China and India: Room for reform

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Yes, these economic dynamos are growing fast. But the McKinsey Global Institute's new study argues they must upgrade their financial systems.

Mention Asia's economic powerhouses, and the first names that jump to mind are China and India. The two countries have made immense strides in recent years, but they can't sit back and enjoy their success just yet. New research by the McKinsey Global Institute [MGI] highlights the shortcomings of their financial systems. To address these, Beijing and New Delhi need to keep up the good work and continue to introduce rapid reforms.

In China's case, must-do reforms include deregulating interest rates, boosting competition in banking, and improving lending and risk management. Beijing also needs to develop its corporate bond and equity markets and speed the setup of an electronic payments system. Together, these changes could boost gross domestic product by $321 billion a year.

In India, financial system reform, coupled with further economic liberalization, could add $48 billion a year to gross domestic. This would increase per capita income levels by a third and raise the country's annual growth rate from the 6.5% forecast now to 9.4% over the next 10 years — thus matching China's rate of expansion.

Wasteful Investments
To do all this, both countries have to tackle one fundamental problem: poor allocation of capital. In India, the government places restrictions on where financial intermediaries can invest their assets so it can finance its persistently large budget deficit and rural investment priorities. Similarly, the Chinese government ensures a continual flow of very low-cost funds into the country's massive, inefficient state-owned enterprises in the interest of safeguarding jobs.

These policies have similar unfortunate consequences. They lead to wasteful investments that yield negligible returns, restricted funding for the private companies that are the main drivers of growth, and high levels of state ownership of financial institutions. The result? A feeble array of financial products for consumers and corporates.

Unlike some other developing countries, China is not lacking for financial capital: The mainland had over $5 trillion in assets at the end of 2005. But most of the lending is to state-owned enterprises. Our research finds that China's private companies now generate more than half of its GDP and are twice as productive as state-owned firms, but they receive only 27% of loans. They are excluded from the country's nascent equity and corporate bond markets as well.

Penalizing Savers
China has artificially created an ample supply of low-interest credit by capping interest rates on deposits. This arrangement penalizes Chinese households, who earn poor returns on their savings, and breeds ever greater inefficiency at the state-owned companies that have become hooked on this cheap money. Consider this: In the first half of the 1990s, China needed to invest $3.30 for every additional $1 of GDP. Since 2001, it has had to invest $4.90 to get the same return.

India's financial system is far smaller than China's, with just $1.4 trillion in assets at the end of 2005, equal to 172% of GDP, compared to China's 230% of GDP. India's dynamic private sector, which includes world-class companies that enjoy productivity double the level of state-owned ones, gets only 40% 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 a persistently large public-sector deficit, and to devote 36% of their loan portfolios to the government's priority sectors.

By freeing its financial system from the government's grip, India could turbocharge its economy, which is already growing at a healthy clip. This would funnel more funding into the most productive areas of the economy, and allow financial intermediaries to develop the consumer financial products necessary to attract more savings. Along with continuing liberalization of the broader economy, these reforms could raise India's growth.

Consensus Needed
Regulators in China have been moving to reform the financial system. Most notably, they are listing shares of several of the largest commercial banks. These initial public offerings have drawn considerable interest from foreign investors. But much more needs to be done. 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 also considering several important reforms. These include proposals to develop the moribund corporate bond market, reform the pension system, and further liberalize the capital account. But progress in enacting legislation has been painfully slow. Still, the country's sound equity markets and high-performing private banks give it a good foundation on which to build.

And, with the right policies, India's financial system could evolve quite quickly. But India's policymakers have yet to build a consensus that financial liberalization would better serve India's rural poor, rather than distorting the financial system to funnel credit into wasteful public-works projects and other government schemes that generate a limited number of temporary and low-paid jobs.

For both countries, financial reform is much more likely to achieve the social objectives that are currently used to justify government-enforced distortions of the financial system. Such reforms should be among the highest priorities for China and India's policymakers.

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

This article originally ran in Businessweek.