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Financial Sector Reforms in India

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Mahendra Pal
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 Financial Sector Reforms in India

Mahendra Pal

UGC-Emeritus Fellow
DEPARTMENT OF COMMERCE, DELHI SCHOOL OF ECONOMICS &
Visiting Faculty DEPARTMENT OF AFRICAN STUDIES, D.U

Theme Lecture delivered at National Seminar of Management

MSM, Meerut 8-9th February,2014

The paper is based on the research carried out under the UGC sponsored FOREIGN CAPITAL AND ECONOMIC GROWTH IN INDIA- A
CO-INTEGRATION APPROACH. Financial Support from UGC is highly acknowledged. I am also thankful to Prof. K.L. Krishna,
V.N.Pandit, Prof. J.P. Sharma, Prof. K.V. Bhanumurthy, DSE for helpful guidance and comments 1
 Financial Sector Reforms in India
• Instruments of Monetary Control
• Banking Sector Reforms
• DFI’s Reforms
• RBI autonomy
• Money Market Reforms
• Interest Rate Reforms
• Financial Globalization Reforms

2
 Banking Industry
Changing Phases of Banking Industry in India

Nationalization in Deregulation
Under Private Social Control
July 1969 1991
Sector Control In 1968 only
Before 1968

Competition
Liberalization
Globalization
Privatization &
Integration
3
 Performance of nationalized Banks
Credit to deposit ratio or C/D ratio
Year (amount in Cr.)
1950 1969 1991 2010
Bank Deposits 820 5,910 1,93,000 42 lacs

Bank Credit 580 4,690 1,16,000 30,00,000

Under New Economic
Policy

C/D Ratio = 70% to 80% (range), during the entire period except in 1991(in 1991 it was only 60.1%).

Time Deposit to M3

Ratio 1980 Present

TD/M3 33% More than 80%
M3/GDP 33% More than 80%
Credit/GDP 33% More than 40%

4
 Major Recommendation of NCR-I, 1991
• Directed Investment Programme
• Directed Credit Programme
• To reduce NPA (Non-performing Assets)
• Capital Adequacy Ratio (CAR)
• Free entry for foreign bank and for private bank
• Merger and acquisition of un-viable and un-economic
branches
• There should be at least 4 international banks in the
country
• Government borrowing should be market oriented.
• To replenishing/refill the capital base of week/sick
banks, there should be re-capitalization of banks
capital.
5
Performance: - Follow-up Action of NCR-1

Success Failure
CRR (Cash Reserve Ratio) Merger and Acquisition
SLR(Statutory Liquidity Ratio) Directed Credit Program
CAR (Capital Adequacy Ratio),
Re- Capitalization
NPA (Non-Performing Assets)
High Competition
Banking Technology
Good Banking

6
 Instruments of Monetary Control

• Bank Rate
• Cash Reserve Ratio (CRR)
• Statutory Liquidity Ratio (SLR)
• Open Market Operations (OMO)

7
8
 CAR- Capital Adequacy Ratio
• Technical Name- Capital to Risk Asset Ratio (CRAR), or Capital
Risk Weighted Ratio, or Risk Weighted Assets (RWA).
• The committee recommended that CAR initially @8% for all
the Indian commercial banks and banks having foreign
branches, all are required to maintain CAR @8%.
• In 1988, a new mechanism took place in BASEL (Basel –I,II,III,
it is a place in Switzerland) and it was done by the Bank of
International Settlement (in Switzerland) and all central banks
assembled at one place for safety of banking industry.
• CAR should be fixed at 8% for all banks as a safety net.
• In India this mechanism has been developed by NACHNE in
RBI working paper

9
 Indian Case Study
• NCR-I recommended in India that CRAR initially it was @4% but later it
was compulsory @8% for all the banks (including scheduled
commercial banks, private banks, public sector banks).
• Re- Capitalization: - Success area, Re-Capitalization means filling up
the capital base (Capital + Reserve) of the bank. Capital base means,
the ratio of paid up capital and reserves to deposits.
• As per NCR, already said CRAR (in March 1996) @8% but Indian
banking industry emerged in a very efficient manner and it achieve 9%
CRAR in 2000-01, but again all the banks increase this ratio up to 11%.
Now, it is 13% some banks achieve the target of 17% such as, Kotak
Mahindra Bank, Development Credit Bank
• On the basis of this ground, we can say that Indian Banking Industry
has shown a very significant record as compared to other countries.
• As per Economic Survey of 2009-2010 Indian Banking Industry avoided
the financial crises of 2008, it was just due to the High CRAR. This
shows the great success and achievement and Transparency in Balance
Sheet.
• NCR-I recommend 4% & 8% by 1996. In Budget 2001, it fixed 9% but
banks achieved 11% more than Budget requirement. Now Kotak
Mahendra Bank 13%, and Development Credit have achieved 17%
10
 NPA (Non- Performing Assets)
1998 2004 Recently (Amt in Cr.)
Amount 60,000 54,000 54,000
% 17% 3% 2%
No bank in India shows zero NPA, % is low but absolute amount is high.
ICICI- 8%, Axis Bank- 5%, One public sector bank (IOB) - 4%

To solve this problem NCR suggested Asset Re-construction Funds so that bad
and doubtful assets could be transferred to these funds, but Government of
India (GOI) did not accept this idea and established Debt Recovery Tribunal at
five different places of India such as, Delhi, Chennai, Calcutta, Jaipur and
Ahmadabad. But very soon a dismal picture emerged 1/3rd recovery was due to
DRT and 2/3rd was due to write off in the balance sheet against the Government
loans.

11
 Dismal Picture of NPA
• As per one statement of Indian Bank Association in 1997, 11700
cases were reported to DRT’s involving Rs.9000 Cr. but the result
was dismal only 1050 cases were solved and only Rs. 187 Cr. was
recovered. In India it is very difficult to recover money.(Example if
GOI wants to recover one rupee from the individual, it will have to
spend Rs. 10)
• Middle class of India- highest consumable class in the world &
highest richest class in the World.
• In India, NPA problem is the biggest problem in Banking Industry
but it is satisfactory result that some of banks in India have very low
NPA such as SBI, PNB etc. PNB has rank 1st in low NPA.
• However, NPA problem can not be solved because it is a case of
asymmetric information between banks and customer. Private
sector banks also show high NPA.

12
 Asia’s Financial Soundness Indicators
Capital Ratio NPLs
Country
2000 2011 2000 2011
PRC* 13.5 12.7 29.8 1.0
Hong Kong, China 17.8 15.8 6.1 0.7
India 11.11 13.1 12.7 2.7
Indonesia 21.6 16.1 18.8 2.1
Japan 12.2 14.2 6.1 2.1
Republic of Korea 10.5 14.0 6.6 0.5
Malaysia 12.5 17.7 15.4 2.7
Philippines 16.2 17.1 16.6 2.7
Singapore 19.6 16.0 3.4 2.6
Taipei, China* 11.9 11.9 4.4 0.4
Thailand 11.9 12.3 17.7 4.1
Viet Nam N/A 11.6 N/A 1.6

Notes: Capital ratio means the Ratio of Bank Regulatory Capital to Risk-Weighted Assets, % NPL= Ratio of non performing loans to weighed
risk assets, %. *PRCs NPL ratio, Taipei, China’s Ratio and NPL Ratio for 2000 and 2011 data.
Source: Financial Soundness Indicators, IMF, available at http://fsi.imf.org/, accessed 13.02.2013; Bankscope (for Taipei, China, Thailand
13
(2010-2011), and Viet Nam (2007-201).
 Competition
• Public sector banks monopoly has been dismantled
• Public sector banks had complete monopoly before
1991 but under the new economic policy, due to free
entry of foreign and private banks in the Indian banking
industry competition has increased.
Foreign Banks- 400 branches
Private Banks- 6500 branches
Hence, the market size has been shared by foreign and
private banks in terms of deposit and credit and customer
facility. Hence effective competition has taken place which
is a healthy sign for banking industry.

14
 Foreign Banks & Loan- Push Theory
When banks chasing you;
• Pushing you for taking loan
• keep in dept trap
• Liquidity effect.
In 1973, oil prices increased from $4 per barrel to $27 per barrel
after, 3 or 4 years prices were increased to $33 per barrel and with
this OPEC Countries (Saudi Arabia, Qwait, UAE) collected petro
dollar very high but at the same time they did not had any banking
system, hence they put the entire money with European Banks and
because of that European Banks use loan push theory to remove
the excess liquidity of fund/ availability of funds. Mexico, Brazil and
Argentina they took the entire amount as short term loan but after
some time they denied to repaying the amount and the entire
world fall in to debt crisis and because of that 1980’s decade was
called as lost decade

15
 Development Financial Institutions
(DFI’s) and industrial finance
• DFI’s lend money only for long term and for
development purpose. They are:-
• Industrial Finance Corporation (IFC).
• State Financial corporations (SFCs).
• Industrial Development Bank of India (IDBI).
• Industrial Credit and Investment Corporation
of India (ICICI).

16
 NCR-I, 1991 Pointed the following
defects in all these institutions
• Ownership was defective.
• Project appraisal was not effective and no
transparency.
• They were asked by the Government to nurse the sick
industries in India. As per the report of 1991, India was
the first country having largest number of sick
industries. As per the Goswami Report, India provides
shelter to sick industries and having largest number of
sick industries.
• They always acted as a sister concern of the
Government.
• Consumers had no choice in taking loans.

17
Recommendations given by NCR-I for
Improvement
• Ownership should be broad based - Include some other
institutions also.
• They should be de-linked with the Government.
• They should be made autonomous in term of finance,
administration and management.
• Chairman of these institutions should be appointed on
professional ground for maximum up to 5 years.
• Project appraisal should be done by efficient managers
and technical experts.
• Accountability should be laid down.
• Low or No gap between ex- ante and ex-post return.

18
 Conversion during the Last 40 Years

• IFC - IFC converted into a public Ltd concern and IFC

has asked to go in the market to collect funds for its
operations
• IDBI Act 1964 - Changed in 1994 asked to float its own
bonds and also fixed own interest rate. It also starts
functioning in NSE, Mutual Fund, SIDBI
• ICICI- Converted into a bank and 1st universal bank of
India and it also started functions in mutual fund and
SCICI has emerged later (Shipping Credit and
Investment Company of India)
• UTI - Converted into a bank.
DFI Universal Bank Commercial Bank

19
 Project Cycle
Market

Social Economic

Financial Commercial

For Example:
Ex-Ante Return =20% Technical
Ex-Post Return = 5%
Net Loss = 15%
20
 Time and Cost Overruns in Indian
Projects
For comparisons to be meaningful it is important to
consider delays and cost overruns in percentage rather
than in absolute terms. Using the above definitions,
percentage time and cost overruns have been calculated
for each project. The magnitudes of cost overruns seem to
have come down over the years. However, the decline in
delays is less obvious. Moreover, cost overruns are still too
frequent and unacceptably large. According to latest MOSPI
report, as on 31st March 2009, more than one-third of the
ongoing projects are experiencing cost overruns.
Collectively, cost overruns for these projects are huge at Rs.
73,791.51 crore, which is 54.75% of their original cost and
13.45% of the cost of all projects.

21
 Summary Statistics : Delay and Cost
Overruns in Infrastructure Projects
Sector No. of Projects % of projects with Positive % of projects with
Cost Overrun Positive Time Overrun

Atomic energy 12 25.00 91.67

Coal 95 22.11 61.05

Fertilizer 16 25.00 62.50

Health and Family 2 100.00 100.00

welfare
Petroleum 123 20.33 79.67

Power 107 46.73 60.75

Railways 122 82.79 98.36
Road & Highways 157 54.14 85.35
Steel 43 18.60 81.40
Telecommunication 69 15.94 91.30
Urban Development 24 41.67 100.00
22
Source: Ram Singh, Delhi School of Economics, D.U, RBI report
 Autonomy of the RBI
• The issue of the autonomy of the RBI has received
much attention in recent years. The agreements signed
on September, 9 , 1994 and March, 6, 1997 between
the GOI and the RBI with regards to phasing out of the
ad-hoc the Treasury Bills and the introduction of the
system of WAYS AND MEANS ADVANCES (WMA) by the
RBI to the GOI, have been projected as indicators of the
RBI having become more independent now.
• The system of WMA in the place of that issuing ad-hoc
Treasury Bills has been regarded as a significant
development in the directions of a desirable and better
fiscal policy-monetary policy co-ordination.

23
• The accord between the RBI and the government reached in 1994
eliminated the automatic monetization of the Central Government
fiscal deficits through the issue of ad-hoc TBS by April 1997.
• Under WMA, the RBI gives ways and means advances to the central
government in mutually agreed amounts at market-related interest
rates.
• Under this system, since the RBI has the rights to trigger floatation’s
of fresh government loans as and when the actual utilization of
WMA process 75 % of the limit, the WMA does not acquire the
cumulative character of the ad-hoc.
• Thus, the RBI now can accommodate the government at its
discretion, and can impose market discipline of fiscal profligacy.
• However, the new system notwithstanding, the fiscal dominance
has continued to persist as reflected in the growing volume of
government borrowing.

24
 RBI BALANCE SHEET CHANGED
Reserve Flow Equation
Y=C+I+G Absorption (A)
• Therefore, Y = A. If A > Y, In this case Economic crises occur
in the country and theory of economic crises sets in. In this
situation consumption (C), investment (I) and government
expenditure (G) must be reduced.
So that, Y = A
• In case of fiscal deficit, income is less than expenditure. In
case of deficit financing, high powered money increased
and simultaneously money supply increased which lead
increase in the general price level and then increase in
inflation.
High Powered Money Money Supply General Price Level
Inflation

25
 Ms = mxH
H=D+R
• D = Domestic Assets (or Credits)
• R = International Reserve
H = NDA + NFA
• NDA = Net Domestic Assets
• NFA = Net Foreign Assets
• Example: Ms = mxH
100=1x100
200=1x200
300=1x300
1. It D is increasing and R is decreasing
2. After opening up the economy in 1991
H = D(Decreasing ) + R (Increasing)

26
 RBI Balance Sheet Changed

100
NDA NFA (International Reserves)

NDA
NFA
0
1991 2012

27
 The Offset Coefficient
Country 2000-07 2000-02 2003-04 2005-07
India* -0.79 -0.72 -1.00 -0.72
Indonesia -0.82 -0.85 -0.79 -0.77
Korea -1.00 -0.93 -1.02 -1.06
Philippines -0.85 -0.72 -0.92 -1.15
Thailand -0.87 -0.91 -0.69 -0.90
Source: IMF staff calculations.

1 The sterilization coefficient is the coefficient from a regression on the contribution

of net domestic assets to reserve money growth on the contribution of net foreign
assets to reserve money growth. Net domestic assets in the regression are defined
as reserve money minus net foreign assets.
2 An asterisk denotes that the null hypothesis of full sterilization (a coefficient equal
to or smaller than -1) cannot be rejected at the 95 percent confidence level
* At present Indian Sterilization Coefficient is about 90%
28
 Money Market Reforms
Government Borrowing made market oriented

• TR Bill of 91 days
• 182 days TR Bill
• 364 Days TR Bill (1 Year TR Bill)
• Dated Government Securities
• 14 days Intermediate TR Bills
• 14 days TR bill
• Certificates of Deposit
• Commercial Papers
• LIQUIDITY ADJUSTMENT FACILITY-Liquidity adjustment facility (LAF)
was introduced by RBI during June, 2000 in phases, to ensure
smooth transition and keeping pace with technological
upgradation. The funds under LAF are used by the banks for their
day to day mismatches in liquidity.

29
Liquidity Adjustment facility (LAF)
Money market or Liquidity Market

High level of liquidity Low level of liquidity

Rate of interest is low Rate of interest if high

30
Interest Rate Reforms: Theory of Repression-
By M.Pal

31
McKinnon’s Complementarity

(Md )  1 Y 
  f , ,d   
P  Y P 
f1/Y > 0. fY/P > 0, fd- ∏ > 0
(M d )
 The real money Stock
P

d -  = The real deposit rate of interest

1
Y = the ratio of investment to output
d = the nominal interest rate on deposits
π = the expected future rate of inflation
P = The price level

32
 TRANSMISSION PROCESS

I Y
d-π Md
Y P
P

Real
Investment Real Income

Real Deposit
Rate Real
Money Balances
or Financial Deepening

33
 Nominal Deposite Rate Inflation
14 30

12 25

20
10

15
8
10

6
5

4 0
75 80 85 90 95 00 05 10
75 80 85 90 95 00 05 10
NDR
INF

Real Interest Rate

30

20

10

-10

-20
75 80 85 90 95 00 05 10

RR
34
 Financial Deepening
90 T rend of T D/ M3, M3/G DP and M1/ G DP in India
100
80

70 80

60
60
50
40
40

30 20

20
75 80 85 90 95 00 05 10 0
75 80 85 90 95 00 05 10
M3
TD M3 M1

Private Saving Openness

10 50

8 40

6
30

4
20

2
10

0
75 80 85 90 95 00 05 10 0
75 80 85 90 95 00 05 10
PVT SAVING
35
OPENNESS
 Growth Rate Pcy
12 10

8
5

4
0
0

-5
-4

-8 -10
75 80 85 90 95 00 05 10 75 80 85 90 95 00 05 10

GR PCY

36
 Logic of putting high real r (or positive real r)

• Specially 1991 onward we find high jump in real r in

India. We find there is a positive relationship between
real r and economic growth because positive real r
promotes financial deepening in the country.
• Mahendra Pal’s study on the relationship between
Finance and Growth during the period 1971-2012 with
the help of Co-integration methodology shows that 1%
rise in M3/GDP (Finance) causes 0.55% growth rise in
India. Hence Govt. of India should continue its existing
policy of financial liberalization & Globalization.

37
 Sequencing of Reforms

Trade Liberalization = X+M/GDP

Fiscal After that:
Deficit Exchange Rate
Management
Financial Liberalization = M3/GDP

Current Account Convertibility

Capital Account Convertibility

India has a success story in sequencing of reforms. India has trade

liberalization more than USA and financial liberalization is very impressive. 38
 Comparative Analysis of All Types of
Foreign Capital
Till 1999, Y = f (ODA)
After 1991, Y = f (ODA, FDI, FII, Remittances, etc.)
AID = f ( Poverty + low EOC & SOC + Good Diplomacy + Corruption)
Debt Creating Capital Non-Debt Creating Capital
1)Foreign Aid/ Official Development 1)Foreign Direct Investment (Positive
Assistant/ External Assistance (Grant impact on product market)
Element=25%)
2)Commercial borrowings ( No Grant 2)Portfolio Investment
Element) FII (Impact on financial market, give
3)NRI Money ( No Grant Element) general confidence, boost industrial
production, give confidence to industry)
4)Loan from IBRD (Grant Element=6%) ADR
5) IDA (Grant Element=80%) GDR
IDR

India has acquired almost all types of debt creating and non-debt creating capital.

39
 Need for Foreign Capital
Need for Foreign Capital
Debt Capital Non-Debt Capital
ODA FDI
IBRD For SOC, EOC FII (Give General Confidence
Boost Industrial Production)

IDA
NRI
Commercial Borrowing
India needs all types of capital because each one has its own merits and demerits. Every
market is a perfect market and substitution does not take place. India still need all types of
foreign capital because India being a poor country in ECO & SOC and having high level of
poverty. India still needs ODA, IBRD, and IDA money. The recent performance is 4 to 8 billion
dollar is utilized in term of ECO & SOC. In 2010 world bank give a 9 billion dollar to India. We
40
can say that India is still using huge amount of ODA.
• Today India is a favorable destination of capital inflow, all types of capital
inflows are came in India. India still needs each type of foreign capital
because all have their merits and demerits.
• India ranked 2nd in attracting FDI & it has impact on product market (China
ranked 1st)
• FII/FDI cannot be used for EOC & SOC but it is needed for general
confidence and boost industrial production.
• International development Association (IDA) - It get money from rich
countries, and it does not flow its own money.
• IBRD- It has only source of money by selling bonds and its bonds are AAA
rating bonds, highest quality of bonds in the world.
• Mostly European churches purchase these bonds.
• Rich countries also give money to IBRD (its get money at 7% and give at
subsidize rate e.i, 6%).
• Foreign capital helps in reducing poverty.

41
 Global Governance- Group-20
1. Universal Membership Increased
1945 2012
IMF 34/35 188
IBRD 34 188
IDA 16 (1960) 188
2. Weighted Voting-Power changed
USA declined from 34% to 17%
Industrialized Countries-57%
Emerging Countries, increased to 19%
India and China’s voting power also increased
3. World Bank President- South Korea, IMF- Managing Director: Still Traditional.
4. IMF facilities have increased but conditionality has become tough.
5. A question of New Bretton Woods-is in?
6. BRIC demand for New Bank-Not based on economic facts but only political,
7. Purchasing Power Parity.

42
 IMF facilities have increased but
conditionality has become tough
• Before 1985, World Bank and IMF were two separate institutions and their
functions were totally different.

Before 1985, there was Two Conditionality

IMF World Bank

Conditionality
Conditionality
Project Base

Macro Economic Conditionality

•Low Fiscal Deficit
•Low DRS
•Low External Debt Ratio
funds should be utilized for the
actual purpose and no diversion
funds is allowed and removal of
43
economic distortion
 Now, these two conditionality has been merged together as
Cross Conditionality

“There is someone who can look after crisis- Joseph E. Stiglitz”

IMF
World Bank

Cross-Conditionality Done in 1985

India is case of Cross-Conditionality in 1991: as
success story.

44
 A question of New Bretton Woods-is in?

• It is better to improve the existing institutions.

• IMF has evolved a new system of stress testing so that
the country could be warned in advance to avoid the
crisis.
• Stress test provides an estimate of the changes in the
value of portfolio due to certain changes in the risk
factor such as interest rate and exchange rate.
• It is a test which tells us about the sensitivity of
balance sheet and balance sheet is equal to the assets
and liabilities and to what extent it is sensitive towards
interest rate and exchange rate, these are called as
external shocks.

45
 Purchasing Power Parity (PPP) in
quota calculation
• If a PPP is taken into account.
• GDP PPP is used in quota calculation formula.
• Then emerging countries will anonymously be
benefited.
• Top ten will include- U.S, U.K, Japan, Germany,
France, Italy, Russia, India, China and Brazil.
• But again it shows lopsided development.

46
 GDP comparison
Projections

Country 2011-12 2012-13 2014 2018

India 4.4 6.5 6.2 7.0
China 7.5 8.5 8.2 8.5
Philippines 6.6 6.0 5.5 5.5
Pakistan 3.7 3.5 3.3 3.0
Nepal 4.6 3.0 4.0 4.1
Japan 1.6 0.7
Germany 0.9 0.6
France 0.2 0.3
Brazil 1.5 4.0
U.S 2.2 2.0
U.K -0.1 -0.9
Italy -2.2 -0.1
47
Spain -1.3 -1.4
 Future Area for Research in
Management
• Flow of Fund Technique.
• Econometric Application in Management.
• Term Structure Theories and understanding of
Yield curve.
• Relationship between Financial Sector and
Real Sector (Priority designed by T.N Srinavisa
and C. Rangarajan and Mahendra Pal in
INDIA).
• Foreign Capital in a disaggregated model.
48
 Thank You

49
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