From the Economist Intelligence Unit ViewsWire
India's financial system remains inefficient
India's financial system is dominated by state-owned commercial banks that allocate capital inefficiently. Part of this inefficiency stems from regulations that require banks to provide funding to "priority" sectors, loans that have traditionally had a high risk of turning bad. Although the stockmarket is relatively developed, it remains inadequate as an alternative source of funding for the bulk of Indian companies. This lack of effective financial intermediation, combined with a low savings rate, means that the economy continues to face capacity constraints.
Mindful of these funding shortfalls, the government has sought to attract greater foreign direct investment (FDI). More generally, a broad-based approach towards financial-sector development is needed, one that includes greater co-ordination of macroeconomic policies. Financial liberalisation set within the context of a stable macroeconomic environment would be the ideal scenario. Vested interests will, however, remain an obstacle to financial reforms, as the government benefits from the status quo of banks having to use a certain proportion of their deposits to buy public debt.
What is the issue?
Indian companies face investment constraints owing to the country's low savings rates and the inability of financial intermediaries to channel funds effectively. The financial system is dominated by state-owned commercial banks that have long been criticised for the inefficient way in which they allocate capital. State banks control around 80% of the deposits and assets in the banking system, while the banking sector as a whole accounts for around three-quarters of overall financial assets. The government has thus far failed to adapt the country's financial system to the increasingly sophisticated needs of the real economy, which has become more linked to global trade in recent years. This has meant an over-reliance on the banking system for funding, which, combined with onerous rules relating to the issuance and the purchase of domestic debt instruments, and limits on derivatives trading, has undermined financial innovation.
Part of the weakness of Indian banks (both state-owned and private) stems from the fact that they are mandated to provide funding to government-defined priority sectors dominated by small-scale business and agriculture. Loans to these sectors are at high risk of becoming non-performing. Private-sector banks must ensure that 25% of their loans are directed towards these priority sectors, while state-owned banks must direct 40% of loans towards these categories of borrowers. The rules restrict the level of credit available to more efficient companies in non-priority sectors.
Despite ostensibly strict lending criteria set by regulators, the nature of directed lending in India means that bad loans would be significantly higher if internationally accepted criteria--defined as any arrears of more than three months--were used. (In India non-performing loans, or NPLs, are defined as those loans where either interest or principal payments are unpaid for at least two quarters.) Moreover, much of the lending to priority sectors, by definition, is to those on low incomes. This means that even small increases in interest rates can result in loans turning bad.
A further problem is that large and persistent budget deficits mean that the government regularly issues public debt instruments. Banks are subject to the Statutory Liquidity Ratio (SLR), whereby they have a legal obligation to hold 25% of their deposits in government securities. The SLR reduces banks' scope for lending to the private sector and thus lessens their ability to act as effective intermediaries. As a result, India's average loan-to-deposit ratio is much lower than that of many other emerging economies. The authorities have an interest in sustaining the implicit contract that allows local banks to offer low interest rates on deposits in return for these institutions then acting as a captive source of investment in government bonds. Non-bank financial institutions are, however, given more freedom in terms of how they use their funds, but they lack the depth required to play a significant role.
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Although India's stockmarkets are relatively developed--the two national exchanges represented around 145% of GDP in September 2008--they remain inadequate as a source of funding for the bulk of Indian companies. The obvious alternative is the bond market. However, this market is dominated by government debt instruments (these make up around 90% of the total bond market); the corporate bond sector remains well below its potential as a means of funding for the private sector. Despite strong private-sector credit growth since 2004/05, the corporate debt market (defined as bank credit to the sector plus corporate bonds) stood at 20% of the total debt market in the 2006/07 fiscal year, compared with an average of around 60% for emerging markets.
Why is it critical?
India recorded a robust annual average economic growth rate of 8.9% during the five fiscal years up to and including 2006/07. However, the economy faces a number of acute capacity constraints owing to lack of funding for infrastructure and for corporations. India's structural current-account deficits are a reflection of its low savings rate. Companies rely on foreign capital inflows. As such, external commercial borrowings (ECBs) have taken an increasingly important role. However, the global financial crisis has illustrated the dangers of relying on such sources of financing.
The solution requires a multi-pronged approach, including the development of a corporate bond market and a reduction in directed lending. This would enable the financial sector better to fulfil its role as an intermediary. Indeed, according to the IMF, the corporate sector's savings rate (as a percentage of GDP) has been generally below the level of its investment on the same measure, since 1990/91. This reinforces the Economist Intelligence Unit's view that the corporate sector relies, and will increasingly rely, on external financing.
What is the government doing about it?
Prior to the global financial crisis, the government had adopted a cautious but progressive approach to capital-account liberalisation. However, as part of this process it had liberalised portfolio flows considerably more than FDI flows, partly because allowing inflows of the former is easier to achieve politically--many sectors remain closed to FDI owing to the difficulty of overcoming vested interests. The preponderance of portfolio investment over FDI has added to financial-sector risk, owing to the greater volatility of portfolio flows.
High budget deficits will ensure that the government continues to crowd out borrowers from the corporate sector. Restrictive issuance rules and quantitative limits on corporate bond purchases act as a further drag on the development of the sector. The lack of an effective secondary market for either government bonds (which are generally held until maturity) or corporate bonds also restricts investor interest in the bond market, as the lack of liquidity makes it difficult for investors to realise profits. A number of other restrictions remain in place, including a tax structure that makes it less attractive to issue debt. Nevertheless, regulators have taken several steps in recent years, particularly in terms of promoting a secondary market for bonds. Corporate debt instruments are, for example, traded on both the Bombay Stock Exchange and the National Stock Exchange. Mutual funds are beginning to play an important role in the broader bond market.
Since 2000 the government has also allowed the development of a derivatives market. In the long run this ought to improve the efficiency of capital markets by improving price discovery. However, the government is concerned that these types of relatively sophisticated financial instruments could disrupt the underlying products from which the instruments are derived, as has been the case in more mature financial markets in the US and Europe.
The EIU view
India needs to adopt a broad-based approach towards financial-sector development that includes greater co-ordination of macroeconomic policies. For example, there are currently inconsistencies in monetary policy, with the Reserve Bank of India (RBI, the central bank) looking at both inflation and economic growth. Moreover, with the gradual (though incomplete) opening of the capital account since 2000, the RBI has had to focus on an inconsistent combination of policies: using interest rates to target these macroeconomic variables, while seeking to ensure the stability of the Indian rupee in the foreign-exchange market.
Improving the financial sector's depth would help to mobilise savings and improve the efficiency of capital allocation. The role of vested interests--including employees and their unions--and the government's own need to sell bonds to banks will continue to obstruct reforms. Turning state-owned banks into more commercially oriented operations will remain a slow process owing to political sensitivities (potential job losses and a loss of control over a key lever in the economy being but two of these restraints). The state-owned banks' central role in India's financial system means that such reforms are essential. Some reforms could be less contentious, however, including allowing foreign investors to buy government bonds, thus relieving pressure on the balance sheets of local banks.
A cautious approach to liberalising the domestic financial sector is viewed as having protected India's financial institutions and thus the economy from the worst of the crisis in global financial markets. However, the foregone benefits of faster economic growth--that is, the growth that could have been achieved if financial innovation had not been inhibited--are difficult to measure.
