The creation of a functional financial system is essential to the growth of developing countries. In the decades following its independence, the Indian government imposed numerous misguided policies on its nascent financial sector with the intent of promoting broader economic growth, reducing poverty, and financing its fiscal deficit. Over time, these policies considerably undermined the financial sector’s ability to contribute fully to the country’s development. Reforms undertaken since the 1990s have removed many of these distortions, enabling the sector to more effectively and efficiently channel resources into productive investments. Indeed, by some measures, India has a better performing financial sector today than its BRIC counterparts. Despite this progress, considerable obstacles still remain that limit the financial sector’s ability to maximize its potential.
The financial sector plays a central function at all stages of an economy’s development. Banks and capital markets promote economic development by channeling savings towards productive new investments. In emerging economies, the development of the financial sector is closely tied to broader economic development. King and Levine’s 1993 cross-country study found compelling evidence that financial development is strongly correlated with future rates of economic growth, physical capital accumulation, and economic efficiency improvements. Financial sector development also benefits a country’s poorest citizens: Beck, Demirguc-Kunt, and Levine find that financial development “disproportionately boosts” the incomes of the poorest quintile and reduces income inequality by expanding access to credit and financing job-creating businesses.
The Indian government’s approach to the financial sector has historically been guided by three primary objectives: channeling credit to priority sectors determined by the government’s centralized economic plans, reducing poverty, and financing the government’s fiscal deficits. To achieve these goals, the government had historically relied on nationalization and highly restrictive policies on interest rates and direct lending. This essay focuses on the impact of the major reforms undertaken in banking and capital markets since the 1990s and supplements this review with an analysis of the performance of the Reserve Bank of India in maintaining macroeconomic stability.
The restrictive policies imposed on the financial sector beginning in the 1960s mirrored those imposed in all other major sectors of the economy throughout the highly socialist period of 1965-81. What differentiated the restrictions imposed on the financial sector from other areas of the economy, however, was the invasiveness of government control. In most other sectors, the Indian government largely respected existing private firms and, as a result, continually struggled to direct a mixed economy via the “license raj” of burdensome regulation. The financial sector, by contrast, was almost totally nationalized, a sign of its importance to the state’s economic objectives. As Panagariya makes clear, these controls stifled growth instead of driving the economy forward. GDP growth during the highly restrictive period of 1965-81 averaged only 3.2% per year, a drop of 0.9 percentage points relative to the comparatively liberal post-independence period, and considerably less than that of other Asian economies that began to grow rapidly after adopting an export-oriented economic model.
2.1 Banking sector
Banking has historically been the largest component of India’s financial sector. In 2001, banks accounted for 66% of financial assets, compared to 18% allotted to the country’s investment institutions. As a result, reforms in this sector have had the greatest impact on the country’s finances as a whole and economic growth. The liberalization period of the early 1990s undid many of the most harmful and distortive interventions in the banking sector, such as the strict regulation of interest rates. Despite this considerable progress, the Indian government still plays an outsized role in banking through its continued, albeit diminished, ownership of major banks and the reliance on directed lending policies.
Prior to the 1990s-era reforms, government intervention in the banking sector was multifaceted and reflected multiple economic, development, and political objectives. The most prominent of these objectives were designed to channel investments to priority sectors identified as part of the government’s Five-Year Plans, reduce rural poverty, and finance the government’s fiscal deficits. The deepest intervention was the nationalization of the country’s fourteen largest banks in 1969, giving the public sector control over 86% of the country’s deposits at the time. A second nationalization, occurring in 1980, brought the public sector’s share of deposits to 92%. The public sector’s share of banking assets fell to 62.2% as of 2007, as the private sector’s share of assets grew eleven-fold since 2005 to 17.2% in 2007 from 1.5%.
A second major intervention was the imposition, beginning in 1967, of “priority sector” credit prescriptions that set mandatory targets for politically important sectors, including agriculture, small-scale industries, and housing. The Reserve Bank of India communicated these targets, which by 1984-5 required that all scheduled commercial banks extend 40% of their net bank credit to priority sectors. India’s directed lending policy withstood the reformist period of the 1990s and continues to this day, despite a November 1991 recommendation by the prominent Narasimham Committee to dramatically reduce its scope..
The 1970s-80s were also characterized by repressive policies designed to support the government’s large fiscal deficits. The Indian government rationalized these deficits within the broader context of its economic policy, arguing that it could better invest in the long-run interests of the economy than the private sector. To finance these deficits, the government imposed a mix of reserve requirements that forced banks to hold high levels of government securities and interest rate ceilings that limited the government’s borrowing costs. These policies had the effect of penalizing savers and crowding out private investment, compromising the efficient allocation of capital essential for optimal economic growth. Kletzer estimates that the government collected an enormous annual subsidy of as much as 8.2% of GDP during the 1980s, a sum that in all probability would have been invested more profitably and with greater long-term contributions to growth had banks been able to lend freely, independent of government control.
A final policy, and perhaps the most visible of the intervention-era from the perspective of the Indian people, was the rural branch expansion rule. This rule required that banks seeking to open a new branch in urban areas must establish 2-3 branches in rural ones. The rationale behind the policy’s adoption was based on a supply-side approach to development, which holds that expanding access to financial services to India’s poorest would help reduce poverty. Rural branches as a share of all bank offices doubled from 22.2% in June 1969 to a peak of 58.7% in 1985, before the rule was repealed in 1991. The extent to which the branch expansion rule actually reduced poverty is unclear, as the rule coincided with multiple government initiatives supporting rural development.
The experience with the rural branch expansion rule is a worthwhile case study of the impact of intervention-era policies. In general, India’s interventions can often be characterized as nominal successes that achieved their intermediate targets but failed to achieve their ultimate objectives. While the number of rural bank branches did expand dramatically over the period, it is unclear whether this was a direct effect of the policy in question or whether a mix of other government subsidies and legitimate profit opportunities were the primary drivers of expansion. It is unclear if estimated poverty reduction due to network expansion justified the considerable operating costs incurred and the opportunity cost of more productive investment elsewhere. After the rule was withdrawn, the share of rural bank offices subsequently declined 13 percentage points from 1985 to 2005. This suggests that the rural branch rule forced expansion in excess of the optimum with the consequence of meaningful efficiency losses.
The other major interventionist policies also appear to have been narrow and nominal policy successes, but ultimately real failures. Priority sector lending targets were met by the RBI’s deadline. Unfortunately, many of the target sectors reported high levels of non-performing loans, implying that credit extension was misdirected and could have been better invested in the absence of restrictions. The justification of nationalization as essential to achieving the state’s development objectives was undermined by the fact that the sector had low returns on assets and considerable inefficiencies while profit-maximizing private firms did not. Any positive societal externalities from politically-driven management of the banking sector were likely far eclipsed by the lost welfare gains that would have resulted had the sector been free to optimally allocate capital according to the demands of the market. Indeed, Demetriades and Luintel estimate that directed credit policies, fixed lending rates, and fixed deposit rates led to long-run reductions in financial depth (measured as the ratio of bank deposits to GDP) of 4.86%, 6.84%, and 12.48%, respectively, resulting in large losses in long-run growth relative to potential growth.
Reforms and new developments
Beginning in the late 1980s, but increasingly during the reformist period of the early 1990s, the Indian government began to roll back many of the restrictions that had constrained the country’s banking sector. In 1988, the Credit Authorization Scheme, which required banks to receive approval from the RBI for loans in excess of 40 million dollars, was replaced by a system that allowed banks to lend without prior approval so long as certain conditions were met. In 1993, new private banks were allowed to be established for the first time in more than twenty years and restrictions on branches of foreign banks were similarly eliminated. Interest rates were also significantly deregulated, allowing greater market determination and more optimal flow of capital. Finally, in 1994 and 1997, the statutory liquidity ratio was reduced from a peak of 38.5% to 25%, enabling banks to extend more credit to the private sector.
These reforms, in conjunction with those realized in other sectors, have enabled a dramatic surge in the depth and vitality of the country’s banking system. From March 1990 to March 2005, the country’s aggregate deposits and credit have grown roughly ten-fold to surpass some 17 and 11 trillion rupees respectively and credit as a percentage of nominal GNP has increased 10 percentage points over the period to 39.1%, an historic high for the country. Bank efficiency also notably improved, with operating costs for all commercial banks falling by 31% over the 1991-2007 period and return on assets more than doubling to 0.99%. The return on assets figure is still only half that of foreign banks in India, an indicator of how far the country still has to go.
Nevertheless, liberalization has been criticized for not meaningfully increasing financial inclusion. Chavan writes that the period of financial liberalization has brought with it “a distinct deterioration in the access to banking for the rural masses.” He cites evidence that access to formal credit has declined for farmers, making them more dependent upon informal moneylenders. From 1991 to 2002, the share of rural household debt held by these informal moneylenders increased from 17.5% to 29.6%. It is arguable that the deterioration in credit access to rural and farm households is more a reflection of continued structural deficiencies linked to agricultural policies than financial liberalization. For example, strengthening land claims would be an important agricultural policy with major financial inclusion implications. By doing so, farmers would be able to use their land as collateral, improving their access to formal credit sources. These gains cannot be achieved by rolling back financial sector liberalization but only through improved agricultural policy.
The concern about financial inclusion has been acknowledged by government officials, including Usha Thorat, Deputy Governor of the Reserve Bank of India. Since 2005, the RBI has undertaken several initiatives designed to encourage financial inclusion. These have included encouraging banks to offer “no-frills” savings accounts with no minimum balances and offering a general purpose credit card with a low credit limit and deregulated interest rates. The RBI has also permitted banks to partner with microfinance institutions to serve the poor. All of these initiatives are notable for their pro-market orientation and suggest the Indian government’s continuing, if more modest, commitment to economic liberalization.
The banking sector’s continued performance is contingent upon giving greater freedom to the private sector, particularly by phasing out priority sector lending requirements. It is clear from the experience with rural households that reforms elsewhere, particularly under the remit of agricultural officials, must be undertaken concurrently to ensure that these sectors can benefit from the gains of financial liberalization that other reformed sectors of the economy have enjoyed.
2.2 Capital markets
A mature banking sectors lead to the development of liquid capital markets. Capital markets build on the intermediation gains generated by the banking sector by further allocating risk, absorbing shocks with derivatives markets, and promoting good governance through market-based incentives and oversight. Karacadag, et al. describe the typical development of capital markets as following a progression beginning with money markets, followed by foreign exchange, treasury bill and bond markets, corporate bond and equity markets, and finally asset-backed securities and derivatives.
Indian capital markets remain significantly smaller than the banking sector, but they have grown sharply over the past two decades. The IMF reports that market capitalization of traded stocks as a percentage of GDP has surged from 8.6% in 1991 to 61% in 2010 and the number of listed domestic companies has jumped from 2,556 to 4,987 over the same time period. Capital markets have benefited from reforms that have simultaneously opened India’s economy to the rest of the world and reduced excessive regulatory burdens. The sustained growth of the Indian economy depends upon the further development of these markets, particularly the corporate bond market.
Despite the opening of the Bombay Stock Exchange in 1875, Panagariya notes that the market was “highly undeveloped” until the 1990s. The capital markets were restricted by the Capital Issues Act of 1947 and by the Office of Controller of Capital Issues, which controlled price and share premiums. While the equity market has grown greatly since reforms were undertaken two decades ago, the corporate bond market today remains notably underdeveloped. In 2009, the market capitalization of listed companies in India stood at $1.17 trillion (IMF, 2011); the total value of corporate and financial sector domestic debt outstanding, however, was a mere $72.5 billion (BIS, 2011).
As Turner notes, the absence of bond markets “either constrains investment possibilities or leads to dangerous financing decisions.” Without long-term financing options, decisions may be biased against long-term investment, making it more likely that borrowers will become too dependent upon short-term financing (creating liquidity risk) or too dependent on international markets (and the accompanying foreign exchange risk). Second, the absence of debt markets concentrates corporate risk in the banking sector in a destabilizing way. Finally, liquid debt markets, supported by active markets as well in sovereign debt, make monetary policy more effective because rate decisions immediately impact the economy’s actors.
Reforms and new developments
The creation of the Securities and Exchange Board of India (SEBI) in 1987 signaled the beginning of a new direction for Indian capital markets. However, Panagariya writes that it was not until the passage of the 1992 SEBI Act, which awarded the agency independence and statutory status, that development of the financial sector began in earnest. Newly empowered, the SEBI led the repeal of the Capital Issues Act and Office of Controller of Capital Issues, greatly opening access to the capital markets to companies which met basic regulatory standards. The creation of the satellite-linked National Stock Exchange drove innovation and sparked positive competition for the Bombay Stock Exchange. Finally, the introduction of derivatives trading in 2000 added additional sophistication to India’s capital markets and gave firms greater capability to hedge risks.
As a result of the reforms, the scale of Indian financial markets has surged. Average daily turnover in money, government securities, foreign exchange, and equity markets is at least five times greater in 2007 than it was in 1991. Greater openness to foreign portfolio investment and the emergence of mutual funds have delivered new resources to a corporate sector eager to invest in growth. The World Bank currently ranks India higher than all other BRIC nations on investor protection.
Mohan rightly concludes that “[now] there exist well-functioning, relatively deep, and liquid markets for government securities, currency, and derivatives in India.” The SEBI-led reforms of the past two decades are chiefly responsible for this development. Areas for further reform and progress, however, are clear, and include strengthening the vitality of the bond market (briefly explored in the section on future reforms). As development continues, the capital markets will take an ever more central role in the financial sector, making their proper regulation even more critical to growth and the preservation of macroeconomic stability.
2.3 Reserve Bank of India
Mohan has characterized the objectives of the Reserve Bank of India as “somewhat unorthodox” in comparison to its major international counterparts. Where other central banks in developed economies focus primarily on price stability and full employment, the RBI has chiefly focused on the financial stability and contagion risks that often accompany the integration of developing countries with the broader global economy. India’s development has been notable for the absence of a severe financial crisis, a testament to the fact that sound regulation does indeed underpin the system, despite its historically distortive and regulatory excesses. During the 1970s and 1980s, the Reserve Bank of India was frequently an instrument for enforcing many of the repressive policies that characterized the banking sector. Since the 1990s era reforms, the Reserve Bank of India has been more able to conduct an independent monetary policy, delinked from what Panagariya terms its historical ‘subservience’ to the fiscal and political needs of the government. It has also been an important actor in the maturation of the banking and capital markets sectors. Evidence to date suggests that the Reserve Bank of India has been largely effective in its newly independent role.
In the post-reform era, the RBI’s primary responsibilities are the maintenance of financial stability through the supervision and regulation of the banking sector, the administration of monetary policy, and the management of the exchange rate. In terms of the first objective, the RBI has performed well in its capacity as regulator of the banking sector. The banking sector was minimally affected by the global financial crisis, with no banks needing a rescue or guarantee. The RBI closely monitors banks for regulatory compliance. Most banks have maintained a healthy capital to risk-weighted asset ratios above 10%, which exceed global Basel II norms. In recent months the strength of banks’ capital base has weakened as bad debt has increased due to temporary strains in the broader economy, which is practically inevitable after a sustained period of robust growth. Officials believe that these losses and the new, crisis-inspired Basel III capital requirements mean that Indian banks will need to raise several trillion rupees within the next few months. The RBI has also been active in accelerating institutional development through better clearing systems, greater transparency, and the use of technology. These reforms strengthen the essential basic infrastructure necessary for further deepening of the capital markets.
In terms of inflation, India, unlike many other developing countries, has had “a record of moderate inflation, with double-digit inflation being the exception and largely socially unacceptable.” However, concern has increased in recent months about the RBI’s ability to constrain inflation and prevent the economy from overheating. Despite 12 interest-rate increases in 18 months, inflation has remained elevated at slightly below 10%, which is double what economists and politicians believe is appropriate for India’s economy.
Third, the Reserve Bank of India’s management of the exchange rate is a particularly important concern as India sheds decades of economic isolation to adopt policies of global integration. The rupee trades on global markets with a value based on supply and demand conditions, with intervention by the RBI undertaken only as necessary to counteract excess volatility. Mohan has described the objective of the RBI with respect to the exchange rate as to allow for a “market determined rate based on market fundamentals, not speculative flows.” A review of exchange rate performance over the reform period suggests that the nominal exchange rate of the rupee is nearly fairly valued..
In sum, the RBI has responded well to 1990s-era liberalizations of the financial sector and broader economy. The management of inflation in recent years has emerged as a challenge for the institution politically and the economy, but historical inflation suggests that it will be contained. Mohan’s assessment that the “blurring of boundaries between financial institutions and markets raises significant policy challenges” will likely be proven correct given India’s experiences thus far. The Reserve Bank’s efforts to support India’s integration with the global economy (while minimizing the risks developing countries often face from foreign capital flows) have allowed the economy to chart a prudent course between the benefits and risks of financial globalization.
3. Future reforms
For all its progress, India’s reforms efforts in the financial sector are by no means complete. Indeed, in a 2006 report, McKinsey & Company identified potential reforms to the Indian financial sector that would unlock $48 billion of capital per year, or 7% of GDP at the time, highlighting the considerable inefficiencies and distortions that impede economic development. McKinsey estimates that these reforms would raise India’s growth rate by 2.5 percentage points per year, which would lift millions of Indians out of poverty. A major priority should be phasing out or dramatically reducing the scope of the priority sector lending program, as discussed above. This paper recommends three additional reforms policy makers should consider going forward.
Unleashing “dead capital”
Hernando de Soto has observed that growth in many developing countries is constrained by high levels of what he terms as “dead capital.” This term describes capital prevented from being used as collateral for productive investment because of the absence of formal ownership rights to land, buildings, or other assets. Panagariya laments that the problem of dead capital is pervasive in India, where the absence of formal land titles on farms and rent laws “effectively rob the owner” of his property rights. According to Wadhwa, Indian property records “hardly reflect the present day reality regarding ownership of land.” As part of its efforts to deepen the country’s financial sector, India’s government must undertake efforts to enhance the ability of its abundant assets to be used as collateral, and thereby tap a considerable source of savings that can facilitate further development. In addition to its implications for the financial sector, strengthening rural farmers’ title to land can contribute substantially to the country’s poverty reduction efforts.
Developing a corporate bond market
The development of a deep corporate bond market is an important next step in the maturation of India’s financial sector and would allow the corporate sector to competitively finance its growth ambitions. In 2004, the size of the Indian corporate bond market was only 5.4% of GDP, less than half that of China and Brazil, and significantly less than the size of the government bond market in India, which reached 40% of GDP in 2005. Bhagwati claims that a principal reason for the small size of the corporate bond market is the existence of a yield curve that “is not adequately arbitrage free.” Small and medium-sized enterprises are the principal victims of the limited access to bond markets. Bhagwati suggests three needed reforms that will aid the development of a strong corporate bond market. First, raising the $3 billion cap on investments by foreign institutions could be an important step in generating demand for debt placements. Second, better infrastructure for providing bond market information would give the market heightened transparency. Finally, clarifying creditors’ rights and reducing the variance in stamp duties on bonds would also be a considerable boost to the bond market.
Bank privatization and liberalization
After India’s broadly successful (albeit partially complete) deregulation of the banking sector in the past two decades, the clear next step for its government to take is the sector’s full privatization. As of 2007, the public sector held 62% of banking assets. International and local evidence suggest that large public concentration of deposits unnecessarily diminishes economic growth and that India would benefit from greater private-sector leadership in the banking sector. Despite large improvements in the past two decades, public sector banks continue to lag behind their private sector counterparts in many metrics, including return on assets and net nonperforming assets. Indeed, the work of Kumbhakar and Sarkarsuggests that India may not yet have realized the full gains of liberalization attained thus far, finding that deregulation boosts the productivity of private sector banks with no impact in productivity growth for those in the public sector. Thus, further privatization may unleash as yet unrealized gains. A more independent banking sector free to focus explicitly on profit maximization is the surest way to promote the efficient allocation of capital and robust economic growth.
For much of India’s history, the optimal development of India’s financial sector has been hindered by a web of interventionist and distortive policies. While many of these policies succeeded in achieving their stated targets, these policies did not meaningfully realize their ultimate objectives of enabling higher growth. For example, most banks complied with the government’s priority sector lending targets, but evidence suggests that the results were likely counterproductive to the ultimate objective of promoting growth. The 1990s-era reforms have subsequently done much to make the financial sector more efficient and to strengthen its contributions to India’s economic growth, which has accelerated to an average of 6.3% per year over the past two decades. Financial sector liberalization has been particularly crucial in this acceleration by amplifying the impact of liberalization of in other sectors. In other words, had the industrial sector been free of capacity and expansion constraints but lacked access to the financial resources necessary to grow, liberalization in those sectors would have effectively been undertaken in vain.
Despite this considerable progress, the Indian financial sector continues to possess critical structural deficiencies, including the large portion of the banking sector which remains under the control of the public sector and the absence of a corporate bond market, which constrains private sector expansion. Further reforms must be undertaken for India to sustain the momentum of economic growth that was unleashed with such force in the past two decades. Continued reform of the financial sector in the short-run, however, may be complicated by broader global economic uncertainty and mixed signals about the impact of liberalization thus far, particularly on measures of financial inclusion. Retrenchment on measures of financial inclusion should not be viewed as evidence of a failure of liberalization of the financial sector, but as a failure of reforms in other areas of the economy, particularly in agriculture, to take advantage of a transformed – however imperfectly – financial system.
Many Indian officials harbor the desire of building four of India’s financial firms into global powerhouses. Short-term capital pressures and the considerable remaining structural issues that this paper has highlighted, compounded by a stalled political system that has lost its fervor for reform, make clear that these global ambitions will remain just that for some time.
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