India's financial system: More market, less government

By Diana Farrell, Susan Lund, Leo Puri

A stronger financial system would make the economy grow more quickly and ensure higher tax revenues—without higher tax rates.

A casual observer might infer from India's flourishing stock markets, fast-growing mutual funds, and capable private banks that the financial system is one of the country's strengths. But closer inspection reveals that while policy makers deserve credit for liberating these high-performing parts of the system, tight government control over almost every other part is undermining India's overall economic performance. To sustain rapid GDP growth and spread its benefits more broadly, the country needs a financial system that is comprehensively market oriented and efficient.

The financial system's shortcomings fall largely into three areas. First, formal financial institutions attract only half of India's household savings and none of the $200 billion its people keep tied up in gold. Second, these financial institutions allocate more than half of the capital they do attract to the economy's least productive areas: state-owned enterprises (SOEs), agriculture, and the unorganized sector (made up mostly of tiny businesses). The more productive corporations in India's dynamic private sector receive only 43 percent of all commercial credit. Third, since the financial system is inefficient in both of its main tasks—mobilizing savings and allocating capital. Indian borrowers pay more for capital and depositors receive less than they do in comparable economies.

These failings place a heavy burden on India's economy; fixing them would give it an immense boost. Research by the McKinsey Global Institute (MGI) indicates that an integrated program of reforms for the financial system could add $47 billion to India's GDP each year. This increase would in turn raise India's real GDP growth rate to 9.4 percent a year, from the current three-year average of roughly 7 percent. India's growth would be roughly on par with China's and just shy of the government's 10 percent target. Household incomes would be 30 percent above current projections by 2014, lifting millions more people than expected out of poverty.

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