Unlocking India's potential

By Diana Farrell

Reform of India's financial system would mean better use of capital and the elevation of millions from poverty, McKinsey Global Institute research shows.

Reform of the financial system would mean better use of capital and the elevation of millions from poverty, according to the McKinsey Global Institute

With stock values in Bombay tripling since 2003, private banks forging ahead, and the Indian Reserve Bank maintaining its prudent stance on macroeconomic management, India has a reputation for robust financial institutions.

These are star turns, however, in a financial system that elsewhere remains locked firmly in the government's grip. The McKinsey Global Institute (MGI ) calculates that a program of liberal reforms could release as much as $48 billion of capital a year for investment. Coupled with broader reforms that promote job creation, financial sector liberalization could raise real GDP growth to 9.4%, just shy of the government's 10% target, and well above the 7% levels seen in recent years. This would increase household incomes 30% above current projections by 2014, lifting millions more out of poverty.

To realize gains on this scale, though, the government must surrender control of the financial system. That would allow banks to draw in more savings, allocate them to more productive investments, and do both jobs more efficiently. A raft of regulations governing banks, financial intermediaries, and bond markets now serve to channel most savings directly to the government or its priority investments. These rules are partly motivated by admirable welfare aims such as maintaining rural incomes. But they leave the most productive areas of India's economy short of capital, holding back growth on which all incomes ultimately depend.

The financial system could attract a lot more capital than it does now. Indian households currently save 28% of their disposable income, high by international standards. But they invest only half their savings in financial assets. The rest goes to housing, and to machinery and equipment for India's 44 million tiny enterprises. Last year, Indian families also bought more than $10 billion of gold, making them the world's largest gold consumers. A measure of how much capital escapes the formal system is India's low financial depth. India's bank deposits, equities, and bonds represent just 160% of GDP, compared with 220% in China and 420% in Japan.

Household businesses have very low productivity, and returns on gold have been negative in recent years. Investing in both is rational for rural households only because few can find more attractive investment opportunities. They would be better off if the financial system could pool their savings to fund larger-scale enterprises that might yield higher returns.

Here too there is ample room for improvement. At present, India's dynamic private corporations receive less than a third of total credit from the financial system, while the rest goes to state-owned enterprises, agriculture, and the "unorganized" sector (including very small businesses). But state-owned enterprises are only half as productive as the private sector, while productivity in agriculture and the unorganized sector is 90% lower.

MGI estimates that if the financial system could attract just half of the savings that households now invest elsewhere, it would add $7 billion each year to India's GDP, while reforms that direct more capital to the most dynamic areas of the economy could generate a further $19 billion of output a year.

Restrictive Regulations
Why does the financial system now channel so much funding to low-performing investments? In large part it's because the government says it must. Regulations require banks to hold 25% of their assets in government bonds. Government policy also requires banks to direct 36% of their loans to agriculture, household businesses, and a dozen or so other priority sectors. But directed loans have higher default rates and cost more to administer. As a result, India's banks restrict their total lending to just 60% of deposits, one of the lowest ratios in the world.

Similar policies stifle the development of domestic financial intermediaries. Regulations require that 90% of pension-fund assets and half of life-insurance assets be held in government bonds and related securities. Without these rules, provident funds, mutual funds, and insurance companies would invest much more in corporate bonds and equities, as is the case in other countries.

India's banking sector has a higher level of state ownership than any major country other than China. India's private banks perform well, but they have only 9% market share. And they feel little competitive pressure to get leaner: They can meet the costs of their inefficiency by maintaining a wide margin between lending and deposit rates—which ultimately means higher interest rates for borrowers and lower returns for savers. Reforms that would make operations more efficient in every component of the system could save $22 billion for the economy as a whole.

Let The Market Rule
India's financial institutions should be guided more by market signals and less by government fiat. That means lifting directed lending policies and restrictions on the asset holdings of banks and intermediaries. The state should begin selling its stakes in the state-owned banks and ease regulation of the corporate bond market, provident funds, mutual funds, and insurance companies. A carefully integrated program of reforms would boost competition in India's financial system, raise its efficiency, and improve the way it allocates capital. That will let banks, insurance companies, and mutual funds create more attractive consumer financial products, which would help draw in a larger share of household savings, and make savers better off.

Some of India's policymakers resist such reforms. They fear that abandoning directed lending would raise rural unemployment, arguably the country's biggest social challenge. And losing the captive market for government bonds would increase the state's borrowing costs. But helping productive firms expand is the best way to reduce poverty, increase employment, and boost government revenues for spending on rural welfare. Designing and sequencing the reforms to minimize short-term costs of transition will be essential. But India's population will pay a higher price if the government forgoes financial system reform altogether.

Diana Farrell is the director of the McKinsey Global Institute, McKinsey's economics think tank.

This article originally ran in Businessweek.

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