The mouse and the elephant
But, India’s international financial stature remains moderate by comparison. While the stock market is thriving, India’s government bond market is illiquid and its corporate bond market is moribund at under 7% of GDP, a fraction of the size of the markets in Korea or China. With the banking system dominated by public sector banks, which control over 70% of banking assets, and entry by foreign banks limited, India has few world-class financial institutions with global reach and scale. Moreover, regulation hamstrings the ability of institutional investors such as pension funds and insurance companies to participate in domestic financial markets, and thereby help those markets develop. For example, derivatives markets, the “oil” in the engine of global finance, remain underdeveloped, and increasingly trade offshore—in fact, trading in contracts like over-the-counter interest rate and currency products and in Nifty futures has migrated to the friendlier regulatory environ of Singapore.
Can growing economic might and lagging financial power continue to coexist? Our view is that they cannot. Finance is not merely a veil over economic activity—it is an essential input without which the engine of economic growth cannot remain well- oiled. More and more international evidence suggests that financial and economic development go hand-inhand, and that countries which become integrated with global markets but that lack deep and broad domestic financial markets sacrifice growth in the long run. For India, the case for financial development and growth is particularly clear: India needs $500 billion in social and physical infrastructure investment over the next four years to sustain rapid growth, and the public finances and domestic markets are simply not up to the task of funding investment on such a scale. Nor is the banking system: the assets of all scheduled commercial banks total only about $800 billion, and moreover it would be imprudent to lay all the risks of long-term, uncertain infrastructure investment on bank balancesheets. Again, to take a macro view, India generates sufficient savings to finance the necessary investment but it is the financial system that links saving and investment together; an underdeveloped financial system undercuts the efficiency of this linkage and wastes financial resources, and thereby sacrifices growth.
What is the way forward to develop financial markets and support growth, while maintaining and even bolstering financial stability? The prescriptions are many, as outlined in the report on Mumbai as an international financial center (Mistry report), the report of the committee on financial sector reforms (Rajan report), the report of the expert committee on corporate bonds (Patil report), and many others, and the direction of needed reforms is becoming clearer. Common recommendations include, first and foremost, reducing the role of the public sector in finance: downsizing public ownership in banks, and allowing foreign institutions to enter more freely to bring newer and more innovative financial techniques to India’s financial system. Second, revitalising the full range of bond, currency and derivatives markets: most crucially, expanding foreign currency derivatives markets, to allow banks and corporations to hedge the risks associated with India’s growing integration with global financial markets, and developing the corporate bond market to provide a venue for infrastructure finance. Third, allowing domestic institutional investors freer rein to invest, at both home and abroad.
To be sure, great progress has been made in financial sector reforms since the early 1990s, notably in liberalisation of interest rates, freer entry of private banks, and development of financial markets. And progress is still underway today, notably in the Reserve Bank’s initiative to introduce exchange-traded interest-rate and currency futures. But there is no time to lose in pushing forward in a determined fashion with financial reforms. The sacrifices involved in delay and inaction—in terms of foregone growth and living standards—are too great.
Kalpana Kochhar is senior advisor and Charles Kramer chief of the South Asia Division in the IMF’s Asia & Pacific Department. These are their personal views