Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
Financial Repression- A Case with India
Yasmeen Khalid Aowte*
Financial repression is any of the measures that governments employ to channel funds to
themselves, that, in a deregulated market, would go elsewhere. In the context of Indian
economy:this paper tries to trace the cases of financial repressions and policy measures
adopted by different countries and with special reference to India.In India, Statutory Liquidity
Ratio (SLR) Strict investment guidelines for financial firms,High inflation are some of the
causes of financial repression. Financial repression is a term used by economists which
means the government taking ordinary people’s savings to achieve some goal, typically to pay
for the government itself, by exploiting imperfections in the financial system. It is an indirect
form of a much more widespread process, that of governments (or the elites which control
them) commanding resources in the economy for their own uses. To some extent it is an
alternative to taxation, which is a more obvious and legitimate way for the state to take
resources. But because it is less transparent, there is a risk that governments use financial
repression excessively.
Key Terms: Financial Repression, Statutory Liquidity Ratio, Corporate Social
Responsibility, Disinvestment
1. Introduction:
Financial Repression is any one of the measures that government employs to channel
funds to themselves that in a deregulated market would go elsewhere. Financial
repression can be particularly effective at liquidating debts. The term financial repression
was introduced in 1973 by Stanford economists Edward S Shaw and Ronald I McKinnon.
It was meant to include such measures as directed lending to the government, caps on
interest rates, regulation of capital movement between countries and a tighter association
between government and banks. In layman's term, it refers to the means by which the
government expropriates savings of ordinary people or corporations. Clearly financial
repression is a key ally of profligate governments.
2. Review of Literature
Carmen Reinhart and Belen Sbrancia speculate on the possible return by governments to
this form of debt reduction in order to deal with high debt level following the 2008
economic crisis. They classify Financial Repression into following key elements:
•
Explicit or indirect capping of interest rates such as on government debts and
deposit rates.(Eg Regulation Q)
•
Government ownership on control of domestic banks and financial institutions with
barriers that limit other institutions seeking to enter the market.
•
High reserve requirements
•
Creation or maintenance of captive domestic market for government debts via
capital requirements or by prohibiting or disconnecting alternatives
•
Government restrictions on transfer of assets abroad through the imposition of
capital controls
______________________________________________________________________
*Head, Dept of Business Economics, Gogate Jogalekar College, Ratnagiri, Maharashtra, India,
yasmeenmaam@rediffmail.com, Cell: 09423292430
Proceedings of 30th International Business Research Conference
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These measures allow the government to issue debt at a lower interest rate. A low
nominal interest rate can reduce debt servicing costs while negative interest rates erode
the real value of government debts. Thus Financial repression is most successful in
liquidating debts when accompanied by inflation and can be considered a form of taxation
alternatively a form of debasement.
Unlike income, consumption or sales tax, (or rates) are determined by financial
regulations and inflation performance that are opaque to the highly politicised realm of
fiscal measure, given that the fiscal deficit reduction and (or) tax increased …..The
relatively ―stealthier‖ financial repression tax may be more politically palatable alternative
to the authorities faced with the need to reduce outstanding debts.
3. Governments Repression:
3.1 Why was it easy to cut debt immediately after war?
Inflation helped. Between 1945 to 1980, negative real interest rate ate away
government debts. Savers deposited their money in banks which lent to the
government at rate of interest below level of inflation. The government then
repaid their savers with the money that brought less than the amount
originally lent which corresponded to improvement in government's balance
sheet. The mystery is why did the savers accept crummy returns over long
periods?
Exchange rates and capital control of Briton Goods financial system kept
savers from seeking high returns abroad. High reserve requirements forced
the banks to lock up much of economies savings in safe asset classes like
government debts. Caps on banks lending rates ensured that trapped
savings were lent to the sovereign at below market rates. Such rules were
not necessarily adopted to facilitate debt reduction, through that side effect
surely didn‘t go unnoticed. The system was ubiquitous reducing pressure on
governments to abandon it.
Repression delivered impressive returns. In the average ‗liquidation year‘ in
which real interest rate were negative, Briton and America reduced their
debts by 3% and 4% of GDP.
Italy and Australia enjoyed annual interest rates above 5%. The effect over
the decade was large from 1945 to 1955. Repression reduced America's
debt load by 50% points from 116% to 66%
In the wake of financial crisis banks' reserve requirements are rising. Britons
Financial Services Authority is mandating that banks boost their holdings on
safer government bonds for liquidity reasons. The new Basel III norms on
bank capitals still privileges government debts over other assets, nudging
Proceedings of 30th International Business Research Conference
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holdings towards sovereign debts despite the possibility of below market
returns. From 1981 to 2007 real interest rates were almost always positive.
Since then they have been negative about half of the time.
3.2 Governments Repression
 Ireland- raided its national pension reserves to help meet financing needs
 European leaders- Considering text book examples of repression to postpone
reconing on Greece debt
 European bank understate pressure voluntarily to roll over or retrofire their holds of
Greece government debts
 China- World second largest economy is the financial systems arc repressor. Tight
controls over banking systems and strict limit on capital movements enable China
leaders to hold down value of its currency. An implicit tax on Chinese savers keeps
down government borrowings despite hefty tax expenditure.
Repression alone is not enough to solve debt woes. Inflation is necessary too. Most
important is government must stop adding new debts even in a financially repressed
systems austerity is entirely avoided. Most economies must cut their debts in a hard way.
4. FINANCIAL REPRESSION- A CASE WITH INDIA
4.1 Economic Reform in India and Capital Inflows
After independence, India had a comparatively unrestricted financial system until the
1960s, when the government began to impose controls for the purpose of directing credit
toward development programs. Over the 1960s, interest rate restrictions and liquidity
requirements were adopted and progressively tightened. The government established the
state banks and by the end of the decade had nationalized the largest commercial banks,
giving authorities broader control over the allocation of credit across sectors and
enterprises. Through the 1970s and into the 1980s, directed credit took a rising share of
domestic lending, and interest rate subsidies for targeted industries became
commonplace. With the start of economic reforms in1985, the government began to
reduce financial controls by partly deregulating bank deposit rates. In 1988 these controls
were reinstated, and the government began to relax ceilings on lending rates of interest.
Progressive relaxation of restrictions on both bank deposit and lending rates of interest
and the reduction of directed lending had begun by 1990. The gradual reduction in
interest rate controls and directed lending proceeded throughout the 1990s.21
Until reforms began in the late 1980s, international capital inflows and outflows were
restricted by administrative controls or outright prohibition on the purchase of foreign
assets by residents, direct investment by foreigners, and private external borrowing. After
India encountered balance of-payments difficulties in 1991, the authorities began to
gradually relax restrictions on inward capital flows and on currency convertibility for
current account transactions. The rupee was made fully convertible for current account
transactions in August 1994, when the government agreed to the obligations of Article VIII
of the Articles of Agreement of the International Monetary Fund. Trade liberalization also
proceeded during the 1990s, wit tariff rates reduced substantially. Over the last several
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years, restrictions on foreign direct investment, portfolio borrowing, and foreign portfolio
equity ownership have been relaxed. This marked a significant turnaround from banning
foreign investment and ownership to actively seeking it (at least in the case of direct
investment). Restrictions on the share of foreign ownership in enterprises
Demetriades and Luintel (1996, 1997) estimate the impact of banking controls on
economic growth in India and conclude that they had a negative effect. Their index of
financial repression for India based on quantitative restrictions on financial intermediation
displays an upward trend from 1969 through 1984, followed by a decreasing trend
beginning in 1988.have been removed in most sectors, and the upper bounds for
automatic approval of direct and portfolio investments have been progressively raised.
The procedures for investments over these thresholds have also been simplified and
clarified in an effort to reduce delays and arbitrary rulings. Foreign investment income is
fully convertible to foreign currency for repatriation. External commercial borrowing has
been relaxed but is regulated with respect to maturities and interest rate
spreads.22Effective restrictions remain on residents‘ acquisition of foreign financial assets
and on currency convertibility for capital account transactions. Recently, these restrictions
have been slightly eased to allow domestic residents to invest in foreign equities. It is also
apparent that some domestic investment, notably in equity, by domestic residents is
intermediated through Mauritius to take advantage of favourable tax treatment under
India's reciprocal tax agreement with that country. Direct deposits and equity and bond
holdings by non-resident Indians are subject to favourable treatment but remain small
relative to the size of the financial sector.
The imposition of controls on cross-border financial transactions in the1960s paralleled
deep government intervention in domestic financial intermediation. As in other countries,
the initial motivation for financial controls was to direct savings toward investment in
certain targeted sectors as part of a development plan. State ownership of intermediaries,
interest rate restrictions, foreign exchange controls, and directed credit schemes were all
part of a policy of financial repression.
The government also required, and continues to require, that banks hold a large share of
their assets in public debt instruments. These instruments paid below-market rates of
interest, imposing an implicit tax on financial intermediation and providing a significant
source of revenue for the government. Indeed, the role of financially repressive policies
evolved over the decades, from one of addressing development objectives to one of fiscal
necessity, as it has in a number of other developing countries.23 As analyzed below,
liberalization has brought about a decrease in the fiscal revenue generated by financial
repression. Policies of financial repression impose an implicit tax on saving and
investment, one that can vary widely by source and activity. Such policies can
significantly distort and discourage capital accumulation and slow economic growth.
This observation is documented by Fry (1988, 1997) and Giovannini and de Melo(1993),
among others .different degrees when they essentially eliminate private international
financial transactions, as they did in India in the 1970s and 1980s. The selective
imposition and partial relaxation of controls (the current situation in India) also distorts
financial activities in myriad ways, which may not be recognized or easily quantified.
Because the differences in rates of return to different saving and investment vehicles can
Proceedings of 30th International Business Research Conference
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have large effects on the size of financial flows, the microeconomics of capital controls
can have macroeconomic impacts.
One of the focal points of inward capital account liberalization in India has been, as
already noted, the encouragement of foreign direct investment. Total flows of foreign
direct investment into India increased sixty-fold in dollar terms from 1990–91 to 2001–02,
to over $6 billion, and inward portfolio investment was $2 billion in 2001–02. However,
foreign direct investment inflows to India remained less than 6 percent of total foreign
direct investment entering the developing countries of Asia in 2001.
Financial repression is any of the measures that governments employ to channel funds to
themselves, that, in a deregulated market, would go elsewhere. In the context of Indian
economy:
4.2
Statutory Liquidity Ratio (SLR) is one such tool by which commercial banks
are statutorily required to invest in Government securities. While it is okay to
ensure solvency of banks but 22.5% of total liabilities is quite high. Since the
Government securities. don't earn enough interest for banks (they're less risky
though), the banks tend to charge higher interest in lending to customers. Imagine
if half of this amount could be transferred to private/priority sector lending.
4.3
Strict investment guidelines for financial firms, for example, 25% mandatory
priority sector lending despite already high SLR. This also leads to crowding out of
private investment. Moreover, banks usually lend to already rich "zamindars" (yes,
they still do exist in some form or the other) so that the loan may not turn into a
non-performing asset in future.
4.4
High inflation due to high fiscal deficit gives low returns (real interest rate
decreases due to high inflation) to customers who invest in financial assets. So,
household financial savings go down, yet another cause of financial repression.
Those customers start investing in gold which tends to increase the inflation due to
high current account deficit.
The state-owned oil companies were forced to bear 40% of the total calculated oil
subsidies, and even the remaining amount that is to be paid by the government is done
so with an inordinate delay which will force the oil companies to go on a borrowing spree
for sheer survival. This flexing of muscles by the government not only reduces its
borrowing requirement but also provides some relief in its debt servicing requirement.
5. The Findings:
As the Indian economy shows distinct signs of slowdown and with the politically and
financially challenged government clearly on the back foot, 2012 has witnessed a series
of announcements and actions that shows that financial repression is alive and kicking in
India. Although the last quarter of the current financial year (FY2012) is yet to be
completed, the following stands out:
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5.1 Seventeen Public Sector Units (PSUs) will be made to invest $USD35 billion in
infrastructure with an aim to jump start an economy struggling to find appropriate
growth drivers.
5.2 The first serious effort at disinvestment (selling government‘s 5% share in Oil &
Natural Gas Corporation equity through auction) during the current financial year
(mismanaged as the entire process was) resulted in the government asking the
Life Insurance Corporation of India (LICI) to bailout the issue which faced heavy
weather due to absolutely muted private participation. Available information
shows that LICI picked up 88% of the shares on offer (377 million shares),
thereby increasing this existing shareholding in the company by another 4.4%.
5.3 The government has managed to arm-twist India‘s insurance regulator
(Insurance Regulatory and Development Authority) to allow LICI to exceed the
cap of 10% that an insurance company can own in any listed company. The aim
is clearly to ensure that when the government gets into disinvestment mode
(remember during the recent budget the government budgeted for disinvestment
revenue to the tune of INR300 billion revenue during the next financial year
starting April i.e. FY2013) they can always fall back on LICI to ensure success of
the disinvestment process.
5.4 In February, LICI agreed to pick up a 5% stake in a few state owned banks like
Punjab National Bank, Central Bank of India and Indian Overseas Bank, for
INR37 billion. In March, Dena Bank allotted preferential shares to LICI amounting
to INR1.51 billion. This had to be resorted to, as the cash strapped government
was not in a position to meet the growing capital requirements of these banks.
We are most likely to see repeat of such investments in FY13 as bank
capitalization requirement goes up. In fact, there‘s also a possibility of the
government forcing several state-owned companies to buy some portion of the
government‘s share in other state-owned companies, in the guise of
disinvestment. Such a decision may lead to the affected companies not being
able to generate adequate resources to meet their own investment needs.
5.5 Given the government's mindless spending on such schemes, many with
questionable benefits, the government's borrowing requirements remain
elevated. However, not much of the borrowing is done from lenders who are
willing to lend. In fact, a good chunk of government bond issuance is forcibly
placed with various financial entities. These include banks, insurance companies
and pension funds.
5.6 Banks, for example, are forced to set aside 23% of their deposits in government
bonds as statutory liquidity ratio as part of what is called prudential management.
That apart, they have to maintain 4% (it was higher earlier) of their deposits as
cash reserve ratio, on which the government has stopped paying any interest
whatsoever since March 31, 2007. In all, the banking sector has to keep 27% of
their deposits with the government.
5.7 The pension system operated by the Employee Provident Fund Organization
(EPFO) is almost entirely invested in domestic government bonds. That apart, of
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the 12.11 trillion rupees (US$222 billion) invested by life insurance companies on
March 31, 2012, 38.64% was invested in central government securities; a further
17.71% was invested in state government and other approved securities.
6. Observations:
The Indian financial policy, therefore, ensures that the government gets roughly all EPFO
assets, more than half of the assets of life insurance companies and more than a quarter
of the assets of banks.
Not that financial repression is new in India. In fact, this is true for all developing
economies. For a capital-scarce country like India, capital control was a natural outcome,
since the idea was to direct savings toward investment in certain targeted sectors as part
of a development plan.
Financial repression took the form of government's ownership of intermediaries,
restrictions on interest rates, control of foreign exchange (especially outflow), credit
schemes that are favourable to a few sectors and so forth. Regulation also stipulated (and
this continues to be the case) that the banks hold a large share of their assets in public
debt instruments. These debt instruments paid below-market rate interest and hence
imposed an implicit tax on financial intermediation while providing cheap source of capital
to the government.
Unfortunately, for India, the requirement to follow such policies has transcended the need
to address various development objectives; it is now being resorted to simply because
governments of various hues have failed to adhere to fiscal discipline. I believe that the
fiscal deficit is but a natural consequence for a capital scarce developing economy like
India that strives to move to a path of high and sustainable growth. The problem lies with
the quality of the deficit, as wasteful expenditures and politically motivated populist
measures contaminate the nature of the deficit, thereby leaving very little fiscal space to
carry out the developmental activities.
Thus disinvestment efforts by the government are being bailed out by state-owned
institutions like the State Bank of India and the Life Insurance Corporation of India (LICI).
The government has arm-twisted the Insurance Regulatory Development Authority to
allow LICI to exceed the cap of 10% that an insurance company can own in any listed
company.
Even the cash rich state-owned companies are being made to use their funds to buy
stakes in other companies whose shares the government plans to sell, irrespective of
whether such acquisitions make sense for the acquiring companies. Without such
support, the government's disinvestment program during the fiscal year 2012-13 would
have been an utter failure.
What is even more galling is that, while the government's wasteful expenditure is on the
rise, it is way behind other countries (even many poorer countries) in terms of the share of
gross domestic product spent on health and education - higher spending on which is
essential if India is to reap the So the government has, very recently, mandated that
corporate entities with a net profit of 50 million rupees and turnover of 10 billion rupees
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should mandatorily spend 2% of their net profit on acts of "C" - a perfect example of how
a government forces private sector entities to fill in the void created by their inability.
7. Summary:
The best way to deal with financial repression is to reduce the fiscal deficit by reducing
the government borrowing from the domestic market, increase the household financial
savings by easing the investment rules for financial firms and reduce inflation. They all
reinforce each other. However, in India there is another way: setup an authority (Public
Debt Management Agency) in x years, who will submit the assessment report in x^2
years and then never apply its suggestions and play the blame-game for the whole mess!
Markets remain worried that India will experience more capital flight this year, after 2013
seems likely to be remembered in India as the year of taper fear and rupee roil.
Domestic banks are the main buyers of Indian sovereign debt — a factor that can help
keep government borrowing costs reasonable even in case of renewed capital flight. But
a new Moody‘s report highlights one factor working in India‘s favor: The government
doesn‘t rely too much on foreign investors to finance its borrowing.Less than 10% of
India‘s sovereign debt was held by nonresidents last year—a larger share than in Brazil,
but far smaller than in Indonesia, where nearly 60% of debt is owed to foreigners,
according to the report.
The Indian government‘s borrowing is also overwhelmingly in rupees: Less than 10% is in
foreign currencies, compared to around 40% in Indonesia and the Philippines. That
means another round of volatility in capital flows and exchange rates isn‘t likely to
jeopardize India's credit rating and send government borrowing costs soaring.
Moody‘s also notes that Indian sovereign bonds have relatively long maturities, which
means the government doesn‘t have to repay or refinance so much of its debt each year.
Even though India‘s budget deficit is markedly higher as a share of gross domestic
product than many of its peers‘, Moody‘s shows, its gross financing requirement for 2014
is smaller.
India still has a large external deficit related to private spending and investment. And
foreign capital could still flee if private investors don‘t think India‘s economic prospects are
worth the higher interest rates, especially with rates set to rise in the developed world too.
The report doesn‘t address the risks from Indian companies‘ external borrowing, which
could slam their bottom lines if interest rates rise sharply.
But government borrowing, at least, is probably safe. That says a lot about the nature of
India‘s financial system, which has a lot more in common with China‘s than most people
probably realize.
Capital controls prevent Indian residents and companies from easily keeping their savings
overseas, where they might earn higher returns. This ensures that Indian banks have a
large deposit base with which to make loans—including to the government, which
mandates that commercial banks hold almost one-quarter of their basic deposits in the
form of sovereign bonds and other approved securities.―Financial repression,‖ as these
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practices are called, enables the government to run budget deficits steadily, without fear
of sudden swings in foreign-investor sentiment.
But repression isn‘t a free lunch. Budget deficits at some point can grow too large for the
government to keep borrowing at such low rates and long tenors. And if India‘s slow GDP
growth and high inflation persist, households will have less money to stash in bank
deposits, and Indian banks will see even more of their loans go bad.
According to the latest data from the Reserve Bank of India, non performing assets
represented 4.2% of Indian banks‘ loans in September, up from 2.4% in 2009. Some 90%
of those bad loans are held by state-run banks.
Prolonged stagflation, could impair domestic banks‘ asset quality, profitability, and deposit
growth to an extent that lowers banks‘ capacity to absorb government debt. India will
have a tougher time borrowing on today‘s favorable terms if some of its biggest and most
reliable creditors are struggling.
8. Conclusions:
Financial repression is a term used by economists which means the government taking
ordinary people‘s savings to achieve some goal, typically to pay for the government itself,
by exploiting imperfections in the financial system. It is an indirect form of a much more
widespread process, that of governments (or the elites which control them) commanding
resources in the economy for their own uses. The historically extreme form was forced
labour or slavery, in which a king, pharaoh or emperor forced the building of tombs,
palaces or temples. Financial repression is less obvious to people, so it can be used
even in a democracy. To some extent it is an alternative to taxation, which is a more
obvious and legitimate way for the state to take resources. But because it is less
transparent, there is a risk that governments use financial repression excessively.
Governments can take resources with more or less legitimacy from their citizens to use
for various purposes. Financial repression is when this happens through stealthy
distortions in the financial system, and people are unable to escape. Highly liberalised
systems make financial repression very difficult, because savers have alternative places
to put their money. Less liberalised systems have the potential for deliberate or incidental
extraction of savers‘ wealth by the government.
India has a different mechanism, the ―statutory liquidity ratio‖ (SLR). Indian banks must
hold 23% of their assets in the form of government bonds (it was cut from 24% in July).
This is far higher than they would naturally choose to do. It means that the banks must
pay lower rates to their depositors than they would be able to do if they could invest in
higher return assets and it distorts the financial system‘s ability to fund the private sector.
The official reasons for the policy are to restrict the growth of credit to the private sector
and to ensure the financial strength of the banks. But both of these goals can be achieved
by other means and the real reason is to make it easier to fund the government‘s deficit,
meaning that interest rates are lower than they would otherwise be. In effect, by cutting
the government‘s interest payments, this policy reduces the need for taxation. But it is
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much better to be explicit about a government‘s spending and taxation so that the people
can clearly see what the state is doing with their money.
SLR is mis-named. Liquidity is the ability to turn assets into cash at short notice at low
cost. The Basel II and III rules require banks to hold a proportion of their assets in liquid
form, including high quality securities such as (some) government bonds. But 23% is
vastly in excess of any plausible liquidity needs.
A fully liberalised financial system can, as we know, malfunction in various ways, but it is
less vulnerable to financial repression because people have choices and can evade
attempts by governments to cajole them into lending money at below market rates.
Governments in rich countries now mainly have to fund their deficits in a clear way, by
borrowing in the open market or by raising taxes. That doesn‘t stop the state grabbing
resources from the rest of the economy but it makes the process a bit more auditable.
To conclude, financial repression engendered by systemic inefficiency has the potential to
distort savings and investment activity in the economy and eventually impact growth. It's
time India learned from the Chinese experience and finally showed the courage to take
appropriate policy measures to right the wrong. However, given the way the political
circus playing out in the country, that is a long shot.
References:
1. General analysis of financial repression:
http://www.imf.org/external/pubs/ft/fandd/2011/06/reinhart.htm
2. Financial repression in China: http://www.iie.com/publications/pb/pb08-8.pdf
3. Financial repression in India:
http://www.nipfp.org.in/newweb/sites/default/files/wp_2011_80.pdf
4. Financial Repression – Indian Style Kunal Kumar Kundu · March 30th, 2012
5. http://www.economonitor.com/analysts/2012/03/30/financial-repression-indianstyle/#sthash.JmlNsbvJ.dpuf
6. Moodys Corporation http://www.sec.gov/Archives/edgar/data/-index.htm