Unleashing India's potential: the key is to modernize the financial system.

• Author: Farrell, Diana

A casual observer might infer from India's flourishing stock markets, fast-growing mutual funds, and capable private banks that the country's financial system is one of its strengths. But closer inspection reveals that tight government control over almost every other part is undermining the overall performance and curbing India's economic resurgence. If India is to sustain rapid GDP growth and spread its benefits more broadly, it a financial system that is comprehensively market-oriented and efficient.

The financial system's shortcomings largely fall into three areas. First, India's formal financial institutions attract only half of Indian households' savings, and none of the $200 billion they keep tied up in gold. Second, India's financial institutions allocate more than half of the capital they do attract to the least productive areas of the economy: state-owned enterprises, agriculture, and the unorganized sector (mostly made up of tiny businesses). The more productive corporations in India's dynamic private sector receive only 43 percent of all commercial credit. Third, India's financial system is inefficient in both of its main tasks of mobilizing savings and allocating capital. That means Indian borrowers pay more for their capital and depositors receive less than in comparable economies.

These failings place a heavy burden on India's economy, and fixing them would give it an immense boost. Research by the McKinsey Global Institute (MGI) calculates that an integrated program of financial system reforms could add $48 billion to GDP each year (Figure 1). This would raise India's real GDP growth rate to 9.4 percent per year, from the current three-year average of roughly 7 percent. India's growth would be roughly on par with China's and just shy of the government's 10 percent target, and household incomes would be 30 percent above current projections by 2014, lifting millions more households than expected out of poverty.

WHERE THEY ARE SAVING

Not long into our study we discovered that, despite India's 130-year-old stock market, long history of private banks, and generally well-developed public institutions, the nation's financial system intermediates a surprisingly small amount of the economy's total capital. This is demonstrated by the relative shallowness of India's financial system, measured by the value of all financial assets in the country relative to GDE At 160 percent, India's financial depth is significantly lower than that of other fast-growing Asian economies, notably China (Figure 2).

Closer examination revealed just how much of the savings and investment fueling India's economic growth occurs outside India's formal financial system. Indian households save 28 percent of their disposable income, but invest only half of these savings in bank deposits and other financial assets. Of the other half, they invest 30 percent in housing, and put the remainder--which amounted to $24 billion last year--into machinery and equipment for the 44 million tiny household enterprises that make up the economy's unorganized sector. This is despite the fact that, with a few exceptions, household businesses are below efficient scale, lack technology and business know-how, and have low levels of productivity. In 2005, Indian households also bought more than $10 billion worth of gold, arguably another form of non-financial...