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Home > Blogs > Anthony Harrington > The Indian financial sector - pity about the State's thumb on the scales

The Indian financial sector - pity about the State's thumb on the scales

The Indian financial sector Anthony Harrington

The Indian financial sector did rather better through the 2008 global financial crisis than the financial sectors in many western economies. However, as we move into the third month of 2013 all is not entirely well with the sector. As a recent IMF report (January 2013) on the Indian Financial Sector makes clear, there is just too much state involvement in the sector for the IMF or any dispassionate observer to be entirely at ease.

Not only does the government own large financial institutions outright, it uses them for captive government financing and directs credit towards its priority sectors, a purely political rather than a commercial rationale. It also maintains exchange controls, restricting the availability of foreign capital. All of this militates against capital being used "wisely" by banks to secure economic growth for the country. Of course, we saw many an instance in the run up to the 2008 crash, of banks in advanced markets, under no pressure from the state, doing anything except allocate capital "wisely".

When  a government has a stranglehold on its banks, it is very tempting for it to argue that requiring banks to hold large amounts of government bonds is just a way of ensuring that the banks are properly capitalized with plenty of reserves. Before the European sovereign debt crisis that argument might have held some weight. However, after it became clear that default was a possibility no government bond looks entirely safe any more, and the idea that any state should force its banks to load up on state debt is now frowned upon - though paradoxically, the IMF also reckons that one of the reasons why India's financial system is in reasonable shape to withstand shocks to the system is precisely because of the amount of government paper that banks are holding - along with quite high cash reserves.

The IMF is also unhappy about the multiple roles of the Reserve Bank of India (RBI), with the Bank's officers nominated as directors on the Boards of public banks in India, while at the same time the RBI has a major role as the prudential supervisor of those banks. A far better state of affairs would be for directors on the boards of these banks to be well qualified and independent, and to come from anywhere by the RBI. The RBI also acts as the Government's debt manager, monetary authority and bank regulator, which brings us back to the temptation to push banks in the direction of holding far more government paper than is good for them.

In fact, the IMF's strictures probably err way too much on the mild side. A more potent way of putting things would be that India's socialist legacy is getting in the way of its development big time. For example, in the annual ranking provided by the Index of Economic Freedom, a joint effort by the Heritage Foundation and the Wall Street Journal, India rates only 124th, way behind Malta (ranked 57th) and even Tsonga (ranked 118th). To score more highly, India will need to implement much greater transparency in the government decision making process and free up investment by doing something to alleviate exchange controls. It also needs to dial way down on the bureaucratic hurdles confronting anyone wanting to start a small enterprise. India, unsurprisingly, scores badly on the World Bank's ease of doing business index. Less state involvement and more economic freedom are things that Indian politicians should be striving for, the IMF hints.

Further reading on India and Asia

Tags: exchange controls , IMF , India , Indian Business , Indian economy , Indian investments , Reserve Bank of India , World Bank
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