Combination lock to recombination unlock

Financial Express, 26 December 2006

When China transformed its manufacturing sector, India lagged behind. Today China is transforming its banks, and India may once again be lagging behind. Over the last one year China has embarked on a radical strategy of selling PSU banks to foreigners and to the private sector.

How is the banking sector in China being refomed? It is widely known that Chinese banks are in very bad shape, with loans given to PSUs made at the behest of the government which don't get repaid. China is selling shares of these very PSU banks. In the last one year, Bank of America, Goldman Sachs, the Royal Bank of Scotland, UBS, Merrill Lynch, HSBC and American Express have all bought stakes in Chinese banks. China Construction Bank's IPO in Hong Kong in late 2005 raised $9.2 billion. The Bank of China topped that, raising $11.2 billion in an IPO in mid-2006. And in October, the Industrial and Commercial Bank of China (ICBC), the largest bank of China with over $800 billion in assets, sold 16% for $22 billion in the world's biggest IPO. Today ICBC has a market capitalisation of roughly $130 billion.

Moreover, China has not stopped at only selling minority stakes in PSU banks. It has even privatised one. Guangdong Development Bank, which is roughly half the size of the State Bank of India, has been sold to a consortium of foreign and private buyers, led by Citigroup. Guangdong Bank is essentially bankrupt. However, the consortium paid $3.1 billion in order to get a 86% stake. With its 500 branches and 12,000 employees the Bank offers Citigroup an opportunity to be part of the fastest economy in the world.

Why might India lag behind China on banking? First, in contrast to India, the Chinese Communist Party has already begun privatising banks by selling off 20 percent to foreigners. Hardly any politician or party in India appears to believe, at least publicly, that India should even consider going this way. PSU banks remain a holy cow. It may be years before the political class squarely discusses such sales.

The second remarkable thing about Chinese banking, when compared with India is the sheer size of Chinese banks. The biggest Chinese bank - ICBC - has assets of $800 billion and a market capitalisation of $130 billion. In comparison, India's largest bank, SBI is a midget with assets of $110 billion (Rs 493869 cr) and a market capitalisation which is merely $14 billion (Rs 64466 crore).

In the years to come, Indian banks and Chinese banks will compete in world markets - just like Indian steel companies and Chinese steel companies compete in world markets today. If there is a gulf between the size of Chinese banks and Indian banks, this will make it more difficult for India to achieve market share in international finance.

Why are Indian banks so small? Some of the reasons are exogenous to banking policy. For example, the first factor is the difference in GDP. Chinese GDP in 2006 stands at $2.2 trillion while India is at $0.78 trillion. If we want bigger banks, we have to get to a bigger GDP. There is a 2.8 times difference between China and India by GDP. As a thumb rule, we can apply scaling of bank size by this same factor. In that case, SBI would have assets of $310 billion and market capitalisation of $40 billion. The difference in size explains some of the gap, but not all of it.

The next issue is the India's relative success with the equity market. The equity market is the only healthy part of Indian finance, with speculative price discovery, and without government interference in how capital is allocated. The equity market now dominates the financing of Indian firms. The market capitalisation of the biggest 2548 Indian firms stands at $767 billion (Rs 34,53,206 cr) while the aggregate bank borrowing of all these firms stands at only $50 billion (Rs 2,25,884 cr). China, as yet, lacks a comparable stock market, and firms rely much more on bank financing.

The acute domination of equity financing in India reflects a mixture of considerable progress in the equity market, and a lack of progress on banking reforms and the debt market. On one hand, a market-dominated financial system is the direction in which all mature market economies go, and India has done well in shifting away from bank financing. But at the same time, such a shift should not come about owing to of incompetent banks. It should come out of genuine competition between markets and banks. In India, there has been no contest, with poor banking policies competing against revolutionary changes on the stock market.

There are other issues that related directly to government policy and to the regulation of the banking sector. The first issue is that of competition policy. Banking is one of the worst sectors in India in terms of barriers to competition. Domestic banks have to take permission from RBI to open branches. All foreign banks, put together, are permitted to open only 18 branches a year. In addition, there are rules that keep voting rights below ownership, resulting in reduced interest in owning bank stocks and thus lower market cap.

Restrictive rules have ensured that there is essentially no entry into the business of banking taking place from either domestic or foreign companies. In one decade, only two serious new banks -- Yes Bank and Kotak Mahindra Bank -- have entered the industry. This is in contrast with every other sector of the Indian economy, where there is vibrant competition based on new firms trying to get in and take away market share. This competitive pressure forces the pace of innovation, and grows the business. But such pressures are not found in banking, since there is no entry.

Innovation is further impeded by an intrusive model of regulation where RBI controls every detail of operation of every activity of the bank. In the modern world, banking is seen as only activity of large multi-product firms. Large global companies which might be called "banks" are engaged in every financial activity imaginable. In India, we are still in a paradigm where RBI narrowly defines the business called banking, and prevents banks from engaging in any other activities. This yields unhealthy, small, underdiversified banks.

Such restrictions on business are a throwback to 1970s vintage economic policy. In order to make progress on these questions, there is a need to make a fresh start, by rethinking the laws, shifting banking regulation out of RBI, and bringing in a new team which is able to inject fresh ideas.

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