Financial Infrastructure and Economic Development:
Theory, Evidence and Experience
V. B. Angadi*
Last three decades have witnessed economists’ growing interest in exploring
for a possible link between financial structure and economic activities. In
more recent years, the horizon of economists’ inquiry has expanded to include
the interrelationship between financial infrastructure and economic development.
Financial infrastructure of an economy is defined in this paper to include financial
system, legal system, accounting standards, and payment and settlement system.
The financial system consists of financial institutions, markets and instruments.
An attempt has been made in this paper to address some of the theoretical issues
and discuss evidence thereon in relation to the following proposition: there
is a direct and symbiotic relationship between sound and efficient financial
infrastructure and financial stability and economic development.
JEL Classification : F360
Key Words : Finance, Economic Integration
Introduction
Undoubtedly, the canvas of the above proposition is not only
very vast but also highly complex. For, the proposition engenders a number of
complicated questions such as: does efficient financial intermediation lead
to an increase in saving rate and enhancement in efficiency of investment? Is
';supply-leading role'; as against ';demand- following role';
or active versus passive role of the institutions like banks significant for
development? Is financial infrastructure merely the catalytic agent or one of
the endogenous factors affecting the growth? Are microeconomic dimensions of
financial intermediation such as transaction costs, scale and scope economies,
information asymmetry, innovations/inventions, monitoring, risk and uncertainty
management, and so on, important factors affecting growth and development? Does
institution matter? Are institution perspective and market perspective in the
matter of
* The author is Director, Department of Economic Analysis and
Policy, History Cell, Reserve Bank of India, Central Office, Mumbai. Views expressed
in this paper are the author’s personal views.
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Financial intermediation mutually exclusive in the context of increasing technological
advancement? Is efficient financial system alone or the entire financial infrastructure
sufficient for contributing to the financial stability and sustained economic
growth? Do the available theoretical literature and evidence provide satisfactory
answers to these questions? By discussing briefly experience and evidence relating
to such inquiries with special reference to India, this paper purports to offer
broad answers at least to some of the questions.
An evaluation of contributions in theoretical literature and empirical studies
provides a rich insight essential for understanding and appreciating the interaction
between financial infrastructure and economic aggregates. Accordingly, section
I of the paper focuses on select theories/models on the interrelationship between
financial system and economic development both at macro and micro levels. An
analysis of macroeconomics as also microeconomics of financial intermediation
is presented in this part. Incidentally, an evaluation of studies based on the
institution perspective and market perspective is found to be supportive of
the eclectic theoretical approach. The integrated approach to study the financial
intermediation is essential to gain a complete understanding of the interrelationship
between financial infrastructure and economic development. The experience of
financial sector reform and financial policies is examined in section II. Here
it is highlighted how the efficient financial system alone is not adequate enough
to ensure financial stability and growth. For, weaknesses in legal system, accounting
standards and payment system might pose serious threats to financial stability.
Hence the financial stability necessitates the overall efficiency of the financial
infrastructure. In the light of discussion in the preceding two sections, development
experience of financial infrastructure in India has been traced in section III.
An analysis of the policy environment and package of policy measures including
those concerned with the financial sector reform is also presented in this part.
Broad evidence in regard to link between financial infrastructure and economic
growth and development with special reference to India is presented in section
IV.
FINANCIAL INFRASTRUCTURE AND ECONOMIC DEVELOPMENT
Section I
Financial Infrastructure and Development: A Macro Perspective
The strong and positive correlation between the level of financial infrastructure
and economic growth has been widely recognized in the pioneering works of Gurley
and Shaw, Schumpeter, Goldsmith, Patrick, Greenwood and Javanovic, Bencivenge
and Smith, Diamond and Dybvig, Prescott and Boyd, and Sussman and Zeira. The
salient feature of the theoretical literature is, as Mark Gertler (1988) aptly
observes, that ‘the theoretical models developed thus far are highly stylized
and capable of generating only qualitative prediction’.
Financial institutions as intermediaries between lenders and borrowers mobilize
savings and ensure their efficient allocation among the competing economic activities.
Such efficient intermediation has positive impact on growth and development.
The resultant higher level of growth, in turn, necessitates establishment of
sound and sophisticated institutions with horizontal or vertical integration,
instruments and markets. Furthermore, smooth integration and development of
the financial infrastructure requires an efficient legal, accounting, and payment
and settlement system. Clearly the subject of interrelation between financial
infrastructure and economic development represents a vast canvas.
Financial Institutions in General Equilibrium –Development Theory
The traditional theory of financial intermediation is based on the classical
notion of perfect market a la Adam Smith, Walras and Marshall. The concept
has attained its formal status in the resource allocation model developed by
Arrow and Debreau. In competitive equilibrium, under the assumption of complete
market, banks and other financial institutions play only a passive role. In
keeping with, the majority of the first generation development economists were
greatly influenced by the spirit implicit in Joan Robinson’s observation that
‘where the enterprise leads the finance follows’. The second generation development
economists of 1970s became more concerned with the role of financial system
in carrying out its allocation and intermediation between savers and investors
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The development economists began to recognize
the significance of ';supply-leading'; role of the financial institutions
(Patrick, 1966). Following the experience of adverse selection, moral hazard,
information asymmetries and transaction costs, weaknesses in the legal and accounting
systems as well as their adverse impact on the growth and development, the economists
have begun to attach considerable weight to the role of efficient financial
system. Thus, the emphasis has been shifted from demand following to supply-leading
role of financial institutions, and thereby from the passive role to the active
and dynamic role of the financial intermediaries.
Market Failure – Link between Financial Structure
and Economic Development
In the aftermath of the Great Depression of 1929,
there has been a flurry of studies on financial markets and their interface
with real economic activities. While one set of such studies was mainly concerned
with devising an alternative paradigm to the market system, the other set focused
on exploring the linkage between performance of the financial markets/ banks/aggregate
money supply and output. For instance, Fisher (1933) looked into debt deflation
and its impact on down turn in the trade cycle. The borrowing class with high
leverage position in the wake of prosperity prior to 1929 was prone to suffer
from high risks associated with a sharp decline in net worth, fall in current
expenditure and future commitments as a result of price deflation. As drop in
prices, output and income was accelerated, debt liabilities far exceeded total
assets. In sequel, number of bankruptcies rose significantly. The business down-turn
was intensified by the poor performance of financial markets. Fisher’s idea
of the link between the financial structure and aggregate economic activity
is reflected in a number of subsequent works. For instance, Gurley–Shaw (1955)
maintained that financial intermediaries play a critical role in facilitating
the circulation of loadable funds between savers and investors. Similarly, Goldsmith
(1969) argued that a positive correlation exists between economic development
and sophistication of the financial structure. The Keynesian economists, by
and large, have not explicitly recognized the critical role of financial intermediaries in economic development, albeit
the financial system implicitly formed an integral part of the Keynesian macroeconomics.
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Emergence of Money View
The General Theory of Keynes has engendered highly
influential literature focusing on the indirect link between financial markets
and real economic activities via liquidity preference. Implicit in this approach
is the ';money view';— the medium of exchange role of money. The ‘money
view’ considers the aggregate money supply as the most relevant concept representing
the aggregate economic behavior. The money view insists that bank liabilities
(money) alone matter. In the process, it broadly ignores the impact of bank
loans on real economic activity.
The issues relating to the linkage between money
supply, output and prices as well as the empirical mechanism have been debated
since long. Among the notable ones, Modigliani-Miller (1958) argued that real
economic decisions are independent of financial structure and that investment
decisions are independent of credit. According to this theorem, finance is a
veil. The monetary policy in such situation can have only transitory impact
on real variables through unanticipated changes in money supply. Similarly,
the famous work ‘A Monetary History of the United States’ by Friedman–Schwartz
(1963) laid a strong foundation of monetarism. The main finding of this study
is that the aggregate money supply declined sharply along with output from the
start of down-turn in 1929 through 1933. Thus, the role of money supply in causing
the Great Depression has been highlighted. Furthermore, this study has given
birth to the new era in which money occupies the central place in the macro-economic
activity instead of the financial system.
Resurgence of Credit View
Mishkin (1978) and Bernanke (1983) have explored
the relative significance of money stock as against financial forces (represented
by break-down in banking), in explaining the depth of the depression. In particular,
Bernanke has shown that the monetary forces (shown up in the aggregate money
supply) alone are quantitatively insufficient
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to explain the severity in the down-turn in the
business cycle. The collapse of the banking system is relatively important.
Thus, the credit view as reflected in Gurley-Shaw model has revived with emphasis
on bank loans in stimulating the aggregate economic activities.
Emergence of New Paradigm
The distressing experience of the Great Depression
created wide spread mistrust in the efficacy of markets. The subsequent policy
making during 1960s and early 1970s has, therefore, attached a significant weight
to measures like directed investment, directed lending and regulated interest
rates structure. Furthermore, these restrictive policies have been justified
on the ground that financial institutions in developing countries are unable
to facilitate risky investment as well as risk-sharing of new investments. Besides,
the oligopolistic financial institutions are found to be abusing the environment
of unregulated interest rates by charging usurious interest rates on the borrowers.
In the process, the critical issues of financial intermediation such as operational
efficiency, allocation efficiency, financial viability of the institutions,
governance, developing instruments, markets and other segments of financial
infrastructure needed for the sustained growth of the financial system and economic
growth have not received much attention, particularly in the developing countries.
Financial Repression and Efficiency of Financial
Intermediation
Several studies including the pioneering one by
McKinnon-Shaw (1973) have examined the repercussions of a regulated regime on
macroeconomic aggregates. The major finding of such studies is that the interest
rate structure regulations, directed lending and investments have distorted
the financial markets. The distortions, in turn, affect adversely the saving
and investment decisions. The regulated and/or subsidized interest rates structure
depresses savings and promotes inefficient investments. This phenomenon has
come to be known as financial repression. In the light of such analysis, a strong
case for liberalization of the repressed credit markets has been made. In the
context of paucity of savings and relatively large demand for investible resources,
deregulation of interest rates on borrowing and lending
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would lead not only to higher savings but also
to more efficient use of funds. On the other hand, development of the financial
sector per se entails two pronged macroeconomic effects: enhancing efficiency
of investment and augmenting savings mobilization and hence scale of investments
(Gold Smith, 1969 and McKinnon-Shaw, 1973). Partly under this theoretical influence,
there has been a strong move towards liberalization and financial sector reform
since the early 1970s in both developed and developing countries. Incidentally,
the reform experience has been mixed in different countries depending on the
prevalent conditions. The detailed discussion of this issue is presented in
Section II.
The endogenous growth literature as contributed
by Romer (1986), Prescott and Boyd (1987), Rebelo (1987) and Lucas (1988) provides
an insight into savings behavior that enhances and maximizes the growth potential
of the economy. The financial intermediaries, by effecting transformation of
savings into capital, tend to promote capital investments and also raise rates
of growth. As early as 1960s, economists like Schumpeter, Gold Smith, and Patrick
underlined the critical contribution of financial intermediaries in stimulating
economic growth. However, accent of the recent endogenous growth models (e.g.,
Greenwood and Jovanovich, 1990) has been on efficiency of financial intermediaries
and two way causal relationship between financial development and economic growth.
The growth process in the economy brings about a chain effect: fostering participation
in financial markets; deepening as well as widening of financial markets; emergence
of sophisticated financial structure; selection of efficient investment projects;
and finally improvement in allocative efficiency of financial institutions.
The resultant financial infrastructure in turn stimulates economic growth and
development.
Bencivenge and Smith (1993) have introduced an
endogenous growth model with multiple assets. The model considers the effects
of introducing financial intermediation in an environment in which agents accumulate
capital in liquid but unproductive assets taking into account the future uncertainty.
The introduction of financial intermediaries brings about shift in the composition
of savings towards capital in less liquid but productive assets, which promote
growth.
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Furthermore, the presence of financial intermediation
reduces the socially unproductive liquidation. The financial intermediaries
stimulate economic growth in two ways: (1) by channelling savings of individuals
into productive areas of development and (2) by allowing individuals to reduce
their risk associated with their liquidity needs. This is possible for financial
intermediaries because they enjoy the advantages out of the laws of large numbers
and coalition of investors, which enable the financial intermediaries to invest
in illiquid but more profitable securities while preserving enough liquidity
to satisfy needs of individuals investors (Diamond and Dbvig (1983).
In this connection it is appropriate to refer to
a banking model developed by Bernanke and Gertler (1987). The model highlights
the role of banks in facilitating the flow of credit in the economy. Interestingly
the model demonstrates how the financial health of the banking institution plays
significant role in expanding the base of the loanable funds and loan portfolio
of the bank. The healthy bank with high net worth (capital and reserves) is
able to attract larger volume of deposits. With large deposits base/resource
base the bank is in a position to allocate larger fraction of its portfolio
to risky loans. The model also reveals how the monetary policy can matter to
real economic activity by influencing the flow of bank credit.
Micro-Economic Perspective – Financial Intermediation
As the motives behind saving and investment are very different,
it is very unlikely to have any semblance of equality between the two and more
so in the absence of financial intermediation. If there is a complete market
of Arrow-Debreau type, there exists a complete set of contingent claims. Consequently,
the degree of uncertainty is almost absent or very much minimum. However, in
a real world situation, the degree of uncertainty from the point of view of
individual saver or investor is certainly high since the preference pattern
undergoes change depending on the time horizon. It is, particularly, true from
a long run perspective for market equilibrium between demand for and supply
of savings. Another factor that contributes to uncertainty and risk is the extent
of imperfection in financial markets. Notwithstanding the
market imperfection, financial markets are important since they provide signals
to the agents to assess the risks arising from fluctuations in the market.
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The characters of individuals and critical aspects
of the individual financial institutions in the process of financial intermediation
such as liquidity preference, safeguard against risk associated with liquidity
needs, transaction costs, choice and monitoring of the projects, governance,
regulation/supervision, information asymmetries and incentives, adverse selections,
moral hazards and asset/liability-risk related aspects, legal and enforcement
systems, accounting standards etc. are also essential elements in explaining
the behaviors of savers and investors as well as coordination between saving
and investment in the economy. In short, a reference to microeconomics of financial
institutions, instruments, markets, and other segments of the financial infrastructure
is equally important and instructive in understanding and appreciating the linkage
between financial infrastructure and economic development.
Gurley-Shaw (1960), Benston-Smith (1976), and Fama
(1980) argue that financial intermediaries like banks, insurance companies,
and mutual funds are there to transform financial contracts and securities.
For, conditions like indivisibility and non-convexities in transaction technology
necessitate the service of intermediaries to undertake the transformation. For
instance, banks transform such as demand deposits (divisible in amount, in maturity
and with low risk) into non-marketed loans (large in amount with indivisibility,
longer maturity, high risks). Thus banks are specialized in providing financial
services of divisibility, term and risks transformation. One might argue that
individuals with adequate knowledge of markets might also undertake the type
of asset transformation, which banks are supposed to perform. But the missing
point in this argument is the importance of scale and scope economies involved
in transfer technology. Thus, Benston and Smith (1976) observe that the raison
d’etre for financial intermediaries is the existence of economies of transaction
costs. If they perform supply-leading role, they go beyond these economic demands.
Developments in the transfer technology, telecommunication, computer, and also
innovations in financial services and instruments would bring about radical
changes in the extant transaction costs.
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Miscellaneous Micro Factors
Other areas of operations where financial institutions
enjoy distinct economic advantages include systematic screening of projects,
efficiency and effectiveness in monitoring project finance, ensuring end use
of credit and recovery of loans and so on. As seen in the preceding paragraph,
they enjoy substantial costs advantages on account of the operation of the scale
and scope economies. Furthermore, they are endowed with the comparative advantages
of having reliable and credible information on the nature and quality of the
projects, its execution, cash flows, credit worthiness of individual borrowers
and its future prospects. With these distinctive advantages, financial institutions
are arguably in a position to prevent adverse selection of projects, moral hazard,
and opportunistic behavior of borrowers during realization of projects. In this
connection it is plausible to argue that individual investors and rating agencies
can also undertake the screening and monitoring activities. However, in such
cases, individual investors will have to incur exorbitant costs to undertake
such activities. Indeed, the models developed by Helloing (1991), Broacher (1990),
Holmstrom and Tirole (1993), Diamond (1984) emphasise the important role of
the financial institutions in screening and monitoring the project finance.
They also stress that the effectiveness and efficiency of the financial institutions
in these areas of operations are the significant contributory factors for economic
growth and development.
Theory of Firm Approach
Busman and Zebra (1995) have extended the monitoring
model of Diamond (1984) by including transportation costs. As a matter of fact,
the transportation costs represent an element of horizontal differentiation.
The model demonstrates that the horizontal differentiation could be an important
source of feed-back effect between economic development and financial development.
This model belongs to the theoretical approach known as industrial organization
approach to financial intermediation. Such models
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provide useful insight into issues pertaining to
cost effectiveness, innovations, risk management, market failures and effectiveness
of monetary policy. The focus of these models is on the responses of the financial
institutions as independent entities to different kinds of environment. Broadly
in these models the banking sector is not treated as a passive player as is
done in the standard approach to the monetary policy. As a matter of fact the
banking sector is viewed as the active and independent entity reacting optimally
to the changing environment in the economy. For instance, the industrial organization
approach to modeling the financial institutions like banks considers the banks
as firms specialized in generating spectrum of financial products and services
to their customers’ changing and growing preferences. By using the inputs (men
and materials) the banking firms produce output in the form of portfolio of
assets and liabilities as well as diversification by transforming shorter position
in liability portfolio into long-term position in the loan/ asset portfolio.
From the perspective of balance sheets of financial institutions, financial
transactions are only the visible counterpart to the financial services provided
by the banking firms. The cost of providing these services in relation to their
earnings involves a number of economic functions such as exploiting scale and
scope economies, asset/liability risk-return management, product differentiation,
innovations/inventions, selling costs management, corporate governance and so
on. These and other related aspects need to be considered alongside assets-liability
structure and balance sheet size in order to assess the operational and allocative
efficiency of the financial intermediaries.
Integrated Approach
An integrated approach encompassing macro considerations,
micro aspects of financial institutions including scale and scope economies
and asset/liability risk management, etc or industrial organization approach
and balance sheet approach would be essential to comprehend the inter-relation
between economics of growth and financial infrastructure. The above discussion
of select theoretical models reveals clearly that micro and macro aspects of
financial intermediation are not mutually exclusive. The efficient financial
performance as measured in terms of cost effectiveness, productivity,
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profitability, sustainability and so on hinges
on both micro and macro factors. From a macro perspective, efficient operations
of financial intermediaries in a given environment, contribute to efficient
life cycle allocation of household consumption and efficient physical capital
to its most productive use (Merton-1993).
Eclectic-Theoretic Approach
The theoretical models briefly discussed above,
can broadly be classified into two categories: (1) those dealing with institutional
perspectives – organizational matters, functional matters, at both macro and
micro levels etc., and (2) those dealing with market perspectives -issues relating
to marketing of financial products and forms of markets, full equilibrium and
partial equilibrium conditions, perfect/imperfect markets and so on. There is
a vast body of literature dealing distinctly with each group. But in the present
context of increasing use of advanced technology, rapidly growing financial
innovations, rising trend in portfolio diversification and asset/ liabilities/risk
management, it is very difficult to maintain a separate identity of different
bodies of literature. The theoretical literature concerned with financial intermediation
is likely to become inseparable in the dynamic conditions. Thus, the eclectic
or integrated theoretic approach seems to be appropriate in understanding and
assessing the role of financial infrastructure in growth and development. Metron
(1995) in his model on dynamics of financial evolution has viewed the financial
institutions as financial intermediaries performing important latent economic
functions. Their economic functions are concerned with creating and testing
new products before they are seasoned enough to be traded in a market. The resultant
interactions between financial institutions and financial markets reinforce
and improve the efficiency of their functions. Ultimately this process pushes
the financial system – consisting of institutions, markets and instruments —
towards an idealized goal of full efficiency.
Lihui-Lin et al (2001) argue that financial
intermediaries should be viewed against the backdrop of a financial system.
Financial institutions produce '; matching'; between markets and participants.
The traditional financial intermediaries act like manufacturers and/
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or wholesalers while the financial markets act
like retailers. Even this distinction becomes absurd in the case of electronic
banking and use of Internet device in financial transactions. The financial
intermediation based on highly advanced technology encompasses both production
process and marketing of financial products and services. Such financial intermediation
representing integration of institution perspective and market prospective can
only be studied by employing an integrated approach. Incidentally, a major part
of the traditional theory of intermediation by treating market mechanism as
exogenous, has not recognized fully the value addition generated by the process
of marketing.
Clearly, there exists a two-way causal relationship
between development of the financial system and development of the economy.
It is possible to explain the sub-optimal level and rate of growth of savings,
and investment as also financial weaknesses and low efficiency of the institutions
in the developing countries. It is observed that financial repression is one
of the important factors responsible for the sub-optimal performance of the
financial system in these countries. In view of this, financial sector reforms
in many developing countries are designed to eliminate ill effects of ';financial
repression.';
Section II
Experience with Structural Reform
Policies
As stated earlier, the McKinnon-Shaw hypothesis
has had a far-reaching influence on the financial policy making in a number
of developing economies, inter alia, in terms of easing of the regulated
interest rates structure, directed lending and investment, and imparting a diversified
ownership pattern of financial institutions. However, experience with the structural
reform policies especially in the developing countries has been mixed with notable
failures in Latin American countries. Following financial reforms in 1980s and
1990s in Mexico and other southern cone countries, their banking sector experienced
chaotic situation and even collapse. Fry (1995) has analysed the international
experience in financial sector reforms over the past two decades and identified
five important pre-requisites for
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success of financial reforms: (1) adequate prudential
supervision and regulation of commercial banks, efficient legal and accounting
systems and also other financial infrastructure facilities, (2) reasonable degree
of price stability, (3) fiscal discipline, (4) profit maximizing competitive
behavior of the commercial banks, and (5) taxation system that does not impose
discriminating (explicit or implicit) taxes on financial intermediaries. The
liberalization and structural reform not based on the conscious and critical
assessment of the situation could not yield expected results Gibson and Tsakalotos
(1994).
Williamson and Maher (1998) have reviewed the experience
of financial sector reforms in 34 countries and found that the benefits of financial
liberalization are greater the higher are the financial depth and efficiency
in allocation of investments. The financial sector reforms do not, however,
support decisively improvement in savings as predicted by McKinnon–Shaw. Dobson-Jacquet
(1998) has also observed that the effect of financial liberalization on rate
and level of savings is less robust in reality. Therefore, contribution of financial
liberalization to growth and development lies more in quality of resource allocation
than in quantity of resources potentially available. As per Pagano (1993), there
are three important channels through which the efficient financial sector can
influence the long-term growth, viz: (1) increase in the proportion of savings
transferred to investment spending; (2) improvement in social marginal productivity
of investment; and (3) augmenting the private saving rates. The survey results
of King and Levine (1993) also reveal that the benefits of the financial sector
reforms accrue to the economy as a whole in the form of faster economic growth.
According to Levine (1996), efficiency in financial intermediation affects favorably
net return to savings and gross return on investment.
Financial Infrastructure and Economic Development
The overall efficiency of the financial system
is closely linked with the efficiency of the legal system, accounting standards,
and payment and settlement system. Weaknesses in enforcement mechanism for financial
contracts, lack of standardized accounting system or transparency deficiencies
in payment and settlement system hinder the growth of financial sector and hence
economic
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development. Similarly, there has been evidence
of early recovery from the financial crisis with efficient and sound financial
infrastructure. Besides, success or failure of financial reforms in a given
country depends to a large extent on the efficiency of financial infrastructure.
Indeed, prior to the introduction of financial sector reform, there is an imperative
need for refinement in the legal system, particularly in the areas of bankruptcy
laws, secured transactions, enforceable contracts, banking Act for prudential
supervision and regulation. Financial infrastructure also plays a vital role
in not only stimulating but also sustaining the economic growth (John L. Walker,
2001). For instance, a legal system based on common law being more flexible
and dynamic is found to be more effective in contributing to the overall efficiency
of the financial infrastructure as compared with the system based on civil law.
Such a system provides for more diversified ownership structures and development
of capital market. Alongside the sound legal system, transparency and credible
accounting standards are emphasized. The recent episodes of accounting irregularities
in the US corporate sector highlight the imperative need for evolving a system
of credible accounting standards and extensive transparency to improve the efficiency
of the financial infrastructure. The payment and settlement system constitutes
one of the most significant segments of the financial infrastructure facilitating
smooth transactions with minimum risks for the economy. Besides, an efficient
payment and settlement system has a decisive bearing on efficacy of the monetary
and credit policy.
Financial Infrastructure, Financial Stability
and Economic Growth
Confidence of the participants in various segments
of the financial infrastructure forms the essential pillar for financial stability
in a country. The extent of confidence and trust of the participants is, thus,
dependant, among other things, on the presence of sound and strong financial
institutions, efficient financial markets, and financial infrastructure. Financial
stability also requires establishing links between financial markets and the
macro economy; and within the financial markets among different participants.
Finally, credible crisis management system is essential for ensuring financial
stability. Effective execution of the task necessitates exchange of information,
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proactive remedial measures, and coordination among
the financial policy-making bodies, namely, central bank, government and supervisory
authorities (if they are separate entities).
In an interesting review of empirical literature,
Simson Johnson (2002) focused on the relationship between economic prosperity
and quality of institutions in an individual country. In particular, the issue
is whether an effective legal system, regulatory/supervisory system enforcing
laws, prudential norms relating to protection to depositors /investors rights,
transparency, stability and viability of the financial institutions contribute
to economic growth and development. It is demonstrated beyond doubt that institutions
do matter and countries with strong institutional set-up experience relatively
high long-term growth. Johnson also highlighted contribution of efficient institutions
to the success of financial sector reforms in Poland as against Czech Republic.
While designing reform packages and policies thereof, Poland took care of protecting
the investors’ rights by introducing certain effective regulatory measures.
In contrast, Czech Republic established far fewer institutional protections
to the investors’ rights, relying more on market forces. Outcome of these two
models of financial sector reform is quite revealing. Czech Republic model was
not only less successful but also suffered series of financial crisis. On the
other hand, Poland’s financial sector reform turned out to be quite successful.
Johnson’s study of the East-Asian financial crisis also reveals that countries
with strong institutional set-up have handled the crisis much better than those
with weak institutional set-up.
Section III
Indian Experience with Financial
Infrastructure and Economic Development
Last five decades have witnessed concerted efforts
of the Government of India and the Reserve Bank of India to develop and promote
the financial infrastructure in the country. The driving force underlying the
persistent endeavor in respect of the financial infrastructure seems to be the
planners and policy makers’ belief in the concept of ‘supply-leading’ role as
against the ‘demand following’ role of the financial intermediaries. The policy
thrust since 1969 and
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till the mid-1980s had been relatively on achieving
equity in regional distribution of banking facilities in general and institutional
credit in particular as compared to the sustained growth and stability of the
financial infrastructure such as viability and soundness of the institutions.
With the financial sector reform introduced since the early 1990s, there has
been a paradigm shift in the financial sector and the necessity of reform measures
in the legal, accounting and payment systems alongside the financial system
has come to the fore. At present what is required is to identify gaps in the
segments of financial infrastructure and devise appropriate policy measures
as well as the strategy for effective implementation. It is towards such an
end, the following discussion starts with agricultural finance.
Agricultural Finance–Institutional Development
Owing to the then predominantly agricultural basis
of the Indian economy, there has been the imperative need to expand and coordinate
the credit facilities available to agricultural sector. Recognizing this distinctive
feature of the Indian economy, the Reserve Bank of India Act 1935, has itself
laid down in section 54 that the Bank should set up a special Agricultural Credit
Department (ACD).
Accordingly, the ACD was set up with the establishment
of the Reserve Bank of India in 1934. The major findings of the preliminary
reports prepared by the Department were: (i) money lenders were by and large
the sole financiers of agriculture with negligible finance by institutional
agencies like cooperatives; (ii) legislation needed to be framed for regulating
the money lenders; (iii) credit extended by money lenders was subject to high
interest rates and other usurious practices; and (iv) land mortgage corporations
might be set up for meeting the long term credit needs of the farmers.
Several other expert committees subsequently addressed the issues
pertaining to augmenting the agricultural credit and strengthening the multi-agency
set-up for agricultural finance. For example, the Committee of Direction of
the All-India Rural Credit Survey (1951-52) suggested for supplementing cooperative
credit by commercial banks. However, a majority of the expert committees on
agricultural credit held the view at least till the early 1980s that the major
responsibility of providing credit to agriculture should be that of co-operatives.
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Since inception of the Five Year Plans, a number
of steps have been taken by the Bank/Government of India to augment the institutional
credit flow, inter alia, through provision of national agricultural credit
(long term operations) funds, national agricultural credit (stabilization) fund,
geographical expansion of commercial banking facilities to rural areas and directed
lending at concessional rates.
The major institutional arrangements for agricultural
credit, which have been created over a period of time consist of establishment
of new institutions and supportive policy measures: gigantic cooperative credit
structure, Agricultural Refinance and Development Corporation, rural branch
network of State Bank of India and 14 leading commercial banks following their
nationalization in 1955 and 1969 respectively, Regional Rural Banks (RRBs) to
focus upon the targeted rural groups, National Bank for Agriculture and Rural
Development (NABARD) by merging the erstwhile Agricultural Refinance and Development
Corporation and ACD of the Reserve Bank, comprehensive branch licensing policy
and branch expansion programme, and service area approach. In the co-operative
sector, at the apex level, there are state cooperative banks and their branches.
The district or central cooperative banks and their branches form the middle
layer of the structure. A sizeable number of primary agricultural societies
at the village level are at the bottom level of the cooperative of credit structure
in the country. The cooperative institutions account for 30 per cent of rural
deposits, and 44 per cent of outstanding loans and advances of the banking system.
About 55 per cent of the short-term production loans for the agriculture sector
have come from the cooperative credit institutions. A number of other initiatives
have been taken in recent years to improve the flow of the institutional credit
in the rural areas: launching of new tranches of Rural Infrastructure Development
Fund (RIDF), enhancement of the reach of schemes relating to Kissan Credit Card
(KCCS), Self- help and Micro-Credit. Thus, a vast network of rural branches
of commercial banks, RRBs, cooperative banks/credit societies and other
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
financial institutions like chit
funds money-lenders and indigenous bankers are engaged in financing rural economic
activities. During 1990s, a comprehensive framework of prudential regulation
and supervision of urban cooperative banks as well as other cooperative institutions
has been put in place to strengthen their financial viability.
Commercial Banking Sector
The accelerated progress in spread of banking has
taken place from 1969 when 14 major commercial banks were nationalized. The
number of bank offices has since risen from a little more than 8000 in 1969
to 68000 in 2000. The population per bank office has declined substantially
from as high as 64000 to as low as 15000 during the period. There has been a
spectacular growth in rural branches from 1833 in 1969 to 32654 in 2001. In
sequel, deposits of the scheduled commercial banks as per cent of national income
(at current prices) recorded a significant increase to 55.7 per cent in 2001
from 15.5 per cent in 1969. The per capita deposits have gone up from Rs.88
to Rs.9770. Similarly, the per capita credit has increased from Rs. 68 to Rs.
5228 during the period under consideration. The flow of credit to the hitherto
neglected sector, i.e., priority sectors expanded sizably from 14 per cent of
total bank credit to 35.4 per cent during the period under review. As the commercial
banks’ credit, under policy intervention, has begun to flow to agriculture and
other priority sectors, the credit flow to medium and large-scale industries
has shown a sizeable decline since the late 1960s. This trend could also be
attributed to the introduction of credit discipline in the field of industrial
credit since the mid-1960s.
Industry and Commercial Sector Financing:
Institutional Development
In order to provide long and medium term industrial
finance, particularly in the absence of a vibrant capital market, a vast financial
structure consisting of development financial institutions, investment institutions,
insurance companies, mutual funds, other non-banking financial institutions
and credit guarantee institutions in addition to the commercial banking network
has come up both at State and all-India levels mainly under the initiatives
of the Government of India and the Reserve Bank.
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There has been a general aversion on the part of
the commercial banks to extend medium and long-term finance to the industrial
sector due to the strong influence of the British banking practices and the
lessons from banking failures. Way back in 1931, the Central Banking Enquiry
Committee recommended for formation of provincial industrial credit corporations
given the prevailing constitutional position. The Committee also did not rule
out the desirability of formation of all-India industrial finance corporations.
Further, the Committee suggested that sound and conservative banks such as the
Imperial Bank should adopt the German System of mixed banking (i.e., universal
banking). The Committee also recommended for investment by banks in debt instruments
and equities. However, the material progress in industrial financial infrastructure
has taken place only after independence. Following the Act passed by the Constituent
Assembly, IFCI was established in 1948. Subsequently, similar institutions came
up in provinces under the State Financial Corporations Act, 1952 with a focus
on small-scale industries.
Today, the industrial financial set-up includes
a wide spectrum of institutions such as Industrial Finance Corporation of India,
18 State Financial Corporations, Industrial Credit and Investment Corporation
of India (now ICICI Bank), Industrial Development Bank of India, Industrial
Investment Bank of India, Power Finance Corporation, several industry specific
or trade–specific companies/ corporations, Small Industries Development Bank
of India, Export-Import Bank, Unit Trust of India, other private mutual funds
organizations, Life Insurance Corporation of India, General Insurance Corporation,
private insurance companies, several State Industrial Development Corporations,
Deposit Insurance and Credit Guarantee Corporation, Export Credit Guarantee
Corporation, non-bank finance companies including companies for housing finance,
investment finance, loan, lease and hire-purchase, mutual benefit companies,
infrastructure finance companies, Discount and Finance House of India, Securities
Trading Corporation of India, Primary Dealers, Bombay Stock Exchange, National
Stock Exchange and regional stock exchanges.
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
Financial Instruments
The majority of savers in India have low income
and hence their saving potential is limited. Such small savings need to be pooled
for financing indivisible (large) capital investment. Herein, the basic need
is to engineer a variety of saving instruments to suit preferences of different
individuals and institutions. Faced with this challenge, the banking industry
in India has introduced various types of deposit schemes in course of time,
inter alia: cash certificates, annuity or retirement schemes, farmers’
deposits scheme, insurance linked deposits, housing deposits scheme, automatic
extension deposit scheme, and suvidha deposit scheme. Alongside, banks have
come out with different instruments to finance the economic activities. Similarly,
a host of other instruments have come in vogue such as debentures, equities,
bonds, treasure bills, government dated securities, stock investment, zero coupon
bonds, tap stocks, term money, repos, intercorporate deposits, commercial papers,
certificates of deposits, mutual fund schemes, insurance schemes, swaps, futures,
options and so on.
Strategy for Developing Diversified Financial
Markets System –Promoting Integration
The basic theoretic approach underscores the need
for a diversified system of financial markets coupled with an institutional
infrastructure of banks and non-bank financial institutions. The network of
diversified markets enhances efficiency in resources pooling, resource allocation,
and thereby maximize return and minimize risk besides providing risk sharing
opportunities for investors and borrowers. According to Mr. Greenspan, Chairman
of the US Federal Reserve System, coexistence of domestic bond market and banking
system helps each to act as a backstop for the other. In short, it lays foundation
for effecting an appropriate integration of the markets.
Over the years, the Reserve Bank and the Government
of India as policy-makers and regulators have been making concerted efforts
towards establishing sound practices and procedures in different segments of
the financial markets, inter alia: inter-bank call market,
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commercial paper market, certificate of deposits
market, Government securities market, private corporate debt market, equity
market, foreign exchange market, and derivatives market. Particularly, the decade
of 1990s have witnessed both quantitative and qualitative changes in the financial
markets; quite a few new markets have been added and the financial markets in
general have been widened and deepened significantly. The market specific developments
are discussed in the following paragraphs.
Equity Market Development
The equity market in India has a long history.
However, in the 1990s and beyond it has witnessed far-reaching changes. The
National Stock Exchange has been set up in 1992 The Bombay Stock Exchange (BSE),
which is the oldest stock exchange in Asia, has been thoroughly modernized.
The number of regional stock exchanges has gone up from nine at the beginning
of 1980s to 24 in 2000. The number of listed companies has recorded a substantial
rise from 2,265 in 1980 to 7,500 in 2000. Besides, there is the OTC exchange
of India.
In recognition of the imperative need for a strong
and powerful watchdog for securities industry, Securities and Exchange Board
of India (SEBI) was set-up in 1988. The SEBI Act, 1992 encompasses the entire
gamut of securities industry covering, inter alia, the activities of stock brokers,
sub-brokers, merchant bankers, underwriters, registrars to issue and transfer
agents, insider trading, mutual fund, debenture trustee, disclosure norms, credit
rating.
Several steps were undertaken to ensure a vibrant
capital market with healthy market practices. The statute was amended in July
1987 permitting corporate membership of stock exchanges. The restrictions on
rights and bonus issues were withdrawn. New or established companies are now
able to price their issues according to their assessment of market conditions.
All the listed companies are required to publish quarterly financial accounts.
For ensuring greater transparency, negotiated and cross deals are not allowed
presently. Besides, screen-based trading, uniform and rolling settlement cycles
in all exchanges, and banning of deferred products in cash segment have been
introduced.
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
Debt Market
A well-functioning debt market acts as a mechanism
of monetary policy transmission and provides access to funds at competitive
rates. There are mainly three segments of debt market, viz., government securities
market, public sector unit (PSU) bonds market, and private corporate sector
bonds market. The aggregate outstanding debt amounted to Rs.8,50,000 crore and
formed 37 percent of GDP in 2001. Government securities market constitutes the
major segment of debt market while private corporate bonds/debenture market
accounts for a small proportion. In the recent period, around 90 per cent of
corporate debt instruments have been privately placed. Both government and corporate
debt instruments are being traded in the stock exchanges.
Over the years, the Reserve Bank has introduced
numerous measures to enhance efficiency and impart stability of the market,
e.g., exposure and valuation norms, and asset-liability management guidelines.
Besides, there has been a phased deregulation of bank’s investment limit in
non-government debt instruments. In addition to risk weights for interest rate
risks, investment fluctuation reserves have been mandated. Legal changes have
also been announced in the budget for 2002-2003 to create conducive atmosphere
for securitization of assets.
It is encouraging to note that the Fixed Income
Money Market and Derivatives Association of India (FIMMDA) and Primary Dealers
Association of India (PDAI) are working broadly as self-regulatory organizations
(SROs) for the development of bond and money markets in India. These bodies
are involved in evolving standard practices and code of conduct for market players.
Government Securities Market
Government securities accounted for 75 percent
of the total outstanding debt stock and nearly 95 per cent of the volume traded
in the secondary market. Currently, government securities are being traded on
the stock exchanges as also through negotiated dealing system involving members
of stock exchanges. Two depositories, viz.,
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National Securities Depository Limited and Central
Securities Depository Limited maintain records of securities holding in dematerialized
form.
While the Reserve Bank regulates the issue of government
securities, corporate debt securities fall within the purview of SEBI. The development
of government securities market has been one of the primary concerns of the
Reserve Bank for a variety of reasons, inter alia: (i) A deep and liquid government
securities market facilitates public borrowing and avoidance of automatic monetisation;
(ii) It provides the backbone of most fixed income markets across the world;
(iii) It enables use of indirect instruments of monetary policy; and (iv) It
makes available instruments with zero credit risk to institutions and high net
worth individuals for parking their surplus funds. With a view to catering to
the different investor preferences for government securities, the Reserve Bank
has experimented with various types of instruments such as fixed coupon bonds,
zero coupon bonds, floating rate bonds, bonds with put and call options, etc.
Most of the bonds are of the fixed coupon variety though recently floating rate
bonds have also been issued.
The institution of Primary Dealers (PDs) has been
adopted in India in 1996 for developing both primary and secondary markets in
government securities. PDs obligations include giving annual bidding commitment,
underwriting the primary issuance, and offering two-way quotes. In return, the
PDs are extended liquidity support by the Reserve Bank and access to call money
market as borrowers and lenders. Gilt Mutual Funds dedicated almost exclusively
to investment in government securities were also established in 1996.
Money Market Development
One of the prerequisites for developing a vibrant market for
bond/ dated government securities is the existence of an active money market
since the latter supports the former through availability of liquidity. The
money market in India has its both formal and informal segments. The Reserve
Bank of India, commercial banks, cooperative banks, insurance companies, mutual
funds, term lending institutions are the main participants in the formal market.
A host of non-banking companies like loan
companies, chit funds, nidhis, indigenous bankers, and moneylenders constitute
the informal market.
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
During the last two decades, a number of measures
have been taken to widen and deepen the market, particularly in line with the
Committee to Review the Working of Monetary System (Chakravarty Committee, 1985)
and Working Group on the Money Market (Vaghul Committee, 1987). Rationalisation
of term structure of interest rates, progressive deregulation of interest rates,
introduction of several financial instruments, establishment of Discount Finance
House of India, Securities Trading Corporation of India and Primary Dealers,
etc are some of the important measures adopted during the 1980s to improve the
functioning and efficiency of the money market. Recently a number of steps have
been taken to develop a short-term Rupee yield curve. The call money market
is being developed as a pure inter bank market with a phased withdrawal of non-bank
market participants. For improving the system of clearing and settlement, Clearing
Corporation of India Ltd (CCIL) has been established.
Credit Rating and other Confidence Enhancing
Legal Measures
Credit rating is one of the important tools to
instill confidence among investors in financial markets. SEBI is the regulator
of credit rating agencies. Credit rating of all public issues including debentures
with maturity exceeding 18 months has been made compulsory Amendment to the
Indian Stamp Duty Act, 1899 has exempted dematerialized debt instruments from
stamp duty. The recent amendments to section 47 of IT Act facilitating securities
lending and borrowing operations will ensure safe and smooth settlement through
the Clearing Corporation of India Ltd. The most remarkable legislative measure
in the recent times has been ‘The Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest, 2002’, strengthening creditors’
right to foreclosure and enforcement of securities by banking and financial
institutions. The other noteworthy legal and institutional steps were the Government
Securities Act, replacing the Public Debt Act and facilitating wider participation
in government securities market, and the Fiscal Responsibility Bill, introducing
STRIPS, Negotiated Dealing System (NDS) and
Real Time Gross Settlement System (RTGS), among others.
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Historically, a number of committees and commissions
with their foresights and insight contributed to the legal framework of the
Indian financial system: The Indian Central Banking Enquiry Committee (1931)
for a comprehensive banking legislation covering organization, management, audit,
and liquidation of banks, Banking Commission (1972) for suggesting suitable
changes in banking legislation, and Committee on Banking Law (P.V. Rajmannar
Committee) for its report on Negotiable Instrument Act, Real Property Security
Law, Personal Property Security Law, Documents of Title to Goods, and Narasimham
Committee on the financial system for identifying various gray areas in financial
laws and regulations.
Accounting Standards
A sound accounting system is essential to ensure
reliability of information for customers, regulators, shareholders, planners
and policy makers while evaluating strength and weaknesses of financial players
and institutions. In this regard, the recent initiative of the Reserve Bank
has been setting up of the Standing Committee on International Financial Standards
and Codes. The standing committee, in turn, constituted 10 advisory groups in
the areas of banking supervision, bankruptcy law, corporate governance, data
dissemination, fiscal transparency, payment and settlement system, and securities
market regulation. The recommendations of the standing committee are in various
stages of implementation.
Prudential Supervision/Regulation
While evolving a credible accounting and auditing
standards in line with the best international practices is important, equally
important is their compliance on an on-going basis. This necessitates presence
of a sound and efficient regulatory and supervisory system. In regard to the
supervision of banking and non-banking financial institutions, a system of on-site
and off-site supervision has been put in place. Micro-prudential norms for monitoring
institution-specific idiosyncratic risks and macro-norms for identifying and
containing systemic risks have
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
been adopted. The micro-prudential framework uses
a set of indicators enabling: 1) peer group analysis based on critical financial
ratios and (2) development of bank-rating systems. Such monitoring approach
employs CAMELS model based on capital, assets, management, earning, liquidity,
and systems. In addition, Prompt Corrective Action Framework based on micro-prudential
indicators such as capital to risk-assets weighted ratio, net non performing
assets and return on assets has also been operationalised. This system is meant
to trigger corrective action at the earliest possible sign of weaknesses and
prevent deterioration in financial viability and growth.
The refined risk-based supervisory /regulatory
approach on the lines of the second Basle risk supervisory norms is being developed
and is likely to be put in place shortly. Furthermore, a comprehensive management
system and credit information system are being developed. The present genre
of risk based supervision-prudential regulation is essentially a macro-level
supervision. The Securities Exchange Board of India (SEBI), Insurance Regulatory
and Development Authority, and Department of Company Affairs (Ministry of Finance
& Company Affairs) are also engaged in evolving regulatory mechanism to
monitor operations of capital market, insurance sector, and other non-banking
non-financial companies respectively. Alongside the regulatory/ supervisory
role, the regulatory authorities in India also shoulder the responsibility of
discharging promotional and developmental role with a view to ensuring stable
environment for sustained growth of financial institutions.
Payment and Settlement System
The payment and settlement system forms one of
the basic segments of the financial infrastructure. The Reserve Bank has taken
a number of initiatives to improve the efficiency of payment and settlement
systems broadly in line with the core principles enunciated by the Group Ten
Report (BIS). According to the Report, the safety and efficiency of the payment
systems is governed by 10 core principles including well founded legal basis,
clear rules and procedures, clearly defined risk management systems and procedures,
prompt settlement during the day, timely completion of daily
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PAPERS
settlements under multilateral netting system,
using claims on central bank as assets for settlement, high degree of security,
operational reliability and efficient contingency arrangements, practical means
of payments, publicized criteria and open access, and effective, accountable
and transparent governance.
Section IV
Indicators of Financial Development
As observed in the preceding paragraphs, influence
of financial infrastructure is reflected in the behaviour of macro-economic
aggregates like savings and investment as well as their composition. In particular,
the increasing trend in saving and investment could, inter alia, be attributed
to the development in the financial infrastructure over a period of time. The
gross domestic saving (GDS) as a percent of GDP registered a consistent improvement
from 9.9 percent in the 1950s to 12.7 percent in 1960s, 17.5 in 1970s, and further
to 19.4 per cent in 1980s before attaining the peak of 23.0 percent in the 1990s.
At present, the GDS/GDP ratio is hovering around 22.0 percent to 23.0 percent.
In tandem with the GDS rate, the gross domestic capital formation (GDCF) as
a percent of GDP moved up from 11.3 percent in the 1950s to 17.6 percent in
the 1970s, 21.2 percent in the 1980s and further to 24.4 percent in the 1990s.
The significance of the financial infrastructure,
in general, and the role of financial intermediation, in particular, can be
better appreciated by observing the shift in the composition of GDS. The share
of household financial saving in total saving increased from 51.6 per cent in
early 1970s to 66.7 percent in the late 1990s. Correspondingly, there had been
a downward shift in the share of physical saving from 48.4 percent to 33.3 percent.
Bank deposits constituted the major proportion of total financial saving. This
period also witnessed a significant rise in contractual savings, e.g., in the
form of fixed deposits, company deposits, provident funds and insurance funds.
The growing financial saving could be attributed, inter alia, to financial
diversification, geographical spread of banking, accessible financial assets
with a spectrum of yields in terms of risks, returns
and maturities. The growing scale of operations of the financial intermediaries
has facilitated pooling of independent risks.
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
The movements in finance ratio (FR), defined as
a ratio of financial issues to national income, reflect, among others, developments
in the financial system in relation to the real sector. A high FR indicates
greater widening and deepening of the financial system. The FR, which was as
small as 0.01 in the 1950s grew to as high as 0.37 in the 1980s and further
to 0.46 in the 1990s. The closely related ratio to the FR is the financial interrelation
ratio (FIR). This represents the total volume of financial assets in the economy
in relation to stock of physical assets. The FIR has gone up significantly over
the years from 0.11 in the 1950s to 2.41 in the 1980s and further to 2.39 in
the 1990s. The two ratios – FR and FIR – taken together reflect substantial
geographical spread, functional specialization and diversification of the financial
sector. Yet another indicator of financial development is the ratio of new issues,
which indicates the amount of primary issues in relation to capital formation
and thereby tracks the extent of financial needs of the non-financial sector
met up by the financial sector. The ratio has increased from 0.18 in 1951-52
to 1.42 in the 1980s and further to 1.32 in the 1990s. Similarly the intermediation
ratio, which represents the extent of institutionalization of financing, shows
the importance of financial institutions relative to non-financial institutions
in raising resources to finance investment. The ratio stood at a negative of
0.39 in 1950-51. Thereafter, it went up to 0.71 in the 1970s and further to
0.82 in the 1990s. The financial assets of scheduled commercial banks as percentage
of GDP went up substantially from 31 percent in 1980 to 43.5 percent in 2000.
The financial assets of financial institutions like IDBI, ICICI, EXIM Bank,
IFCI, SIDBI, registered a sharp increase from 11.6 percent of GDP in 1980 to
25.6 percent in 2000. The market capitalization in 1981 accounted for merely
3.8 per cent as against 47 per cent in 2000.The market capitalization as percentage
of scheduled commercial banks’ financial assets rose from 12.2 per cent in 1981
to 107 percent in 2000. The real GDP growth in India recorded a progressive
increase from a low of 2.9 per cent in the 1970s to 5.8 per cent in the 1980s
and further to 6.4 per cent in the 1990s (excluding 1990-91 and 1991-92). Similarly,
the rate of growth of net fixed capital formation has
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risen from 3.6 percent in the 1970s to 4.2 per
cent in the 1980s and further to 5.3 in the 1990s. The contribution of productivity
to growth has been about 4 per cent, fluctuating significantly from negative
contribution in the 1980s to positive contribution in the 1990s.
Section IV
Concluding Observations
Faster expansion of financial structure in relation
to GDP growth is found to facilitate the growth process at least in the early
phase of economic development. This is corroborated in the case of India, wherein
financial institutions have played a ‘supply-leading role’ until recently. In
particular, the Indian banking industry has witnessed remarkable geographical
spread and functional diversification mainly due to policy intervention. The
progressive institutionalization of savings, shift in its composition as also
in investment pattern are attributable, inter alia, to the development
of financial infrastructure over the last five decades. The evidence and experience
also corroborate the following oft-quoted hypotheses. The efficient financial
system can influence the long term growth through three important channels,
namely, 1) increase in the proportion of saving transferred to investment spending,
2) augmenting private saving rate and 3) improvement in the social marginal
productivity. The financial intermediaries stimulate economic growth in two
ways: (1) by channeling the individual saving into productive areas of development
and (2) by allowing the individuals to reduce risk associated with their liquidity
needs. In the Indian case, the trend in three major financial indicators, viz.,
gross domestic saving as percentage of GDP (about 23 per cent), share of household
saving in total saving (around 86 per cent) and proportion of financial saving
to aggregate saving (about 50 per cent) could partly be explained in terms of
vast network of financial infrastructure developed over a period of time. The
concerted efforts directed towards expanding institutional set-up, developing
spectrum of saving instruments, and diversified markets, reducing risk perception
and uncertainty, ensuring liquidity and safety to the savers/investors and so
on, have definitely contributed to the growth of household saving. The relatively
low saving of both private corporate and public sectors has been contributed,
among others, by low investment efficiency. The
FINANCIAL INFRASTRUCTURE AND
ECONOMIC DEVELOPMENT
gaps and gray areas in the segments of financial
infrastructure reflecting its operational inefficiency, might have also adversely
affected the investment efficiency. Contribution of the financial liberalisation
to economic growth and development has been more by way of enhancement in the
quality of resource allocation rather than through augmentation of quantity
of resources potentially available in the economy.
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