1. Column: India’s uneven financial development

Column: India’s uneven financial development

In the Asia-Pacific region, the country had been doing quite well—until the last couple of years.

By: | Published: September 14, 2015 12:27 AM

Economists are still struggling with measuring precisely the role of finance in economic development. At a basic level, an economy obviously cannot operate, let alone grow, without a well-functioning financial sector. The global financial crisis, however, suggested that the financial sector can be distorted, with negative consequences for the wider economy. In India, though, financial stability has been relatively high, but arguably at the cost of some stunting of India’s financial development.

Interestingly, amid the headlines about land acquisition and the Goods and Services Tax (both important issues in their own right), India has been pursuing a major, comprehensive reform of the laws that govern its financial sector, in the activities centred on, and flowing from, the Financial Sector Legislative Reforms Commission. There are still numerous challenges and pitfalls in such a massive process, but the signs of progress are encouraging. In this context of major reform, it is useful to examine how India is doing in its financial development.

It turns out that answering the central question is not easy. Financial development has many dimensions, and there are multiple ongoing attempts to measure it, usually through some single index, but increasingly by allowing for multidimensionality. There are comprehensive, complex efforts from the researchers in World Bank and the IMF. Each distinguishes between financial markets and financial institutions, with the basic distinction being that the former focuses on the size and functioning of stock and bond markets, while the latter refers to banks, other financial institutions, and their activities. In modern finance, the dividing line between markets and institutions may be blurred (after all, financial institutions trade, and markets require institutional rules and structures), but we leave aside that issue. More importantly, within each category, financial development is now seen as having distinct measurable characteristics, namely depth, access, efficiency and stability. India’s push for greater financial inclusion through greater availability of banking services is an obvious example of trying to increase financial access.

If we look at the IMF’s financial development indicators, India does surprisingly well. Its financial development score is much higher than the average of 85 emerging market economies (EMEs). Decomposing this, the real advantage of India is in financial market development, rather than in financial institutions. This alone hints at Indian financial sector reform being on the right track, in trying to strengthen the legal framework that is what ultimately enables good institutions. Within the category of financial institutions, India does better than the EME average on access, but worse on efficiency. This is, perhaps, a reminder that simply pushing for more bank accounts without better functioning of banks and other components of the financial institution ecosystem may not be the way to go. India’s scores on financial market development also illustrate the limitations of these numerical summaries. The thinness of the Indian markets for corporate bonds, and for many types of relatively simple derivatives, is not captured in the measures.

A partial alternative to the complex approach of the IMF and World Bank is that of the World Economic Forum (WEF), which, within its Global Competitiveness Index for 144 countries, constructs a sub-index of what is called financial market development. Arguably, though, the measure uses indicators for financial institutions as well as markets. What is different about the WEF is that it uses executive opinion surveys quite heavily in its indices, especially in the case of financial development. India does quite well here too, ranking 51 in the latest year, with a rank of 43 for efficiency and 55 for trustworthiness and confidence.

My co-author Linh Bun and I at UC Santa Cruz have been working with the WEF index of financial market development, focusing on Asia-Pacific countries. Compared to 14 countries in that region, India was doing quite well on financial development scores a few years ago, but there was a substantial decline in the past year or two, unlike those regional comparators, which were more stable. Ratings of soundness of banks, regulatory quality, and even availability and affordability of financial services all dropped in the Indian case. Some of this no doubt reflects the volatility of subjective opinions, but a similar trend, though slower and less pronounced, is also seen in the IMF data, which does not rely on surveys.

While measuring financial development is not easy, and numbers tell only part of the story, one can conclude that India’s financial development has been uneven, with strength in some areas, and relative weakness in others. Linh Bun and I have developed a way of capturing heterogeneity of patterns in financial development, and I will describe that in my next column. The important takeaway for now is that India’s financial sector development cannot be taken for granted. After significant improvements in the first two decades of reform, there has been a lull, and even some reversal in measurable financial development over the last few years, suggesting that continued reform is important.

The author is professor of economics, University of California, Santa Cruz

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Tags: India
  1. No Comments.

Go to Top