incorporate Shariah compliant products in banking sector for Muslims.

6.      There should be at least 12% Muslim working staff in special financial institutions like NMDFC, SIDBI and NABARD. Moreover such institutions should introduce interest free credit schemes for Muslims because interest is most important hurdle in financial inclusion of Indian Muslims.

7.      To allow inflow of capital on profit loss sharing basis for our vulnerable enterprises associated with unorganized sector and farmers in agriculture sector, it is necessary that such investments should be exempted from all taxes and free from undue formalities.

8.      Bilateral trades could be developed for agriculture and allied sector to promote FDI from Midlle East countries so that we could get interest free funds for agriculture sector and could also increase export of increased agricultural products after investments.

 

It would help India to attain sustainable inclusive growth and counter problem of Terrorism because if Indian Muslims are allowed to earn better livelihood, it would certainly help us reduce poverty and ensure inclusive growth. It is very important to ensure that all human resources are engaged in constructive works and there must not be dissident group among minorities who may otherwise feel insecurity and could shake hands with national enemies.  We wish political parties will now frame fair policies for Muslims instead of manipulating special schemes to fetch votes of Minorities.

Political courage is needed for economic growth

Hardly any political party says that the financial sector regulations have been more beneficial to the formal sector compared to informal sector especially in terms of access to equity finance. Political parties do make agenda over religious, social and civil matters, but they rarely speak on economic injustice of poor and vulnerable workers (known as Aam Aadmi) making their livelihood from unorganized sector enterprises. There is a great deal of injustice to the unorganized sector in financial terms due to regulatory imbalances which reflects some impurities in democratic structure of Indian economy. Similarly it is rather unfortunate that political parties do not tire taking positions on issues like national security, but there is hardly any coordination to resolve economic problems which are some times as pressing, if not more, as the issues of national security. Take for example, the issue of recession, which is assuming alarming proportions with each passing day.

 

Slogans like ‘Shine India’ do not feed the Poor and Vulnerable:

During NDA Government the BJP did not notice the economic disparity among formal and informal sector, rather proud to celebrate ‘Shine India’ with some growth in formal sector; but the ballot paper reflected the anguish of Aam Aadmi associated with the unorganized sector who suffered a lot due to unjust regulations. In democracy a stage comes where citizens seek democracy in economic reforms along with political and social freedom. This time the UPA Government is happy to announce schemes like loan waiving, pay revision and some enhanced aids to marginalized groups including minorities, but it may face awkward ballot paper scripts because it has yet to correct the discriminatory regulations prevailed for formal and informal sector enterprises which is increasing the economic disparity among formal and informal sector. The grants and aids may not feed any family. Just and fair financial regulations are required for true democracy by bridging economic disparity, which has not been an agenda for UPA Government so far. The regulators have yet to review the effectiveness of financial sector regulations related to more than 93 percent Indian workers associated with the unorganized sector. There is no Chamber of Commerce or Federation to demand specific regulations so that the poor and vulnerable could improve their livelihood through equity based banking and finance schemes.

 

Even Micro Finance Schemes do not favour Poor and Vulnerable:

The objective behind Micro Finance Schemes through Self Help Groups was not to provide economic justice to poor and vulnerable by providing easy access to finance; but to expand debt based credit market for formal financial institutions by reaching to those poor and vulnerable who had no access to formal sector financial institutions; that too with short term smaller credit amounts on higher interest rates. There been hardly any voice for just and fair financial regulations for poor and vulnerable, instead regulations were made to justify increase in interest rate for Micro Finance schemes. The effectiveness of Micro Finance Schemes in improving the livelihood of poor and vulnerable is yet not proved. So far the formal financial institutions have been just replacing the business of informal financial institutions; and there is no regulatory progress to allow equity finances for the unorganized sector enterprises required to compete with organized sector enterprises.  

 

The real culprit behind inflation and recession:

The financial regulations are designed in such manner that after liberalization of capital account, through stock markets the inflow of capital is mostly directed towards the corporate sector; and disallowed the benefits to the unorganized sector. While this capital inflow through capital account jacked up the stock market prices; it also boosted inflation in commodity and derivative trades; and did not helped the unorganized sector enterprises to compete with organized sector under numerous resource constraints. That’s why when during April to December 2007 Stock Market Capitalization increased by over 100 percent of GDP value, Inflation rate increased and India’s real GDP growth rate declined. It proved increased stock market capitalization against inclusive growth. There is indeed a point for the policy makers to reflect on, whether they desired the same outcome. Let UPA Government blame global financial crisis or oil prices as the culprits behind economic problems, the suffering of poor and vulnerable due to unjust economic policies and financial regulations would spell out the truth in near future.

 

Recession is bound to reduce the demands for debt based credit:

The fall in current account balances due to global recession is reducing the demand for output of enterprises; forcing them to cut their output prices. This means the enterprises need more equity finance instead of debt based credits to reduce their input costs. If stock market (with falling market capitalization) is unable to provide more equity finance, banks should be allowed to start dealing in equity based banking and finance so that input costs of enterprises could be reduced, otherwise recession may prolong. When corporate sector cannot afford debt based credits, there is hardly any scope for banks to induce SMEs for debt based credits because the lower financial risk bearing capacity and stiff competitions with organized sector enterprises restrains them take interest based credits from banks. If demands for interest based credit further declines, difficulties for banks may increase unless they are allowed to transact equity based banking products.

 

Policy makers should go for Equity based banking:

It is rather unfortunate that instead of rectifying regulatory imbalances and removing the constraints through required regulatory changes, our policy makers just go on saying that ‘the difficulties could spill over into 2009-10’. They should better evaluate the effectiveness of financial regulations to counter the problems associated with recession and make due changes to ensure financial flow towards growth oriented projects. Unorganized sector enterprises which are least affected by global recession and have better growth prospects due to huge domestic consumerism for their products and services need amendments in financial regulations. They are disallowed to access equity finances or Direct Foreign Investments. The equity based banking, finance and investments to facilitate the unorganized sector enterprises would not only help them compete with organized sector enterprises, but would also promote domestic consumerism by flow of credit to the unorganised sector whose benefits would reach to Aam Aadmi. If regulators could take initiative to promote SHG schemes for the unorganized sector, why cannot they take due steps to promote equity based banking and finance for SMEs?

 

Banks may find new markets to grow with smaller equity funds:

Since stock markets do not provide smaller amounts under equity finance while, unorganized sector enterprises and SMEs mostly required lower investments, thus banks may be allowed to accept equity deposits with maximum amount limit and also make finance with maximum limit which might be lowest limit for listing of any company at stock market. Banks may smoothly handle smaller amount equity funds through local administration and management. Such finance may enable unorganized sector enterprises to increase labour capital ratio and art of technology required to produce qualitative products and services for domestic consumption at comparative prices. There is high scope for products like Mudaraba, Musharaka, Ijara and Shukuk under equity finance to help small enterprises at local levels. These products don’t need stock market technology for investments, and are being proved as popular products in many Islamic banks outside India. Through such products, commercial banks may find new markets to grow under situation while debt based credit demands are declining and stock market is not duly expanding its sphere to SMEs and unorganized sector enterprises. It is time to drop proposal of stock market for SMEs and allow equity based banking to meet financial need of small companies. If US federal reserves with even 0 percent bank rate unable to succeed in unfolding the financial crisis, it is not clear how Indian banks would adjust interest rate instruments under market conditions where credit demands is declining due to recession.

 

Politics courage is required for economic growth:

To allow RBI regulate the equity based banking in India, Indian legislative machinery needs to amend the Banking Regulation Act. However, it appears that the UPA government is hesitating to take required steps with a fear that the introduction of bill on equity based banking may allow NDA to raise the familiar bogey that UPA is appeasing Muslims before election. But we need to ensure that politics must not hinder economic growth on the name of religious. In case of down stock market, if equity based banking is needed by Indian enterprise to get equity finance for cutting input cost during recession, who would oppose bill of equity based banking if it benefits more to Indian economy compared to Indian Muslims. If consumerism attracts foreign investors to India, it would be much better in part of Indian economy to allow equity banking so that even unorganized sector could grow along with corporate sector by affording higher art of technology, labour capital ratio and infrastructure. Aids, subsidies and grants can’t be alternative of genuine financial sector regulations; and no financial or monetary instrument could help counter recession than equity based banking and finance.

 

Political Silence over financial sector reforms may cost UPA Government:

If the UPA government keeps mum over issue of equity based banking, the cracking Indian stock market will not help the enterprises get due finance to overcome the crisis of recession, and Indian banks will be feeling uneasy to attract more credit demands despite reducing the interest rates; and GDP growth rate will keep on falling.  Collectively these all may reflect failure of the UPA government to tackle the economic problems at a time when it needed to deliver boldly. And during election, opposition party may fetch this failure as an issue. Therefore in interest of the economy and the ruling party, the government should introduce equity based banking system at earliest so that the economic problems could be resolved; the unorganised sector growth potential could be optimally utilized and benefits may reach to Aam Aadmi who would be well off by the time of coming election.

Financial Sector Regulations and Economic Growth

 

It is not a time for Indian financial sector regulators to be panic due to economic recession as they seems by issuing statement like ‘the year 2009 would be harder than 2008’. Rather it is time for India to capitalize the opportunity to become super power through making due regulatory changes in financial sector and allowing the unorganized sector grow faster enough to compensate the loss due to recession.

 

Innovative banking and finance mechanism for unorganised sector may help India become a super power. Indian huge domestic consumerism need to be boosted through exploring growth potentials in the unorganised sector at a time when global economic recession is threatening our current account balances and putting challenges for corporate sector and MNCs. This is not possible unless financial sector regulators pay due attention over access to equity finance for the unorganized sector where over 95% Indian workers are engaged. There is no level playing ground for unorganized sector enterprises as far access to credit is concern when then need to compete the formal sector enterprises.

 

Concerns for Financial losses due to sluggish regulatory forces:

 

Though Reserve Bank of India (RBI), through monetary instruments succeeded in protecting Indian commercial banks from global financial crisis, the Securities and Exchange Board of India (SEBI) did not succeed as much to protect the stock markets.  From January to September 2008, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) jointly lost Rs. 56,47,685 crores in terms of market capitalization which amounted to  more than Gross Domestic Product or Aggregate Liquidity Stock of India.  The regulators of stock market presumably did not pay enough attention to this loss, probably because it is not a debt based entity and they saw no need to bail it out. But does this loss have anything to do with economic growth of India? Or has Indian regulators ever thought about converting this amount into real capital formation instead of paper assets?

 

A sincere thought may suggest that India needs strong regulators to attain sustainable growth in financial sector; otherwise there would be mismatches between the financial and real sectors in terms of growth.  Dr. D. Subbarao, Governor, Reserve Bank of India at the RBI-BIS Seminar on “Mitigating Spillovers and Contagion – Lessons from the Global Financial Crisis” at Hyderabad on December 4, 2008 raised following five questions:

 

i) How do we manage global imbalances?

ii) Is self-insurance a viable option for emerging economies?

iii) How do we reform financial sector regulation?

iv) How do we address regulatory arbitrage?

v) How do we keep the financial sector in line with the real sector?

 

Though his focus was mainly on capital account management after global financial crisis, it is good to see that he is willing to review the Indian financial regulations as well. Certainly time has come up to act upon such issues because some lapses in this regard pull us down. During the years 2006-07 and 2007-08, the growth rate in financial sector has been higher than other reality sector growth rates. We have now reduced demand of credit and RBI Governor opines that it is due to slow down of economic growth whereas practically the higher cost of credit during global recession has restricted growth in credit demand.

 

 

 

 

  Data Source – RBI

  

Financial Sector Growth verses Real Economic Growth:

 

There is a correlation between the growth of financial and real sectors; and wherever the financial sector growth rate exceeds than the growth rate of other real sectors, the appreciations in financial sector might start eating up economic growth potentials of other sectors. It might be apprehended that this is what has been happening in India   where capital market appreciations, growth in aggregate deposit at Scheduled Commercial Banks (SCBs) and credit growths have surpassed growth rates in real sector. The confidence and financial strength of enterprises declined considerably due to poor monetary and economic policies and some instruments designed to counter the side effects of poor policies. If the monetary policies will not be in accordance to national plans, the economy will not grow according to set plans and planners may need to review the plans. The pro and cons of prevalent monetary policies and instruments may need separate debate.

 

Why SEBI is still back bench regulator?

 

RBI launched the capital market and with development of capital market SEBI was formed to regulate capital market. Since the strategy was not very clear to develop an investment market instead of capital market, SEBI could not develop the stock markets into market for investment funds; rather it developed the stock market as OTC to transact equities. Despite the fact that in due course of time, the values of stocks in capital market surpassed the total deposits in all banks; SEBI still finds itself on back bench to regulate the financial sector because the monetary policies are mainly regulated through RBI. This approach of financial sector has yielded boom in speculation business as the trade of equities has just enabled the speculators make money through screen touch pricing at stock markets and the invested funds in stock market were not delivered to production units.  Instead, it was, absorbed by appreciated equity prices and increased values of derivatives.

 

Unable to attract even 10% of national domestic household savings form less than 2% Indians, with liberalization of capital account, the Indian stock market has been mostly heated up with portfolio investments by Foreign Institutional Investments (FIIs). After liberalization of capital accounts in 2004-05, with increased foreign inflow the stock indices started picking up new heights due to increased trade volumes; but after sense of global financial crisis, the decline in indices is also noticed at faster rate with rapid outflow of capital from stock markets. The stock markets are now more exposed to international capital market, thus the global financial boom and crisis considerably affected the Indian stock market. Now any appreciation or deflation in stock market indices up to 5% in a single day is a normal rate of fluctuation. Now the question is how successful these stock markets in economic growth of India?

 

Role of Speculation in Investments:

 

An Investor is basically speculative by nature, but excessive role of speculation in financial sector is not only dangerous for the financial sector alone. It also entails dangers for real economic growth. The development of screen based trading for primary and secondary markets was needed to invent prices at daily basis, but it also increased uncertainty in the stock prices where instead of companies real business trend, the speculator’s temperament depending upon capital inflow and outflow decides the stock prices. Further the market capitals are not flowing towards real enterprises because the focus is on speculation based trade of equities instead of real term investments.

 

Liberalization of Capital Account and Stock Market:

 

With liberalization of capital account, Indian regulators were not prepared to divert the capital inflow towards productive units, and thus the immediate concentration of inflow capital in secondary market increased the volumes of equity trade which inflated the values of equities, stock indices and market capitalization. These increased values of equities, indices and market capitalization did not favoured economic growth rather created pressure for inflation. The liquidity absorption capacity of Indian stock market failed to control the pressure of increased volume of equity trades through screen touch price mechanism and Indian economy observed appreciation of capital resources at stock markets. We failed to grab economic advantage of financial boom in stock market and thus could not retain the growth momentum and the capital market started falling after boom.   

 

Stock Market Capitalization is not supporting GDP Growth:

 

When the Market was moving upward, during nine months period Market Capitalization at BSE increased by 102.25% (from Rs. 35,45,041 crores in March 2007 to Rs. 71,69,985 crores in December 2007) and by 94.32% in NSE (from Rs. 33,67,350 crores in March 2007 to Rs. 65,43,272 crores in December 2007);  financial experts were quite happy to cite the growth rate in stock indices. Pity to observe that this tremendous increase in stock Market Capitalization has not helped the GDP growth rate to move north, instead during this period, the GDP growth rate has declined from 9.2 in the first quarter to 8.8 in the third quarter during 2007-08. Since this considerable increase in Stock Market Capitalization was not chanalized to productive system, rather restricted to speculative trade only which could not last long without real economic growth, by January 2008 onwards the Stock Market started falling and during a period of nine months, Stock Market Capitalization of BSE declined by 41.91% (amounted as Rs. 41,65,384 Crores by September 2008) and NSE by 40.39% (amounted as Rs. 39,00,185 crores by September 2008).    

 

 

 Data Source: RBI

During growth of market capitalization at BSE and NSE, unprecedented amount of money been invested in stock derivatives. These trades and investments in stock and derivatives did not helped GDP growth, rather created inflationary pressures in India. Since the real economy could not grow by speculations and derivatives businesses, with global recession and fall in GDP growth rate, the stock market started falling. While empirically it is proved that screen touch price mechanism of stocks could allow growth of speculative business only, and not the real business, the regulators have to think about means to convert the stock market capitals into real assets for production units instead of paper assets. 

 

Corporatization of Stock Exchanges is not helping Economic Growth:

 

After corporatization and demutualization of stock exchanges, stock exchanges itself has became an attractive business and the stock market intermediaries put all efforts to boost trade volumes instead of mobilizing real investment funds because on every trade they get commissions. So we cannot expect market ethics from stock markets intermediaries, and thus SEBI should set norms for trade of equities and put targets for issuance of IPOs to make balances in ethics and business, so that the stock market could succeed in meeting capital requirements of Indian economy. The motives of generating capital resources for enterprises has left behind motives to earn commissions on every trade and the stock market intermediaries are more conscious about falling trade volumes instead of capital formations. SEBI need to pay immediate attention on such issues.

 

Sensex is not reflecting the real index of Bombay Stock Exchange:

 

The system of free-float market capitalization of just 30 companies instead of all listed companies to calculate index value does reflects good index while market is moving north, but create unfavourable environment when market moves to south. Moreover it never reflects the overall strength of capital stock. The stock market capitalization does not help the companies get advantages because the value of market capitalization increases due to increased stock prices after increased trade volumes and it do not increases the liquidity of companies. Even 100% growth in stock market capitalization has not helped the GDP grow at 10% because stock market capitalization is not really boosting domestic capital formation due to high intensity of trade compared to investments.   

 

Preset Index system is allowing some companies make money:

 

The present index system in stock markets is allowing some companies raise their equity prices and gain excess income through manipulations. Needless to say that Reliance has gained undue advantages in practice of first excessive increase in equity prices and then through buying back the equities at time of distress sale after declined prices. How fare it is to observe that Reliance alone had shared around 30% value of sensex at time of its peak prices, while there has been over 5,000 listed companies. In fact the value of sensex does not reflect even 1% capitalization of all listed companies because it just covers 30 companies out of more than 5000 companies. Thus the methodology to calculate sensex itself is promoting speculation and cheating, instead of real capital formation.

                                                                                                              

Regulatory lapses in stock market:

 

Provision to buy stocks against borrowed securities is allowing the speculators make faster trading which misleads the real growth of stock market. It simply reflects provision of excess liquidity in stock market which inflates the stock prices. The introduction of short term capital gain tax is not enough to control business of speculation because last year the amount of share delivered were only around 30% of transacted trade values.  Moreover the uncertainty in stock markets is forcing investors pull their hands back during financial crisis causing chaos.  

 

The provision of reserving some shares from free float and putting rest on market price risk is unfair in terms of general investors.  The condition of limited liability by subscribing shares is also not helping the corporate to mitigate risks of liquidity crisis, which has caused many financial giants to collapse despite having large share subscribers. The listed companies should not be allowed to take debt based credits and equity finance simultaneously; rather the listed companies should be allowed to raise more capital through equity only because it should be the right of share subscribers to know financial risk of listed company which increases if companies take debt based credits.

 

India is still a favoured economy for Investment:

 

The data on FDI shows that India is still a popular economy for Investment; and there is neither scarcity of investors nor avenues for investments in India, condition we provide security to investors against uncertainty in the stock market which is more due to speculation compared to real economic factors. Increase in FDI and outflow of portfolio investments by FIIs reflects that investors realizes that India has the business potential, but stock markets are not safer to invest at the time of global financial crisis when rumours act faster than other market forces. SEBI must come up with assuring higher returns in terms of dividends over shares despite global financial crisis.

 

Debt based credit market is not favourable:

 

After global recession since the current account balances is bound to decline, the growth potential for multinational companies will decline, however Indian domestic market is strong enough to compensate the losses if we make due regulatory changes in financial sector. With capital outflow the shortage of credit is observed by corporate sector and with declining demand in global market; they might find it difficult to accept debt based credits. There is no sane in promoting interest based banking as alternative to equity finance because the lower financial risk mitigating capacity of unorganized sector enterprises does not allow them have interest based credits; and under pressure of decreasing sales and higher input costs, even corporate sector might not increase their debt based credit demands. So, it is obvious that with global recession, the stock market will decline and so does the debt based credit demands.

 

We need to provide Equity Finance to unorganized Sector:

 

Till now the unorganized sector enterprises in absence of adequate capital labour ratio, art of technology and facilities of equity finance have been finding unfair grounds to compete with the organized sector. It is time for Indian financial regulators and planners to evaluate potentials of unorganized sector and introduce suitable banking and financial services so that the unorganized sector enterprises may avail advantages of equity based credit to grow faster and mitigate the overall loss in economic growth of India. Since their market is localized and unaffected by global recession, Indian financial sector regulators have to promote localized equity based banking and financial institutions for these enterprises that have ample market to grow. Equity finance for unorganized sector would let them afford increasing labour capital ratio and art of technology to produce qualitative products and services for domestic consumption at comparative prices. It would allow the unorganized sector grow at desired rate and compensate economic loss even if corporate sector growth rate declines due to reduced demand at international market. 

 

 

 

RBI and SEBI may need to work jointly:

 

Thus RBI and SEBI should jointly focus on developing policies and schemes to promote equity finance for unorganized sector. This might be possible through linking small localized equity based banks with stock markets where investors might approach with funds for FDI. The local area small equity banking and financial institutions would be required to finance and closely monitor the business projects for returns. Local statutory audit team may be deployed to monitor the accounts of unorganized sector enterprises. This would help the unorganized sector enterprises get accustomed of standard accounting practice and allow them use art of technology and adequate capital labour ratio to perform at optimally. This would not only improve the infrastructure of the unorganized sector, but also ensure faster and inclusive economic growth of India.

 

If our regulators do not open local equity based banking, the financial sector may face harsh situation in near future because the aggregate deposits are increasing at SCBs, especially the interest based term deposit are increasing against fall in capital market. The banks are already observing fall in growth of credit demand because the corporate sector and multinational companies cannot afford debt based credit because these companies cannot afford to increase the input costs with interest based credits under a condition that requires reduction in prices of products and services by reduction in their input costs. Whereas if banks starts promoting equity based banking, it would reduce the deposit mobilization costs for bank and allow these banks to offer equity finance to both organized and unorganized sector enterprises.   This would not only allow the banks find new sources of funds but also provide economic viability under conditions of global recession.  

 

Innovative Banking is required to remove the recession:

 

At present the stock market can’t rely on inflow of capital except FDI which might be linked to enterprises in domestic markets. But to do so, stock markets need to be much federal in nature comprising network of smaller exchanges linked with each others.  It needs some revolutionary changes in nature of work and focus of SEBI which has been serving the corporate and multinational companies so far. The local equity based banks and smaller stock markets may not be developed immediately, thus instantly SEBI and RBI need to came together and develop understanding to promote equity based banking and finance which might open up scopes for smaller banks and stock markets at local levels.

 

Equity based banking might help us succeed against recession:

 

The nature of equity based banking might be different from capital market where investors used to transact equities through screen touch price mechanism. However for local equity based banking or interest free banking may interact with stock markets to get investment funds for local small enterprises where shares might not be sold at stock markets through mutual funds rather composite business projects could be offered for partnerships. The investment funds could be transferred to local banks that might finance and monitor the projects with help of local statutory audit teams and deliver returns to investors through stock markets and take its due share as management charges to administer the funds.

 

The regulators should control the market through innovations and art of technology along with ethical supervision to protect the markets from excessive speculations. Economic rationality is needed to boost financial sector growth, but ethical norms should be well insulated into the system to protect it from excessive speculation. SEBI must make policies to promote IPOs instead of allowing stock markets to increase the trade volumes. Like, it may restrict that any investor can’t sell any particular purchased share in a specific period like one month or three months, similarly it may be regulated that no company can offer more than 10% equities to free float market. There should be efforts to find long term investors as subscribers of IPOs.

 

Liquidity Instruments can’t help us fight against recession:

 

With monetary instruments we may handle liquidity pressure for shorter period, but cannot avoid consequences of recession without policy initiative to allow interest free or equity based banking and finance which is meant to counter problems like higher input costs, default in lease finances and gap in transacted and transferred traded values. The focus of SEBI to promote stock market trading should now be shifted to arrange FDI on project basis instead of encouraging share trading. The investments should be canalized into genuine project finances on medium and long term basis instated of short term investments on equities. For short term investors arrangements could be made for investments in short term trade finances. And the derivatives have to be purified from business of speculation and shifted to real term business.     

 

This way we might resolve the problem of financial imbalances among sectors and economies. This would allow the unorganized sector to grow faster and help India attain desired growth even in case of unfolding global recession. Probably such regulations may help us get escape from loss of equity values worth over Rs. 56,00,000 crores in a period of just nine months. Rather it may help India double its national income through participation of unorganized sector enterprises who have been suffering in absence of equity finance and never find it easy to compete the formal sector that always enjoyed equity finances.

 

I hope Indian regulators especially RBI and SEBI would find solutions for some concurrent financial problems associated with global economic recession.  But if we have to allow our financial sector and real economy grow despite global recession, the interest based banking has more challenges compared to equity based banking which might help us find new emerging Indian economy under new financial sector regulations.