Financial-sector reform in India: Bridging the gulf SINCE taking office in September Raghuram Rajan, the governor of India's central bank, has championed financial-sector liberalisation as a way to boost growth and help the poor. Change is risky, he has said. But as India develops, not changing is even riskier. India's financial system is like a ramshackle engine lovingly maintained by a sect of oil-spattered engineers and wearily tolerated by most people who depend on it. After Indira Gandhi, then prime minister, nationalised most banks in 1969, India slipped towards financial socialism, with a central bank that printed rupees on politicians" command. When India opened up in 1991 a wave of reform took place. The system today is a mishmash. Market forces have a role, but the state looms large. There are several well-run private banks, such as HDFC. But public-sector banks (most of which are listed but under state control) make three-quarters of all loans. Foreign banks" market share is 5%. Unlicensed moneylenders thrive, hinting at lots of unmet demand for credit. The Reserve Bank of India (RBI) is now fairly independent and no longer sets the rates of interest banks charge, but it still manipulates the flow of credit to assist the government and, at least notionally, the poor. Banks must invest 23% of their deposits in government bonds, and park a further 4% with the RBI. This creates a captive market for public debt, the bulk of which is owned by banks. Some 40% of loans must be directed towards "priority sectors," mainly agriculture. Taken together these rules mean that 58% of the deposits the banking system raises are deployed according to the government's preference. A plethora of restrictions means the corporate-bond market is tiny. This helps the government since it means that its bonds are the only game in town for fixed-income investors. Whereas the stockmarket is very open, capital controls govern the flow of foreign funds into the debt market and limit the use of currency derivatives. The RBI intervenes in the market to manage government-bond yields. This helps the state to borrow cheaply. This hybrid system is not an accident of history. Many officials feel that finance is too important to be left to either free markets or politicians. After all, India's bubble-wrapped system was unscathed by the Asian crisis in 1997-98 and the global crisis in 2007-09. The RBI is one of India's best institutions - uncorrupt and capable. But for all the good intentions the truth is that this hybrid system may now promote social inequality and financial instability - the twin evils it is meant to eradicate. For a start, after decades of state direction only 35% of adults have bank accounts. This perpetuates poverty and makes it hard to collect taxes. Bad debts have become a problem, too. About 11% of state banks" loans have soured. The reserves they hold are low and their capital levels are mediocre. Because of India's weak legal system, banks dislike forcing firms into bankruptcy. Part of the problem is temporary, reflecting the economic slowdown and bottlenecks in infrastructure projects. But state banks have been pressed to roll over credit lines to troubled but well-connected big firms that most private banks steer clear of. This sort of cronyism makes the banking system less stable. It is also unfair: the public is subsidising inept tycoons. Nanny finance has not created a national champion. India's biggest lender by market capitalisation, HDFC, is ranked 63rd globally. No local bank yet has the international savvy of its Chinese, Brazilian and Russian counterparts. All those rules have pushed activity offshore. At least half of all rupee trading is abroad. Citigroup and Standard Chartered, which along with HSBC are the biggest foreign banks in India, have an overall exposure to the country (including loans, trading positions and derivatives) that is 1.9 times the size of their regulated Indian operations. The hybrid system is complicit in a borrowing binge by the government: the budget deficit is running at 7-8% of GDP. Since bond yields are held down artificially by the RBI, which buys bonds itself and forces banks to, politicians can borrow heavily without fear of a buyers" strike. Low interest rates and fast-rising prices mean the return savers get on deposits is below consumer-price inflation (CPI). Some people buy shares instead, but many bypass the formal financial system and buy gold, straining the balance of payments. Over half of the current-account deficit of 4.8% of GDP in the year to March 2013 was due to bullion imports. The vicious cycle of borrowing, inflation and gold partly explains the 22% slump in the rupee between May and August. It has since recovered a third of its losses, partly thanks to Mr Rajan's soothing presence. Mr Rajan's liberalising vision was outlined in an official report that he wrote in 2008, when he was an academic. It was politely ignored at the time by an establishment that was enjoying a moment of Schadenfreude as Western countries which had hectored India saw their banks implode. Now he is in charge at the RBI he wants to create a blast of competition that will spread finance to more Indians. The RBI will give licences to new banks, probably early next year, and allow foreign banks to expand faster as long as they create local subsidiaries that can be regulated easily. The rules that force banks to buy government debt will be relaxed "in a calibrated way." Mr Rajan says he will stop tycoons from exploiting the system and force banks to recognise bad debts. His unspoken hope is probably that state banks will be fully privatised and forced to raise their game. All this is easier said than done. Letting private shareholders own a majority of state banks would require an act of parliament. India's politicians like the power they have over these lenders. Palaniappan Chidambaram, the finance minister, has been urging them to lend more to revive the economy. The public-sector banks are unionised and resistant to change. Private banks, meanwhile, are not charities. Some struggle to gather enough deposits, limiting their growth. A huge expansion in the number of branches would help, but might not be profitable. These institutions prefer to lend to yuppies than to farmers and infrastructure projects. If the RBI gave new licences to industrial houses such as Reliance Group, they might use their powerful brands to attract a surge of deposits. But that would further concentrate power in the hands of a few, and lead to accusations of cronyism. Nor are foreign banks saints. HSBC and Standard Chartered make 70-90% of their Indian profits from investment and corporate banking. Citi and HSBC, along with Barclays, have already burned their fingers in a push to lend to individuals. In 2006-10 they led a frenzy in unsecured consumer loans and collectively lost $3 billion. Too-big-to-fail foreign banks might be keen to take over lenders in India. But their jumpy regulators in the West might object. Mr Rajan is trying to reform at a low-point in the economic cycle. That creates its own problems. Would he really be prepared to trigger a wave of defaults in order to clean up India's bad debts? It seems unlikely. If he raised interest rates above CPI, savers would applaud but growth would fall further. And just months after a financial panic and a dangerous spike in yields, it will be near impossible for the RBI to deregulate the bond market. In mid-November he said the RBI would again intervene to prevent "liquidity tightness." The central bank now owns at least 17% of all central government bonds, the highest level since the crisis years of the early 1990s. It now owns more of its local bond market than the Federal Reserve after years of quantitative easing (see chart). For a quick jolt to the system, Mr Rajan's best hope is to embrace low-cost mobile-banking. India has lagged Africa in embracing this technology. But to reform the bond market and traditional banking he will first have to change the RBI. Today it is the honourable guardian of the status quo. Tomorrow it could be a force for reform that takes risks and persuades politicians that a nimbler financial system will make India richer and more stable. Confronting vested interests and ingrained thinking will be a slog but the rewards could be immense.