Monday, June 09, 2008

India needs a better financial system

With a Indian GDP of over a trillion dollars and a savings rate of over 30%, the Indian financial system is involved in intermediating massive flows of money. Writing in Financial Express, Kalpana Kochhar and Charles Kramer remind us that this underlines the need for a good financial system. That Kalpana and Charlie are bang on the money, with a timely and much-needed article, is partly a comment on the quality of the Indian economic policy discourse. Also see this article by Aadisht Khanna in Pragati, and an article by Kalpana Kochhar on the need for financial sector reforms in order to do infrastructure finance.

Kalpana, Charlie and Aadhisht point to the Patil, Mistry and Rajan reports as being the essence of what needs to get done. So far, there is little progress on doing these things. I see three possible scenarios:

  1. In one scenario, we get our act together and set about implementing these reports. That'd be just great.
  2. In a second scenario, a bigger and bigger slice of India-related financial intermediation would get done outside the country, as the private sector tries to escape the brunt of the domestic license-permit raj. This has started happening in many interesting ways. It is critically linked to the extent to which capital controls bind. While such movement is bad for domestic financial firms, there is no role for protectionism. While this is a good solution for the country in some ways, I think it is inefficient and suboptimal because it is costlier for financial intermediation done outside the country to obtain good information and analysis about alternative investments in India. And, as Percy Mistry's report has emphasised, going down this route involves wasting a natural opportunity for India to be a player in international financial services on a global scale.
  3. In a third scenario, capital controls bind and the private sector is a captive customer of the domestic financial system. In this case, an unreconstructed financial system would involve capital going into the wrong places; it would map a given savings rate into a lower GDP growth rate than is possible with financial sector reforms. As an example, the comparable surge in savings in China was associated with a lot of NPAs being created by the unreconstructed financial system.

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