|“Financial Sector Reforms for Making India a $ 20 Trillion Economy”
11th-12th June 2015, Mumbai
Final Paper for 40th Skoch Summit Submitted by
Mukesh Kumar Mishra,
Krityanand UNESCO Club
With a gross domestic product that is growing by more than 7 percent a year, India has made remarkable progress since opening its economy, in 1991. Indian Economy is trying to become a $20 trillion economy from $2 trillion. Government is trying to achieve the goal and preparing a ground for such a giant leap. India is a $2 trillion economy today, so it is very tough to make all the changes. Quick and easy reforms will not be enough for designing a fast and growing economy. We should make a sufficient environment for this to happen. Over the next decade, there will be a huge thrust on financial services in India. As the government envisions inclusive growth, the next wave of growth can be achieved by including the unbanked population in the formal financial system and empowering them so that there is a significant increase in the average per capita income. Also for the industries, especially in sectors where there is a significant financial crunch, enabling financial access is imperative for re-invigorating their growth and steady contribution to development. Government policies coupled with the efforts of the financial services industry, both public and private, to look for growth will help enhance financial inclusion and access.
Still, to finance economic growth, India must raise its investment rate substantially. If that is to happen, the financial system must mobilize savings more effectively—a goal that calls for reducing the government's fiscal deficit, which crowds out private investment, and for reforming banks and capital markets.
Keywords: Financial sector reform; financial inclusion; financial regulation;
India has a diversified financial sector, which is undergoing rapid expansion. The sector comprises commercial banks, insurance companies, non-banking financial companies, co-operatives, pension funds, mutual funds and other smaller financial entities. The financial sector in India is predominantly a banking sector with commercial banks accounting for more than 60 per cent of the total assets held by the financial system. India's services sector has always served the country’s economy well, accounting for about 57 per cent of the gross domestic product (GDP). In this regard, the financial services sector has been an important contributor. The Government of India has introduced reforms to liberalize, regulate and enhance this sector. At present, India is undoubtedly one of the world's most vibrant capital markets. Challenges remain, but the future of the sector looks good. The advent of technology has also aided the growth of the industry. About 75 per cent of the insurance policies sold by 2020 would, in one way or another, be influenced by digital channels during the pre-purchase, purchase or renewal stages.
Financial systems issues undermine the effectiveness of monetary policy, exacerbate economic downturns, trigger capital flight and exchange rate pressures, and create large fiscal costs related to rescuing troubled financial institutions. Moreover, with increasing connectivity among financial institutions and tighter financial and trade linkages between countries, financial shocks in one jurisdiction can rapidly spill over across financial sectors and national borders.
Financial Market Size
The size of banking assets in India reached US$ 1.8 trillion in FY14 and is expected to touch US$ 28.5 trillion by FY25. The Association of Mutual Funds in India (AMFI) data shows that assets of the mutual fund industry have hit an all-time high of about Rs 12 trillion. Equity funds had inflows of Rs 5,217 crore, taking total inflows on a year-to-date basis to Rs 61,089 crore. During 2013-14, the life insurance industry recorded a premium income of Rs 3.14 trillion, as against Rs 2.87 trillion in the previous financial year, registering a growth of 9.4 per cent. India’s life insurance sector is the biggest in the world with about 36 crore policies, which are expected to increase at a compounded annual growth rate of 12-15 per cent over the next five years. The insurance industry is planning to hike penetration levels to five per cent by 2020, and could top the US$ 1 trillion mark in the next seven years. The total market size of India's insurance sector is projected to touch US$ 350-400 billion by 2020.
According to the recent data released by the Insurance Regulatory and Development Authority (IRDA), the gross direct premium underwritten by non-life insurance companies during 2013-14 was Rs 77,538.25 crore compared to Rs 69,089 crore in 2012-13. India is the fifteenth largest insurance market in the world in terms of premium volume, and has the potential to grow exponentially in the coming years. Life insurance penetration in India is just 3.1 per cent of GDP, which has almost doubled since 2000. A fast growing economy, rising income levels and improving life expectancy rates are some of the many favorable factors that are likely to boost growth in the sector in the coming years. Investment corpus in India’s pension sector is expected to cross US$ 1 trillion by 2025, following the passage of the Pension Fund Regulatory and Development Authority (PFRDA) Act 2013.
Developments in Financial Sector
India has moved a step closer to having a Singapore- or Dubai-like financial hub, with the Securities and Exchange Board of India (SEBI) approving a framework for international financial centre’s (IFCs).
The RBI has allowed bonds issued by multilateral financial institutions like World Bank Group, the Asian Development Bank and the African Development Bank in India as eligible securities for interbank borrowing. The move will further develop the corporate bonds market, RBI said in a notification.
Maharashtra’s plans to promote Mumbai as a global financial centre have received further encouragement as Wall Street firm JPMorgan Chase & Co. and the Japanese government arm Japan External Trade Organization (Jetro) agreed to partner with the state government to hold road shows to attract financial services companies to Mumbai.
Yes Bank Ltd has signed a memorandum of understanding (MoU) with the US government’s development finance institution Overseas Private Investment Corp. (OPIC) to explore US$ 220 million of financing to lend to micro, small and medium enterprises (MSMEs) in India, the bank said in a press release.
Several measures have been outlined in the Union Budget 2014-15 that aim at reviving and accelerating investment which, inter alia, include fiscal consolidation with emphasis on expenditure reforms and continuation of fiscal reforms with rationalization of tax structure; fillip to industry and infrastructure, fiscal incentives and concrete measures for transport, power, and other urban and rural infrastructure; measures for promotion of foreign direct investment (FDI) in selected sectors, including defense manufacturing and insurance; and, steps to augment low cost long-term foreign borrowings by Indian companies. Fiscal reforms have been bolstered further by the recent deregulation of diesel prices. The launch of ‘Make in India’ global initiative is intended to invite both domestic and foreign investors to invest in India. The aim of the programme is to project India as an investment destination and develop, promote and market India as a leading manufacturing destination and as a hub for design and information. The programme further aims to radically improve the Ease of Doing Business, open FDI regime, improve the quality of infrastructure and make India a globally competitive manufacturing destination.
Key challenges - Road Ahead
India is today one of the most vibrant global economies, on the back of robust banking and insurance sectors. The country is projected to become the fifth largest banking sector globally by 2020, bank credit to grow at a compound annual growth rate (CAGR) of 17 per cent in the medium term leading to better credit penetration. Life Insurance Council, the industry body of life insurers in the country also projects a CAGR of 12–15 per cent over the next few years for the financial services segment. Also, the relaxation of foreign investment rules has received a positive response from the insurance sector, with many companies announcing plans to increase their stakes in joint ventures with Indian companies. Over the coming quarters there could be a series of joint venture deals between global insurance giants and local players.
As the financial sector prepares to scale up services and spread into rural markets, technology should be a focus area. Data security will be a big challenge, especially with the expected growth in Internet and mobile banking transactions.
Innovations in savings, investment, and payments services present another challenge, Banks and financial institutions will also have to address increasing demands for customization of products and services for both households and business; their work will be made more challenging by the increasing financial sophistication of their customers. Foreign technology and expertise may address these issues.
Further easing of FDI in pensions and insurance will be another important step. The new government has made a positive start by hiking FDI limits in insurance to 49 percent from 26 percent in the budget for 2014–15. Among other measures, foreign banks will be encouraged by moves to allow them to open wholly owned subsidiaries. To incentivize banks to take this up, they will be treated on par with domestic banks.
Greater private-sector participation in the financial sector is also needed. While new banking licenses would help, more accountability and transparency in the management of public-sector banks is needed.
The purpose of this paper is to examine the current Indian economic crisis in the context of the Indian financial policy, system, and architecture and identify critical imperatives for reform and policy and regulatory changes are needed.
Need for Reforms
A strong and efficient financial sector is essential for the optimal allocation of capital not just in advanced economies but also in emerging market economies, especially in fast-growing ones. India’s financial sector has undergone major reforms and a remarkable transformation since the 1990s but, in many respects, it still reflects the institutional set-up that was put in place when India was run as a directed economy. Interest rates have been deregulated and new entrants allowed in the banking and the securities business. The Indian equity market has become world-class. New private banks have emerged that are more customer-oriented than the older state-owned banks. Meanwhile, the scale of saving within the economy has expanded considerably, much as in East Asian economies during their high-growth period. This adds to the need for further financial-sector reform. The regulatory and legal framework also needs to be overhauled, consolidating the diverse legislation. While such reforms would improve financial sector efficiency they would also likely have positive spillover effects on the rest of the economy and help sustain rapid growth.
Moreover, growth has not come without challenges, including poverty alleviation, income distribution, urban planning, and environmental degradation. Policymakers also face greater demands and scrutiny from a more-educated population, especially a vocal middle class, which has been redefining India’s economic, political, and social space.
Financial sector reforms in India will be better served by further enabling market forces to dictate the allocation of financial resources and thereby facilitate the price discovery process. In this regard, further deregulation and liberalization will provide the right incentives for financial institutions to compete across products and markets. Financial sector reforms also have to be more holistic, encompassing not just banking supervision by central banks and banking regulators but a wider environment in which all financial intermediaries function and have the operational freedom to take commercial decisions.
These reforms will help increase greater direct and indirect household participation in equity and bond markets, allowing them to diversify their portfolios and raise returns on them.
3. Recommendations for Financial Sector Reform
Following Reforms will be needed if the financial system is to capture more of the country's domestic savings and to reduce the share financing the public debt.
A. Macroeconomic Policy Reform
India experienced strong inclusive growth between 2003 and 2011, with average growth
above 8% and the incidence of poverty cut in half. This reflected gains from past structural reforms, strong capital inflows up to 2007 and expansionary fiscal and monetary policies since 2009. These growth engines faltered in 2012. Stubbornly high inflation as well as large current and fiscal deficits left little room for monetary and fiscal stimulus to revive growth.
In 2014, the economy has shown signs of a turnaround and imbalances have lessened. Fiscal consolidation at the central government level has been accompanied by a decline in both inflation and the current account deficit. Reducing macroeconomic imbalances further key to sustaining consumer and investor confidence and to containing external vulnerabilities – this will require adhering to the fiscal roadmap and implementing the proposed changes to the monetary policy framework.
Structural reforms would raise India’s economic growth. In their absence, however, growth will remain below the 8% growth rate achieved during the previous decade. Infrastructure bottlenecks, a cumbersome business environment, complex and distorting taxes, inadequate education and training, and outdated labor laws are increasingly impeding growth and job creation. Female economic participation remains exceptionally low, holding down incomes and resulting in severe gender inequalities. Structural factors such as poor infrastructure and capacity, labor market inefficiencies, lack of land acquisition reforms, and a poor distribution system often have resulted in supply bottlenecks, and are some of the primary reasons for inflation and poor investments in the economy.
B. Financial sector reform
A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities. The financial sector reforms since the early 1990s could be analytically classified into two phases. The first phase - or the first generation of reforms - was aimed at creating an efficient, productive and profitable financial sector which would function in an environment of operational flexibility and functional autonomy. In the second phase, or the second generation reforms, which started in the mid-1990s, the emphasis of reforms has been on strengthening the financial system and introducing structural improvements. Against this brief overview of the philosophy of financial sector reforms,
India’s financial system has developed considerably since the 1990s and has weathered the global crisis better than a number of other countries. Competition in the banking sector has intensified as new private banks have been allowed to enter and most interest rates have been liberalized. Still, more is needed to make the financial sector stronger and more efficient and to ensure optimal allocation of capital. While such an optimal allocation is important, it is even more important in a fast-growing economy like India. Another challenge is to promote financial inclusion which can notably support the development in rural areas and help the poor cope with high income variability.
Key reforms of the financial sector and segments
Banking, financial services, and insurance (BFSI);
The main objective of banking sector reforms was to promote a diversified, efficient and
Competitive financial system with the ultimate goal of improving the allocate efficiency of resources through operational flexibility, improved financial viability and institutional strengthening. The reforms should be focused on removing financial repression through reductions in statutory preemptions, while stepping up prudential regulations at the same time. Since the unleashing of economic reforms in India in 1991, the BFSI sector has benefitted from fast economic growth, rising incomes, a growing middle class, product and services innovation, and financial literacy.
As the BFSI sector prepares to scale up services and spread into rural markets, technology should be a focus area. Data security will be a big challenge, especially with the expected growth in Internet and mobile banking transactions. Innovations in savings, investment, and payments services present another challenge, especially in a place where smart phones are set to assume a greater role. Banks and financial institutions will also have to address increasing demands for customization of products and services for both households and business; their work will be made more challenging by the increasing financial sophistication of their customers. Foreign technology and expertise may address these issues. Further easing of FDI in pensions and insurance will be another important step. The new government has made a positive start by hiking FDI limits in insurance to 49 percent from 26 percent in the budget for 2014–15. Among other measures, foreign banks will be encouraged by moves to allow them to open wholly owned subsidiaries. To incentivize banks to take this up, they will be treated on par with domestic banks.
Greater private-sector participation in the BFSI sector is also needed. While new banking licenses would help, so would greater disinvestment of public-sector units. Public-sector banks account for 70 percent of total banking assets in India. Similarly, in the insurance space, Life Insurance Corporation of India dominates the life insurance segment with a more than 70 percent market share. Along with disinvestment, there must be more accountability and transparency in the management of public-sector banks. By extending banking services to excluded customers, the government is aiming to improve the formal financial savings, reduce leakages through direct benefit transfer, and reduce the use of cash, all of which will result in significant business opportunities for banks. Banks also have a unique opportunity to introduce digital banking and payment services, thus providing speed, security, transparency, and cost efficiency.
Reduce the fiscal deficit
Cutting the deficit would raise India's savings rate and make room for more private investment. As opportunities to profit from government bonds fell, banks would also feel prompted to put more deposits into loans.
Increase bank penetration
India's banks must do better at offering personal financial services to attract household savings. Today they mostly compete for the profitable business of affluent households, but appealing to unbanked rural ones is equally important. Banks must develop a keener understanding of what rural households need and offer new products and distribution networks to suit them.
Reduce the cost of bank intermediation
More of the savings that India's financial system captures could finance investment if
banks reduced their cut from matching savers and users of capital
Equity and corporate-debt markets open new sources of funding for businesses, cut their cost of capital, give savers new investment options, and are essential to financing pension programs.
C. Reforms in the Monetary Policy
The basic emphasis of monetary policy since the initiation of reforms has been to reduce market segmentation in the financial sector through increased inter linkages between various segments of the financial market including money, government security and forex market. The key policy development that has enabled a more independent monetary policy environment as well as the development of Government securities market was the discontinuation of automatic monetization of the government's fiscal deficit since April 1997 through an agreement between the Government and the Reserve Bank of India in September 1994. In order to meet the challenges thrown by financial liberalization and the growing complexities of monetary management,
Currently, monetary policy in India has three main objectives: maintaining price stability; supporting economic growth by ensuring an adequate flow of credit to productive sectors and securing financial stability. In addition, the RBI intervenes in the foreign exchange market to avoid excessive exchange rate fluctuations. Twin objectives of “maintaining price stability” and “ensuring availability of adequate credit to productive sectors of the economy to support growth” continue to govern the stance of monetary policy, though the relative emphasis on these objectives has varied depending on the importance of maintaining an appropriate balance.
For reforming the monetary policy framework following set of recommendations is a coherent roadmap towards a monetary policy framework largely consistent with best practice:
A change to the monetary policy framework is needed to make it “transparent and predictable”. Inflation should be the nominal anchor for monetary policy, giving the headline Consumer Price Inflation (CPI) preference over Wholesale Price Inflation (WPI).
The inflation target should be 4%, with a band of +/-2%, following a 3-year transitional phase (the target would be 8% for one year and 6% for the next two years). The RBI should publish an inflation report every 6 months.
To improve monetary policy transmission, the government should comply with the fiscal roadmap and eliminate the practice of setting prices, wages and interest rates. The Statutory Liquidity Ratio should be reduced to a level consistent with Basel III prescriptions. Existing sectoral interest rate subsidies, in particular for agriculture, should be reconsidered.
Monetary policy faces the challenge of achieving a smooth normalization. Monetary policy in India is charting its future path amid a host of challenges. The actual path of the policy interest rate will depend on a number of factors, especially the evolving macroeconomic picture regarding unemployment and inflation, as well as concerns about financial stability risks. At the same time, interest rates will be a major determinant, not just of the macroeconomic performance, but also the extent of financial stability risks and global spillovers. Policymakers must determine the optimal magnitude and timing of interest-rate changes while dealing with a difficult trade-off: to delay the policy tightening could create asset mispricing and financial stability risks; however, an unwarranted quick tightening could weaken the still unfledged recovery.
Recognizing the concerns with regard to the banking practices that tend to exclude rather than attract vast sections of population, the Reserve Bank has urged banks to review their existing practices with a view to aligning them with the objective of financial inclusion. All banks were advised in November 2005 to make available a basic banking ‘no-frills’ account either with ‘nil’ or very low minimum balances as well as charges that would make such accounts accessible to vast sections of population. With a view to encourage financial inclusion the KYC procedure for opening small accounts were simplified. Banks are allowed to use the services of NGOs/ SHGs, MFIs and CSOs as intermediaries in providing financial and banking services through the use of business facilitator and correspondents.
Financial markets are a vital part of an economy making it possible for industry, trade and commerce to flourish without any obstacle in terms of resources. Today most economies around the world are judged by the performance of their financial markets. Well developed financial markets enable the central bank to effectively conduct monetary policy and help in improving the allocate efficiency of resources. Interest rates on benchmark Government securities facilitate appropriate pricing of other financial assets. It has, therefore, been the endeavour of the Reserve Bank to promote development of all the segments of financial market under its regulatory provision.
The financial markets have indicators in place that reflect the performance of companies whose securities are traded in those markets. The financial markets also serve a vital purpose in the growth and development of a company, which wants to expand. Such companies with expansion plans and new projects are in need of funding and the financial market serves as the best platform from which a company can determine the feasibility of such possibilities.
According to Krishnan financial markets could lead to increased economic growth by improving the efficiency of allocation and utilization of savings in the economy. Financial markets, which should be based on meeting the following objectives:
Increase competition and thereby enhance the efficiency of financial intermediation and promote overall savings;
Widen and deepen the reach of the formal financial sector;
Ensure that the country’s savings are utilized most productively; and
Manage the risks stemming from disturbances in global markets to insulate the financial sector and the Domestic economy.
4. Summary of Conclusion
In India, recent policy moves such as the RBI’s shift to an inflation-targeting framework, along with the new government’s focus on fiscal consolidation, have helped improve business sentiment. Another positive indicator is the government’s initiatives to upgrade ties with major economies, ease decision making, develop infrastructure, and promote manufacturing. Businesses are watching whether the government keeps its promise of reducing its direct presence in the economy and instead turns into a facilitator.
However, it’s still a long road ahead for the government. While it has made the right gestures, it has yet to lay out a clear roadmap, especially for tough economic reforms. The government is likely to find that the journey is a tough one with political compulsions and inertia getting in the way. Change is never easy, but the government can draw comfort from the economy’s inherent strengths. They will serve as a solid base from which policymakers can steer India’s economic ship to catch the next wave of growth and prosperity.
Specific labor market policies are also required to address the various challenges; Macroeconomic policies and structural measures need to target employment creation;
Concrete policies are needed to address long-term unemployment;
Priority is needed for addressing the financial architecture and banking system to create a more broad-based financial sector with a better understanding of actual risk-reward portfolios as opposed to a collateral based approach. The banking system is failing in its risk management and portfolio diversification as well as its ability to practically provide financial access where it is needed for growth and development as opposed to where it is most easily accessible.
The financial system also needs to broaden the access to credit and other financial services to facilitate sustainable investments. Managing the trade-offs in reducing risks while promoting access to resources presents a complex challenge for policymakers.
Since coming to power the new government’s main concern has been the revival of growth in the Indian economy, it has chosen to give the financial sector a structural push to achieve its goal. Need for realignment of policies to expand the outreach of the Indian Financial Sector. It would deliberate on the implications of recent banking license reforms and the presumptive consolidation of banks. Further implementation and new policy initiatives are required for ; Need greater freedom to banking operations, Improve competition in the banking system; Reduce conflicts of interest in the RBI; Improve the regulatory structure; Improve market functioning. There is needed to make the financial sector stronger and more efficient and to ensure optimal allocation of capital. While such an optimal allocation is important in any country, it is even more important in a fast-growing economy. Another challenge is to promote financial inclusion which can notably support the development in rural areas and help the poor cope with high income variability.
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