Changing face of India’s Financial System – Embarking on new growth paths
by: Cashonova - The Finance & Investments Club at IIFT
With the double dip recession in sight and the worst of the first decade of the 21st Century, we have seen the resilience and robustness of the Indian Financial System. We have also seen a spree of activities at an unprecedented pace in India. Policy makers are thinking of reforms day and night and many of these are getting implemented to change the face of India. Though India has gracefully steered clear of the global slowdown, the task ahead is not simple. India has to keep working for maintaining the growth rate of 9% or even taking it to double digits.
In an effort to achieve all this, let us revisit the effect of the Inclusive Growth Policy of the government and the proposal of the Reserve Bank of India to come up with new banks. And that is not all; India is changing the pattern of global investments in the world. In the darkness of the Financial Crisis, let us revisit the reforms and policies which are changing the face of India under the Global Financial System.
Inclusive Growth: A Utopian dream or a reality?
“Towards faster and more inclusive growth “– the theme of the Eleventh Five Year Plan clearly depicts the will and intention of the government to find a sustainable balance between growth and inclusion. The parliamentary election campaign of 2004, with its ‘India Shining’ vs. ‘Aam Aadmi’ confrontation, highlighted an apparently widespread perception that the benefits of economic growth were simply passing too many people by. Inclusive growth by its very definition implies an equitable allocation of resources with benefits accruing to every section of society.
Therefore, a key element of the strategy for inclusive growth must be “to provide the majority of our people access to basic facilities such as health, education, clean drinking water etc, and that governments at different levels have to ensure the provision of these services”. The thrust of the government is that the economic benefits accrued as a result of globalization should be inclusive and that the issues of employment generation, poverty reduction and human development must be addressed.
The question to be asked is, “Is possible to include the most disadvantaged in the production and distribution of products and services?” And the answer to this is that it is indeed possible, and that innovation is the way. At the bottom of the pyramid access to real opportunities to create wealth has the potential to transform lives in an inclusive way. Sectors such as healthcare, energy, clean water, education, and housing, present opportunities which are ripe for innovation.
The acknowledgement by the government of the two major sectors leading to inclusive growth – Agriculture and Infrastructure, is the first major step taken in this regard. There is a huge problem of productivity gap in these sectors even at the existing levels of technology. In simple words if we can get farmers to adopt better cultivation practices, more rational use of inputs and so on, we can get a yield increase. However, it is not as effortless as it seems. It majorly involves the issues of knowledge transmission and system performance, absence of any one of them would not give us the desired result. One can tell the farmers to move to an optimal way of seeding, but there must be trusted certified seeds available. On the other hand, knowledge transmission is also a critical issue with the farmers being rigid and orthodox in their approach.
In addition to agriculture and infrastructure, the two other critical areas we need to focus on are education and health care. The other important aspect of inclusiveness is that when the growth process takes off, the dispersion of skills across the population is not uniform. That is why it is essential to revamp the educational system — and doing that in a way which improves access is very important.
All these areas require a lot of participatory work by the community. And in a vibrant democracy such as ours it is important that the affluent sections of society realize their wider social responsibility.
As the PM said in his recent CII address, “For India to be a global player it is essential to understand the need to make our growth process more inclusive; to save more and waste less; to care for those who are less privileged and less well off; to be role models of probity, moderation and charity. This realization has made us wiser today of the consequences of our actions and thus collective movement towards this ‘seeming utopia’ is well under way. And as a nation still in the process of developing itself, it would perhaps be very premature to let go of the dream of inclusive growth but with some hard realities thrown in too.”
Banking in India undergoing metamorphosis
India was relatively unaffected by the financial crisis thanks to the Reserve Bank of India (RBI)! The stringent rules laid down by the RBI brought us safely onto the other side of the Financial Turmoil. The Indian Central Bank is vested with powers to issue guidelines on any issue relating to the functioning of banks. Various prudent guidelines of RBI include liquidity maintenance, capital adequacy, income recognition, asset classification and provisioning, connected lending and prudential norms on large exposures. The Banking Regulation Act vests powers in the RBI to ensure compliance with its provisions. And thus all these guidelines and the Banking Regulation Act together have resulted in a robust Banking Sector in India.
The need of the hour for the Indian Banking sector is to increase penetration of formal banking services in unbanked rural areas. As per statistics, among India’s population of 1.2 billion, 50% are yet to be covered under formal banking. This justifies the requirement to step up the opening of branches in rural areas so as to meet the objectives of increasing banking penetration and financial inclusion rapidly and meet the targets set out for providing banking services in villages with population over 2,000. For this purpose Banks are advised to prepare their Annual Branch Expansion Plan where they should allocate at least 25 percent of the total number of branches proposed to be opened during the year in the unbanked rural areas. This will benefit a huge number of rural populations if appropriately applied but more such initiatives are needed.
According to the Wall Street Journal, Reserve bank of India is likely to issue four new banking licenses in order to include a large chunk of the country’s population in the formal banking system. One of the main reasons for rapid transformation of banking sector is Financial Inclusion. Advent of new players in the market will foster competition and thereby reduce cost while improving service quality. According to the regulations set by India’s Central Bank it would be planning to impose a condition which will ensure only those corporates with sound financial backing can apply for new banking licenses. The track record of the promoters will be ascertained from other banks, supervisory/regulatory departments as well as from SEBI, the Capital Market Regulator. Financial strength of the promoters and long-term viability are the important factors which will affect the decision of the RBI.
In addition to this, Non-Banking Financial Companies are also in talks with the RBI for their conversion into banks. If NBFCs are allowed to be converted to banks then it would eliminate the arbitrage opportunities available to them due to lighter regulations. Regulations on NBFCs are not soft either. No NBFC can carry out its business without obtaining a certificate of registration from the RBI. Also, maintenance of liquid assets at a specified percentage of public deposits is compulsory. But in aggregate these regulations are less strict than those for banks and thus it makes arbitrage opportunities possible. Another way we can approach this conversion is that only standalone NBFCs are considered for conversion to banks and not the ones which are associated with any corporate. In the real world however, NBFCs with corporate backing like Siemens Financial Services Private Limited, Mahindra and Mahindra Financial Services Limited have strong financial backing of their parent companies for conversion to banks.
With new branches in the rural sector, new licenses in banking and with the possible conversion of NBFCs to banks, the Reserve Bank of India is well on track in making the banking industry more dynamic and to increase the reach of financial services.
Changing patterns of investments – Domestic and Foreign
The economic crisis of 1991 led to the opening up of the Indian economy and the impact it created is very visible from the fact that India grew from a small $132 million economy in 1991-92 to $5.3 billion in 1995-96. However, the Mexican Crisis (1996) and South East Asian Crisis (1998) were so intense that the respective economies were pushed back by twenty five years, which reiterated the fact that too much dependence on foreign capital could be harmful. At that time, India adopted a cautious approach by not allowing foreign investments in various sectors.
In the pre-reform period, Foreign Direct Investment (FDI) accounted for only 0.3% of GDP, while as of 2008-09 it stood at 3.55% of GDP .The composition of FDI has also undergone a tremendous shift from FDI in primary and manufacturing sectors to that in the services sector. The pattern of FDI within these sectors has also changed drastically. For example, there has been a shift from FDI in Chemical Industry to FDI in FMCG, even though all the areas have improved in nominal terms. There has been increasing export orientation of FDI ever since 1991 which can be primarily attributed to the IT services and general increase in share of exports.
Similarly, after the entry of Foreign Institutional Investors (FIIs) the market depth has increased tremendously. Presently, a lot of debate is going on about whether or not to open up FDI in multi brand retail. FDI in retail would lead to improvement in supply and the operational side, thus further strengthening the retail sector by building a strong backend infrastructure. The backward integration by multi brand would lead to better prices for the farmers, and their technology would help us enhance food security by reducing wastage.
From the patterns and trends in FDI inflows of India, it can be seen that while the reforms of 1991 have led to impressive growth, they’re still minor in comparison to the country’s potential. In fact, looking at the graph of the Indian growth story, it is evidently visible that the economy needs to be opened up even more for increasing the growth rate. Even though the projected growth rate for 2011-12 was 9%, the first quarter showed a poor growth of 7.8%. Furthermore, it is highly unlikely that the projected growth rate would be achieved due to other pertinent structural and circumstantial issues prevalent in the Indian economy.
By: – Priya Juneja, Priya Singh, Archie Gangrade