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[LosingNow]

Asia Insight
By Diana Farrell


Unlocking India's Potential
Reform of the financial system would mean better use of capital and the elevation of millions from poverty, according to McKinsey Global Institute


With stock values in Bombay tripling since 2003, private banks forging ahead, and the Indian Reserve Bank maintaining its prudent stance on macroeconomic management, India has a reputation for robust financial institutions.

These are star turns, however, in a financial system that elsewhere remains locked firmly in the government's grip. The McKinsey Global Institute (MGI ) calculates that a program of liberal reforms could release as much as $48 billion of capital a year for investment. Coupled with broader reforms that promote job creation, financial sector liberalization could raise real GDP growth to 9.4%, just shy of the government's 10% target, and well above the 7% levels seen in recent years. This would increase household incomes 30% above current projections by 2014, lifting millions more out of poverty.

To realize gains on this scale, though, the government must surrender control of the financial system. That would allow banks to draw in more savings, allocate them to more productive investments, and do both jobs more efficiently. A raft of regulations governing banks, financial intermediaries, and bond markets now serve to channel most savings directly to the government or its priority investments. These rules are partly motivated by admirable welfare aims such as maintaining rural incomes. But they leave the most productive areas of India's economy short of capital, holding back growth on which all incomes ultimately depend.

INEFFICIENT. The financial system could attract a lot more capital than it does now. Indian households currently save 28% of their disposable income, high by international standards. But they invest only half their savings in financial assets. The rest goes to housing, and to machinery and equipment for India's 44 million tiny enterprises. Last year, Indian families also bought more than $10 billion of gold, making them the world's largest gold consumers. A measure of how much capital escapes the formal system is India's low financial depth. India's bank deposits, equities, and bonds represent just 160% of GDP, compared with 220% in China and 420% in Japan.

Household businesses have very low productivity, and returns on gold have been negative in recent years. Investing in both is rational for rural households only because few can find more attractive investment opportunities. They would be better off if the financial system could pool their savings to fund larger-scale enterprises that might yield higher returns.

Here too there is ample room for improvement. At present, India's dynamic private corporations receive less than a third of total credit from the financial system, while the rest goes to state-owned enterprises, agriculture, and the "unorganized" sector (including very small businesses). But state-owned enterprises are only half as productive as the private sector, while productivity in agriculture and the unorganized sector is 90% lower.

MGI estimates that if the financial system could attract just half of the savings that households now invest elsewhere, it would add $7 billion each year to India's GDP, while reforms that direct more capital to the most dynamic areas of the economy could generate a further $19 billion of output a year.

RESTRICTIVE REGULATIONS. Why does the financial system now channel so much funding to low-performing investments? In large part it's because the government says it must. Regulations require banks to hold 25% of their assets in government bonds. Government policy also requires banks to direct 36% of their loans to agriculture, household businesses, and a dozen or so other priority sectors. But directed loans have higher default rates and cost more to administer. As a result, India's banks restrict their total lending to just 60% of deposits, one of the lowest ratios in the world.

Similar policies stifle the development of domestic financial intermediaries. Regulations require that 90% of pension-fund assets and half of life-insurance assets be held in government bonds and related securities. Without these rules, provident funds, mutual funds, and insurance companies would invest much more in corporate bonds and equities, as is the case in other countries.

India's banking sector has a higher level of state ownership than any major country other than China. India's private banks perform well, but they have only 9% market share. And they feel little competitive pressure to get leaner: They can meet the costs of their inefficiency by maintaining a wide margin between lending and deposit rates—which ultimately means higher interest rates for borrowers and lower returns for savers. Reforms that would make operations more efficient in every component of the system could save $22 billion for the economy as a whole.

LET THE MARKET RULE .India's financial institutions should be guided more by market signals and less by government fiat. That means lifting directed lending policies and restrictions on the asset holdings of banks and intermediaries. The state should begin selling its stakes in the state-owned banks and ease regulation of the corporate bond market, provident funds, mutual funds, and insurance companies. A carefully integrated program of reforms would boost competition in India's financial system, raise its efficiency, and improve the way it allocates capital. That will let banks, insurance companies, and mutual funds create more attractive consumer financial products, which would help draw in a larger share of household savings, and make savers better off.

Some of India's policymakers resist such reforms. They fear that abandoning directed lending would raise rural unemployment, arguably the country's biggest social challenge. And losing the captive market for government bonds would increase the state's borrowing costs. But helping productive firms expand is the best way to reduce poverty, increase employment, and boost government revenues for spending on rural welfare. Designing and sequencing the reforms to minimize short-term costs of transition will be essential. But India's population will pay a higher price if the government forgoes financial system reform altogether.

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Diana Farrell is the director of the McKinsey Global Institute, McKinsey & Company's economics think tank

[fineleg]

Thanks for posting this.
IMO, Liberalization is good (done the right way).

[kban1]

http://www.nytimes.com/2006/07/06/opinion/06mishra.html

The Myth of the New India

By PANKAJ MISHRA (Op-Ed Contributor)
Published: July 6, 2006, London

INDIA is a roaring capitalist success story." So says the latest issue of Foreign Affairs; and last week many leading business executives and politicians in India celebrated as Lakshmi Mittal, the fifth richest man in the world, finally succeeded in his hostile takeover of the Luxembourgian steel company Arcelor. India's leading business newspaper, The Economic Times, summed up the general euphoria over the event in its regular feature, "The Global Indian Takeover": "For India, it is a harbinger of things to come — economic superstardom."

This sounds persuasive as long as you don't know that Mr. Mittal, who lives in Britain, announced his first investment in India only last year. He is as much an Indian success story as Sergey Brin, the Russian-born co-founder of Google, is proof of Russia's imminent economic superstardom.

In recent weeks, India seemed an unlikely capitalist success story as communist parties decisively won elections to state legislatures, and the stock market, which had enjoyed record growth in the last two years, fell nearly 20 percent in two weeks, wiping out some $2.4 billion in investor wealth in just four days. This week India's prime minister, Manmohan Singh, made it clear that only a small minority of Indians will enjoy "Western standards of living and high consumption."

There is, however, no denying many Indians their conviction that the 21st century will be the Indian Century just as the 20th was American. The exuberant self-confidence of a tiny Indian elite now increasingly infects the news media and foreign policy establishment in the United States.

Encouraged by a powerful lobby of rich Indian-Americans who seek to expand their political influence within both their home and adopted countries, President Bush recently agreed to assist India's nuclear program, even at the risk of undermining his efforts to check the nuclear ambitions of Iran. As if on cue, special reports and covers hailing the rise of India in Time, Foreign Affairs and The Economist have appeared in the last month.

It was not so long ago that India appeared in the American press as a poor, backward and often violent nation, saddled with an inefficient bureaucracy and, though officially nonaligned, friendly to the Soviet Union. Suddenly the country seems to be not only a "roaring capitalist success story" but also, according to Foreign Affairs, an "emerging strategic partner of the United States." To what extent is this wishful thinking rather than an accurate estimate of India's strengths?

Looking for new friends and partners in a rapidly changing world, the Bush administration clearly hopes that India, a fellow democracy, will be a reliable counterweight against China as well as Iran. But trade and cooperation between India and China is growing; and, though grateful for American generosity on the nuclear issue, India is too dependent on Iran for oil (it is also exploring developing a gas pipeline to Iran) to wholeheartedly support the United States in its efforts to prevent the Islamic Republic from acquiring a nuclear weapon. The world, more interdependent now than during the cold war, may no longer be divided up into strategic blocs and alliances.

Nevertheless, there are much better reasons to expect that India will in fact vindicate the twin American ideals of free markets and democracy that neither Latin America nor post-communist countries — nor, indeed, Iraq — have fulfilled.

Since the early 1990's, when the Indian economy was liberalized, India has emerged as the world leader in information technology and business outsourcing, with an average growth of about 6 percent a year. Growing foreign investment and easy credit have fueled a consumer revolution in urban areas. With their Starbucks-style coffee bars, Blackberry-wielding young professionals, and shopping malls selling luxury brand names, large parts of Indian cities strive to resemble Manhattan.

Indian business tycoons are increasingly trying to control marquee names like Taittinger Champagne and the Carlyle Hotel in New York. "India Everywhere" was the slogan of the Indian business leaders at the World Economic Forum in Davos, Switzerland, this year.

But the increasingly common, business-centric view of India suppresses more facts than it reveals. Recent accounts of the alleged rise of India barely mention the fact that the country's $728 per capita gross domestic product is just slightly higher than that of sub-Saharan Africa and that, as the 2005 United Nations Human Development Report puts it, even if it sustains its current high growth rates, India will not catch up with high-income countries until 2106.]

Nor is India rising very fast on the report's Human Development index, where it ranks 127, just two rungs above Myanmar and more than 70 below Cuba and Mexico. Despite a recent reduction in poverty levels, nearly 380 million Indians still live on less than a dollar a day.

Malnutrition affects half of all children in India, and there is little sign that they are being helped by the country's market reforms, which have focused on creating private wealth rather than expanding access to health care and education. Despite the country's growing economy, 2.5 million Indian children die annually, accounting for one out of every five child deaths worldwide; and facilities for primary education have collapsed in large parts of the country (the official literacy rate of 61 percent includes many who can barely write their names). In the countryside, where 70 percent of India's population lives, the government has reported that about 100,000 farmers committed suicide between 1993 and 2003.

Feeding on the resentment of those left behind by the urban-oriented economic growth, communist insurgencies (unrelated to India's parliamentary communist parties) have erupted in some of the most populous and poorest parts of north and central India. The Indian government no longer effectively controls many of the districts where communists battle landlords and police, imposing a harsh form of justice on a largely hapless rural population.

The potential for conflict — among castes as well as classes — also grows in urban areas, where India's cruel social and economic disparities are as evident as its new prosperity. The main reason for this is that India's economic growth has been largely jobless. Only 1.3 million out of a working population of 400 million are employed in the information technology and business processing industries that make up the so-called new economy.

No labor-intensive manufacturing boom of the kind that powered the economic growth of almost every developed and developing country in the world has yet occurred in India. Unlike China, India still imports more than it exports. This means that as 70 million more people enter the work force in the next five years, most of them without the skills required for the new economy, unemployment and inequality could provoke even more social instability than they have already.

For decades now, India's underprivileged have used elections to register their protests against joblessness, inequality and corruption. In the 2004 general elections, they voted out a central government that claimed that India was "shining," bewildering not only most foreign journalists but also those in India who had predicted an easy victory for the ruling coalition.

Among the politicians whom voters rejected was Chandrababu Naidu, the technocratic chief minister of one of India's poorest states, whose forward-sounding policies, like providing Internet access to villages, prompted Time magazine to declare him "South Asian of The Year" and a "beacon of hope."

But the anti-India insurgency in Kashmir, which has claimed some 80,000 lives in the last decade and a half, and the strength of violent communist militants across India, hint that regular elections may not be enough to contain the frustration and rage of millions of have-nots, or to shield them from the temptations of religious and ideological extremism.

Many serious problems confront India. They are unlikely to be solved as long as the wealthy, both inside and outside the country, choose to believe their own complacent myths.    

Pankaj Mishra is the author of "Temptations of the West: How to Be Modern in India, Pakistan, Tibet and Beyond."

[LosingNow]

I read it ..and I was waiting for you to post it. 

[kban1]