Sucheta Dalal :Signals missed by the Finance Ministry and the RBI of an impending domestic financial crisis
Sucheta Dalal

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Signals missed by the Finance Ministry and the RBI of an impending domestic financial crisis   

January 3, 2009


This is an open letter to the Finance Secretary by E.A.S.Sarma (Former Secretary to GOI)
E.A.S.Sarma                                                                                                                                           Visakhapatnam
14-40-4/1 Gokhale Road                                                                                                                   November 5, 2008
Visakhapatnam 530002
Tel. No. 0891-6619858/ 9866021646
Email address: [email protected]
Shri Ashok Chawla
Finance Secretary
Govt. of India
Dear Ashok,
I have been reading news reports on the global financial crisis and its impact on our economy. While the government and the RBI have risen to the occasion by taking quick corrective measures, I thought I should share with you some of the concerns I have about what is happening right now within and outside the financial sector.
First, for the last couple of years, the changes taking place in the capital market indices and the trends in the exposure of the banks to some sensitive sectors have been such that they should have alerted the Finance Ministry and the RBI of an impending domestic financial crisis. I will first deal with the capital markets.
A reading of the latest Economic Survey shows that, between 2005 and 2007, the number of FIIs had increased by 48% and the number of the FII sub-accounts increased by 60%. During the same time span, the share of FIIs in the total capital market turnover had increased from 10.5% to 20.8%. The gross buys and sales by FIIs in 2005 were Rs.2,86,021 Crores and Rs. 2,38,839 Crores respectively. The volume of these transactions increased by a whopping factor of three during the next two years! These were unusual changes that should have made all those concerned with the supervision and regulation of the capital markets sit up and take notice. It was a casino-like situation in which the Indian capital markets literally became a captive gambling arena for the FIIs. As a result, the FIIs could push up the SENSEX or depress it at their will and derive arbitrage from it, at their pleasure. The small investors became their helpless victims.
With the reform fever gripping the North and the South Blocks, any increase in SENSEX and NIFTY is perhaps perceived as a sign of the well being of the economy. In such a situation, everything else assumes a subordinate position, including the need for caution and prudence in managing the entry of fly-by-night operators like some FIIs.
As on 30-12-2007, as per the data published in the Economic Survey, the ratio of market capitalization to GDP for India touched the astronomical figure of 150, whereas the corresponding index was only 129 for USA, 116 for S.Korea, 104 for Japan and 137 for China! In fact, the Economic Survey seems to cite these figures to show how well our capital market has developed, as though an unusually high level of this index is more a virtue than an evil. Clearly, such an abnormally high level of market capitalisation should have alerted SEBI and the government of an impending crisis of excessive asset valuation, irrespective of the sub-prime crisis in the USA.
When the slide started, from what I saw on the TV, the Finance Ministry had advised the investors not to worry and, instead, invest in Mutual Funds (MFs)! From the end of 2004 till the end of 2007, the volume of investments in MFs went up by a whopping factor of 3.7! MFs are indeed a part of the bubble itself, as they too are usually carried away by the mood set by the FIIs in the market. Moreover, the promoters of MFs are also the players in the other sub-sectors of the capital markets and the possibility of conflict of interest cannot be ruled out. As of now, the MF investors have already lost more tan 18% or more than Rs.1,00,000 Crores of what they thought was their wealth. The bounty must have been shared by the FIIs and the brokers, both better informed about the happenings in the capital markets, than the small investor!
Coming to the banks, there is another kind of bubble that is forming! Once again, on the basis of the data from the Economic Survey, between 2006 and 2007, while the share of their lending to agriculture and SSIs had come down, their exposure to "sensitive sectors" like real estate and capital markets had gone up. In 2007, their exposure to these sensitive sectors was as high as 20.4%. Meanwhile, the real estate companies themselves were becoming highly vulnerable, as a result of the artificial boost given to them by the Central and the State governments and their own imprudent plans of expansion, unrelated to the real demand for housing.  
As a part of the ongoing economic reform programme, the sale of government lands to private companies to raise resources for the government has become rampant and widespread.  During the last three to four years, many State urban development authorities and other State PSUs have indiscriminately sold government lands in auctions that are supposed to fetch them huge cash inflows. The prices at which the lands have been sold have no relation to the real value of those lands or the demand for their use. These are generally in the nature of real estate speculation. As a result of the slump in the capital markets and as a consequence of the inadequate demand for luxury housing, the real estate companies that are the main players in these auctions have started defaulting in payments due to the government agencies that have sold the lands to them. UNITECH and DLF have already defaulted huge amounts, running into hundreds of crores of rupees, scheduled to be paid to NOIDA, Hyderabad Metropolitan Development Authority and, I am sure, a host of other government agencies. This implies that the banks that stand excessively exposed to the real estate business and the capital markets are going to be the ones that will take the hit soon!  
I am not sure about the kind of skeletons that will roll out of this whole saga of misplaced reforms and lack of oversight. I am also not sure whether the government is seized of what is happening all around. I felt disturbed at reports that the Ministry of Finance still wished to boost up real estate and construction business, hoping that it will stimulate the demand for cement and steel, which in turn will accelerate GDP growth. In my view, such a step will only worsen, not improve, the perilous situation that exists today. Many SEZs so far sanctioned and the others about to be sanctioned will eventually meet the same fate as these real estate companies. Even though the RBI was initially reluctant to relax the norms for bank loans to SEZs, it had to yield to pressure from the government and agree to relaxations.
In this crisis, it is possible that some insurance companies are also involved. This needs to be ascertained. It is inopportune for the government to have decided in favour of lifting the cap on FDI in the insurance sector at this very moment, when the economic environment is still hazy. The government, in the name of reform, were trying to rush into permitting pension funds being invested in the capital market. It is providential that there are enough checks and balances within our political system to dampen all such efforts.
Against this background, I suggest that your Ministry should make a quick assessment of the banks and insurance companies likely to get a hit from the failing real estate companies and the slump in the share markets, so that you may consider some immediate correctives. Some PSU banks may require recapitalization. The government's perception of the capital market indices and their relevance for the economy will need some rethinking. You must worry when the indices go up steeply, as much as you worry when they go down steeply.The government should also introspect on whether artificially propping up the housing and other construction activities is the best way to achieve economic growth. A low-interest rate regime is desirable but the fall in the interest rates should come as the outcome of reduced inflation and more efficient functioning of the banking system.
At the root of all these problems lies the need to revisit the regulatory environment in which our financial markets operate. The government should provide greater autonomy to RBI and SEBI in the matter of regulation of the banking and capital market regulation. The regulatory laws applicable to these two institutions may have to be strengthened. The government should also focus attention on reforming the two regulatory bodies and the PSU banks. The process of selecting the top executives of these two institutions and those of the banks should be apolitical and independent. RBI should be free to formulate its credit and monetary policies. Similarly, SEBI should have the freedom to formulate the policies relevant to the capital markets.
The project appraisal systems in the banks are weak and the absence of professional leadership is the reason for this. This issue needs to be addressed.
The financial sector has complex inter-linkages within itself and anything going amiss in it will impact the economy in a far reaching manner. I request you to consider looking at the sector in its long-term perspective. Economic liberalization is good in theory but it can play havoc when the factors that make it work are absent.
I am writing this letter, not as a fault-finding exercise but with a view to make constructive suggestions. I hope you will consider my suggestions in that spirit!
Yours sincerely, 
Former Secretary to GOI 

-- Sucheta Dalal