Fizzling financial sector: Three decades of growth story

The achievements and growth of India as a nation altogether in the last three decades are commendable but the performance as a developing economy is not nourishing. Finance led growth model in the country is collapsing, especially in the last one decade. Economic liberalization effected not in the long-term growth but which did create deep financial cracks and inequalities. India has lagged hardly in creation of human capital and urban infrastructure that is altogether the lack of pre-requisites made the growth model a deprived one. In this paper we will have a closer look at the Indian economy and try to answer the question of how India’s growth bubble fizzled out in the last 3 decades with special reference to financial sector in the country?

There was already a warning given by economists like Paul Krugman that the so-called liberalization that India adopted could be a one-time economic boost but they couldn’t generate long term growth. The present downturn is not simply a short-term distraction rather a financial bubble that began inflating nearly for last thirty years finally starts fizzling out. GDP growth rate has slowed sharply from 8% to 5% towards the end of 2019. Any shocks which are uncertain and sudden can affect the pop of a bubble. The various immature reform measures initiated in the economy during the last three to four years made the bubble began to inflate. Rise in interest rate was also one of the usual reasons to pop up the bubble. The initial effect of economic or financial bubbles are positive as in their growth stage as it stimulates the economy and increases spending, borrowing, investments & boost aggregate demand and once they collapse lead to higher risk aversion, lover spending, investments and reduced aggregate demand. The effect of handling the situation through a wrong call of monetary policy change is very risky and dubious and can have serious macroeconomic corollaries. In such a situation, a risk averse central bank may decide not to take any action at all. But in the case of India, it was somewhat contrary. Bernanke, an economist, once said that ’even if asset bubble can be identified, monetary policy is not the appropriate tool for safe popping.’ According to him, a modest increase in short term interest rates cannot arrest asset bubbles. A small hike will slow down the economy but may not have significant impact on the bubble itself or even to an unwarranted recessionary environment. But proper and credible monetary policy does contribute to asset price movements. That is lowering policy rate reduces borrowing cost and encourages more loans for households leading to increased demand for assets which will in turn raise the price resulting in higher consumption and higher investment due to the net wealth effect in the economy and vice versa. Therefore, monetary policy does have spill over effects in asset markets.

Once it comes to the case of India it is true that there won’t be any permanent or satisfactory result through monetary policy. It is because effect of asset prices on the real economy is limited in India as they don’t influence spending decisions significantly and affect lending and borrowing decisions only to some extent. Therefore, monetary policy alone cannot to be used to address asset bubbles. In altogether we can say a more stable financial and economic system imperatively requires policy response from more than just the central bank i.e. from the fiscal authority too.

When it comes to the fiscal initiatives there also lies a list of problems. One of such issue is the political instability. In India, economic crisis was deepening along with increasing political instability till 90’s. Economists today agreed that the policies followed during Rajiv Gandhi’s regime led to the economic crisis of 1991, even though he was having a clear and overwhelming majority in the parliament, was not able to steer the economy away from fiscal mismanagement and crisis. The root cause of the crisis was the huge and growing fiscal imbalances that led to high levels of borrowing by the government from RBI, creating an expansionary impact on money supply leading directly to high inflation. But in this 21st century the problem of political instability is solved whereas it leads the way to the so-called political anarchy as one of the main reasons for the continuing economic downturn.

Now we may have a look at the banking and financial sector of the country and the major reform measures adopted in the last three decades particularly after the new economic policy of 1991. In banking sector, the reduction of holding of share by government in the public sector banks to 51% and granting of licenses to the private sector banks to open new banks with new ruleset were the major imposed measures. Increase in interest rates from 16 to 20% during the time of Structural Adjustment Program (SAP) and witnessed high liquidity in banks along with capital inflows from abroad. Development Finance Institutions (DFI) access to government guaranteed funds from the banking sector and long-term funds from the RBI were cut off, given the fact that the DFI’s were the most important source of long-run funds for new and higher growth projects. By 1996, the NPA has been brought down to 16% for all public sector banks. The financial results of the co-operative banking structure however show some degree of vulnerability though they may not be systematically very large. In short run, the stock market saw a quick rise in its indices. But the rise was powered by a financial scam committed by the stockbroker Harshad Mehta, who borrowed illegally from banks to push stock prices up. After reforms in 1991, financial and real estate sector witnessed the fastest growth. If we look at the average annual FDI inflow from 1998 to 2013 we can see clearly an increasing trend as it was 2.85 billion (1998-2004), 15.44 billion (2004-2009) and 26.19 billion in 2009-2013. But the sector employs only a few people even with outrageously large compensation. There is a growing trend in the share of total gross value added by finance and real estate sector (from 1984-85 to 2018-19). Deregulation of financial sector through India’s SAP and the changes in the financial sector and the macro-economic policies of the central banks, in effect became the shocks to the economy from large cross border financial flows. Financial sector reforms intended to reduce the number of controls over the banks and other financial market participants as well as to strictly regulate the sector as a whole. Financial reforms and integration of external market with domestic money market was one of the major steps. In 1993, Foreign Institutional Investors (FII) were allowed in Indian capital market which provide greater opportunities for Indian companies to gain from foreign countries through Global Depository Receipts (GDR’s) and helped in the inflow of foreign currency in the domestic market. Merging of Forwards Market Commission with SEBI (2015), mandatory assurance of CSR by stock exchanges increased the level of transparency. In addition, there are some proposals to start a Public Debt Management Agency, a sector neutral Financial Redressal Agency, an option for Employees Provident Fund to reduce the over-deduction in the salary of low paid workers etc. During 1990’s, Indian capital market showed its worst performance regarding risk indices and efficiency level. Then there happened radical transformation over just one decade, especially witnessed an unprecedented boom from mid-1995 till 2010. Introduction of above said mechanisms made this sector ahead of many developed countries market system. Along with the secondary market, the market for Initial Public Offerings (IPO’s) has also witnessed a gradual expansion. Government approved 100% FDI for insurance intermediaries and the industry has been expanding at a fast pace despite of the different challenges. Non-Banking Financial Companies (NBFC) sector also faces the crisis of confidence. Any NBFC lending to infrastructure entails a serious asset-liability mismatch. The IL&FS Ltd., an important NBFC has created turmoil in the financial market and the sector as a whole. The main problem was that of illiquidity arising from the use of short-term funds to finance infrastructure and this pushed the company towards bankruptcy. In order to understand the changes much deeper, we will analyze the major saving and capital formation in the economy over the past 7 years from 2011-2018.

From above table 1.1; showing the average savings and capital formation in the financial sector it is clear that from 2011 onwards we are witnessing a continuous decline in both gross and net savings as well as in the gross and net capital formation in the nation. The major reason for this downward trend is the increasing fear of uncertain financial returns along with the crisis of confidence in investments. When we look at the GDP growth rate from 2012- 18 in particular it is clear that there was a marginal increase followed by a significant decline in the rate. It is also witnessed that there were dramatic improvements in twin deficits (current account and fiscal account) and also in the Consumer Price Index (2013-14). BSE Sensex rose from 9% (2013-14) to 30% (2014-15). But towards the end of 2018, there were rapid deterioration in the current and fiscal deficit, decline in savings and investment particularly in financial savings and external shocks of Demonetization and GST altogether brought down the final economic output in the country. Clearly speaking there was a continuous and intensifying growth in the investment sector but the last decade in particular faces an incessant reduction that made the fizzling out of the growth bubble. This can be easily identified from the below table 1.2

The above table shows the escalating drift of total investments, aggregate deposits and even the investment in government securities in the last six years. Even the most depressing fact is that the year 2017- 18 onwards total investments began to come down. It also indicates a decline in both the aggregate deposits and investments in government securities during the same period. The main reason for this is due to the presence of inefficiencies in the entire financial sector. One of the main problems is rising Non-Performing Assets (NPA). The establishment of Securitisation and Reconstruction of Financial Assets & Enforcement of Securities Interest (SARFAESI) in 2002 enabling the setting up of debt recovery tribunals and asset reconstruction companies, development of Credit Information Bureau (CIB) in 2005 were much mature in its introductory stage but later on these agencies stays in the same stage of infancy. India’s GDP saw a temporary plunge in the last two quarters of 2016-17 and the 1st quarter of 2017-18 due to the shocks of demonetization and slips surrounding the initial implementation of GST. New income recognition norms have initiated because, several public sector banks showing large losses on the balance sheets. The issue of recent relapse of asset quality in public sector banks along with the concern of financial inclusion is still a burning problem in the organized financial system of the country. As a result of various reform measures, turnover in the foreign exchange market experienced a quantum jump and now it is also undergoing significant decline that is even though the average daily turnover in Forex market is on increasing phase from 2000 onwards the rate of growth is on diminishing trend. The multiplicity of regulators has always become an issue in the functioning of NBFC’s in the country. Cleaning up bank’s balance sheets, realizing the expected growth and fiscal dividend from the GST and continuing the integration into the global economy are the obstacles need to be recovered. Major challenges India needs to resiliently recover is its main engines of growth, they are private investments and exports. India still lacks the main ingredient of efficient human capital. Regardless of the above-mentioned glitches, there are also some positive signs in the sector which still gives the economy a moral hand to overcome the conundrums ahead. The past experience showed that government intervention helped to raise investment & saving rate and supported the strategy of industrial growth. Credit, insurance and investment especially through introduction of India Post Payments Bank (IPPB) helped the rural penetration of financial services. Moreover, the wealth management segment has witnessed growing High Net Worth Individuals (HNWI) participation. Introduction of Clearing Corporation of India Ltd. (CCIL) as a central counterparty to provide assured clearing and settlement for transactions in the sector especially for G-secs, foreign exchange and derivative markets is an affirmative sign of progress. The end of 2016 started showing positive sign of controlled inflation on one side whereas the financial market was devoid of liquidity and buyer confidence. Indian financial system must be reinforced to withstand asset price tremors with policies to tackle corrective measures. As World Economic Forum pointed out that, to sustain a growth rate higher than the trend growth rate of 7 to 7.5 % and reaching a growth rate of 8% or higher, would require combined effort and backing from all domestic sectors as well as support from the global economy. To achieve this there is a high pressure need to reverse the current trend of slowdown in investments, savings and exports. India needs to have a close eye watch on the changing landscape of open trade, reforms in banking sector, strengthening financial institutions and regulatory supervision of the financial sector. Priority reforms are needed in investments, bank credit, exports leverages, external finance conditions. Although the insurance sector initially experienced vigorous growth in the decade of 2001-2010 after opening up, there has been a downturn subsequently. The key issue is need for much greater expansion in services particularly that of life and health insurance. In a country where direct investments by households in equity and debt market are meagre, mutual funds have a large prospective to grow. Considering India’s demographic characteristics, there is large potential for pension funds to provide a depth to the financial markets in both debt and equity market segments. The implementation of new Insolvency and Bankruptcy Code is an important step in improving credit performance and the effort towards recapitalization have the potential to relieve the stress facing by the banking sector as a whole even to reduce the rising trend of NPA’s. It is very important for the development of capital markets particularly the corporate debt market which is dependent in institutional investors. Overpowering unorganized financial sector is also an unanswered question. Diverting resources of banks and financial institutions through various schemes towards the unorganized sector can help this question answered to some extent. If we compare the economic difficulties of the current period with that of 1991, we can see that was mainly of increasing debt borrowing and fiscal imbalances whereas problems of this decade are mainly due to demand deficiency and declining public confidence on the fiscal and monetary authorities. Focus would be given for reduction of public ownership in banks and insurance companies, enlargement of the contractual savings system through more hasty expansion of the insurance and pension system, greater spread of mutual funds and development of institutional investors. Then only both the equity as well as debt market can come back to the real track of cumulative opulence. At last, there is a higher need of competition of public sector with private sector without compromising equity and efficiency is also a way to overcome this fizzling out effect on the Indian economy.