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India's lagging financial system

The country must develop its financial system in order to keep pace with China. Diana Farrell and Aneta Marcheva Key China and India, the world's two emerging economic giants, have captured the imagination of investors, industrialists, and economists alike. Their parallel bursts of growth are marked by striking differences, however (Exhibit 1). As powerful as the progress of both countries has been, China's industrial development is clearly outstripping that of its neighbor not only because of China's head start in economic liberalization but also because of a commonly overlooked factor: India's financial system.

India's stock of financial assets, reflecting the degree of monetization in an economy and its supply of intermediated capital, is just one-sixth the size of China's total (Exhibit 2). 1 Whereas China accounts for more than 4 percent of the world's financial assets, India holds less than 1 percent. This difference is only partially explained by the size of the two economies. India's financial depth, a measure comparing a country's financial stock with its GDP, is just 137 percentfar below China's 323 percent. In the decade to 2003, India's financial stock increased by 12 percent annuallyhigher than the world average but still well below China's growth rate of 14.5 percent. If these trends hold, by 2010 China will have a financial stock of $14 trillion, thus consolidating its position as a significant player in the global capital market. India, however, will remain a minor player.

Size isn't everything, of course; a financial system's efficiency in allocating capital is equally important. On this measure, India would appear to have some advantages. Nearly two-thirds of China's financial stock is held in bank deposits, compared with less than half of India's total (Exhibit 3). But Chinese banks have a dubious lending history, and estimates of nonperforming loans range from 25 percent to 60 percent of the value of all outstanding loans. 2 In India, nonperforming loans are estimated at around 15 to 20 percent of the total. India's equity markets may also be in better shape. The Bombay Stock Exchange (BSE), while hardly a paragon of efficiency, was established in 1875 and is the oldest in Asia; China didn't even have a stock exchange until 1990. Furthermore, four times as many corporations are listed on India's exchanges as on those in China, where most companies are state-owned enterprises and the government holds up to three-quarters of all outstanding shares. Neither country has developed much of a market for corporate-debt securities, which constitute only 5 percent of China's total financial stock and a mere 1 percent in India. But whereas China's corporatedebt stock has grown by 18 percent annually during the past decade, India's has averaged zero growth. In contrast, corporate debt is the largest and fastest-growing component of the financial stock in the United States and most European countries, accounting for roughly one-third of their financial stock.

Still, though India's equity markets and banking system are slightly more efficient than China's, there is an enormous gap between the amount of intermediated capital available to each nation. Even if China's bank deposits were discounted by 25 percent to reflect the country's nonperforming loans, its financial stock would still be more than $4 trillionnearly five times as large as India's. (One could argue that since India's $200 billion government debt is not an instrument to transfer capital from savers to borrowers, it should be excluded from consideration. Doing so would reduce India's financial stock to just $700 billion.) The bottom line is that India simply has a lot less money circulating in its financial system than one would expect, given the size of its economy. One reason is its national savings rate, which, though respectable, is only half of China's rate of 40 percent. Foreign capital inflows could compensate for India's lack of domestic capital, but unfortunately they widen the gap: in 2003 foreign direct investment in China equaled 3.7 percent of GDP, but just 0.9 percent in India. 3 As a result, India's economy has been less able to finance investment and accumulate physical capital (which includes infrastructure, machinery, and buildings). In 2002, the country's investment in physical capital was 23 percent of GDP, compared with 40 percent for China. This factor may explain why China has invested more in heavy industry and manufacturing, while India has had success in the less capital-intensive business-service-outsourcing sector. India has ample opportunities to develop its financial system further. The current round of reforms, which allow pension funds to invest more in equities, will help spur market growth, as will the continued privatization of state-owned enterprises. Opening more parts of the economy to investment from foreign corporations and from expatriatessomething China has done very effectivelyalso holds potential. India has made remarkable economic progress since opening its economy in 1991. To continue that growth, it must now focus on developing its financial system. About the Authors Diana Farrell is director of the McKinsey Global Institute, and Aneta Marcheva Key is a consultant in McKinsey's San Francisco office.


This article is based on a McKinsey Global Institute report, $118 Trillion and Counting: Taking Stock of the World's Capital Markets, available free of charge online. 2 Matthias M. Bekier, Richard Huang, and Gregory P. Wilson, "How to fix China's banking system," The McKinsey Quarterly, 2005 Number 1, pp. 1109. 3 Diana Farrell and Adil S. Zainulbhai, "A richer future for India," The McKinsey Quarterly, 2004 special edition: What global executives think, pp. 2635.