BANKING
India's Evolving Banking and Payment Systems, Fostering Free Trade
January 24, 2005
Kuresh Sarjan, Bank of America Global Treasury Services Originally published on www.IdeasLab.info - the working capital web site created by Bank of America and gtnews

Not so many years ago, India was regarded as a third-world country, a source of cheap imports but not a hot market where multi-national corporations (MNCs) were eager to establish business operations. This is no longer true. India is a stunning economic success story. CEOs and business development teams from a growing list of leading global corporations are looking for ways to share in the robust growth and rising affluence that characterize India today. Wherever business opportunity leads, treasury must follow.

Treasury managers at many MNCs are boning up on the banking and financial infrastructure of India, so that they can make cash flow efficiently to and from whatever business activities their companies need to support. They're finding an infrastructure in the throes of modernization, managed by a government that is distinctly friendly to world trade but at the same time keen to promote growth in a manner that mitigates social disruptions caused by the rapid economic expansion. They're finding indigenous banks that often are unprepared to offer sophisticated treasury services. And they're finding familiar global banks that have the treasury sophistication but a relatively limited local presence. Therefore, treasury staff generally can get some, but not necessarily all, of the banking services they would like.

India's Banking Structure

India has a multi-tiered indigenous banking structure. At the top is the Reserve Bank of India (RBI), the country's central bank, which exercises control over monetary policy, currency exchange, banking structure and regulation. The banking sector is dominated by approximately 80 scheduled commercial banks (defined as those listed in the Banking Schedule of the RBI), most of which are majority owned by the government through the RBI. There are also some 200 regional rural banks and more than 350 cooperative and special-purpose development banks. This banking structure reflects India's heavily rural population, which isreliant on an agrarian economy. The government-owned, scheduled commercial banks, and the rural banks make up for their lack of sophistication with their reach. While the scheduled commercial banks are working hard to modernize, the rural banks offer little that would interest MNC treasury staff.

Treasury managers are also finding a growing number of private Indian commercial banks and about 25 foreign banks with 180 branches that offer a variety of services not always found in the public commercial banks. Historically, only foreign banks have offered the kind of treasury services MNC staffs expect and use for their global treasury operations. However, certain Indian banks, and certainly the private Indian commercial banks, are starting to offer standard cash management offerings to Indian corporations and even some MNCs.

Evolving Payment Systems

A lot of MNC treasury concern rightly centers on the Indian payment system. The RBI web site proudly declares, "Anyone can make payments to whomsoever one likes, whenever one likes, in whatever type of currency one likes, at the cost of a few cents per transaction. There are no settlement delays or mountains of paperwork, and value is received instantaneously. There are no distinctions in costs or delays between a domestic and a foreign currency transaction. Interest is computed real-time rather than on a 'settlement day', a relic from the ancient times when accounting was done manually. Finally, privacy and security are guaranteed."

While transactions are cheap and currency restrictions, particularly for trade accounts, are minimal, bankers on the ground in India describe this statement as the RBI's 'vision', not current reality. In fact, the system is still plagued by a persistence of 'ancient' problems:

• By delays in receiving credit for deposits, due to the tremendous geographical spread of the subcontinent,
• By payment uncertainty due to relatively low levels of banking automation,
• By reconciliation problems due to an inadequate, though rapidly modernizing, communications infrastructure,
• By high fraud potential due to gaps in the postal infrastructure and an over-reliance on private courier service and
• By a generally heavy administrative burden.

The key to realizing the vision of a reliable, modern, electronic payment system in India is the recently introduced Real-Time Gross Settlement System (RTGS), supplemented by the Special Electronic Fund Transfer (SEFT) system. RTGS was first used for settling inter-bank transactions, but once tested, client transactions immediately followed. For now, inter-bank settlement is carried out, more or less in real time, by debiting the paying bank's account at the RBI and crediting the receiving bank's account at the RBI. However, both paying and collecting banks have to be RTGS-enabled. Naturally, foreign banks, the larger scheduled commercial banks and the private Indian banks generally have moved quickly to be RTGS-enabled so their sensitive clientele can benefit from the electronic clearings.

Payments made within the RTGS system should avoid the problems of slow and uncertain clearing, difficult reconciliation and exposure to fraud that have plagued the paper-based payment system. Real-time settlement will occur transaction-by-transaction; transactions will not be batched. Settlement will be clean, requiring no netting. Settlements will be final and irrevocable, virtually eliminating counter-party risk, and funds should be available immediately. Other advantages include:

• The ability to initiate RTGS transactions from a desktop or laptop computer over the Internet, wherever you may be, if your bank supports such on-line access;
• The elimination of transit delays;
• Later cut-off deadlines for fund transfers;
• Quicker value on deposited funds;
• More accurate cash forecasts, based on real inflows rather than estimates and on certain knowledge of the timing of payment outflows;
• Lower transaction costs, and
• Reduced paperwork.

In addition to RTGS, banks in India now offer electronic settlement through SEFT although current system limitations make this applicable only for corporate payments. Both inter- and intra-bank transactions are eligible, and the network works both intra- and inter-city. About 2,000 branches in more than 120 cities currently participate, but participation is voluntary; banks can nominate a branch for SEFT or not, as they prefer, based on business considerations. And SEFT isn't for every transaction; the RBI recently ruled that wage and salary payments made through this window will be restricted.

While the RTGS gets up to speed, the bulk of payments still are cleared through net period settlement systems that use 1,040 clearing houses, 15 of them operated by the RBI and the rest by the State Bank of India and its affiliates. High-value transactions typically clear through a paper-based inter-bank network with end-of-day settlement. Low-value payments typically settle through the Electronic Clearing Service, which requires a six-day cycle, with settlement at the end of the fourth business day. Altogether, India has five payment clearing systems.

Fostering Free Trade

If the payment system is still a work in progress, India does offer relatively free borders for trade flow. Lower tariff barriers over the years in line with globalization and to some extent WTO compliance are driving this change. For example, GATT will benefit India from January 2005 onwards when 'quotas' for textiles will be lifted and Indian exports will likely see a major fillip. Added to these freer trade considerations, the government of India is making efforts towards putting together free trade agreements with Asian countries such as Singapore and Thailand. Reasonably well-developed trade technologies are now available to Indian exporters and importers and to global firms selling to India. In a quota-free trade environment, global firms are likely to step up India purchases and can expect to tap into innovative trade solutions such as local presentment and, going forward, even corporate private label letter of credit programs.

Currency conversion is rarely a big problem. The rupee is quite liquid and freely convertible, with relatively few restrictions on the trade account. Local business will often be done in rupees, but international trade transactions usually are denominated in U.S. dollars, euros, Japanese yen or British pounds. Taxes are significant. Resident companies (those incorporated in India or with management and control located in India) normally are taxed at a rate of 35 per cent plus 2.5 per cent on their worldwide income. Nonresident companies normally are taxed at a 41 per cent rate on their India-sourced income only. However, the Indian tax code is complicated, with a variety of offsets available, making it critical to get competent tax advice.

Bank Account Structures

Balance reporting in India does not easily offer the streamlined, one-view look that MNC treasury managers have come to love, but they can operate a core account with a foreign bank, which will take care of funding various Indian bank accounts, as well as sweeping surplus balances from those accounts. Think of it as a concentration account with electronic reporting, linked to a variety of Indian ZBA accounts and you'll have a rough idea of the structure that is possible in India. Maintaining multiple rupee accounts for accounting or treasury reasons usually is not a problem. As a practical matter, most MNCs operating in India maintain local accounts in Indian banks and interface them to a regional or global account structure so that they can manage rupee exposure and concentrate cash in the most efficient manner, which usually entails initiating some transactions manually.

However, netting and notional pooling are not permitted in India, and leading/lagging is subject to specific rules governing the timing and amount. Lockboxes are allowed, but, without a central clearing system, they have not flourished. Instead, global banks use Indian correspondents to capture and report information on receipts and to concentrate cash upward. Controlled disbursement has been impossible since all clearing systems settle no sooner than the end of the business day. Instead, corporations often use a book transfer from a depository account at the same bank as the disbursing account. While conducting treasury operations in India may not initially be as smooth or high-tech as conducting them in the U.S. or the European Union, the obstacles can be managed. MNC treasury staff working with global banks and accounting firms can find adequate ways to see that cash flows to where it is needed.

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