Changing Landscape of Finance in India During Last Decade: Finance and The Economy
Changing Landscape of Finance in India During Last Decade: Finance and The Economy
Changing Landscape of Finance in India During Last Decade: Finance and The Economy
Introduction
Strengthening financial systems has been one of the central issues facing emerging markets and developing economies. This is because sound financial systems serves an important channel for achieving economic growth through the mobilization of financial savings, putting them to productive use and transforming various risks. Many countries adopted a series of financial sector liberalization measures in the late 1980s and early 1990s that included interest rate liberalization, entry deregulations, reduction of reserve requirements and removal of credit allocation. Domestic banks were given access to cheap loans from abroad and allocated those resources to domestic production sectors. A financial system is a network of financial institutions, financial markets, financial instruments and financial services to facilitate the transfer of funds. The system consists of savers, intermediaries, instruments and the ultimate user of funds. The level of economic growth largely depends upon and is facilitated by the state of financial system prevailing in the economy. Efficient financial system and sustainable economic growth are corollary. The financial system mobilizes the savings and channelizes them into the productive activity and thus influences the pace of economic development. Economic growth is hampered for want of effective financial system. Broadly speaking, financial system deals with three inter-related and interdependent variables, i.e., money, credit and finance.
households and firms (Shah, Thomas, and Gorham, 2008).The nominal rupee-dollar exchange rate exhibited a depreciation of roughly 9% over this period. Hence, the bulk of the change across this decade can be interpreted as a change expressed in nominal dollars. Over this decade, India went from being a medium sized developing country (with an aggregate GDP of $379 billion in 2000-2001) to being a member of the G-20 (with an aggregate GDP of $1.13 trillion in 2010-11), with a rough tripling of aggregate GDP. Alongside this, the savings rate went up dramatically from 24.13% to 34.65%.This combination gave a 4.64 times rise in gross domestic savings: the financial system which used to handle a flow of $91 billion of savings in 2000-01 was handling $390 billion of savings in 2010-11. In addition, the private corporate sector, which is the focus of the formal financial system, came to play a bigger role in investment. Gross capital formation by the private corporate sector grew from 7.67% of GDP to 14.53% of GDP over this decade. There was a rise of 6.71 times: private corporate investment went from $29billion in 2000-01 to $153 billion in 2010-11.Through this combination of high GDP growth, rise in household savings, and a bigger role for private corporate investment, the financial system has come to play a more prominent role in the economy, and has achieved a significant size by world standards. Through these changes, the materiality of financial reform has risen. With $390 billion of household savings being produced a year, and $153 billion of private corporate investment taking place a year, modest improvements in the capability of the financial system would help accelerate growth.
Financial Repression
In most areas, the interaction between the Indian State and the economy is ruled by sound procurement principles. As an example, purchases of steel or cement by the government are done through auctions, where these commodities are purchased from the lowest voluntary bidder. However, in the area of government borrowing, the Indian State does not borrow from voluntary lenders. The bulk of government bond issuance is forcibly placed with financial norms. These include banks, insurance companies and pension funds. As an example, banks are forced to hold at least 24% of their assets in government bonds. The pension system operated by the Employee Provident Fund Organization (EPFO) is almost entirely invested in domestic government bonds. Of the Rs.7.43 trillion invested by life insurance companies on 31 March 2010, 42.5% was in central government bonds and another 14.4% was in state government bonds. Indian financial policy thus ensures that the government gets roughly all EPFO assets, roughly half of the
assets of life insurance companies and roughly a quarter of the assets of banks. Of the total stock of Rs.11.47 trillion of government bonds, only Rs.1.7 trillion or 15 per cent were held voluntarily.
Protectionism
In most aspects of the merchandise trade, the Indian State has shifted away from protectionism. The Indian buyer of steel or benzene or mobile phones is able to choose between local and global producers without either quantitative restrictions or tariffs imposed by the State. With financial products and services, in most areas, the local buyer is inhibited from purchase of products or services from offshore providers. This is done either through outright prohibition or quantitative restrictions (typically through capital controls), or constraints upon establishment of distribution channels for foreign producers (typically through financial regulation). One example of such protectionism lies in the treatment of banks, where all foreign banks (put together) are permitted to open no more than 18 branches in India. This disables the extent to which foreign banks are able to build branches in India and offer competition to Indian banks. For another example, the Indian buyer of futures on the NSE-50 index has a choice of three venues where orders can be placed: Indias NSE, the Singapore Exchange (SGX) and the Chicago Mercantile Exchange(CME). However, the prevailing capital controls are structured in a way which prevents an Indian resident from paying initial margin on overseas futures exchanges. Through this, offshore competition against the NSE-traded Nifty futures and options is undermined.
Central Planning
The fourth defining feature of Indian finances lies in the extent to which the government controls minute details of financial products and processes. The structure of legislation and regulation is one where everything is prohibited unless explicitly permitted. Hence, every time a firm wishes to make a modification to a small detail about a product or a process, it has to go to a government agency in order to request permission. In most OECD countries, governments do not get involved in specifying the time at which trading starts and ends. On a related note, on the equity derivatives market, options trading on the index involve cash-settled European-style options and options trading on individual securities involve cash-
settled American-style options. None of these parameters can be changed without explicit approval from SEBI. In most OECD countries, decisions about whether options should be cash-settled or physicallysettled, and decisions about whether options should be European-style or American-style, are not the purview of government.
reforms effort aiming at a fundamental transformation of the equity market. The changes on the equity market from December 1993 to June 2001 were quite dramatic: A new governance model was invented for critical financial infrastructure such as exchanges, depositories and clearing corporations. This involved a three-way separation between shareholders, the management team and member financial norms. These three groups were held distinct in order to avoid conflicts of interest. The shareholders were configured to have an interest in liquid markets, and not maximize dividends. Floor trading was replaced by electronic order books. Counterparty credit risk was eliminated through netting by novation at the clearing corporation. This has supported a competitive environment where entry barriers have been set to very low levels and a steady stream of norm goes out of business every year. Exchange membership for foreign securities norms was enabled, thus making it possible for foreign investors to transact through their familiar securities norms. Physical share certificates were eliminated through dematerialized settlement at multiple competing depositories. Exchange-traded derivatives trading commenced on individual stocks and indexes. The NSE-50 (Nifty) index became the underlying for one of the worlds biggest index derivatives contracts, with onshore trading at NSE, offshore trading at SGX in Singapore and CME in Chicago, and an entirely offshore OTC market. A diverse order flow was accessed from all across India and abroad, through hundreds of thousands of trading screens. This gave heterogeneous views, and a large mass of investable capital. This is a major change when compared with the India of old, where none of the financial markets worked well. Looking forward, the institutional capabilities and experience of these reforms will help in transforming other components of the financial system.
While some of these new private banks fared badly, others have done well. They have experienced sharp growth in assets. As an example, public sector banks now accept computers and ATMs on a scale that was not seen earlier, and it is likely that competitive pressure from private banks has helped. In summary, the limited economic reform was one of the important milestones of change in Indian finance.
Financial Innovations
There has been an explosive growth in financial innovations. Now exploring various aspects of financial innovations, It is divided into following sections: 1. WHAT AND WHY OF FINANCIAL INNOVATIONS Miller, Silber, and Van Horne characterize and analyze financial innovations somewhat differently. - Miller describes financial innovations as unanticipated improvements in the array of financial products and instruments that are stimulated by unexpected tax or regulatory impulses . - Silber looks at financial innovations differently from Miller. He considers innovative financial instruments and processes as devices used by companies to reduce the financial constraints faced by them. -Van Horne views a new financial instrument or process as innovative, if it makes the financial markets more efficient and/or complete. A financial innovation makes the market more efficient if it reduces transaction costs or lowers differential taxes . According to Van Horne the following factors prompt financial innovation: volatile inflation and interest rates, regulatory changes, tax changes, technological advances, the level of economic activity, and academic work on market efficiency and inefficiency. Collectively, the Miller, Silber, and Van Horne suggest that the following factors drive financial innovations: Tax asymmetry, Regulatory or legislative changes, Volatility of financial prices, Transaction costs, Agency cost, Opportunities to reduce some form of risk or reallocate risk, Opportunities to increase an assets liquidity, Academic work, Accounting benefit, Technological advances, Level of economic activity.
2. TYPES OF FINANCIAL INNOVATIONS Financial innovations may be divided into the following categories: A. Consumer-type instruments B. Securities C. Derivative securities D. Process Variable life insurance policy Money market mutual fund Zero coupon bond Indexed linked gilts Options Futures Shelf registration process Screen based trading
Since categories A, B and C represent financial products, we may broadly define financial innovation as a new product or a new process or a creative solution to financial problem.
3. FINANCIAL INNOVATIONS IN INDIA In the last two decades, financial innovation in India has picked up and it is expected to grow in the years to come, as a more liberalized environment affords greater scope for financial innovation. The important financial innovations that have taken place in India are listed below. Debt-oriented schemes of mutual funds, specialized mutual funds , money market mutual fund Tax benefit Partially convertible debentures and fully convertible debentures Pricing and interest rate regulation obtaining under the Capital Issues Control Act Deep discount / Zero coupon bonds Volatility of equity prices, interest rates, foreign exchange rates, stock prices. RBI restrictions Interest rate caps/floors/collars Automated teller machines Technology, Screen-based trading, electronic funds transfer Investor preferences Exchange-traded options Project finance, Risk sharing
Conclusion
One of the most important areas of economic reform lies in the financial system. On one hand, finance is the brain of the economy, and the skills of the financial system shape the efficiency of translation of gross capital formation into GDP growth. In addition, a sophisticated financial system gives resilience to shocks, particularly in an increasingly internationalized India. But certain areas of greater success have not been
adequate in obtaining a financial system that is commensurate with Indias needs, for intermediating $390 billion of savings and investment a year for an increasingly complex and internationalized economy.
References
*Shah, A and S. Thomas, (2001), The evolution of the debt and equity markets in India, paper presented at the Seminar on Capital Market Reforms, Indian Council of Research in International Economic Relations, New Delhi, September 3, 2001. * Mohd. Arif Pasha, "Financial Markets and Intermediaries", Kalyani Publishers, New Delhi, 2009 * Mohan, Rakesh. 2004 "Finance for Industrial Growth." March. * 2007. "India's Financial Sector Reforms: Fostering Growth while Containing Risk." Yale University; www.rbi.org.in * 2003. "Transforming Indian Banking: In Search of a Better Tomorrow." January. * Reddy, Y. V. 2005. "Banking Sector Reforms in India: An Overview." June. * 2006. "Reforming India's Financial Sector. Changing Dimensions and Emerging Issues. * http://www.nyfedeconomists.org/research/epr/00v06n4/0010lown.pdf * http://library.wur.nl/way/catalogue/documents/FLR18.pdf * http://www.erf.org.eg/CMS/uploads/pdf/0208.pdf