A big bang reform that may be spot on

The reassuring message in the Pradhan Mantri Jan Dhan Yojana is that in pursuing its economic objectives, the government wants to accord an important role to the public sector even while relying on market mechanisms

Updated - December 04, 2021 11:27 pm IST

Published - September 02, 2014 12:56 am IST

The goal is hard to achieve. It is costly and unviable. It will create huge stresses in the banking system. The Narendra Modi government’s Pradhan Mantri Jan Dhan Yojana (JDY), an ambitious scheme for financial inclusion aimed at creating 7.5 crore new bank accounts in the banking sector by January 26, 2015, has its sceptics and critics. There is more than a fair chance that they will be proved wrong.

Think back to the last comparable attempt at financial inclusion — Indira Gandhi’s bold move to nationalise 14 banks in 1969 (with another six being nationalised in 1980). We heard pretty much the same arguments then. Bank nationalisation was denounced as populist, a socialist gimmick, politically-motivated and worse. Today, not many would question the beneficial impact nationalisation had on banking and the Indian economy. To put JDY in perspective, it is useful to see what bank nationalisation achieved.

Rise in saving Bank nationalisation saw a huge expansion in branches into the hinterland. The expansion of the branch network, in turn, caused money kept under the mattress to be swept into the banking system. Cash under the mattress may be savings for an individual but these do not translate into “saving” for the economy. “Saving,” in economic terms, is whatever is available for lending or investment, that is, savings that come into the financial system.

Bank nationalisation caused the saving rate to go up from 12 per cent of GDP in 1968-69 to 20 per cent in 1979-80. The rise in saving facilitated a commensurate rise in the investment rate from 13 per cent to 21 per cent. The increase in the investment rate set the stage for the growth rate of the economy to shift from the much-derided “Hindu” rate of 3.5 per cent up to the 1970s to 5.5 per cent in the 1980s. It was the first shift in trajectory in India’s economic growth in the post-Independence period.

This outcome was not anticipated by economists then and is not adequately appreciated even now. It required a politician with her finger on the pulse of the nation to sense the economic potential of bank nationalisation, whatever the political motivation for the timing of the move.

Inclusion not only increases deposits, but also brings in lowcost deposits through savings and current accounts. For public sector banks, the high proportion of low-cost deposits in total deposits turned out to be a source of competitive advantage.

Financial inclusion benefited not just the economy but also the public sector banks (PSB) despite initial setbacks. Investments in branches and the servicing of millions of small accounts pushed up operational costs in nationalised banks. Combined with bad loans, the investment resulted in the net worth of public sector banks turning negative by the early 1990s. However, the infusion of capital by government was modest by international standards — less than 2 per cent of GDP, compared to anywhere between 5-60 per cent elsewhere.

Bank recapitalisation was part of a larger package of banking sector reform. Another key reform was the listing of PSBs which subjected them to market discipline. At the same time, India’s economic growth began to accelerate in the 1990s.

In these new conditions, the long-run benefits of financial inclusion began to kick in. Inclusion not only increases deposits, it brings in low-cost deposits through savings and current accounts. For PSBs, the high proportion of low-cost deposits in total deposits turned out to be a source of competitive advantage. Their financial performance improved through the 1990s and the noughties and even after the financial crisis of 2007 until the problems in the infrastructure sector came to the fore. Judged over some three decades, bank nationalisation proved a winner with financial inclusion being a key driver of success.

JDY has the potential to have a similar impact. It could see the household saving rate go up and boost the overall saving rate. And it could impart a shot in the arm to PSBs which have been losing market share to new private sector banks. Financial inclusion entails upfront costs but begins to pay off once a certain scale has been reached.

Direct benefit transfer Critics of the scheme contend that merely scaling-up will not help the banks or the economy. They say that many of the new accounts created by inclusion initiatives in recent years have low balances or remain inoperative. They overlook a crucial change in the situation: large amounts are poised to flow into bank accounts, thanks to the direct benefit transfer scheme (DBT) rolled out in January 2013.

Right now, DBT covers 28 schemes, mostly payment of pensions and scholarships. It will soon cover payment of subsidies as well as wages under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA).

Payment of subsidies is scheduled for the first phase of financial inclusion, that is August 2014-August 2015. Once this happens, PSBs will have substantial “float” funds (on which they pay zero interest) in the accounts they have opened. These are equivalent to low-cost deposits and should compensate for high operational costs. Over time, banks should have in place the infrastructure and the processes to make loans to the new account holders. Small loans have been freed from interest rate regulation and we know from the experience of micro-finance institutions that they can be hugely lucrative. Then, there is the fee income from selling insurance products. Putting all these together, in the long-run, JDY could replicate the effect that nationalisation had on the financial performance of PSBs.

The add-ons There are details that need to be worked out. Every account under the scheme comes with a RuPay debit card and Rs.5,000 overdraft facility in the first phase. In the second phase, a Rs.1 lakh accident insurance facility and a Rs.30,000 life insurance facility will be added.

How exactly the premia on the insurance facilities will be paid for has not been spelt out. Some reports indicate that the premia will come out of charges levied on RuPay card transactions. Will the volume of RuPay transactions be large enough to pay for the premia? Banks need to have an idea of the fee income they can hope to generate from the accounts. If the insurance premia involve any subsidy, the government must bear the cost.

The Rs.5,000 overdraft facility has given rise to concerns about another loan “mela.” This would amount to Rs.37,500 crore for 7.5 crore account holders. These concerns are overblown. Banks will provide the overdraft facility only after watching the account holder’s record for six months. There is an incentive for repayment, which is that the account holder can avail of the facility as often as he likes. It should be possible to contain losses at an acceptable level.

Public sector bank-centric Two aspects of JDY are worth highlighting. First, it is “big bang” reform alright but not quite what advocates of reforms have been urging. Mr. Modi has sensed the need for a game-changer at a time of flagging economic growth. However, he has chosen to rely on his own instincts in judging what that game-changer might be. Mr. Modi’s preference for an initiative that combines inclusiveness with the potential to boost growth could turn out to be spot on.

Second, the government has decided that financial inclusion is best pursued through PSBs. This is rather different from the view implied by the decision of the Reserve Bank of India (RBI) to use new institutions, such as payment banks and small banks, to push inclusion. The RBI seemed to have concluded that not much could be expected of PSBs. If JDY works out as planned, one wonders whether there will much space left for payment banks. Why would a customer go to a payment bank that only provides deposit and payment services when he has access to a full-scope bank?

The government’s reliance on PSBs makes sense — and not just because there is an enormous infrastructure that can be readily tapped. Where regulation is weak and contracts ill-developed, it is best to use public institutions to attain larger objectives, instead of relying on regulation or public-private partnerships. It is easier for the government to enforce its writ through institutions that it directly controls. The reassuring message in JDY is that in pursuing its economic objectives, the government wants to accord an important role to the public sector even while relying on market mechanisms.

(T.T. Ram Mohan is a professor at IIM Ahmedabad.)

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