Financial reform key to growth

By Diana Farrell

For both China and India, financial reforms are much more likely to achieve the social objectives that are currently used to justify the distortion of the financial system by the government. Such reforms should be among their highest priorities.

The Governments of China and India must let private sector take a more active role

In the run-up to it's Singapore Annual Meeting, the International Monetary Fund has highlighted how financial system development has helped drive Asia's recent impressive growth. It is certainly true that a great deal of progress has been made, but the giants in the group, China and India, still face significant risks from their financial systems. They must implement a tough, and politically difficult, reform agenda if they are to unleash their economies' full potential.

In a study of Asian economic development, to be published in the IMF's World Economic Outlook, the fund notes that financial sector development has a "strong and significant impact on productivity growth" and that Asia's financial systems, "still heavily centered on banks, will need to be broadened and deepened, for instance, through efforts to develop the corporate bond market".

New research by McKinsey Global Institute demonstrates the depth of the problem.

In India, for instance, the value of the corporate bond market amounts to just 2 percent of its GDP. It is no wonder then that Indian companies rely on retained earnings for nearly 80 percent of the funds they raise and have very low levels of debt by international standards. Although Indian companies have the advantage over their Chinese counterparts of more developed equity markets, the prohibitively high cost of capital continues to compromise their performance.

Diversifying and broadening sources of funding to corporate players in India and China is a critical component of necessary financial—sector reform, but there are even more fundamental structural issues to handle.

On of the striking similarities between these two countries is their poor allocation of capital, due in parts to their governments distorting the financial system to achieve social ends–in India to fund the government's persistently large budge deficit and its rural investment priorities; in the case of China, to ensure a continued flow of funding to its many inefficient but massive state–owned enterprises to preserve jobs.

These policies have similar unfortunate consequences–wasteful investments that yield negligible returns; restrictive funding for the private companies that are driving growth; pervasive state ownership of financial institutions which stifles competition and lowers their efficiency; and a feeble array of financial products for consumers, and, as we have noted, minimal growth in corporate bond markets.

In China, despite the fact that the country has a very large and deep pool of financial capital—an estimated US$4.5 trillion of assets (S$7 trillion)—the majority of lending goes to less efficient state–owned enterprises.

Our research finds that although China's private companies now produce more than half of its GDP, they only receive 27 percent of loans, and they are excluded from the country's nascent equity and corporate bond markets.

This misdirection of capital—together with artificially cheap credit due to the country's regulated ceiling on deposit rates—has contributed to a boom not just in investment but in its inefficiency.

In the first half of the 1990s, China needed to invest US$3.30 for every additional US$1 of GDP, since 2001, it has had to invest US$4.90 to get the same return.

Chinese households, not surprisingly, earn very poor returns on their savings and China has a severe problem with non–performing loans. Major Govt role in financial system.

India's dynamic private sector, which includes some world–class companies with average productivity 10 times higher than that of household enterprises and double the level of state–owned ones, gets only some 43 percent of total commercial credit.

The government dominates the financial system, requiring banks and other financial intermediaries to hold a large portion of their assets in government securities, largely to fund the country's persistently large deficit. Banks also have to devote 36 percent of their loan portfolios to the government's priority sectors.

If India is to successfully complete the transition from agriculture to industry and services that has accompanied rising living standards in all developed countries, freeing the financial system is critical.

We estimate that financial–system reform and further economic liberalization could add US$48 billion a year to India's GDP, boosting its annual growth rate from 6.5 percent forecast now to 9.4 percent over the next 10 years—and therefore matching China's rate of expansion. 

In China, concerted financial system reform—including the deregulation of interest rates; increasing competition in the banking system as well its lending and risk management skills; developing a corporate bond market; accelerating the institution of an electronics payment system; and allocating capital on a commercial basis—could increase its GDP by US$ 321 billion, a full 17 percent, in a year.

Regulators in China, at least, have been moving to reform the financial system. Over the past 18 months, several of the largest commercial banks have listed shares in Hong Kong and others have entered into deals with foreign banks; the commercial paper market has greatly increased in volume, albeit from very low levels; and even the country's lackluster equity market is finally rising, in part due to the government's decision to sell off its portion of formerly non–tradable equity shares.

Nevertheless, there is still much more to do. Transforming China's massive banking system, developing its nascent capital markets and creating the institutional framework, incentives and commercial mindset needed to support a modern financial system will necessarily take time.

India's government is considering several major financial–system reforms—most recently proposals to develop the corporate bond market, reform the pension system as well as further liberalize the capital account—but has enacted few, to date. The country's sound equity markets and high performing private banks give it a good base on which to build. With the right policies, India's financial system could evolve in a timely manner. 

For both countries, financial reform is much more likely to achieve the social objectives that are currently used to justify the distortion of the financial system by the government. Such reforms should be among their highest priorities.

The writer is director of the McKinsey Global Institute, McKinsey's economics think tank.

This article originally ran in Straits Times..

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