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Reforming India’s financial system

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Elusive savings
Why is the stock of financial assets so small? Not because Indians save too little: although the country’s gross national savings rate is half of China’s, it isn’t bad by international standards (Exhibit 2). Furthermore, chronic government budget deficits depress the savings rate. Despite the fact that Indians should save more, the main challenge is to capture more of the existing savings.

Instead of putting money into
financial assets, Indian households invest more than half of their
savings in physical ones such as land, houses, cattle, and gold
(Exhibit 3, on the next page). In rural areas, the proportion is even

higher. In fact, India’s people—mistrustful of banks—are the world’s largest consumers of gold. They possess $200 billion of it, equal to nearly half of the country’s bank deposits, and last year bought $10 billion worth, nearly twice the amount of the foreign direct investment India received. Households could earn higher returns by investing in financial assets, and the country would be better off if savings were pooled to finance more productive investments.

��������than its Chinese counterpart at allocating capital, as demonstrated by

�����������������India’s improving level of nonperforming loans and the amount of capital

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3 India: Investment Climate Assessment 2004, World Bank.

Indian policy makers, in contrast to China’s, remain ambivalent about foreign direct investment; in 2004 India received just $5.3 billion of it.

Even doubling this figure—which

5 Amadeo M. Di Lodovico, William W. Lewis, Vincent Palmade, and Shirish Sankhe, “India—From emerging to surging,” The McKinsey Quarterly, 2001 special edition: Emerging markets, pp. 28–50 (www.mckinseyquarterly.com/links/18354).

replacing myriad state and local imposts is an important first
step because it greatly simplifies collection. But policy makers
must crack down on the informal

economy of businesses—estimated at more than one-quarter of India’s economy—that flout tax and regulatory requirements.8 Doing so will not only raise tax revenues but also level the playing field for more productive and law-abiding companies.

8 Diana Farrell, “The hidden dangers of the informal economy,” The McKinsey Quarterly, 2004 Number 3, pp. 26–37 (www.mckinseyquarterly.com/links/18355).

9 David Moore, “Financial services for everyone,” The McKinsey Quarterly, 2000 Number 1, pp. 124–31 (www.mckinseyquarterly.com/links/18356).

��������of capital (Exhibit 4). Intermediation costs remain high mainly because

�����������������state-owned banks, whose productivity is 10 percent of US levels, control

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10 Anand Giridharadas, “India hopes to wean its citizens from gold,” International Herald Tribune, March 16, 2005.

Perhaps the most politically contentious area is the role of foreign banks.

Today they are not permitted to hold more than a 5 percent stake in any Indian bank, except when the central bank identifies weak private-sector institutions, which foreign banks can acquire outright. Moreover, their organic growth is constrained by restrictions on the opening of new branches. Those who defend these restrictions argue, with some merit, that state-owned banks need time not only to improve their operations before they face foreign competition but also to recover from the limitations imposed by directed lending and strict labor laws. But foreign banks bring credit-assessment and risk-management skills, as well as new technology and capital, and intensify competition. MGI research shows that foreign direct investment has uniformly positive effects on local economies.11 The current plan not to open the banking sector to foreign direct investment until 2009 will substantially delay these benefits at a time when India’s economy needs more financial capital to grow. As 2009 approaches, policy makers may find new reasons to postpone liberalization.

For India to continue on its current trajectory, reforming the financial system must become a priority. Although policy makers fear that reform will cost jobs, the opposite is true. Today India’s banking sector generates 2.5 percent of GDP and employs 900,000 people. With full reform, it could generate up to 7.5 percent of GDP and employ 1,500,000 people, as well as boost investment and growth throughout the economy. Q

12 “Loosening up,” Economist, February 3, 2005.