A Challenge before the Indian Banking System

Tarapore Committee (Chairman Shri S S Tarapore) on capital account convertibility,

appointed by the Reserve Bank of India in pursuance of the commitment to the Finance
Minister in Budget 1997-98 has recently submitted its report. The report has emphasised
improvement of Indian financial system vis-a-vis banking system to effect capital account
convertibility. The signposts and preconditions for capital account convertibility has included
a number of issues relating to the banking system. Thus it is a challenge before the banking
system to achieve the level of efficiency within the time-frame prescribed by the committee.

The terms of reference of the Committee are as follows :

• Review the international experience in relation to Capital Account

convertibility (CAC) and to indicate the preconditions relating to CAC.
• Recommend measures for achieving CAC.
• Specify the sequence and time frame for such measures.
• Suggest domestic policy measures and changes in institutional framework.

Preconditions and Signposts

The major preconditions and signposts mentioned in the report are as follows :
FISCAL CONSOLIDATIONS

• Reduction in Gross Fiscal Deficit as percentage of Gross Domestic Product

from budgeted 4.5 in 1997-98 to 4.0 in 1998-99 and further to 3.5 in 199-
2000.
• Introduction of Consolidated Sinking Fund.
• Introduction of a system of fiscal transparency and accountability on the
lines New Zealand Fiscal Responsibility Act.

MANDATED INFLATION RATE

• The mandated rate of inflation for the 3 year should be an average of 3% to

5%.
• RBI should be given freedom to attain the tarred mandate of inflation
approved by the Parliament.
• There should be clear and transparent guidelines on the circumstances
under which the mandate could be changed.

STRENGTHENING OF FINANCIAL SYSTEM

• Interest rates to be fully deregulated in 1997-98 and any formal or informal

interest rate controls to abolished.
• CRR be reduced in phases to 8% in 1997-98 6% in 1998-99 and to 3% in
1999-2000.
• Non-Performing Assets as percentage to total advances to be brought down
in phases to 12% in 1997-98 9% in 1998-99 and to 5% in 1999-2000.

IMPORTANT MACRO-ECONOMIC INDICATORS

• A monitoring band of +/-5% around the neutral Real Effective Exchange

Rate (REER) to be introduced and intervention by RBI to be ensured when
 REER is outside the band.
• REER band to be declared, published contemporaneously and changes made
in neutral REER made public.
• Debt service ratio to be reduced to 20% from 25%.
• A minimum Net Foreign Assets to currency ratio of 40% to be stipulated by
law in the RBI Act.
• External sector policies should ensured a rising trend in the ratio of current
receipts to cross domestic product from the present level of 15%.
• The ratio of current account deficit to GDP should be even.
• The Foreign Exchange Reserves should not be less than 6 months of imports
i.e. $22 billions as at present.
• Reserves should not be less than 3 months of imports plus 50% of debt
service payments plus one month's export and import leads and lags i.e.
$24 billion as at present.
• 100% mark to market valuation of investments for banks.
• Best practices for forex risk management banks.
• Banks to follow international accounting and disclosure norm
• Capital prescription be stipulated for market risk.

The Committee has elaborately framed timing and sequencing of current account
convertibility.
Impacts of Capital Account Convertibility on Banks
For the success of the current account convertibility a lot depends on the strength and
financial consolidation of the banking system. The impact of current account convertibility
would be the most on the financial system of the country. The impacts of the phased
changes in the policies regarding the banking system to bring about capital account
convertibility are discussed below :
Total Deregulating of Interest Rates
The Committee has recommended total deregulation of interest rates i.e. total transparency
to ensure non- existence to formal or informal interest rate control, in the current financial
year. The measure of withdrawing of interest cap is expected to trigger off deposit rates war
among public sector, foreign and private sector banks. Interest rate on savings bank
account is expected to be increased to 6.5% p.a. from 4.5% p.a. by private sector banks to
wean away deposits from public sector banks. The deposit rate war would also fuel cost of
funds.
Scheduled Plan to Bring Down NPAs
The Committee has suggested time-bound plan for reduction of NPAs of the banking system
to enable it face international competition. The targets for reduction of NPAs as percentage
of total advances are set at 12% in 1997-98, 9% in 1998-99 and 5% in 1999-2000. It has
also recommended a comprehensive banking legislation and an enforcement machinery to
reduce the quantum of NPAs and ensure this framework to prevent future defaulters. With
other costs and returns remaining unchanged the spreads available to the banking system is
estimated to increase by 1.8%.
Restricting Growth of Weak Banks
Strengthening of financial system being the most important precondition for capital account
convertibility, the Committee has suggested monitoring of the growth of weak banks so as
to temper the impact of its growth on the banking system. The Committee has suggested to
convert the weaker banks into `narrow banks' observing that the weaker banks are growing
at a faster rate than the banking system. These `narrow banks' observing that weaker
banks are growing at a faster rate than the banking system. These `narrow banks' are
advised to restrict their incremental resources only to investments in government securities,
restraining their liability growth.
Stringent Imposition of Capital Adequacy Norms
The Committee has recommended to consider the imposition of even more stringent capital
adequacy norms than the Basle norms as the risks faced by financial sector are much higher
in developing countries. It noted that prudential norms should emphasise necessary
safeguard to enable the banks in system to attain the international standards instead of
enabling the weakest segment of the financial system a cushion for survival. It has also
suggested that the supervisory system should be in a position to take quickie, strong and
deterrent actions in cases of inadequacies or deviations from norms.
Liberalisation of Gold Trade
The Committee has noted that the liberalisation of gold regime is necessary before moving
towards capital account convertibility. It has also suggested to allow Indian entities into the
international commodity markets. Banks and financial institutions fulfilling defined criteria
have been suggested to be permitted to operate freely in the domestic and international
markets. This would augment sale of gold to residents, gold denominated deposits and
loans, mobilisation of household gold and working capital gold loans to jewellery
manufacturers and deposits schemes like gold accumulation plans.
Cut in Cash Reserve Ratio
The Committee has recommended a progressive reduction of average effective cash reserve
ratio from the existing level of 9.3% to 8% in 1997-98, 6% in 1998-99 and finally to 3% in
1999-2000. This reduction in CRR by 6.3% is expected to release Rs.35,000 crores into the
banking system over a 3-year period. This would reduce the lending rates as the cost of
funds will be reduced to a great extent, with the huge increase in the lendable resources,
the banks would be able to finance infrastructure sector in a big way.
CONCLUSION
The greatest impact of the capital account convertibility would be felt in the banking sector.
Total deregulation of the interest rates would instil greater competition in the circle. The
weaker banks would further be cornered as `narrow banks`. NPAs reduction would be at
focus of attention of banks which would help regaining of its financial health. margin of
banks would be under pressure, infusing adequate asset liability management system in the
banks. However, banks will have much more liberal limits for borrowing and deploying funds
outside India. Indian banking system should surge ahead in this occasion and accept the
challenge by eradicating its weak points and consolidating its financial health.
Contributed by
U S Ghose
General Manager
Allahabad Bank
CAPITAL ACCOUNT CONVERTIBILITY