India’s failure to create effective markets for short-term financing of its SMEs stands out as a major barrier to growth
In my last column, I noted that India’s progress in financial development appears to have slowed down or stalled, and therefore continued financial sector reform is important. While India’s rankings in measures such as “human development” or “ease of doing business” have received considerable attention in the media and from policy-makers, financial development has not. This is because it is at once more specialised and more complex, not to say controversial. Financial development is not an end in itself, but more of an uncertain means to the ends of growth and human development.
As in the case of other measures of national economic performance, one-dimensional indices of financial development have been constructed for India, as well as for most other economies in the world. Recently, my co-author Linh Bun and I, building on earlier work I did with another co-author, Inderjit Kaur, have argued that one can extract information about financial development beyond the one-dimensional approach. This involves separating out comparisons of patterns of financial development from comparisons of levels.
I will illustrate these ideas by benchmarking India against 14 Asia-Pacific economies. This group includes Japan, South Korea and China, which will all matter greatly for India’s future growth, in various ways. It is made up of seven advanced and seven emerging economies. Even using purchasing power parity adjustments, India is poorer than 12 of these economies, barely ahead of Vietnam, with Cambodia at the bottom. Using what the World Economic Forum (WEF) calls a measure of financial market development (slightly adjusted by us), India lies in the middle of this comparison group. This reflects India’s uneven financial development, since the focus of WEF is more narrowly on financial markets rather than institutions (see my last column “India’s uneven financial development” https://goo.gl/FFrC1B). Paradoxically, India ranks highly on protecting investors’ legal rights, and removing that component from the overall measure moves India closer to the bottom of the comparison group.
There are eight components of financial market development in the WEF measure, including affordability and availability of financial services, access to equity markets, loans, and venture capital, soundness of banks, and regulation of securities exchanges, in addition to investor rights. The World Bank has suggested a measure of distance, which effectively treats financial development as a vector of characteristics, rather than trying to reduce it to a single number. By this distance measure, India’s financial development is closest to that of Vietnam, which has a similar GDP per capita. The next closest, surprisingly, is South Korea, which has some unexpectedly low scores on access to loans and to venture capital. But the main concern is that this distance measure combines the effect of distances in levels and in patterns.
Linh Bun and I have proposed using a correlation-type measure instead, to capture the pure effect of similarities or differences in patterns of financial development. This uses deviations from the average across different components, and so it strips out differences in levels of development. By this measure, India is still close to Vietnam, but it is also relatively close to advanced economies such as Australia and Singapore. On the other hand, India’s pattern of financial development is further from that of Japan, and further still from that of China. In these comparisons, the investor rights measure turns out to influence the results quite significantly. Leave it out and patterns of financial development appear much closer (the correlations are higher). In this case, India’s pattern appears furthest from those of Cambodia and China.
There is much more data available on different components of financial development, including those that pertain to the underlying institutions and infrastructure of finance. For example, a modern digital infrastructure can be important for financial access, in ways that were not conceivable two decades ago. The value of our approach is that it allows summary comparison of economies in terms of patterns of financial development—one country may have better functioning stock markets, while another may have more efficient banking. Another country may have more effective markets for start-up financing.
Measuring differences in patterns of financial development can also highlight possibilities for financial integration. Interestingly, some differences may actually favour financial integration, based on specialisation and comparative advantage with respect to different kinds of financial services. On the other hand, for some aspects of financial development, similarity may be a positive for financial integration, as in the quality of regulatory institutions.
Ultimately, as I noted at the beginning of this column, financial development, while it can contribute directly to measured growth, matters chiefly in how it greases the wheels of the economy, supporting growth of all sectors of the economy. In this context, it is also useful to note that aggregate measures, even if decomposed to vectors of characteristics, may still miss important aspects of financial development. In this context, India’s failure to create effective markets for short-term financing of its small and medium sized firms stands out as a major barrier to growth. This is not well-captured in the benchmarking exercises that are currently possible.
The author is professor of Economics, University of California, Santa Cruz