India - Financial sector reform status report

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Since Independence in 1947 India has pursued a strategy of mixed economic development, relying on state control of many key sectors of the economy on the one hand, and accommodating a vigorous and expanding private sector on the other. The boundaries between public and private sector interaction have not been ruled by rigid ideology, but by changing political and economic conditions and above all by the imperatives of social and economic development. In a country with a large poor populace, divided along ethnic, linguistic and religious lines, national economic policy has required building consensus across a multitude of political and regional spectrums. Faced with a balance of payments crisis of unprecedented proportion, the Government that came into power in June 1991, initiated a program of bold stabilization and reform measures that marked a decisive departure from the past deregister and autarkic development strategy. The medium term strategy for reform aims at promoting rapid and sustainable growth in income and employment coupled with more effective and efficient public interventions to reduce poverty and raise the status of India's human capital. This strategy combines the discipline of competitive market forces with a re-examination and re-orientation of the role of government in fostering the country's human resources and physical infrastructure, as well as a scaling back of the size of the public enterprise sector, elimination of a wide range of regulatory controls, including most industrial licensing requirements; a reversal of the excessive government involvement in financial intermediation and credit allocation; and a decisive shift away from an inward-oriented, import substituting trade regime toward policies that reap the full benefits of closer integration with the world economy. Considerable progress has been made on this agenda during the last three years. The most striking evidence of progress has been in the external sector.
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95113 CONFIDENTIAL 0 INDIA FINANCIAL SECTOR REFO~ STATUS REPORT 0 March 9, 1994 Country Operations, Industry & Finance Division India Country Department Q South Asia Region INDIA: FINANCIAL SECTOR REFORM STATUS REPORT Table of Contents PAGE I. BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. Economic Reform Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 II. FINANCIAL SYSTEM AND INSTITUTIONS . . . . . . . . . . . . . . . . . . . . . . 2 A. Institutional Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 B. Historical Perspective and Key Problems . . . . . . . . . . . . . . . . . . . . . . . 3 III. FINANCIAL SECTOR REFORM PROGRAM . . . . . . . . . . . . . . . . . . . . . . 4 A. Medium-Term Reform Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 B. Liberalization of Financial Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 1. Deregulation of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2. Reductions in the SLR and CRR Requirements . . . . . . . . . . . . . . . . . 7 3. Development of a Broad-Based Government Debt Market . . . . . . . . . . . 8 4. Rationalizing Priority Sector Lending Schemes . . . . . . . . . . . . . . . . . . 9 C. Competition and Promoting Private Sector Participation . . . . . . . . . . . . . . . 10 0 1. Entry of New Private Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2. Broadening Ownership of Public Sector Banks . . . . . . . . . . . . . . . . . . 11 3. Enhancing Autonomy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 D. Restoring Health to Banking Institutions . . . . . . . . . . . . . . . . . . . . . . . . 12 1. Financial Performance of Public Sector Banks . . . . . . . . . . . . . . . . . . 13 2. Improving Recovery of Non-Performing Loans . . . . . . . . . . . . . . . . . 16 3. Rehabilitation of Weaker Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 4. Recapitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5. Improving Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 6. Strengthening and Modernizing Bank Supervision . . . . . . . . . . . . . . . . 20 E. Initiating Reform of Rural Credit System . . . . . . . . . . . . . . . . . . . . . . . . 21 IV. .CAPITAL MARKET ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 V. BENEFITS AND RISKS .· . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Tables Table 1: India: Financial Performance of Public Sector Commercial Banks . . . . . . . . . . . . . . . . . . 15 Table 2: India: Projected Capital Adequacy Position of Public 0 Sector Commercial Banks, March 1995 . . . . . . . . . . . 20 0 INDIA FINANCIAL SECTOR REFORM STATUS REPORT I. BACKGROUND A. Economic Reform Agenda 1. Since Independence in 1947 India has pursued a strategy of mixed economic development, relying on state control of many key sectors of the economy on the one hand, and accommodating a vigorous and expanding private sector on the other. The boundaries between public and private sector interaction have not been ruled by rigid ideology, but by changing political and economic conditions and above all by the imperatives of social and economic development. In a country with a large poor populace, divided along ethnic, linguistic and religious lines, national economic policy has required building consensus across a multitude of political and regional spectrums. In the 1960s and 1970s the configuration of such forces implied a dirigiste approach to economic development, which involved tight control of industrial investment, a highly protective trade regime with a multiplicity of discretionary import licenses, , high tariffs and numerous quantitative restrictions, and establishment of a large number of public enterprises by the central and state governments, often with monopolistic positions in many core sectors. 0 2. Faced with a balance of payments crisis of unprecedented proportion, the Government that came into power in June 1991 , initiated a program of bold stabilization and reform measures that marked a decisive departure from the past dirigiste and autarkic development strategy. The medium term strategy for reform aims at promoting rapid and sustainable growth in income and employment coupled with more effective and efficient public interventions to reduce poverty and raise the status of India's human capital. This strategy combines the discipline of competitive market forces with a re-examination and re-orientation of the role of government in fostering the country's human resources and physical infrastructure, as well as a scaling back of the size of the public enterprise sector, elimination of a wide range of regulatory controls, including most industrial licensing requirements; a reversal of the excessive government involvement in fmancial intermediation and credit allocation; and a decisive shift away from an inward-oriented, import- substituting trade regime toward policies that reap the full benefits of closer integration with the world economy. Considerable progress has been made on this agenda during the last three years; The most striking evidence of progress has been in the external sector. 3. Responding to changes in the unification of the exchange rate, the liberalization of trade policies and the strong fiscal deficit correction achieved in the previous two years, export growth soared to 21 percent in dollar terms compared with 3.8 percent the previous year. Despite wide ranging liberalization of import policy, imports declined by 1. 3 percent in dollar terms. Trade deficit is about US$ 1 billion compared to US$ 9.4 billion in 1990-91. The external current account deficit wa,s reduced to about 0.5 percent of GDP, the lowest since 1977178 and from 0 nearly 3.4 percent of GDP in 1990/91. These favorable developments in the current account, together with the growing inflows of foreign direct and portfolio investment, of nearly $ 3 0 - .2 - billion, have increased the level of foreign cury-ency reserves to $ 14 billion compared to only US$1 billion in July 1991. Inflation is currently around 8 percent down from nearly 17 percent I in September 1991. Real GDP growth is about 4 percent from barely 1 percent in 1991/92. The growth is attributed to improved agricultural performance. Publicly held foodstocks reach 23 million tons, the highest level in seven years. However, industrial production and investment have been slow to recover from the deflationary effects of the initial stabilization measures. 4. Against this backdrop, the budget presented to Parliament on February 28, 1994 aims at stimulating the economy, while further deepening the reform process through the provision of further reduction in tariffs; providing incentives to private sector development and measures for public sector restructuring. The Central Government's fiscal deficit is to be reduced to 6 percent of GDP in 1994/95, from the current year level of 7. 3 percent, through wide ranging tax reform and regaining on expenditure increases. Maximum customs duties have been reduced from 85 percent to 65 percent; reduction in general capital goods imports duty from 35 percent to 25 percent and the rate on spare parts from 85 percent to 25 percent. To provide impetus to the private sector, corporate taxes have been unified at 40 percent (from 45 percent to 50 percent), however there remains a surcharge of 15 percent on incomes above Rs.75,000/-. The capital gains tax realized by domestic companies have been reduced by 30 percent from 40 percent. The package is expected to generate an overall growth rate of about 5 percent and keep inflation under control .. 0 II. FINANCIAL SYSTEM AND INSTITUTIONS A. Institutional Set-Up 5. India's fin~ncial system is one of the largest in the world with a broad variety of banking and capital market institutions and instruments. Despite the country's low per capita income, financial assets consisting of bank deposits and corporate securities now amount to 97 percent orcfriP, up from 19 percent in the early 1970s. Commercial banks (with total assets of US$101.6 billion as of March 1993) are the mainstay of India's financial system. Since nationalization in 1969 and 1980, the commercial banking sector has been dominated by 27 public sector banks which account for nearly 90 percent of deposits, and 92 percent of bank branches. Their widespread network of 45,000 branches enables them to raise deposits countrywide, and some have established subsidiaries for leasing, underwriting, mutual funds, merchant banking and other corporate services. Private commercial banks presently in operation consist of twenty-three Indian and twenty-three foreign banks, each category accounting for about five percent of total assets. Three important all-India term-lending institutions -- (ICICI, IDBI and IFCI) --with total assets of US$ 17.1 billion as of end March 1993, are increasingly being compelled to tap local and foreign marke~s, and are active in areas of asset management, securitization, and investment banking. ! 0 6. The country's large mutual fund industry has played an instrumental role in resource mobilization and in development of the capital market. The industry was opened to private 0 -3- sector entry in 1992, with the first one commencing business in October 1993. With a market capitalization of US$ 87 billion, and with over 6000 companies listed India's capital market is among the largest in the developing world. The market is composed of fifteen regional exchanges, with Bombay being by far the most important exchange in terms of number and market value of listed companies and turnover, accounting for over 75% of market capitalization in India. With liberalization of foreign direct investment and removal of administrative restrictions on interest rates on debentures and public sector bonds, new capital issues have risen dramatically in recent years, from US$ 0.88 billion in 1991192 to US$ 6 billion in ten months, April to January 1993/94. The Indian money market is broadly based, consisting of call money, rediscounting of bills, treasury bills, commercial paper, certificates of deposit, and the intercorporate deposit market, and in recent years has revived considerably with the regular auctioning of treasury bills, and reactivation of repurchase agreements between RBI and commercial banks in Treasury Bill market. 7. The Indian rural credit system comprises two main streams: the banking system, which includes Commerical Banks - CBs - (through their 32,000 rural and semi-rural branches) and 196 Regional Rural Banks - RRBs - providing short, medium and long term credit, and the cooperative credit system, which is represented by 28 State Cooperative Banks- SCBs (through affiliated 351 District Central Cooperative Banks and 89,000 Primary Agricultural Credit Societies) for short term credit and 20 State Land Development Banks and 708 Primary Land 0 Development Banks for long term credit. At the apex of the credit system is the National Bank for Agriculture and Rural Development (NABARD) which refinances the system. India's large urban non-bank financial market, consist of the finance and hire purchase companies, housing finance companies, and other institutions. The market is considered competitive, and relative to commercial banks is technologically advanced, and has expanded in recent years much faster than banking industry, and captures currently about ten percent of total deposits of the banking sector. B. Historical Perspective and Key Problems 8. Until quite recently, financial service industries were among the most controlled and regulated of all economic activities in India. Commercial banks were subject to a complex set of interest rate restrictions, high cash reserve requirements, high mandatory holding of government securities, directed lending, and detailed and restrictive norms governing credit operations. Social and fiscal compulsions evolved to dominate interest rate determination and credit allocation. In the face of persistent fiscal' deficits, interest rates on government debt were deliberately kept at low levels to alleviate the debt service burden. Under these circumstances, marketing of government debt involved imposition of mandatory investment in government securities through the stipulation of Statutory Liquidity Ratio (SLR) on commercial banks and other captive financial institutions. With int¢rest rates serving primarily as a fiscal tool, monetary management depended on quantitative credit controls, sector specific rediscount /~ facilities, and a high Cash Reserve Ratio (CRRYrequirements. The combination of the Statutory \.__) - ,4 - I Liquidity Ratio (SLR) and Cash Reserve Ratio: (CRR), which imposed a marginal pre-emption of 28 percent of banking sector deposits in the:early 1950s, increased to 63.5 percent by 1991. In addition banks were required to allocate a· large proportion of their credits to designated priority sectors, comprising agriculture, small scale industry, and weaker sectors of society, with a large part of such lending at concessional rates. 9. As these objectives conflicted with the tenet of a private sector banking system, the authorities nationalized the largest Indian commercial banks in two rounds, fourteen in 1969 and six in 1980. The nationalization achieved many of the Government's initial goals, including exte~ding the reach of banking services to all parts of the country, including rural areas, and in channelling resources to the public and socially designated sectors. It, however, proved costly to the banking industry. For one thing, it politicized banking business in India. The potential to impart subsidies through credit allocation to such politically strong sectors as agriculture and small scale industry without the need for parliamentary deliberation and explicit budgetary support, had a strong political appeal in India's democratic system, and became, over time, an important source of bureaucratic interferences, as well as micro management. Second, the emphasis on meeting social objectives tended to divert supervisory attention from asset quality, and provided a rationalization for bad lending by bank management. Third, the nationalization prompted a strong bank employee union structure, which resisted for a long time introduction of modem communication and computer technologies with the result that Indian banks have 0 lagged behind in the adaptation of the revolutionary changes in technology which have swept financial service industries elsewhere. These shortcomings have had a severe adverse impact on banks' quality of customer services, productivity, and financial health. As is now being unveiled, India's public sector banks suffer from a large volume of non-performing loans, drastically low . profitability, and inadequate capital. In addition the securities market irregularities which surfaced in 1992, exposed the perils of a highly controlled, yet poorly supervised banking system. Ill. FINANCIAL SECTOR REFORM PROGRAM A. Medium-Term Reform Agenda 10. In past few years, several government commission reports recognized the banking sector's problems and have formulated recommendations for their solution. In particular, a High Level Committee (the Narasimham Committee) was appointed in August 1991, to consider all relevant aspects of the structure, organization, functions and procedures of the financial system. The Narasimham Committee was followed by several other specialized committee reports which dealt with the more specialized aspects of financial I sector reform. These committee reports have provided the basis for the government's progr~ of financial sector reform. Over the past two years the program has been intensively debated in the popular press, deliberated in Parliament Q and articulated in several official statements, including the Union Budgets of 1992/93, 1993/94, 0 -5- 1994/95 the Eighth Five Year Plan, and most forcefully the Discussion Paper, Public Sector Commercial banks and financial sector reform: Rebuilding for a better future , released by the Ministry of Finance on December 15, 1993. With a candid recognition of the problems besetting India's commercial banks, the Discussion Paper outlines a medium-term reform strategy. The emerging perspective aims qualitatively to change the ownership structure, operational environment, incentive system, transparency of banks balance sheets and the interface between the fiscal apparatus and the financial system. 11. These changes are expected to transform Indian banks from bureaucratic institutions to commercially oriented, and competitive businesses that would be equipped to meet the challenge of an increasing liberalized economy. In pursuit of such objectives, the authorities have set several medium-term benchmarks. Thus by 1996, one-half of public sector banks (weighted by asset size) would be listed on the stock market, with corresponding representations of shareholders on bank boards; a significant increase in the market share of private banks' commercial banking business; complete liberalization of deposits and lending rates, subject to one concessional rate, a significant reduction in the pre-emption of bank resources through the SLR and the CRR; a broad-based, liquid, and active market for public sector debt; a significant reduction in the non-per
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