The all clear seems to have been sounded for financial sector reforms in the country. Indeed, with the clear electoral mandate for a political combination not dependent on Left parties’ support, protagonists of financial sector reforms seem to have obtained a powerful shot in the arm for furthering their agenda. And true to expectations, even as this piece is being written (18 May), the reforms votaries have already begun talking about ‘far-reaching’ reforms in the sector. Those ‘far-reaching’ reforms, according to this group, are

      (i) greater divestment of government holdings in the banking sector and

      (ii) permitting substantially higher level of foreign investments in the insurance sector.

You would be disappointed if you expected something more profound about the issue of financial sector reforms. Indeed, as far as the reforms brigade is concerned, the above two measures would seem to be the panacea for all the ‘ills’ of the Indian financial sector.

Leave alone the irony in the current environment - where greater private holding and a reduced governmental ownership role in the banking sector are being advocated in India even as higher government stakes, government guarantees of liabilities and assets (and effective nationalisation) is the order of the day in the banking sector of the major western economies.

That irony, of course, has to do with the force of the financial crisis which the western economies have been facing, where even basic financial intermediation had broken down some time back. This is a rare but high risk event which has called for deep governmental intervention to re-set the rules for the orderly functioning of the market economic system. The expectation and stated intention of the policy maker in the western world, therefore, is to gradually move towards completely eliminating a government ownership role in the financial sector. Looked at from that background, the strength which the ‘diluting government stake’ argument has got in India, post the recent elections, is certainly not out of place.
But the more serious issue here is compressing financial sector reforms into just the above two issues - of reducing government stakes in public sector banks and permitting higher foreign stakes in the insurance sector. This is a vast simplification or even belittling of the serious structural issues which have to be addressed in the Indian financial sector. In the flush of electoral victory and in the hype about these two issues, such belittling completely obfuscates the real issues at hand. Unfortunately, such obfuscation may also represent a fine opportunity being missed to address the real, structural issues at hand - issues that would be critical to the long-term economic well-being of large sections of the people.

What are these structural issues?

Indeed, the measuring yardstick for any macro economic or financial sector policy or reform should be if it contributes to long-term economic well-being. It may be a truism to be saying this. But, seen in the light of the unnerving economic experience in India in the past five years, it does seem appropriate to reiterate this truism.

One such structural issue is the role and relevance of foreign capital in the process of economic growth. A related and critical issue is the exchange rate policy. Now, how are these two macro economic and financial sector policy issues related to economic well-being, particularly at the level of the common man or as it is said, the Aam aadmi?

One such unnerving economic experience (referred to above, among the many) of the past few years has been the developments in the residential real estate sector in the country.

It is no secret that residential real estate (prices) - both land and built-up property - has largely gone out of the reach of the common man in India in the past 5 years. Even if we account for the price corrections which have come about in the past 6 to 8 months, it would be no exaggeration to say that housing affordability has been severely undermined in India in the past five years. It would be safe to say that housing - both as an owned asset as well as in rented form - will, henceforth, never be as affordable as the common man would like.

What has caused this severe and permanent strain on housing affordability and hence, on economic well being of the common man?

One of the key reasons behind the large scale rise in housing prices (which has outpaced by several times the rise in the incomes of the common man) is the policy relating to foreign capital flows and that relating to exchange rate management.

Capital flows and exchange rate management

Indian financial sector policy, as it has evolved over the past 15 years, has permitted increasingly higher levels of foreign capital to flow into diverse sectors of the domestic economy.

At a basic level, such a policy does not prima facie appear undesirable. (Though prima facie undesirable, this policy does not appear that necessary as we shall presently explain). Though not undesirable by itself, the deleterious consequences from this policy flow from how these capital flows have been managed in the foreign exchange market.

The exchange rate policy followed in the past several years has meant that while the rupee’s external value (against foreign currencies generally and parti-cularly against the US dollar) has been broadly kept stable (in relative terms), the brunt of the adjustment has been borne by specific asset markets in the local economy - be it real estate, stocks, industrial / agricultural commodities.

From a macro perspective, it is fairly straigh tforward – if you do not allow the exchange rate of the country’s currency (which is an important financial price by itself) to adjust, either upward or downward, in relation to the level of capital flows the country attracts, then the ‘price’ adjustments have necessarily to be borne by the markets in the following segments in the domestic economy- goods and services, real estate, commodities and stocks.

It is no surprise that Indian real estate and the general price levels in the goods and services markets have gone up sharply in the past five years even as the rupee was not allowed to rise against the dollar. Housing affordability has, therefore, come under immense strain. The level of consumer prices - that is prices as it relates to the common goods and services consumed at the ground level - also have shot through the roof. This is the background to the CPI inflation stubbornly ruling at the 10 per cent levels even as the government proclaims that it has brought down WPI inflation to near zero levels.

Broadly, what we have seen (continue to see) is a boom-and-bust kind of environment in key asset markets such as real estate, stocks and commodities. A key causative factor for this level of volatility in these markets - which has severely strained affordability as well as undermining sentiments/confidence - is the policy adopted with respect to capital flows and the exchange rate. How is this policy at all reconcilable with the national housing policy’s goal of affordable housing for all?

One would have thought that when talking about financial sector policy reforms, the protagonists would highlight and explore these issues. But, as pointed out, changing government stock ownership norms in banks seems to be the be all and end all of reforms policy.

Capital flows and economic growth

An even more basic financial sector policy issue is whether the Indian economy needs the high level of foreign capital flows it has opened itself to in the past decade. An analysis of Indian savings, investments, foreign capital flows and economic growth data would show it is not necessary. Indian investments have closely tracked the level of domestic savings only. If foreign capital were used effectively, one would have seen Indian investments running far ahead of domestic savings. That has not happened. So, do we need this high level of foreign capital flows and the economic problems it brings? Again, this is an issue which the reforms protagonists are not highlighting or talking about.