Unleashing India's Potential

42 THE INTERNATIONAL ECONOMY FALL 2006
Unleashing
India’s
Potential The key is to modernize
the financial system.
Acasual observer might infer from India’s flourishing stock markets,
fast-growing mutual funds, and capable private banks
that the country’s financial system is one of its strengths. But
closer inspection reveals that tight government control over
almost every other part is undermining the overall performance
and curbing India’s economic resurgence. If India is to sustain
rapid GDP growth and spread its benefits more broadly, it
needs a financial system that is comprehensively marketoriented
and efficient.
The financial system’s shortcomings largely fall into three areas. First, India’s formal
financial institutions attract only half of Indian households’ savings, and none of the
$200 billion they keep tied up in gold. Second, India’s financial institutions allocate
more than half of the capital they do attract to the least productive areas of the economy:
state-owned enterprises, agriculture, and the unorganized sector (mostly made up of
tiny businesses). The more productive corporations in India’s dynamic private sector
receive only 43 percent of all commercial credit. Third, India’s financial system is inefficient
in both of its main tasks of mobilizing savings and allocating capital. That means
Indian borrowers pay more for their capital and depositors receive less than in comparable
economies.
Diana Farrell is director and Susan Lund is Senior Fellow at the McKinsey Global
Institute. For the full report on which this article is based, see Accelerating India’s
Growth Through Financial System Reform, The McKinsey Global Institute, May
2006.
BY DIANA FARRELL AND SUSAN LUND
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INTERNATIONAL ECONOMIC POLICY
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FALL 2006 THE INTERNATIONAL ECONOMY 43
FARRELL AND LUND
These failings place a heavy burden on India’s
economy, and fixing them would give it an immense
boost. Research by the McKinsey Global Institute
(MGI) calculates that an integrated program of financial
system reforms could add $48 billion to GDP each
year (Figure 1). This would raise India’s real GDP
growth rate to 9.4 percent per 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, and household
incomes would be 30 percent above current projections
by 2014, lifting millions more households than
expected out of poverty.
WHERE THEY ARE SAVING
Not long into our study we discovered that, despite
India’s 130-year-old stock market, long history of private
banks, and generally well-developed public institutions,
the nation’s financial system intermediates a
surprisingly small amount of the economy’s total capital.
This is demonstrated by the relative shallowness
of India’s financial system, measured by the value of
all financial assets in the country relative to GDP. At
160 percent, India’s financial depth is significantly
lower than that of other fast-growing Asian economies,
notably China (Figure 2).
Closer examination revealed just how much of the
savings and investment fueling India’s economic
growth occurs outside India’s formal financial system.
Indian households save 28 percent of their disposable
income, but invest only half of these savings in bank
deposits and other financial assets. Of the other half,
they invest 30 percent in housing, and put the remainder—
which amounted to $24 billion last year—into
machinery and equipment for the 44 million tiny household
enterprises that make up the economy’s unorganized
sector. This is despite the fact that, with a few
exceptions, household businesses are below efficient
scale, lack technology and business know-how, and
have low levels of productivity. In 2005, Indian households
also bought more than $10 billion worth of gold,
arguably another form of non-financial savings, and are
now the world’s largest gold consumers.
India’s economy would grow faster if the financial
system could attract more of the nation’s savings and
channel them into larger-scale, more productive enterprises.
We calculate that a program of reforms that
helped India’s financial system to capture and invest
more productively just half of the household savings
now used for gold purchases and investments in subscale
household enterprises could add $7 billion each
year to GDP.
FINANCING
THE LEAST-PRODUCTIVE INVESTMENTS
On the face of it, India’s financial system is better at
allocating capital than those in many other emerging
markets. It has some high-performing private and foreign
banks, and its stock of non-performing loans, at
about 5 percent of all loan balances, is manageable. It
has a well-run equity market that lists mostly private
companies.
But a closer look reveals significant room for
improvement. India’s financial system in fact channels
only a minority of the savings it does manage to capture
to entrepreneurs in the private sector. The majority of
funding goes to the government, and to those investments
that the government designates as priorities.
India’s private corporations receive just 43 percent of
total commercial credit—a level that has not changed
much since 1999.
The rest goes to state-owned enterprises, agriculture,
and the tiny businesses in the unorganized sector.
This pattern of capital allocation impedes growth
because state-owned enterprises are, on average, only
half as productive as India’s private firms, and require
twice as much investment to achieve the same addi-
India’s financial institutions
allocate more than half of the capital
they do attract to the least productive
areas of the economy.
India’s financial system intermediates
a surprisingly small amount of the
economy’s total capital.
44 THE INTERNATIONAL ECONOMY FALL 2006
FARRELL AND LUND
tional output. Productivity in
agriculture and the microbusinesses
of the unorganized
sector is only one-tenth as high
as in India’s modern private
firms, and investment efficiency
is commensurately low.
India’s equity market, as we
have noted, does a somewhat better
job of funding the private sector—
private company shares
represent 70 percent of market
capitalization. But new equity
issues account for little of the
funding raised by companies in
any country, and in India, they
amount to just 2 percent of the
gross funds they raise. Not surprisingly,
Indian companies rely
heavily on retained earnings to
fund their operations and investments—
these account for nearly
80 percent of the funds they raise,
a far higher level than in other
Asian economies (Figure 3).
Reforms that enabled the
financial system to channel a
larger portion of credit to private
companies would raise the economy’s
productivity. State-owned
firms and household enterprises
would need to improve their
operations to compete successfully
for finance. Accompanied
by complementary reforms to
India’s labor and product markets,
India would be able to get
more output for each rupee
invested with a resulting boost to
GDP we calculate at up to $19
billion a year.
IN THE GOVERNMENT’S GRIP
The government’s tight control
of India’s financial system
explains its poor allocation of
capital. Regulations oblige banks
and other intermediaries to direct
a high proportion of their funding
to the government, and to its
priority investments. Banks have
to hold 25 percent of their assets
1. Financial System Reforms Are Worth $48 Billion Annually
Improve banking efficiency
to best practice
Fully implement electronic
payment system
Migrate formal lending
to informal banks
Reduce corporate bond
default rates to benchmark
Shift in financing mix from bank loans to bonds
Direct impact of financial system reform
7.8
6.3
5.1
0.3 2.3 21.8
Direct impact of financial system reform
$ billion, FY 2005
6.6
18.9
25.5
1.1 0.9 0.7 0.1 0.3 3.2 3.5
Indirect impact
Percent
of GDP
Improved
allocation
of capital
Capturing
more
savings
Source: RBI; CSO; McKinsey Global Institute analysis
2. India’s Financial Depth Remains Low Compared to Other Nations
Japan Malaysia Singapore South
Korea
China Thailand India Philippines Indonesia
96
28
20
44
151
34
11
51
55
160
56
2
34
68
220
32
11
160
235
63
68
26
78
371
161
50
42
119
400
161
74
44
120
420
79
50
146
145
214
97
23
20
24
70
17
3
Equity
Corporate debt
Government debt
Bank deposits and currency
Financial depth, 2004
Financial assets as a percent of GDP
Note: Numbers may not add due to rounding.
Source: McKinsey Global Institute Global Financial Stock Database; team analysis.
FALL 2006 THE INTERNATIONAL ECONOMY 45
FARRELL AND LUND
in government bonds—and in practice, the state-owned
banks that dominate the banking sector choose to hold
even more. Government policies then require banks to
direct 36 percent of their loans to agriculture, household
businesses, and the state’s other priority sectors. However,
loans directed in this way have higher default rates than
others and are more costly to administer because of their
small size. As well as diverting credit from the more productive
private sector, this policy also lowers lending
overall, since banks’ unprofitable directed lending has to
expand in proportion with their discretionary lending. Not
surprisingly, Indian banks lend just 60 percent of deposits,
compared to 83 percent for Thai banks, 90 percent for
South Korean banks, and 130 percent for Chinese banks.
Similar policies require that 90 percent of the assets
of provident funds (essentially pension funds) and 50 percent
of life insurance assets are held in government bonds
and related securities. Without these rules, pension funds,
mutual funds, and insurance companies would be an
important source of demand for corporate bonds and equities
in India, as they are in other countries.
These policies have allowed India’s government and
state-owned enterprises to absorb an astonishing 70 percent
of the savings funneled into
the financial system since 2000.
Some of this funding flows to
rural areas and to public sector
enterprises to ensure that
employment remains robust. But
the government also maintains
these policies to finance a persistently
large budget deficit that,
together with state deficits, has
consistently averaged around 9
percent of GDP over the past 25
years, despite large variations in
the macroeconomic environment
over that time.
A COSTLY INTERMEDIARY
The government’s influence on
India’s financial system also lowers
its efficiency and raises the
cost of financial intermediation.
India has the highest level of
state ownership of banks of any
major economy today, apart from
China—and even China is now
seeking foreign investment in
most of its major commercial
banks. India’s new private banks
have a combined market share of
only 9 percent. Foreign banks account for another 5 percent
of deposits, but cannot expand because of limits on
foreign investment in banking.
The prevalence of state-owned banks means that
there is little competitive pressure to improve operations.
These banks meet their costs by maintaining high margins
between lending and deposit rates: bank margins are
6.3 percent in India, compared with an average of 3.1 percent
in the case of South Korea, Malaysia, Singapore, and
the United States.
Banks also face negligible competition from India’s
tiny corporate bond market, whose value amounts to just
2 percent of GDP. The reason the market has remained
so small is a mass of regulations that unnecessarily raise
the cost of issuing bonds, lengthen listing procedures, and
increase disclosure requirements. To avoid these hassles,
most Indian companies look for funding elsewhere. Some
turn to private placements of debt, which total $44 billion—
more than ten times the amount of publicly traded
bonds. The largest companies also issue international
bonds, despite the currency risk involved.
However, most sizable companies are forced to seek
funding from banks, and this in turn crowds out bank
3. Indian Firms Rely Heavily on Retained Earnings
Sources of funds raised
$ billion, percent, 2000–05*
Hong
Kong
United
States
Malaysia Singapore South
Korea
Indonesia Japan India
100% = 204
20
78
2
1,916
26
72
2
40
34
63
3
562
39
59
3
100
47
47
6
393
52
42
6
89
35
55
10
91
40
55
4 Equity
Debt
Internal
funds
*Based on sample of 160 companies per country outside of United States. Companies
were ranked by gross sales, and 40 companies from each quartile were taken as the
sample. U.S. sample includes all listed companies with revenues exceeding $500
million, 1995 to 2004.
Source: Bloomberg; McKinsey Global Institute analysis.
46 THE INTERNATIONAL ECONOMY FALL 2006
FARRELL AND LUND
lending to smaller companies and consumers, the
banks’ natural customers. If India were to develop a
vibrant corporate bond market and the financial system
were to offer the mix of bonds and bank loans
seen in other emerging economies, India’s companies—
large and small—would enjoy substantially
lower funding costs.
Even India’s equity market is constrained by
heavy regulation elsewhere in the financial sector.
The market would function even better if domestic
financial intermediaries, with their long-term
mindset, held more shares—but they are currently
required to invest in government bonds. Instead,
corporate insiders own half of all shares, and this
not only weakens the degree of market oversight
but also potentially lowers the quality of governance.
Retail investors own only 17 percent of
shares, but account for 85 percent of trading—suggesting
that they view the market as a gambling
opportunity rather than a source of steady, long-term
returns.
REFORM WILL SPUR GROWTH
The necessary reforms will primarily affect the
banking sector, the corporate bond market, and
India’s domestic institutional investors. But the set
of reforms must be carefully integrated, since many
problems in India’s financial system cut across its
various markets. To achieve their full potential,
reforms in one area will require complementary
changes in others—for instance, changes in capital
account and foreign investment policies.
Still, a single principle should guide the whole
reform program. The government must loosen its
grip on the financial system and allow financial
institutions and intermediaries to respond to market
signals. This means lifting directed lending policies
and restrictions on the asset holdings of banks and
other intermediaries, in order to release more capital
for more productive investment in the Indian
economy. It also requires reducing state ownership
in the banking sector, developing a corporate bond
market, and easing the many regulations holding
back the development of pensions, mutual funds,
and insurance companies. In addition to raising efficiency
and returns, so doing will also enable intermediaries
to create more attractive consumer
financial products, draw a larger share of household
savings into the financial system, and increase total
investment in the economy.
Financial sector reforms are also needed to
allow reforms of the rest of the Indian economy to
succeed. To achieve higher rates of growth, both
corporate and infrastructure investments must
increase, and this will require a robust bond market
to provide long-term funding, as well as more
investment by foreign companies in many sectors.
Faster growth will, in turn, necessitate a large
increase in construction of both residential housing
and commercial properties—and that will be impossible
without similarly rapid growth in mortgage
financing, which currently comprises only 3 percent
of GDP.
Some of India’s regulators are understandably
resistant to financial system reform because they perceive
it to involve risks and political trade-offs. They
fear, for instance, that abandoning directed lending
would stifle growth in the rural economy, potentially
increasing rural unemployment. However, India’s
rural poor, as well as its entrepreneurs, would be better
served if the financial system was free to allocate
all its available capital to more productive businesses
that can create waged jobs. If total liberation of the
financial system seems a step too far, the government
could, as a transitional measure, provide market-
based incentives—such as tax breaks or
subsidies—for banks to go on lending to priority
areas rather than direct their lending by fiat.
Expanding the most productive parts of the
Indian economy is, over time, not only the best way
to increase the number of well-paid jobs and lift more
people out of poverty, but also to fill the public purse.
The last fifteen years of liberalization of the real economy
have allowed India’s economy to surge ahead. It
is now time that the Indian government allowed its
financial system to do the same. ◆
State-owned enterprises are, on
average, only half as productive as
India’s private firms, and require
twice as much investment to achieve
the same additional output.