Competitive technology-based platforms, combined with strong rules for transparency, will allow financial intermediation to become growth-enabling
India’s economy is struggling to emerge from the shock of the pandemic, with the shadow of a possible third wave of infections looming large. Besides responding to this threat by stepped-up vaccination efforts, what else should be on policymakers’ minds? Perhaps the financial sector ought to be a primary concern in trying to get India back onto a rapid growth path. In the early 2000s, India experienced its most encouraging period of sustained high growth. This was supported by increased rates of savings and investment. Unfortunately, the workings of the financial sector did not ensure that investment was always productive. Money was wasted and stolen. Bad loan problems multiplied, spreading from banks to non-bank financial companies. As growth slowed, borrowers came under stress. A new bankruptcy law was not implemented as smoothly as it might have been. Demonetisation and a difficult roll out of the new goods and services tax further derailed the financial lubricants of the economy. The pandemic was the simply the last straw in this procession of financial misadventures.
Harsh Vardhan, in a piece for Ideas for India, estimates that incremental business credit fell from 13% of GDP in 2011 to 3% in 2020. The collapse in credit came through a negative feedback loop, involving supply and demand. As the economy claws its way back from the effects of the pandemic, making sure that business credit recovers will be critical for future growth. Demand by the private sector may come with a recovery in consumer spending, but it will be aided by a robust fiscal stimulus, especially including whatever can be done quickly to restore efforts to upgrade infrastructure and remove supply bottlenecks. On the supply side, Harsh Vardhan notes the importance of improving the governance and risk management systems of India’s banks, as well as of providing capital to enable a corporate bond market to expand its reach beyond the most highly rated firms.
But probably much more will be needed to provide needed financial grease for the wheels of the Indian economy. A concerted effort to create and expand new platforms for business finance ought to be a top priority for policymakers. In this respect, RBI has been relatively timid in regulatory actions to enable technology-based solutions for better financial intermediation. It might be argued that the problems of the past decade illustrate the risks of permissiveness in the financial sector. But this does not seem to be an accurate reading of the situation. The problems that arose with public sector banks and with non-bank finance companies were not the result of lack of regulation, but a lack of transparency and of effective regulatory enforcement.
A case can be made that competitive technology-based platforms for financial intermediation, combined with strong rules for transparency (more easily achievable with digital technology than with thousands of bank branches, or hundreds of interlocking non-bank entities) are what will allow financial intermediation in India to finally become growth-enabling rather than growth-constraining. Digital finance platforms can be monitored intensively by regulators as well as by users, as long as the disclosure rules are well designed. An effective digital ecosystem for financial intermediation can also spur the development of credit-rating systems for businesses and individuals. Even more important, the incentive of being able to access financial resources for day-to-day operations as well as for growth can spur small businesses to improve their financial record-keeping, so that they can participate in digital financing platforms. The analogy to what a company chooses to do in order to list on a stock exchange is obvious.
Government policy has tended to focus financial digitisation on households, especially the poorest, so that they can access savings and payments methods that are lower cost and allow them to manage their finances better. This is certainly desirable, and an important component of economic development. But India’s growth will take off when firms of all sizes can better access financial resources for daily operations and investments that will aid their individual growth trajectories. India’s decade-long credit collapse is a symptom of deep structural problems with its institutions of financial intermediation. The urgency of recovering from the pandemic-induced economic crisis ought to spur regulatory and policy innovation that catches up with the technological innovation that has already occurred.
The author is Professor of economics, Univeristy of California, Santa Cruz