New Banks, Fresh Funding: There's More to Rajan Than Rate Cuts

  • Indian central bank chief focused on financial sector reform
  • His term, due to end in September, can be extended for 2 years

Raghuram Rajan, governor of the Reserve Bank of India.

Photographer: Dhiraj Singh/Bloomberg

Indian central bank Governor Raghuram Rajan is back to his first love in the twilight of his current term.

After stabilizing the rupee, setting an inflation target and securing a deal with the Modi administration to set up a monetary-policy committee, the ex-finance professor with a doctoral thesis in banking is now focusing on micro reforms.

Among his objectives: making rate cuts shared more quickly with customers, extending banking services to remote villages and creating new sources of funding for companies. The wrinkle is that with little of the work yet completed, Rajan may need to win a two-year extension from Prime Minister Narendra Modi when his term is due in September to complete his agenda.

“He has started a lot of things and they are all a work in progress, particularly in banking," said Prasanna Ananthasubramanian, chief economist at ICICI Securities Primary Dealership in Mumbai. “If you want to see them to completion, he has to stick around."

Rajan’s initiatives span regulatory tweaks to sweeping measures that could change the landscape of Indian banking. They include:

Competition for traditional banks

After allowing two new lenders to start operations in 2014, Rajan late last year pioneered the creation of 11 so-called payment banks and 10 small finance banks.

  • Small finance banks can extend loans of less than $1,000 that commercial banks wouldn’t find lucrative. They must prioritize individual borrowers, farmers and small business owners.
  • Payment banks are essentially digital wallets like Paypal but also offer interest on deposits. Analysts say the move will push traditional lenders to become more efficient as payment banks threaten to eat into their deposit streams, which fund 40 percent of loans.

Lower borrowing costs

India’s lenders have been notoriously slow to match the central bank’s rate reductions. One way to prod them is to move toward a benchmark set by the market -- which is far more nimble -- than one set by banks themselves.

  • Come April 1, Indian lenders will have to change the way they calculate a key interest rate to help ensure the Reserve Bank of India’s rate cuts are passed on more quickly to customers. 
  • All rupee loans will be priced based on banks’ latest cost of funds, which take into account market changes, rather than the average costs that help protect lending margins.

New sources of funding

To reduce the clout of India’s powerful banks, Rajan is working to open new sources of funding for companies.

  • The ceiling on foreign investment in rupee bonds will be raised in phases to 5 percent of outstanding debt by March 2018. The central bank estimates this will attract 1.2 trillion rupees ($18 billion) of additional investment. 
  • Local companies saw overseas loan rules eased, allowing them to borrow from long-term investors such as pension, insurance and sovereign wealth funds.
  • Rajan allowed for the creation of "Masala Bonds" named after spices found in Indian curry. This is rupee debt issued overseas, such as China’s Dim Sums.

There’s still much to be done. Rajan has gone slow on an attempt to push foreign banks to set up local units, a move that would boost the RBI’s regulatory oversight. Masala debt is proving a tad too exotic for investors as China’s market turmoil saps risk appetite.

“Only if I see hundreds of Indian companies going and raising it, then I’ll say it’s been a success,” said Madan Sabnavis, chief economist at CARE Ratings Ltd. in Mumbai. “Today it’s only a concept.”

Debt Clean Up

Most crucially, it’ll be a while before the central bank and government win the fight against bad debt. Soured loans at a 13-year high are keeping loan growth near a 20-year low, crimping investment. If the government doesn’t allocate more than the 700 billion rupees planned over the next few years, credit growth will drop to 8 percent or 10 percent, according to ICRA Ltd., Moody’s local unit.

"Currently because you don’t have capital, credit-fueled growth is simply not on the table," said Srikanth Vadlamani, a credit officer with Moody’s Investors Service. "Capital is totally in the court of the government.”

Modi’s administration hasn’t said yet whether it will keep Rajan around. No matter who is in charge, more work is needed to strengthen the monetary transmission mechanism, give banks the legal backing to go after delinquent borrowers and add depth to capital markets, said Bejoy Das Gupta, Asia-Pacific chief economist at the Institute of International Finance in Washington.

"Rajan has been a key player and an extended mandate for the Governor would be good for policy continuity, but no individual is indispensable," Das Gupta said by e-mail. "Indeed, what is most important is that the government and the RBI continue to work together."

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