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India's financial system: Impeding growth? - Views on News from Equitymaster
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  • Nov 8, 2006

    India's financial system: Impeding growth?

    With the recent hike in the repo rate to 7.25%, the Reserve Bank of India (RBI) has signaled banks of maintaining asset quality by keeping close checks on the borrowers. This is a step in the right direction considering that an incessant growth in credit offtake has been leading to some sort of overheating in the economy, as capital productivity has not kept pace with the growth in credit demand. This malaise has continued to haunt the Indian economy in the past and if nothing is done to correct the same, we might be in for some sort of financial crisis in the future.

    India is definitely becoming a major force in the global economy, with real GDP growth averaging more than 7% over the past three years. Even the services and manufacturing sectors have benefited in this round of strong growth momentum. The Indian equity markets have reflected these successes and have almost quadrupled since early 2003. However, for sustaining this growth momentum, the economy needs a strong financial system over and above the prospering equity markets.

    Currently, however, the Indian financial system falls short of meeting the long-term needs of the country. The system intermediates only half of the country's total savings and investment. As reported by McKinsey, while Indian households save 28% of their disposable income, they invest only half of these savings into bank deposits and other financial assets.

    Another issue is that the financial system channels a majority of funding to the least productive parts of the economy - government and priority sector lending. India has a dynamic private corporate sector that has produced some world-class companies. However, this segment receives just 43% of the total credit, a level that has not changed much since 1999. The remaining 57% of the credit goes to state-owned enterprises, agriculture and small unorganised business segments. Now, the fact that these state-owned enterprises have only half the private corporate sector's level of productivity and require twice as much investment to get the same additional output, while productivity in agriculture and unorganised sector is one-tenth as high, impedes the overall growth of the Indian economy. And this shall continue to happen if nothing is done to bring the house in order.

    Finally, Indian banks lend a much smaller fraction of deposits than banks in other countries. Also, the value of Indian corporate bond market is just around 2% of GDP. These shortcomings impose a big burden on the economy. If the Indian economy needs to move on a higher growth trajectory for a long-term in the future, we believe that the financial system has to be strengthened, and the RBI will have to play the most critical role in the same.



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