Small Scale Industries:

4.3.7 Another area which needs a thorough examination relates to small scale industries. The small scale sector has a unique place in a strategy of labour-intensive industrial growth. Due to several policy initiatives taken by the Government, this sector has helped to achieve a reasonable growth in industrial employment, especially at a time when employment in the organised industrial sector has stagnated. Yet, one of the major problems with this sector has been the lack of adequate modernisation and technological upgradation. To take advantage of the technological changes which are taking place in the present day world, it would be necessary for the small scale units to modernise and upgrade their technology. This would help them to compete effectively with the larger industrial units.

Administered Prices:

4.3.8 The proposed rationalisation/relaxation of entry and exit policy should enhance the competitiveness of the industrial sector. These benefits will he somewhat reduced if the Government continues to administer prices and the distribution of various industrial products. At present, the prices of industrial products such as natural gas, petroleum, petroleum products, coal, electricity, fertilizer, sugar and various non-ferrous metals are being administered by the Government. A thorough review of the usefulness of these price controls needs to be carried out. Wherever the product concerned is internationally tradable, the Government should decontrol the prices. In order to ensure that such price decontrols do not allow the existing producers to hike prices and hence enjoy "rents", the tariff rates on the import of these products should be suitably adjusted downwards, as had recently been done in the case of steel. Without such a supportive tariff adjustment, decontrol of hitherto administered prices may lead to unreasonable increase in the prices, thereby hurting the consumers.

4.3.9 Unlike in the case of tradable goods, it is difficult to deal with administered prices of non-tradable goods, such as, say, electricity and public transportation in which the Government sector has a near monopoly. In these cases, the best that can be done is to ensure that the enterprises producing/providing these goods and services cover the Long Run Marginal Cost of Production (LRMC). The basic idea is that prices should cover capital and current costs of efficient production. While the determination of the LRMC of production is sometimes difficult, the Bureau of Industrial Costs and Prices (BICP) has successfully demonstrated that in the majority of industries the computation of LRMC is practicable. Therefore, for effective implementation of such a normative approach to administered prices of non-tradable goods, an organisation such as the BICP may be charged with the responsibility of undertaking comprehensive studies of cost-price structures of such products every three to five years. It is, however, important to distinguish between fixing the normative prices based on LRMC for an industry at a point of time and providing for justifiable changes in costs over time. In this context, a two- step approach which has been suggested by the Ministry of Finance in its paper on

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Administered Price Policy in 1986 may be followed. First, the base level of prices should be fixed after carrying out detailed studies of costs on a normative level of efficiency. Once this has been done, changes arising from increases in input costs should thereafter be made automatic.

Financial Sector Reforms.

4.4.1 A vibrant and competitive financial system is necessary to support the proposed reforms in the structural aspects of the real economy. Over the years, the Indian banking and the financial system has made impressive progress in extending its geographical spread and functional reach. The widening and deepening of the banking system has been a major factor in promoting financial intermediation in the economy and in the growth of financial savings. The credit reach also has been extensive and the banking system now caters to the needs of several million borrowers especially in agriculture and small industry. Besides the banking system, the Development Financial Institutions (DFIs) have also provided the much-needed institutional support for investment in the private sector. The last decade has also witnessed considerable diversification of the money and the capital market. Despite this commendable progress, there has been a steady erosion of the operational efficiency of the banking system. The balance sheet of the performance of the financial sector is thus mixed, strong in achieving certain socioeconomic goals and in general widening the credit coverage but weak in viability.

4.4.2 The Committee on the Financial System which has recently submitted its report to the Government of India, has identified the major factors responsible for the decline in the efficiency and the profitability of the banking sector. These are: (a) directed investment; (b) directed credit programmes; (c) massive and somewhat uneconomic expansion of bank branches and (d) inadequate attention to portfolio quality. There have also been weaknesses in the internal organisational structure of the banks, lack of sufficient delegation of authority and inadequate internal controls. Some of these weaknesses are common to both commercial banks and the Development Financial Institutions.

4.4.3 With a view to giving more operational freedom to the institutions and to inducing greater competition in the financial sector, some of the controls on the financial sector have been relaxed. Until recently, the lending rates of DFIs were fixed by the Government. As part of the recent policy,changes, the DFIs are now allowed to charge interest based on market conditions subject to a floor rate of 15 percent. Similarly, the interest rates on corporate debentures, which were earlier fixed by Government have been freed. The whole interest rate structure for commercial banks has been ad- justed upwards. As a result, the minimum lending rate of commercial banks (on loans above Rs.2 lakhs), has been raised and banks are given the freedom to charge interest rates subject to this floor rate, depending upon their perception of the credit risk of the borrowers. In addition, the term deposit rates of commercial banks has recently been partially deregulated; banks are now free to set these rates subject only to a ceiling. In another important step, the mandatory convertibility clause, under which DFIs could convert 20 percent of their term loans into equity, has been scrapped, thereby removing a long standing irritant to industry. The Government has also discontinued the tax-exempt status of the Industrial Development Bank of India, the country's leading development financial institution so as to put it on a more competitive footing with the other DFIs. Similarly, the mutual fund business in the financial sector, which until now was reserved for the public sector banks and Financial Institutions, has been opened up to the private sector. More recently, the formulabased pricing of new issues of capital by com- panies, hitherto being enforced by the Controller of Capital Issues, has been abolished. Companies are now free to price their new capital issues based on market conditions. The overall thrust of the reforms of the financial sector during the Eighth Plan should be to ensure that the financial system operates on the basis of operational flexi- bility and functional autonomy with a view to enhancing efficiency, productivity and profitability. As a general principle, the Government should allow the entry of private sector into areas which were hitherto reserved only to the public sector, including the banking system.

Statutory Liquidity Requirements:

4.4.4 With regard to the banking system, the Statutory Liquidity Requirement (SLR), which was originally introduced as a prudential re- quirement, has, over time, become a major

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instrument for financing the public sector. The SLR which was about 20 percent of banks' net liabilities when it was originally introduced, has now increased to over 38 percent. Since the average interest rate on banks' SLR-related investments is artificially pegged at fairly low level, the increase in the SLR has adversely affected the profitability of the banks. The Central Government has already reduced its fiscal deficit from about 8.5 percent of GDP in 1990-91 to about 6.5 in 1992-93 and has initiated measures to reduce it further to about 5 percent in 1992-93. It has also expressed its intentions to reduce the fiscal deficit further to about 3 to 4 percent of GDP by the mid-1990s. As the fiscal deficit comes down, it should be possible to reduce the SLR substantially during the next few years. This would not only give flexibility to the lending operations of the banks but also enable them to lend a larger proportion of their funds to the commercial sector.

Directed Credit Programmes:

4.4.5 The directed credit programme under the priority sector lending operations of the banks have served a useful purpose in extending the reach of the banking system to cover sectors which were generally neglected before nationalisation of banks in 1969. The proportion of priority sector lending to total bank credit to the non- government sector was negligible in the beginning of the 70's but now it is about 40 percent. Since these priority sector loans are made at concessional interest rates, the banks' profitability has been adversely affected. Clearly, there is a case for a review of those categories who are entitled to borrow at concessional rates from the banking system. One immediate way of doing this is to eliminate large borrowers from the coverage of the priority sector. No more than two concessional rates of interest for priority sector lending should be prescribed so as to keep the burden on the banking system within limits.

Structure of Interest Rates:

4.4.6 The proposed reduction in SLR and the directed credit programmes should enhance the flexibility of the banking system a great deal. However, the benefits of these changes would be greatly reduced if the structure of interest rates continues to be administered by the Government. In spite of the recent emphasis on the deregulation of the interest rates, the structure of interest rates is highly complex and rigid. The financial system must clearly move towards an interest rate regime which is free from direct controls. Obviously, interest rate is an important policy instrument and monetary authorities the world over try to influence the level of interest rate through the various instruments that are available to them. It is not, however, argued that monetary authorities should abdicate an important function of theirs. The general level of interest rate should be influenced by the monetary authorities taking into account the overall economic environment, without necessarily imposing a rigid structure of interest rates. In moving towards a more deregulated structure of interest rates, there is considerable historical evidence to show that such experiments succeed only when the inflationary pressures are under control. Sharp increases in nominal and real rates of interest can result in adverse economic consequences. However, the broad outlines of the reform agenda on interest rates are quite clear. At least initially, from an elaborate administered structure of interest rates, we should move towards a more simplified system where only a few rates are prescribed by the monetary authorities.

Development Financial Institutions:

4.4.7 Over the years, the DFIs have been nurtured and developed by active Government support, especially in the form of concessional finance. However, active Government intervention in the functioning of the DFIs has also resulted in lack of operational flexibility and competition among these institutions. To remedy the situation, we need to have a two-pronged effort. On the one hand, the DFIs should be given adequate autonomy in matters of loan sanctioning and internal administration. On the other hand, the DFIs should be made to operate in a more competitive environment. For the latter, the privileged access of the DFIs to concessional finance through SLR and other arrangements should be gradually reduced. Instead the DFls should obtain their resources from the market on competitive terms. In addition, the present system of consortium lending by the DFIs should be discouraged. Besides other things, this would require that the present system of crossholding of equity and cross representation on the Boards of the DFIs are done away with.

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Prudential Norms and Guidelines:

4.4.8 The financial liberalisation measures proposed above should, however, be accompanied by formulation of clear-cut prudential norms and guidelines governing the functioning of the various institutions in the financial sector. This is especially important because, during the last decade or so, several new institutions have appeared on the financial scene. Merchant banks, mutual funds, leasing companies, venture capital companies and factoring companies have now joined the already existing institutions in extending a range of financial services. However, the regulatory framework for many of these institutions is still not developed. The Government should, therefore, formulate and enforce prudential norms and guidelines relating, among other things, to capital adequacy, debt-equity ratio, adherence to sound accounting and financial policies, disclosure, regulation and valuation of assets.

4.4.9 Two particularly important aspects of prudential regulation which have assumed greater importance in the recent period relate to capital adequacy and provisioning. The Indian system has so far been slack in relation to both these aspects. Capital adequacy did not perhaps receive adequate emphasis because of the dubious assumption that banks and financial institutions owned by the Government cannot fail or cannot run into problems. With major Indian banks now having branches operating in important money market centres of the world, this question can no longer be ignored. This apart, even banks operating domestically need to build an adequate capital base. Realising this, the Reserve Bank of India has recently prescribed that all banks with international presence should achieve the capital adequacy ratio (i.e. the ratio of unimpaired capital funds to the aggregate of the risk weighted assets) of 8 percent by March 1994 and other banks should achieve a capital adequacy ratio of 4 percent by March 1993 and of 8 percent by March 1996. This is a step in the right direction though this is a highly challenging task for the banks. Given the budgetary constraints and the overall resource crunch facing the Government, it may be difficult for the Government to provide additional capital to public sector banks in the future years. Hence if banks were to achieve the prescribed capital adequacy norms they may have to tap the capital market for raising funds both in the form of loans and equity capital. This would involve a dilution of Government ownership to a limited extent which may serve a useful purpose. What has been said about banks holds good in relation to term lending institutions as well as other financial institutions. Whether they be leasing companies or hire purchase companies or investment companies, prescription of appropriate capita requirements is a must since capital is the last line of protection for all depositors.

4.4.10 Another important aspect of prudential regulations relates to adequate provisioning for bad and doubtful debts. If the profits of banks and other financial institutions are to be a true reflection of their functioning, loan losses must be adequately provided for. It is feared that many banks may not have adequate profits to provide for bad and doubtful debts. Nevertheless, both in relation to banks and the term lending institutions, uniform accounting practices relating to income recognition and provisioning against doubtful debts need to be prescribed. Once again, in recent months the Reserve Bank of India has taken certain measures towards this effect. Besides requiring the banks to present their balance sheet and profit and loss accounts in a particular format so as to better reflect their actual financial help, banks are now required to classify their assets into different categories and make enough provisioning against bad and doubtful debts in a phased manner over a three year period. Such provisioning requirements should be gradually made applicable to other financial institutions too.

Demand Management Policies

4.5.1 Structural policy reforms such as trade liberalisation, industrial and financial deregulation, proposed above, would ensure an efficient use of resources. In the medium term, therefore, these policies would help augment aggregate supply. However, if aggregate demand continuously outstrips aggregate supply, it is difficult to maintain a reasonable degree of price stability and sustainable balance of payments. This, in turn, could lead to slow-down in growth, making it difficult to sustain the pace of on going structural reforms itself. Empirical evidence from a large number of developing countries shows that structural policy reforms, implemented against large macroeconomic imbalances, have generally failed to produce the intended beneficial effects. Appropriate de-

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mand-management policies, aimed at keeping aggregate demand largely in line with increases in aggregate supply, therefore, is a necessary prerequisite for successful macroeconomic management. The key policy ingredients required for this are a prudent fiscal policy and a conservative monetary policy.

4.5.2 A three-pronged fiscal and monetary policy package aimed at, (i) providing a better balance between aggregate demand and supply, (ii) minimising the distortionary effects of the tax system and, (iii) forcing public enterprises to minimise costs and maximise efficiency, should form a key component of such a set of macroeconomic policy initiatives.

Fiscal-Monetary Framework for Macroeconomic Stability:

4.5.3 A common cause behind the twin problems of high domestic inflation and the worsening balance of payments in recent years has been the large and growing fiscal deficit of the Government. Fiscal deficit of the Government (Centre, States and Union Territories together) which has less than 7% of the GDP at the beginning of the seventies rose to about 9% by the beginning of the eighties and by 1990-91 constituted over 11% of GDP. What is even more important, the increase in the growing fiscal deficit was almost entirely due to the sharp deterioration of the balance on revenue account. For example, in 1970-71 the Government had a revenue surplus of about 0.3% of GDP, but by 1985-86, it ran a revenue deficit of about 2% of GDP, which in 1990-91 rose to over 4%. Such high levels of fiscal deficits, both overall and on revenue account, are simply not sustainable. Hence, putting the fiscal house in order is a necessary pre-requisite to obtain a better balance between aggregate demand and supply.