India's Real Wealth Creators

Yesterday I came across an interesting article in The Wire titled, Who Are India's Real Wealth Creators? This article pursued an interesting line of view, but I think totally missed the import of this idea.

For society to grow and progress it is essential that societal savings are transformed into productive investment, which in turn creates jobs, income, and growth. The primary conduit for doing so which has evolved in India is the banking system. Unfortunately, this is also one of the weakest links in our growth process. Not only is our banking system not very effective in transforming domestic savings into productive investment, but they do it very inefficiently. 

Bank Credit to GDP ratio of the Indian banking sector is around 55%, compared to the world average of 99%, China at 182%, and Brazil at 70%. This reflects how ineffective our banks are in the transformation of savings into investments. Moreover, the essentially security-based lending that they practice leaves out much of the services sector of the economy which now contributes more than 50% of GDP but gets only about 32% of bank credit. These statistics are from NCAER Working Paper  141 - Privatization of PSU Banks in India: Why, How and How Far and are about 2-3 years old.

Even the meagre amounts of credit they disburse is of low quality, with periodic instances of industry-wide high NPA levels. Banks are highly leveraged entities with low operating margins. Therefore, the margin of safety available to them is very thin and start making operating losses if their Gross NPA ratio is more than 3% to 4%. What we have witnessed is Gross NPAs levels of over 25% in the mid nineties which was brought down to a very manageable level of 2% by 2009 but went up of over 15% by 2019. Such high levels of Gross NPA levels are not indicative of sick banks – it reflects the hard fact that these banks were technically dead with effective negative networth! Such banks are known as zombie banks and have an extremely pernicious effect on the economy.  

This sad state of affairs has basically been covered by pumping in tax-payers funds in case of PSU banks and by merging sick private banks with other banks, often PSU banks. This in turn creates major moral hazard problems since public funds are used to cover private vices, with little to show in the way of improving governance or outcomes - basically hiding the dirt under the carpet.  

The genesis of this poor state of our banking system can be traced to the policy of bank nationalisation in 1969. In the words of Arvind Subramaniam in his book Of Counsel, "If you were to ask me what the two egregious economic sins we committed in the past were, they are the Industrial Policy Resolution, which started the licensing of industry, and bank nationalisation in 1969.”

Raghuram Rajan & Rohit Lamba are even more forthright in their views on this subject. In their book, Breaking the Mould, they have virtually equated bank nationalisation in 1969 to demonetisation in 2016 and conclude that, "few would assert it benefited the nation"!

As a society we have been very vociferous in denouncing demonetisation, but bank nationalisation which has been much more pernicious and damaging for the economy has got little mention by our media or policy makers. Vast swathes of the public still truly believe that it was an economic masterstroke.

The introspection on this sorry state of affairs started way back in 1991, but there is little improvement to show for it. The pathological effects of control by Department of Financial Services (DoFS) over the banking industry has  been documented time and again starting with the Note by Prof M Datta Chaudhury and Shri M R Shroff in the report of CFS (Narasimham I), to the Nayak Committee Recommendations, and by Viral Acharya and Raghuram Rajan in their 2020 paper, Indian Banks: A Time to Reform, wherein all of them have strongly recommended for abolition of DoFS as essential to ameliorate the poor state of our banking industry. 

Even at the time of nationalisation in 1969 there were some very sane voices who did not agree to this policy. But it was all drowned in adulation for Mrs. Gandhi. I have discussed some aspects of the genesis of this retrograde policy decision in my blog on the subject of Bank Nationalisation. Here is the link - https://sushilprasad1.blogspot.com/2023/07/

The true creators of jobs, income, wealth in our country is the MSME sector which directly employs nearly 6 lakh workers, and contributes about Rs.4 lakh crores to national output and 35% of exports. The broken banking sector makes it difficult for industry to raise funds to set-up and grow thereby stunting equitable growth. The larger borrowers face fewer issues in raising funds due to a number of factors - political backing, ability to offer tangible security, more information being available about them in the public domain - including credit ratings. Most of which is lacking for the MSME sector. 

The damage to the economy and society does not end there. Because our banks are not very good in the lending business, they make up their margins, inter alia, through under-pricing deposits. This in turn means that real interest rates that the savers get on bank deposits have largely been negative over long periods in the past. Over the last 4-5 years there is a steady movement of household savings to the Mutual Fund industry. This can be the cause of systemic risks to the economy and lead to another set of problems, but is nowhere on our radar. The higher returns from MF investments also carries much higher market risks which very few are even aware off. 

The broken banking industry in India was succinctly summed up by The Economist in their issue dated 10th April 2008. In their words, "“they leave India’s savers with too little reward for their thrift, its borrowers with too few alternatives to the money lender, and its incumbent firms with too much protection from upstarts who cannot raise money to compete." There is nothing to remotely suggest that there has been any tangible change in this situation.