Moving India Toward Universal Financial Inclusion: Part 2 of our Q&A with Nachiket Mor
As the Nachiket Mor committee report on financial inclusion in India continues to make headlines, we spoke with Mor to discuss its recommendations in detail. In part two of our Q&A, he covers issues that include:
- Why India needs to move toward a cashless economy;
- How India’s regulatory systems will need to evolve as more non-bank entities begin offering financial products;
- How the committee’s recommendations could impact the Indian economy – and particularly its lower-income communities – in the coming years.
(Part one of our interview can be read here).
James Militzer: The report states that providing universal access to a formal electronic payments infrastructure would be a step toward “an economy that is eventually entirely cash-less.” Why should India transition entirely away from cash, and how soon do you see that happening?
Nachiket Mor: As evident in the July 2002 date of its “Report of the Working Group on Electronic Money,” India was one of the early movers in formally exploring the potential of electronic money. Given the sheer size of the country (3.3 million square kilometers, 1.2 billion population) and the absolute poverty of a majority of its citizens (more than 60 percent with an income below U.S. $2 per day), a large proportion of them do not have the financial capacity to absorb the substantial costs associated with the management of physical currency notes and traditional branches. In this sense, a cash-based economy levies an effective tax on the financial assets of households that are being held using currency notes and in India (as in other developing countries), this tax can be of a highly regressive character since it is the poor that are likely to hold a larger portion of their financial assets in the form of currency. This implies that the financial inclusion and efficiency gains associated with the widespread, even ubiquitous use of electronic money are likely to be very high.
For these reasons, making access to formal electronic payments infrastructure universal is a key component of the overall vision of financial inclusion and the Reserve Bank of India (RBI) vision document on payments correctly aims toward an economy that is eventually entirely cash-less. In addition to the obvious benefits to individuals and businesses, moving away from cash-based transactions to electronic transactions also has important efficiency benefits for the government. For instance, we quote in the report a 2010 McKinsey study which, while assessing the costs and benefits of digitising government payments in India, estimates that the government would save more than Rs.1 trillion per annum if it were to digitize all payments to and from the government.
In India the switch to electronic money is under way but is likely to happen much more slowly and could result in the steady reduction in the seigniorage income of the RBI and impair its ability to finance its assets such as the foreign exchange reserves of the country. The report argues that this builds a case for the RBI or an agent appointed by it to become the sole issuer of e-money in the country and for investing in its rapid adoption as a medium of exchange with the goal of rapid phase-out of currency notes in circulation. If indeed the RBI is able to become the sole issuer of e-money it could issue it directly to the other purveyors of e-money (as it does with notes in circulation now) and thus maintain only wholesale accounts on its books.
JM: Do you expect that the RBI will implement your committee’s recommendations as written – and are you concerned that if they pick and choose which parts to implement, the framework you’ve laid out will fall apart?
NM: The report has laid out a framework and so it can be concluded that a single recommendation, on a stand-alone basis, will not be powerful enough or relevant enough to make significant impact. Each recommendation has a natural way of flowing into a set of closely related recommendations which are to be seen together and not in isolation.
For instance, we recommend an adjusted mechanism for Priority Sector Lending (PSL) that moves away from the current blanket approach for all banking institutions, to one where PSL achievement is calculated using a set of district- and sector-specific weights, while keeping the overall PSL requirement roughly the same. In isolation, this would be construed as difficult. However, a whole set of recommendations around creating a market for tradable assets including PSL assets between all kinds of institutions and priced based on the quality of assets, with easing of constraints for non-banking entities to establish themselves as wholesale banks and to cover the last-mile especially in difficult-to-access regions and sectors – make the recommendation with regard to PSL imminently achievable. We are confident that the regulator is discerning in this regard.
JM: If the recommendations are implemented, how much will India’s regulatory system have to grow to accommodate all the new financial entities that will be created? Are you anticipating/preparing for any conflicts between different regulating bodies as more non-bank entities begin offering financial products?
NM: The regulator in India is already preparing to shift to risk-based supervision regimes. This significantly increases their ability to supervise a larger number of entities. Our recommendations seek to bring more entities that are currently operating in the “shadow” into the banking framework and this will make their treatment regulatorily consistent.
Irrespective of the committee’s recommendations, the need for greater inter-regulatory communication has been gaining recognition across the world. While some jurisdictions have covered the entire distance and have created regulators that are function-specific and span across products, even in India there have been concrete steps in this direction in the form of the Financial Stability and Development Council (FSDC) and the greater role for it envisaged by the FSLRC. Inter-regulatory cooperation can be expected to take on greater prominence in the future as the boundaries between product functionalities blur even more.
JM: If implemented, how do you see your recommendations impacting the Indian economy – and particularly its lower-income communities – over the next five to 10 years?
NM: A well-functioning financial system should at the minimum give every citizen an ability to manage liquidity and risk. The level of financial inclusion and financial depth in India today remains poor and highly inequitable between regions and sectors indicating that it is failing to meet this goal. For instance, if you were to look at financial depth, bank credit to GDP ratio in the country as a whole is 70 percent. In comparison, data from the World Development Indicators show that by 2012 high-income countries had attained an average credit to GDP ratio of close to 200 percent, middle-income countries 100 percent (with China having crossed 150 percent) and low-income countries 40 percent.
A growing body of empirical research has found that the services provided by the financial system, especially credit, exert a first-order impact on long-run economic growth and poverty. In this context, it could be argued that in certain regions like Bihar, where the credit to GDP ratio is as low as 16 percent, access to formal finance is acting as a significant barrier to growth.
As mentioned in the report, we envisage that each district and every “significant” sector of the economy would have a credit to GDP ratio of at least 10 percent by Jan. 1, 2016, and of 50 percent by Jan. 1, 2020. In this sense, the report envisages a financial sector that is an active facilitator of economic growth. The overall framework of the report also seeks to make rapid progress on financial inclusion and financial depth while enhancing the systemic stability of the financial system. For instance, the payments bank model provides a low-risk pathway to establishing a ubiquitous payments infrastructure since all deposits are invested in government securities. Several other recommendations like permitting banks to purchase portfolio level protection against systematic risks, risk-based pricing of credit guarantees and risk-based approach to supervision will help to make the economy more stable and resilient.