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Financial reforms should have a macro-economic growth perspective April 23, 2010

Posted by southasiamasala in : Guest authors, India , trackback

Guest authors: T A Bhavani and N R Bhanumurthy, National Institute of Public Finance & Policy

This article first appeared in The Financial Express 2 April 2010.

The global meltdown has brought the focus back on the financial sector’s role in the overall economic activity. In India, where the financial sector is considered to be overly regulated, the issue of financial sector reform was brought forward and debated extensively. Two important committees, set up in the per-crisis period and headed by Raghuram Rajan and Percy Mistry, made a number of policy suggestions to improve and expand the role of the sector. Although these suggestions may be re-looked in light of the drastic changes in the international markets, the issue of financial access/inclusion needs to be the focus of any furthering reforms in India.

We understand that the financial sector reforms were aimed at bringing down costs and risks involved in providing financial services and thus, widening access of institutional credit to the production agents. Based on the macro data, one can infer that the policy changes since 1991 has indeed brought down costs and risks over the period, although it is still higher in comparison with the advanced countries and emerging market economies. However, the policy changes have not achieved the intended results in enhancing formal financial access to production activities and are quite far in removing involuntary financial exclusion as it appears from the policy discussions and also from official committees (including Rangarajan Committee). At this stage, an assessment of the extent of improvement in financial access is quite pertinent for future policymaking.

Towards this direction, our recent study tries to make an assessment of financial access at the economy level and also at the sectoral (agriculture, industry and service sector) and segment level (organised and unorganised). The study maintains that the financial sector development fosters economic growth by providing the required financial resources for productive investment subject to the extent of financial access and examines the financial access. Financial access is estimated in terms of ‘financial resource gap’, defined as the proportion of (ex-post) investments that are not been financed by the formal financial system based on the unit-level data from various surveys. We share some of the important findings that may be useful while debating the issue of financial sector reforms.

Our project findings reveal a financial resource gap of 39% at the economy level, thus indicate that only 61% of the productive investments in the country have been covered by the formal financial system. Although this doesn’t appear to be alarming, a look at the sectoral and segment level shows that the financial sector is biased against the unorganised segments and also the agriculture sector. This is despite having various policy initiatives such as priority sector lending focusing on financial needs of these groups.

At the sectoral level, the financial resource gap is estimated at 49% for agriculture sector while for services it is 41%. But in the agriculture sector, for which the resource gap is estimated since 1992-93, the gap does not show any secular trend. In 1992-93, the gap was at 55% while in 2003-04 it was 52%. In the intermittent period, the gap has increased to 70% (in 2001-02), which also coincides with fall in overall investments in agricultural sector. In the industrial sector, in which organised component is higher compared to other sectors, the gap is estimated at 22%. Sectoral estimates are based on the assumption that the organised components avail the necessary finances from the formal sources (both domestic and external sources).

But the unorganised industrial segment appears to have difficulties in mobilising resources from formal sources as its resource gap stood at 70% in 2005-06 compared to 78% in 1994-95. At the overall segment level, the unorganised segment found to have the resource gap of 68%. Within this, the unorganised service sector has a resource gap of 91%, which is huge. This is disconcerting to know that the unorganised service sector that contributes nearly one-third of the overall GDP continues to face the financial impediments. This also questions the extent and direction of financial sector reforms in the country.

There has been enormous effort in expanding financial inclusion activity at a micro level through MFIs and SHGs with a focus on welfare, but the sustainability of it is debatable. In our view, future discussion on India’s financial sector reforms should have a strong macroeconomic growth perspective and focus on the real sector needs. Recent discussion (post-crisis) in India appears to move away from this and also appears to assume that the growth of financial sector can be independent of the real sector. However, any excessive expansion in financial sector would only increase the risk, both in the short and long terms as it is learnt from the recent global crisis.

To sum up, there is a definite need to introduce financial sector reforms with a focus to reduce both the costs and risks involved in providing financial resources for productive investment purposes that helps in widening financial access, especially to unorganised segments, and thus smoothens economic growth.

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