1. Household finance in India: What a shift from informal to formal sector borrowing requires

Household finance in India: What a shift from informal to formal sector borrowing requires

Finance occupies an awkward place in present-day economic thinking. Much of economic analysis abstracts away from the role that financial intermediation plays in the allocation of resources.

By: | New Delhi | Published: September 18, 2017 6:20 AM
household, household finance, household finance india, formal sector, informal sector The workings of financial markets as underpinnings of real economic activity have been less of a focus. One exception has been in thinking about macroeconomic impacts of money and credit.

Finance occupies an awkward place in present-day economic thinking. Much of economic analysis abstracts away from the role that financial intermediation plays in the allocation of resources. Financial excesses and financial crises focus attention on the worst failings of the sector, while its smooth functioning goes unnoticed. We know that Indian economic reform began over a quarter century ago, and we think of its core theme as the removal of unreasonable controls on markets, so that market prices can act as effective signals for efficient resource allocation. International trade and industrial activity have been two areas where this idea has played out.

The workings of financial markets as underpinnings of real economic activity have been less of a focus. One exception has been in thinking about macroeconomic impacts of money and credit. Another has been in the idea of financial inclusion, giving the poor access to various kinds of financial services (goo.gl/X4UHcK). Of course, one of the earliest and most successful reforms in India came in the financial sector, when the stock market was modernised almost overnight, and changed the rules of access to capital for a small set of larger Indian firms. In my July 19 column, I argued that improving financial market functioning for the much greater number of smaller firms will have large benefits as well.

Complementing the need to improve business financing is the issue of household finance. In July, the Household Finance Committee, chaired by Tarun Ramadorai, presented a report that is a tour de force. This is obviously not the first report on Indian finance, and at least six earlier committees are acknowledged. But this document provides a deep dive into the nuances of Indian households’ financial behaviour, buttressed by a large amount of empirical analysis and comparisons with household finance in other countries. What do we learn from the report? Here are some partial answers to that question.

Typical households in India (and not just the poorest or richest) have a large fraction of their wealth in physical assets, especially gold and real estate;

Use of mortgages is low early in the life-cycle, when they would be most valuable as a way to smooth consumption;

Pension wealth in India is almost negligible, and pension accounts and investment-linked life insurance products are widely used in only a few states;

There are high levels of unsecured debt, including from moneylenders and other informal sources;

Levels of use of all kinds of insurance (life and non-life) are very low;

The evidence is suggestive of households using high-cost informal borrowing to deal with negative shocks (possibly related to health, natural disasters or just weather, or macroeconomic variability).

As the report notes, some of the above patterns may be related to social structures in India, such as joint families and high spending at the time of marriage. But this is not the whole explanation. Some of what is observed can be blamed on inefficient financial institutions. The report calculates the potential income gains from modifying household patterns of financial and other wealth-allocation decisions. These gains could be several percentage points per year, implying large cumulative gains. This implies that the costs of reducing existing inefficiencies in financial institutions (which are more one-time, but harder to estimate) could be outweighed by the gains.

The report spells out general policy recommendations. These include reducing the bureaucratic impediments to financial access by improving the internal organisation of financial institutions (and possibly improving the working of market competition), using technology to bring down transaction costs, introducing financial products that are suitable for the social structures of Indian household life, improving financial literacy and overcoming behavioural barriers with “nudge” solutions (providing good default options), and generally improving regulation to increase trust and transparency while reducing transaction costs.

Of course, the 180-plus page document provides much more detail on household behaviour, wealth situations, financial institutions, and policy implications. As noted, some of these points have been made in earlier reports, but this one is state-of-the-art in terms of empirical and theoretical underpinnings, its international comparative approach, and in many of its specific recommendations. At least from my perspective, there is nothing too politically challenging in making these recommendations a reality in a relatively short period of time.

The challenges will come from several directions. There will be institutional inertia within the financial sector, since increased efficiency and competition will impose costs on managers and employees. Overcoming this may require bold leadership and new players in the sector. Some who benefit from existing inefficiencies, such as informal lenders, may also have political clout, and be able to sabotage reforms that reduce their profits. Overcoming this may require some co-opting of these intermediaries. A third challenge is coordination of reforms. For example, the report notes that a shift from informal to formal sector borrowing will require a simultaneous development of appropriate insurance markets and products.

There is much more in the report, which is publicly available on the RBI website. Among the gloom coming from the continued negative impacts of demonetisation, slowing growth, and increased suppression of some minorities, the report is a ray of light for India.

Nirvikar Singh, Professor of economics, University of California, Santa Crux

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