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Electoral ATMs

As the financial crisis spreads around the world,many in India have expressed relief and pride that the domestic banking sector...

Written by Shawn A. Cole |
May 2, 2009 12:56:52 am

As the financial crisis spreads around the world,many in India have expressed relief and pride that the domestic banking sector,with minimal sub-prime exposure,may dodge this bullet,just as it avoided major collapse during the Asian financial crisis. Some have attributed this resilience to the fact that the vast majority of Indian banks are government-owned,arguing that privatisation efforts are misguided.

Yet,just two weeks ago the Indian government announced that it was seeking a USD 3 billion loan from the World Bank to… recapitalise public sector banks. This expenditure is of course a drop in the bucket when compared to the 70,000 crore (approximately USD 14 billion) debt-waiver announced just in time to take effect before this year’s elections. While politically expedient,the proposal quickly won widespread support from politicians as quickly as it earned derision from economists.

From an economic standpoint,there was much to criticise: tremendously expensive,it does a terrible job targeting those who truly need relief,while rewarding wilful defaulters. Perhaps most importantly,it provides strong incentives for farmers to delay or default on loans in the future,in the hopes of receiving new debt relief. This in turn provides reduced incentives to banks to lend.

Political interference is often cited by academics as an important reason to oppose government ownership of banks. In India,one does not have to search long to find anecdotes of politicians promising either easier credit or debt relief prior to elections. Yet,it has been difficult to understand the depth and breadth of this problem.

One way to answer this question is to see if lending behaviour responds to the election cycle. In a recently published research paper (available for free on HBS’s website),I analyse bank lending throughout India,over an eight-year period beginning in 1992. I focus on state electoral contests,using a dataset compiled by the Reserve Bank of India. (India is blessed with some of the best banking data in the world.) Several interesting facts were thrown up.

First,public sector bank credit moves with electoral cycles. In particular,agricultural credit increases by 5-10 percentage points in a state in the year leading up to an election. Second,there seems to be significant geographical targeting: one observes the largest increases in credit in districts in which the elections are particularly close. Third,following elections,loan write-offs appear largest in districts in which the winning party enjoyed the greatest margin of victory.

This result is observed in agricultural lending,but not for lending to industry or other sectors. The effect is present in government-owned banks,but not private sector banks.

One might argue that these results indicate that politicians are merely making sure that lazy bankers do what they are supposed to,namely make profitable loans to farmers. If this were the case,one might expect to see an increase in agricultural output in states that experience credit booms. Using state agricultural output data,I test this hypothesis,but find no increase in lending.

Of course,this problem is not unique to India. Research by Serdar Dinc finds that,around the world,government banks lend more in election years than their private counterparts. And at least a few people have observed the recent controversial relationship between the government and the banks in the US with some Schadenfreude.

Yet,India has been among the slowest of emerging markets to privatise banks. This research and recent events suggest several reasons politicians may be reluctant to give up control of public sector banks. Increasing public sector bank lending prior to elections does not require the passage of any law,and can be targeted relatively precisely,in contrast to state or national initiatives. Even if the creditor eventually defaults,the politicians may not need to explicitly budget for the cost,hoping instead that other bank business can subsidise the loans,or that any necessary recapitalisation can be deferred until long into the future. Finally,unlike improved schools or better roads,bank loans can be delivered quickly,with the recipient fully confident of their value.

What should India do? I am reluctant to issue policy prescriptions. There is no question that the strictness of the RBI and other regulatory authorities has limited volatility in the financial sector. But in light of the substantial degree of public interference in lending,advocates of keeping the banking sector in government hands should explain how they will ensure politicians do not meddle in bank affairs,and why regulation cannot work for private sector banks.

The writer is an assistant professor at Harvard Business School where his research focuses on corporate finance in emerging economies

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