SWP739

F E COPY India's Financial System

An Overview of Its Principal Structural Features

Felipe Morris

WORLD BANK STAFF WORKING PAPERSNumber 739

FilE COPYI '. I

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

WORLD BANK STAFF WORKING PAPERS f Z

Number 739 IWOUJ67

India's Financial System

An Overview of Its Principal Structural Features

Felipe MorrisINTERNATiOAIL 4iOUETA)iY FUiD

JOINT LIBRiAEIY

[I U G J 1 2 1985

tNTELRIATIONAL DANK roRRXCONSThRUCYION AND DEVELOPMrNT

WASE!NGTCN. D.C. 20431

The World BankWashington, D.C., U.S.A.

Copyright (© 1985The International Bank for Reconstructionand Development/THE WORLD BANK

1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing July 1985

This is a working document published informally by the World Bank. To present theresults of research with the least possible delay, the typescript has not been preparedin accordance with the procedures appropriate to formal printed texts, and the WorldBank accepts no responsibility for errors. The publication is supplied at a token chargeto defray part of the cost of manufacture and distribution.

The World Bank does not accept responsibility for the views expressed herein, whichare those of the authors and should not be attributed to the World Bank or to itsaffiliated organizations. The findings, interpretations, and conclusions are the resultsof research supported by the Bank; they do not necessarily represent official policy ofthe Bank. The designations employed, the presentation of material, and any maps usedin this document are solely for the convenience of the reader and do not imply theexpression of any opinion whatsoever on the part of the World Bank or its affiliatesconcerning the legal status of any country, territory, city, area, or of its authorities, orconcerning the delimitation of its boundaries, or national affiliation.

The most recent World Bank publications are described in the annual spring and falllists; the continuing research program is described in the annual Abstracts of CurrentStudies. The latest edition of each is available free of charge from the Publications SalesUnit, Department T, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433,U.S.A., or from the European Office of the Bank, 66 avenue d'1ena, 75116 Paris, France.

Felipe Morris is an economist in the South Asia Programs Department of the WorldBank.

Library of Congress Cataloging in Publication Data

Morris, Felipe, 1953-India's financial system.

(World Bank staff working papers ; no. 739)Bibliography: p.1. Financial institutions--India. 2. Credit

control--India. 3. Monetary policy--India.I. Title. II. Series.HG187.I4M67 1985 332'.0954 85-12132ISBN 0-8213-0564-6

ABSTRACT

This paper examines the structure and evolution of the Indianfinancial system over the past three decades. The study concentrates onthe "organized" segment of the system which includes commercial, develop-ment and cooperative banks, the stock market, and various non-bankingfinancial institutions including insurance corporations and mutual funds.The paper also highlights several policy issues in the sector in anattempt to spearhead discussions and further analytical work.

The paper first describes the institutional structure of thefinancial system and then analyzes its evolution and financial interrela-tions using a flow of funds framework and other relevant tools of finan-cial planning. The paper then identifies and analyzes some issues relatedto credit planning, including credit allocation policies and selectedinstruments of monetary and credit policy such as interest rates. Theanalysis of these policies is particularly relevant since credit planningis a important element in India's financial system. The paper provides abroad description and analysis of these policies and indicates areas inwhich further work may be necessary.

ACKNOWLEDGEMENTS

Several people provided valuable comments during the preparationof this project. I am particularly grateful to James Q. Harrison, formerSenior Economist in the India Division, for his extensive comments on anearlier version of the paper. I also want to acknowledge comments andsuggestions from Zafer Ecevit, Roger Grawe, Guillermo Vivado and IsmailDalla. Of course, none of them is responsible for remainina deficiencies.

TABLE OF CONTENTS

Page No.

INTRODUCTION .. ................................................. vii

SUMMARY AND CONCLUSIONS .... .. ............... vii

I. INSTITUTIONAL STRUCTURE OF THE INDIAN FINANCIAL SYSTEM I 1A. Reserve Bank of India . ........ ........ ooo 3B. Commercial Banking ......... . . . . ............... 3C. Post Office Savings Bank .. Bak.....................o 7D. Institutional Finance for Industry ..... o. 9E. Agricultural Financing Institutions ...... o.o ..... o 16F. Financial Companies .... .... . ... . o. ..... o o. . ... . 21G. Stock and Securities Market ... . ........ .. 22

1. Government Securities Market 22.... ...... ... 22. Private Capital Market .. oooo ......... oo..o.. 23

II. MACROECONOMIC DIMENSIONS OF THE FINANCIAL SYSTEM ....... 26A. Evolution of the Financial System: Analysis

of Various Indicators ...... ........ 26B. Financial Development Ratios ........... ............ 30C. Flow of Funds .. ...... . ... ... ... *..... oo....... 32D. Role of the Financial System in the Mobilization

of Savings ....... os....... oo.............................ooo.... 35E. Inter-country Comparison of Financial System Depth . 41

III. CREDIT ALLOCATION ...o ........ oooo .. .o.. .oo. . . o ..... . 44A. Comprehensive Picture ..... ............. ooooo 44B. Deployment of Credit by Scheduled Commercial Banks 44C. Deployment of Credit by Type of Ownership 51D. Term-structure of Bank Credit ..... ooo.oo.o.o ...... 52E. Concluding Notes on Credit Deployment ...... o....o. 53

IV. SELECTED INSTRUMENTS OF MONETARY AND CREDIT POLICY 55Ao Reserve Requirements ..... ... ... .. . .........-... ..... 56B. Credit Authorization Scheme ........................ 59Co Interest Rate Policy oo.oo.oo ... 64

1. Introduction o........*..oo....................... oooo... ....... 642. Structure of Interest Rates ........ oo ...... 653. Commercial Bank Rates .. oo ...... ............. 684. Differential Interest Rate Scheme .............. 715. Nominal versus Real Interest Rates ............. 71

ABBREVIATIONS AND ACRONYMS ........... . .. . . ........... ........ vi

REFEuRvENE.......... 7L

- vi -

ABBREVIATIONS AND ACRONYMS

ARDC - Agricultural Refinance and Development CorporationCAS - Credit Authorization SchemeCCB - Central Cooperative BanksCMIE - Center for Monitoring the Indian EconomyCRAFICARD - Committee to Review Arrangements for Agriculture and Rural

DevelopmentCRR - Cash Reserve RatioCSO - Central Statistical OrganizationDRI - Differential Rate of InterestCIC - Ceneral Insurance CorporationICICI - Industrial Credit and Investment Corporation of IndiaIDBI - Industrial Development Bank of IndiaIFC - International Finance CorporationIFCI - Industrial Finance Corporation of IndiaIRCI - Industrial Reconstruction Corporation of IndiaIRDBI - Industrial Reconstruction and Development Bank of IndiaLIC - Life Insurance CorporationNABARD - National Bank for Agriculture and Rural DevelopmentNCDC - National Cooperative Development CorporationNIDC - National Industrial Development CorporationNSC - National Saving CertificateNSIC - National Small Industries Corporation LimitedPACS - Primary Agricultural Credit SocietyPCB - Primary Cooperative BankPCS - Primary Cooperative SocietiesPLDB - Primary Land Development BankPOSB - Post Office Savings BankRBI - Reserve Bank of IndiaRRB - Regional Rural BankSBI - State Bank of IndiaSCB - State Cooperative BankSFC - State Finance CorporationSIDC - State Industrial Development CorporationSLDB - State Land Development BankSLR - Statutory Liquidity RatioSSIC - State Small Industries CorporationSSIDC - State Small Industries Development CorporationUTI - Unit Trust of India

GOVERNMENT OF INDIA FISCAL YEAR

April 1 - March 31

- vii -

INTRODUCTION

1. The purpose of this study is to provide a descriptive and analyticalview of the structure of the Indian financial system with a macroeconomicperspective. The study also highlights the major policy issues in thesector.

2. The study first describes the institutional structure of thefinancial system and then analyzes its evolution and financialinterrelations using a flow of funds framework and other relevant tools offinancial planning. This allows the examination of three aspects of theprocess by which saving is channelled to investors through the financialsystem: first the amount of savings and investment that go on in theeconomy, then the question of who saves and who invests, and finally, theflow of funds through financial institutions and markets as money passes onits way from savers to investors.

3. The study then identifies and analyzes issues related to creditplanning, including credit allocation policies and selected instruments ofmonetary and credit policy. The analysis of these policies is particularlyrelevant since credit planning is an important element in India's FinancialSystem. The purpose of credit planning is twofold: first, to ensure aplanned credit expansion for the economy as a whole, and second to make surethat credit flows to desired regions and sectors for increasing production,fulfilling output targets and meeting other national social and economicobjectives. Official Government policy with regards to banking is that itsoperations should be related to development priorities indicated in thenational plans as well as to returns on capital. In view of this, theReserve Bank of India, which coordinates credit planning in the country,makes an extensive use of interest rate and credit allocation policies toprovide credit at preferential rates for priority activities, sectors andregions. The study provides a broad description and analysis of thesepolicies and indicates areas in which further work may be necessary. Thefollowing tools of credit planning are analyzed: credit authorizationscheme, Tandon Committee's inventory and working capital norms, ChoreCommittee's Report on the Cash Credit System, reserve requirements,differential interest rate scheme and overall interest rate and creditallocation policies.

SUMMARY AND CONCLUSIONS

Institutional Structure of the Financial System

4. Financial intermediation in India is conducted by a wide range andlarge number of financial institutions. The Reserve Bank of India is theapex institution of the financial system and the commercial banks have apredominant role since they hold 40% of financial assets. Other important

financial institutions are the development finance institutions at theall-India, regional and State level; the insurance corporations; mutual fundinstitutions such as the Unit Trust of India; and the Post Office SavingsBank.

5. The structure and evolution of the Indian financial system sincethe late 1960s have been closely related to an increasing degree of publicownership and control of financial institutions. Practically all theimportant financial institutions are now under public control, and about 85%of total financial assets flow through public sector financial institutions.In addition, the Government regulates and controls capital issues and thefunctioning of the stock market. This extensive control of the financialsystem is aimed at ensuring the flow of finance in desired directions and inparticular to priority areas of development such as agriculture, smallindustries and backward areas; and at assisting in the accomplishment ofPlan goals.

Weaknesses of Financial Institutions

6. The review of the institutional structure of the Indian financialsystem identified the following major weaknesses: (a) proliferation offinancial institutions, (b) low direct mobilization of savings bydevelopment finance institutions; (c) low profitability of the commercialbanking system, and (d) high level of overdues particularly in agriculturalfinance institutions.

7. A major weakness of the financial system which should be addressedis the proliferation of financial institutions, some of which overlap intheir functions and objectives. This proliferation occurs both inindustrial finance and agricultural finance. There is a need to review therole of these institutions, particularly those which are not functioningsatisfactorily. A review of functions and objectives may suggest somerestructurings and/or mergers which could strengthen the remaininginstitutions. A careful assessment of financial viability beforeestablishing new institutions or branches of existing institutions wouldalso strengthen the system.

8. Another area which needs closer attention is the scope for largerdirect mobilization of savings by development institutions. Most of theseinstitutions do not mobilize any deposits directly from the public, and thebonds and debentures floated by them are only taken up by banks and otherfinancial institutions because of reserve requirements. Consequently, theydepend very heavily on the Government, the RBI and the banks for theirfunds. This sluggish direct resource mobilization is due to the combinedeffect of regulations and lack of appropriate returns to investors.

9. The low profitability of the commercial banking system is anothermajor concern. Low profitability results from a combination of factors:(a) loan overdues; (b) overstaffing and low efficiency due to outdatedprocedures and banking technology; (c) high degree of risk absorption andadministration costs associated with priority sector lending; and (d) very

low capitalization ratios 1/ (1% as compared to 5%-6% for US banks). Due tothe predominance of banking in the Indian financial system, efforts shouldbe directed at improving its financial health.

10. High overdues are a problem which affect many Indian financialinstitutions. It is a widespread problem in agricultural finance but alsooccurs in industrial credit. Overdues accounted for 44% of total loansoutstanding of Primary Agriculture Credit Societies in June 1981 and for 22%of credit outstanding to regional banks as of December 1982. In the case ofindustrial finance institutions, overdues accounted for 19% of SFCs'outstanding assistance and are also high in SIDCs'. These levels are veryhigh by western standards and seriously affect the ability of some of theinstitutions to sustain their lending operations. Fund shortages have to bemet by direct assistance and borrowing from State and Central Governments.During the past two years, several SFCs have been implementing variousmeasures to improve the recovery position, with encouraging results sinceoverdues fell from 27% in March 1981 to 19% in March 1983. Similar effortsshould be undertaken by other institutions, particularly agricultural creditcooperatives and Regional Rural Banks.

Evolution of the Financial System

11. Data on the evolution of the financial system since 1950 documentthe increased "financialization" of the Indian economy and indicate that anincreased role of the public sector on the financial system has not retardedits development. This is shown by the ratio of assets of financialinstitutions to GDP which has increased gradually from 38% in 1950 to 73% in1975, then quickly to 103% by 1980. Behind this extensive financialdeepening has been the increase in the assets of the commercial banks.Other key factors in the growth of the financial system are the emergence ofnew financial intermediaries such as development banks and the Unit Trust ofIndia, and the expansion of the cooperative movement and of provident funds.

12. Although the growing public sector involvement has not retarded thedevelopment of the financial system it may have reduced its efficiency by:(a) reducing the flexibility of the institutions, particularly of commercialbanks, to undertake discretionary lending, (b) increasing administrativerequirements for processing requests for financial assistance, (c) reducingthe scope of the system to allocate resources based on economic andfinancial considerations rather than on political or social grounds, and(d) reducing the operational autonomy of top management in the largerinstitutions. Future rapid growth of the system at rates comparable tothose achieved in the recent past concurrent with needed improvements in thefinances of the institutions is likely to require a relaxation of Governmentcontrol over certain aspects of the functioning of the system such as theability of the institutions to engage in discretionary lending and todetermine interest rates.

1/ Proportion of total bank assets to total credit allocation. Itapproximates the inverse of the gearing ratio.

Financial Development and Flow of Funds

13. The analysis of the various measures of financial development alsoshows an increase in the importance of financial institutions in the economyand of financial flows relative to economic activity. This indicates thatthe financial system is playing an increasingly active role in the transferof funds from the surplus to the deficit sectors in the economy. The mainsurplus sectors are Households and Rest of the World (ROW), while the majordeficit sectors are the Government and Private Corporate Business. Thefinancial deficit of the Government increased from 1.8% of GDP in 1951-56to 4.4% in 1961-66 and 6.7% in 1977-81. Similarly, the deficit of thePrivate Corporate Sector also increased from 0.8% of GDP in 1951-56 to 1.6%in 1961-66 and 1.7% in 1977-81. These two deficit sectors complement theirfunding requirements by direct borrowing from Households and ROW, andindirectly through financial intermediation. The Household sector, whichrecorded very high financial surpluses in the 1970s, was the major financierand lent to the deficit sectors and the financial system in the form ofcurrency and deposits, contractual savings, small savings and trade debt.

Savings and The Financial System

14. Particularly since the mid-seventies, India has experienced veryhigh savings rates relative to its low per capita income. The accelerationand maintenance of the saving rate at relatively high levels, has beenclosely linked with income growth--the elasticity of gross domestic savingswith respect to real income exceeds 2.0. The increase in the proportion ofnet disposable income to net domestic product partly explains the risingsaving rate, but other factors have contributed as well: (a) thesignificant financial deepening of the Indian economy since independence,(b) the increasing share of the secondary and tertiary sectors in the NDPwhich have higher marginal propensities to save; and in the 1970s, (c) thestrong growth in production (especially in agriculture), and (d) theimproved saving performance of the public sector.

15. Higher saving rates in the Indian economy since the mid-seventieshave been accompanied by higher levels of financial savings. Householdsavings in the form of (a) financial assets and (b) physical assets haveincreased, with financial savings now accounting for a significant 7.2% ofNDP, compared to 0.7% in 1950/51. Among various financial instruments, netdeposits have shown the largest increase as a percentage of financialsavings of the household sector (see Table 2.8). The bulk of the increasein deposits, and in financial savings, during the 1970s was directed tocommercial banks which increased their role in the financial system.

Private Capital Market

16. The data on financial savings also underscore the decliningimportance of shares and debentures to total financial assets of thehousehold sector during the 1970s. The small growth in capital marketinstruments resulted from the combination of demand and supply factors. Onthe demand side, investors were not encouraged by the market yields whichdiscounted for risk were less favorable than returns on other financialinstruments. On the supply side, companies were reluctant to approach the

capital markets due to high costs, and cumbersome procedures andregulations. Resource mobilization through the capital market has improvedsubstantially in the early 1980s in response to measures which have enhancedindustrial competitiveness and performance, liberalized debt-equity normsand increased interest rate ceilings for debentures which have made themmore interesting to investors. Private corporate capital issues grew fromRs 1.1 billion in 1978/79 to Rs 7.4 billion in 1982/83. Nevertheless, thecapital market still accounts for a small proportion of total financialassets. Further work on capital markets is required to provide an insightinto likely constraints to future growth and to recommend policy changes toimprove their functioning in order to meet the financial requirements ofindustry more effectively.

Credit Allocation

17. The Government intervenes extensively in the credit allocationprocess both by directing commercial banks to lend to priority sectors andby establishing specialized institutions such as development banks to makepriority loans. While the intervention has succeeded in diverting creditinto desired channels, its impact in terms of economic growth and efficiencyin the use of resources is not very clear. Further work in this area isrequired. Although there may be a role for policies which encourage creditallocation to previously neglected economic activities, this should not bedone at the expense of other equally or more productive activities. Abalance has to be maintained between the different sectors, particularlyduring times of tight credit. Another important change in credit allocationby commercial banks since nationalization has been the increase in the shareof credit to the public sector in relation to total credit. Creditoutstanding to the public sector increased from 13.4% in December 1972 to29.5% in June 1977. This highlights the increasing role of the bankingsystem in financing public sector expenditures during the 1970s. Since 1979there has been a reversal of this trend and in June 1981 the share of thecredit outstanding to the public sector stood at 24%. This development iswelcome because it releases bank funds for financing private sectorinvestment and consumption.

Reserve Requirements

18. The public sector uses a large proportion of banking systemresources because, in addition to lending, the banks also invest about 36%of total deposits in Government and Government approved securities. Thisinvestment is in line with reserve requirement regulations which requirebanks to hold 36% of their liabilities in India in Government andGovernment-approved securities. This reserve requirement, also known as thestatutory liquidity ratio (SLR), which stood at 25% of bank liabilities whenintroduced in 1962 has been raised several times to its present level of 36%and has now become the major channel for directing bank resources to theGovernment. Scheduled banks are also required to hold 8.5% of bank depositsas balance with the Reserve Bank under cash reserve ratio (CRR)requirements. These high levels of reserve requirements coupled withpriority sector lending targets significantly reduce the flexibility of thebanking system to engage in discretionary lending.

Credit Authorization Scheme

19. Related to credit deployment is the Credit Authorization Scheme(CAS) introduced by the RBI in 1965 as an additional measure of creditregulation. The CAS went through major modifications in 1975, 1979, and1983 following recommendations of various Committees. The main objectivesof the scheme are to enforce financial discipline on the larger borrowersand ensure that they do not preempt scarce bank resources. Under thisscheme, commercial and cooperative banks are required to obtainauthorization from the RBI prior to extending credit beyond certain limitsto large borrowers.l/ The CAS mostly affects working capital requirementsalthough it also affects term lending. In 1975 and 1979, the CAS wasmodified following the recommendations of the Tandon (1974) and Chore (1979)Committees. The most important recommendations set limits on borrowers forholding inventories and receivables which restrict their ability to borrowfrom the banking system. These limits, and the CAS in general, have beencriticized on various grounds: (a) they do not give the banks theflexibility required to operate in a constantly changing economicenvironment; (b) they are too restrictive since they try to enforce twotypes of control: limit inventory holding by firms and restrict theproportion of bank finance in total hence working capital; and (c) theyclassify industry into only 15 groups, hence they do not make allowance forrelevant individual characteristics, including variances in financialstrength, market circumstances, management strengths; and the differentsubsector characteristics.

20. In 1983 the CAS was reviewed by the Marathe Committee which madevarious recommendations to streamline the authorization process. TheCommittee recommended that banks should be allowed greater discretion todeploy credit under CAS, in certain specific conditions, even without RBI'sprior clearance. The larger discretionary powers are meant to speed up therelease of funds to borrowers. The RBI has endorsed the recommendations ofthe Committee and is moving toward their implementation. A more meaningfulliberalization of CAS may not be feasible unless the cash credit systemwidely used in India is substantially modified (for details refer toparagraph 4.18). A major reason for the establishment of CAS, and for thetightening in its implementation in 1974 and 1979 was to enhance creditcontrol and planning by the RBI on a cash credit system in which this kindof control would otherwise be very difficult. Nonetheless, the fact thatit has been subject to so many revisions in recent years clearly indicatethat there is some dissatisfaction with the effects of CAS on the ability ofBanks to provide timely credit and to be held fully responsible for theallocation of credit. Perhaps other general instruments of credit planning

1/ The scheme has been modified several times in the past to account forchanging economic environment. For more details refer to the section onthe CAS (paragraphs 4.8 to 4.21). As of June 30, 1983, credit limitsunder the CAS stood at Rs 170.5 billion and affected 897 parties ofwhich 188 were of the public sector and accounted for 60.9% of the totalcredit limits.

could be modified to replace CAS and achieve its objectives without theassociated costs.

Interest Rate Policy

21. The level and structure of interest rates in India are fixed by theGovernment through the Ministry of Finance and the Reserve Bank. Theinterest rate policy focuses on the following sometimes conflictingobjectives: (a) mobilization of financial savings by offering attractivereturns; (b) support of activity on particular sectors through lending atpreferential interest rates; (c) financing the Government's considerableborrowing requirements as cheaply as possible; and (d) providing a generalframework for macroeconomic stability. As a result, the structure ofinterest rates is too complex and could be simplified in order to raise theefficiency of financial intermediation. Some aspects of interest ratepolicy such as preferential lending rates for particular sectors andpreferential borrowing rates to the Government have the potential formisallocating resources. In the past changes in interest rates have beenmade on a piecemeal basis and in many cases have caused undesireddistortions by providing too high or too low returns to certain types offinancial assets. The fact that in addition to a complex interest ratepolicy, India also has a very detailed credit allocation policy alsoindicates that there is scope to simplify the interest rate structurewithout significantly altering the direction of credit. The simplificationof the interest rate structure would bring about several benefits to thefinancial system, including lower administrative costs, improved allocationof resources, and possibly an overall reduction in interest rates.

22. Temporary upsurges in inflation have caused real interest rates toturn negative sporadically, particularly for deposits, but negative realinterest rates have not been a significant cause for concern because thephenomenon is temporary and also because the rates turned only slightlynegative (excluding 1973-75). The Government has chosen to tackle theproblem of negative real interest rates by controlling upsurges in inflationrather than by increasing nominal rates. Therefore, adjustments in theoverall level of interest rates have been fairly infrequent over recentyears, though there have been a number of changes in interest rates forparticular categories of lending. The current policy is sensible sinceIndia's inflation is known to fluctuate sharply because it is very sensitiveto agricultural performance which in turn is sensitive to fluctuations inrainfall.

CHAPTER I

INSTITUTIONAL STRUCTURE OF THE INDIAN FINANCIAL SYSTEM

1.1 The Indian financial system is characterized by its two majorsegments: an "organized" sector, which includes commercial, development andcooperative banks, the stock market, and various non-banking financialinstitutions including insurance corporations and mutual funds; and a"traditional" sector also known as the informal credit market which providesfinancing mainly for small enterprises, farms and consumption. The twomarkets are segregated according to categories of customers, rates ofinterest and credit conditions, miscellaneous business practices, and to acertain extent, different geographical areas. Systematic information on thesize of the informal credit market is not available. For instance, accord-ing to Timberg,l/ the informal credit market accounts for up to 30% of allcapital in Indian urban markets while Goldsmith 2/ attributes a much smallershare to its financial operations. This paper will focus only on theorganized financial system.

1.2 Financial intermediation in India's "organized" sector is conductedby a wide range and large number of financial institutions which operatelargely in the major cities. Since the 1960s, however, there has been adrive toward decentralization which has been quite successful at mobilizingsavings, particularly by commercial and cooperative banks in smaller popula-tion centers. The Reserve Bank of India as the main regulator of credit isthe apex institution in the financial system. Other important financialinstitutions are the commercial banks which hold about 40% of the totalassets of the financial system. Outside of the commercial banks, the finan-cial system includes institutions which predominantly mobilize resources,such as the Cooperative Banks, the Life Insurance Corporation, the GeneralInsurance Corporation, and the Unit Trust of India and institutions whichpredominantly provide financing such as industrial, agricultural and housingdevelopment bodies at the all-India regional, and State levels. Otherimportant institutions for resource mobilization are the Post Office SavingsBank and Provident Funds which use almost all of their funds to financegovernment activities. In addition, there are several investment, hire-purchase and leasing companies which have played only a very limited role inthe system due to the small development of the capital markets in India.Chart 1 shows the structure of the organized financial system in India. Thefollowing is a description of the major institutions in the system.

1/ For an overview of the unorganized capital market refer to "InformalCredit Markets in India," T. Timberg (World Bank, Mimeo, August 1979).

2/ "The Financial Development of India 1860-1977", R.W. Goldsmith, OxfordUniversity Press, 1983.

JI_~~~~~~~II~ L

ii M ki ',t

ri lI

-3-

A. RESERVE BANK OF INDIA (RBI)

1.3 The RBI is the central bank of the Indian financial system. It wasestablished in 1935 and from 1949 became a Government-owned institutionunder the Reserve Bank Act of 1948, which empowers the Central Government toissue directions to the Bank, after consultation with the Governor of theBank. The RBI formulates and implements monetary and credit policy, func-tions as banker's bank and Central bank; manages the liquidity reserves ofthe credit institutions and supervises their operations. It also plays animportant role in the maintenance of the exchange value of the rupee,exercises control over payments and receipts for international tradetransactions, and regulates other transactions in foreign exchange. Inaddition to these traditional functions of a Central Bank, it undertakesseveral special functions aimed at developing the financial system such as:integrating the informal credit market into the organized financial sectors,encouraging innovation in cooperative banks and extension of the commercialbanking system in the rural areas, and influencing the allocation of long-term investment credit. It also has a creative role in developing thesystem. For instance, it started the Agricultural and Rural DevelopmentCorporation (ARDC), the Unit Trust (UTI), the Industrial Development Bank ofIndia (IDBI), and developed the Agricultural Cooperative Credit System.

B. COMMERCIAL BANKING

1.4 Next to the RBI, commercial banks are the most important institu-tions in the system. Commercial banking has changed substantially over thepast 30 years due to increasing nationalization and tighter governmentcontrol over bank operations. In 1955 the Imperial Bank, the largest bankin India, was nationalized and merged with the government-owned banks ofsome of the princely States to become the State Bank of India (SBI). Otherimportant changes which occurred in the mid-sixties were the implementationof the Credit Authorization Scheme which subjected banks to obtain RBIapproval on extension of new credit in excess of Rs 1 million to largecompanies, and the enactment of the Scheme of Social Control in 1968 whichset up guidelines for banks to allocate credit to priority sectors. In July1969, the 14 largest privately-owned commercial banks were nationalized,bringing under direct government control about 80% of the commercial bankassets. In April 1980, six additional commercial banks were nationalized.The nationalization and tighter government control over the major banks wasaimed at reducing the Banks' concentration of economic power and theirinfluence on industrial and business monopolies, and at increasing the flowof credit to small businesses and industries. It was intended that thesemeasures would achieve a wider spread of bank credit, prevent its misuse,direct a large flow of credit to priority sectors and make banks more effec-tive instruments of economic progress. In short, the significant changes inbanking were aimed at increasing the role of banks as catalytic agents ofdevelopment.

1.5 The changes in the banking structure have succeeded in: (a) wideningthe geographical coverage and spreading banking into rural areas;(b) increasing mobilization of deposits; and (c) reallocating bank creditin favor of people with limited means and in favor of sectors and activitiespreviously neglected. In addition, however, these have resulted in an

-4-

increasing degree of public ownership and control of financial institutionsand consequently has reduced the operational autonomy of their managements.The major government policies aimed at controlling the scope and operationsof the commercial banking system is reviewed in Chapters 3 and 4.

1.6 Commercial banking in India is largely of the branch banking type.It consists of scheduled and non-scheduled banks, the former accounting foran overwhelmingly large proportion of total commercial bank assets(99.9%).1/ In June 1982 there were 201 scheduled banks and four non-scheduled banks. The status of scheduled banks confers to them severaladvantages such as: (a) eligibility for refinance facilities from RBI; and(b) possibility of being granted a license to handle foreign exchangebusiness. Out of the 201 scheduled commercial banks, 121 were regionalrural banks, 28 were public sector banks and 52 were private (including 18foreign banks). Regional rural banks (RRBs) have been set up starting from1976 under the Regional Rural Bank Act. They are established for the provi-sion of credit to the weaker sections of the rural population, particularlyto small and marginal farmers, agricultural workers, artisans, etc. RRBsare authorized to provide short, medium and long-term credit. If they aresponsored by any commercial bank, RRBs can be set up in any State or Unionterritory with an authorized capital of Rs 10 million and issued capital ofRs 2.5 million, of which 50% is subscribed by the Central Government, 15% bythe concerned State government and the balance left to the sponsor bank. Inaddition, the sponsoring bank aids the RRB by recruiting and trainingpersonnel and providing managerial and financial assistance. To ensuretheir viability, the Reserve Bank of India has granted concessions to theRRBs. For instance, they have direct access to RBI for refinancing assis-tance at 3% below the Bank rate, they are allowed to maintain a lower levelof statutory liquidity than the commercial banks and to pay 1/2 per centmore interest on all deposits than commercial banks (except deposits ofthree years and above).

1.7 There is both support and criticism of Regional Rural Banks. Therationale behind establishing RRBs is that there are rural areas wherecommercial banks would not like to have their branches because of the highoperating cost. However, public sector banks have indicated that many StateGovernments are not very supportive of setting new RRBs because they fearthat they will compete with the cooperative credit institutions. TheCommittee on Functioning of Public Sector Banks indicated that this fear isunfounded and that there is ample scope for coexistence of cooperative andcommercial banks in rural areas.2/ Although some of the RRBs have becomeviable, others have not and will find this very difficult due to lack of

1/ A scheduled bank is registered in the Bank schedule of the RBI afterfulfilling the following conditions: it must (a) have paid-up capitaland reserves of at least Rs 500,000; (b) be a limited company in thesense of the Indian Companies Act or founded by special charter or bylaw; and (c) abide by RBI and central government regulations.

2/ Report of the Committee on Functioning of Public Sector Banks, RBI,1978.

-5-

potential in the area or excessive competition from other banks,particularly cooperatives.

1.8 The main problems of RRBs are the high level of overdues and theirlow profitability. At the end of 1982, the overdues of all RRBs amounted toRs 1.3 billion or about 22.2 per cent of their total loans outstanding. Theposition is likely to deteriorate in the near future unless the RRBs takespecial measures to reduce the overdues such as: (a) upgrading loanappraisal methods; (b) undertaking detailed analysis of their arrears port-folios to identify deliberate defaulters from those with serious problems,and to isolate the cause of the problems; (c) strengthening collectionprocedures and loan supervision, and (d) drawing up a phased program forreduction of arrears to be closely monitored. Profitability is also a majorconcern; 39 per cent of the 107 established RRBs incurred losses in 1981.Several RRBs have accumulated losses which exceed the total amount of theirpaid-up-capital. Low profitability is due to various reasons: (a) highoverdues, (b) low spreads between average lending rate and cost of borrowing(this occurs because RRBs' lending is confined to the weaker sections and atlow interest rates), (c) inadequate staff resources, and (d) rapid branchexpansion without careful assessment of viability or adequacy of infrastruc-ture facilities.

1.9 The important feature to note in Table 1.1 is the overwhelmingimportance of public sector banks on the total assets, deposits and creditsof the commercial banking system. Commercial bank assets totalled Rs 582.2billion as of December 1980. 90.5% of the assets belong to public sectorbanks with the State Bank of India and its seven associates jointly holding31.3% of the total. Private sector banks account for 8.8% of total assetsand regional rural banks for the remaining 0.7%. The distribution ofdeposits and credits between the various types of banks also follow asimilar pattern: the share of public sector banks is about 91%, that ofprivate sector banks about 8%, regional rural banks account for 0.9% andnon-scheduled banks for 0.1%.

-6-

Table 1.1: Structure and Scope of Commercial Banking in India

(Rs billion)December 1980 /a

June 1982 June 1982 Total Total Total# of Banks Bank Offices Assets (Z) Deposits (Z) Credit (Z)

I. Scheduled Banks 201 39150 582.1 99.9 428.7 100.0 272.6 100.0

(a) Public Sector Banks 28 29698 526.6 90.5 391.9 91.4 248.9 91.3

1. State Bank of India (SBI) 1 6047 150.2 (25.8) 93.0 72.12. Associates of SBI 7 2813 31.8 (5.5) 24.1 14.93. 14 banks national-

ized in 1969 14 17804 308.4 247.0 146.14. 6 banks national-

ized in 1980 6 3034 36.2 27.8 15.8

(b) Regional Rural Banks 121 5118 4.1 0.7 2.1 2.5 0.9

(c) Private Sector Banks 52 4334 51.4 8.8 34.7 8.1 21.2 7.8

1. Other Indianscheduled 34 4202 28.8 22.4 12.2

2. Foreign banks 18 132 22.6 12.3 9.0

II. Non Scheduled Banks 4 30 0.1 n.s. 0.1 0.1

Total 205 39180 582.2 100.0 428.8 100.0 272.7 100.0

/a Classification of banks slightly different from that in first and second columns sinceAssets data breakdown is not available beyond December 1980.

Source: RBI, "Report on Trends and Progress of Banking in India 1981-82" and "Statistical TablesRelating to Banks in India."

1.10 The vast increase in the number of banks and the spread of branchesinto rural areas during the past 15 years, while welcome, have placed severestrains in the organizational, financial and administrative capacity of thebanks. Analysis of financial data of scheduled commercial banks shows thatthe profitability of commercial banks has declined overtime. For example,the ratio of profits before tax to total earnings was 21% in 1956, 23% in1961, 11% in 1969, averaged 10% in 1975-78 and 9% in 1979-80. Profit beforetaxes as a percentage of deposits also declined from 1.1% in the early1960's to 0.9% in the late 1970s.1/ Bank profitability has deteriorated dueto the combination of the following factors: (a) higher administrative costrelated to lending to priority sectors and opening of branches in rural and

1/ Data taken from RBI, "Statistical Tables relating to Banks in India",various issues.

-7-

unbanked areas; (b) lower cost recovery associated with credit expansion topriority sectors, particularly to agriculture; (c) interest rate subsidiesfor various activities such as agricultural credit, small industry,differential rate of interest scheme, and other borrowers at concessionalterms; (d) increasing amount of bank funds locked up in "sick industries";(e) higher cost of funds caused by upward trend in interest rates ondeposits and higher proportion of term deposits on total bank deposits;(f) increases in reserve requirements which result in significant amounts ofresources deployed in low-yielding assets; and (g) outdated systems andprocedures which do not optimize the use of manpower.

Table 1.2: Progress of Commercial Banking at a Glance(Outstanding as of June each year in Rs billion)

1969 1972 1975 1979 1982 1983 1984

1. No. of offices 8,262 13,622 18,730 30,202 39,177 42,079 44,5832. Aggregate Deposits 46.5 76.1 125.5 286.7 461.3 540.4 638.5

(a) Demand 21.1 33.6 52.6 110.5 90.6 102.0 119.4(b) Time 25.4 42.5 72.9 176.2 370.7 438.4 519.1

3. Aggregate Credit 36.0 54.8 89.6 191.2 301.8 360.1 430.6% share of prioritysector lending 15.0 23.3 27.5 36.6 39.0 39.0 39.2

4. Credit-DepositRatio (%) 77.5 72.0 7i.4 66.7 65.4 66.6 67.4

5. Investment-DepositRatio (X) 29.3 30.5 32.5 32.7 36.7 37.0 36.3

Source: Report on Trends and Progress of Banking in India, 1983-84; andBanking Statistics, Vol. 8, Dec. 1982; RBI.

1.11 Indian scheduled banks also appear to be somewhat overstaffed. In1979 they had 520,000 employees, or about 18 per branch; in 1982 the averageincreased to 20. Consequently salaries and administrative expensesaccounted for 22 percent of the total expenses of nationalized banks, whileit accounted for only 18% for foreign banks operating in India.

C. POST OFFICE SAVINGS BANK (POSB)

1.12 The Post Office Savings Bank, is run by the Post and TelegraphDepartment on behalf of the Ministry of Finance with the National SavingsOrganization being responsible for promotional work and publicity. ThePostal saving system operates through the network of post offices whichallows it to reach remote corners of the country catering to the savings ofthe lower income population that do not want to venture to commercial bankswhich they may see as too sophisticated. The Post Office Bank gets a largeproportion of its deposits from rural areas: 38% of the deposits and 30% ofits resources come from villages. The average size of the post officesavings account is about Rs 560 while that for an average bank account is

-8-

about Rs 940. The POSB accounts for about 17% of total aggregate depositswhile banks account for 83%.

1.13 The POSB collects funds through various savings schemes such as:(a) savings bank accounts carrying an interest of 5.5% per annum;(b) recurring and cumulative time deposit schemes; (c) time deposits with 1,2, 3 and 5 year maturities; (d) Public Provident Funds with 15 yearsmaturity, offering a tax-free interest of 8.5% per annum. Annual depositsvary from Rs 100 to Rs 30,000; (e) National Saving Certificates (NSC) issuedat intervals; and (f) Social Security Certificates, introduced in 1982, with10-year maturity, paying three times the investment at maturity (rate ofinterest 11.6% per annum) and providing social security benefits.

Table 1.3: Breakdown of Outstanding Deposits in POSB(Rs billion)

March 1980 March 1981 March 1982 March 1983

Savings Bank 20.07 22.38 23.42 23.95Cumulative Time Deposits 2.46 3.05 3.64 4.55Recurring Deposits 3.17 3.77 4.29 5.35Time Deposits 30.20 35.58 42.45 47.64Savings Certificates 11.76 14.04 19.75 29.48Total POSB 67.66 78.82 93.55 110.97

Memo Item

Aggregate Bank Deposits /a 396.22 471.1 545.97 637.40

/a Includes POSB and all scheduled banks.

Source: Report on Currency and Finance, various issues, RBI.

1.14 These POSB schemes offer higher returns than those of scheduledbanks and provide a variety of alternative investment possibilities coupledwith tax saving features,l/ thereby attracting higher income groups as wellas small savers. A major drawback of the Postal Office Saving system is itsinefficiency, related to outdated systems and procedures. This explains whyPOSB does not account for a larger share of the deposits market even thoughit offers yields with tax benefits and safety comparable to, or better than,any bank.

1/ Tax concessions vary depending on the savings scheme selected. Someinvestments provide full shelter from income tax on interest receipts orfrom wealth-tax, while others offer more limited tax concessions.

-9-

D. INSTITUTIONAL FINANCE FOR INDUSTRY

1.15 Since independence in 1947, several institutions have been estab-lished by the Government to provide long-term credit. Thus, India has alarge number of term financing institutions, which were set up to promoteand provide long-term finance to viable investment projects in industry andagriculture. Some of these institutions operate on a national basis (all-India institutions) while others operate within regions or States.

1.16 The all-India institutions, under the direction of the CentralGovernment, specialize in lending to medium and large industries, with somealso providing refinance and indirect assistance to other financial institu-tions and smaller industrial units. The regional and state institutionscontrolled by State Governments concentrate on small and medium industrialunits. These financial institutions obtain their resources partly from theGovernment and partly as loans or refinancing from the capital market. Theassistance provided by these institutions is quantitatively important in thefinancing of corporate investment. All these development finance institu-tions not only provide term loans but also provide equity capital and are,therefore, shareholders in many enterprises. This enhances the role of theinstitutions in providing support to industrial units in the areas ofmanagement and finance.

1.17 The principal all-India industrial finance institutions are theIndustrial Development Bank of India (IDBI), the Industrial Credit andInvestment Corporation of India (ICICI), Industrial Finance Corporation ofIndia (IFCI), Life Insurance Corporation of India, and Unit Trust of India(UTI). At the regional or State level, the most important institutions arethe State Financial Corporations (SFCs), which finance small and mediumscale industries and the State Industrial Development Corporations (SIDCs)which mainly promote and help finance larger industries having direct Stateshareholding. Other institutions at the State level, which also providefinancial assistance, are State Small Industries Corporations (SSICs) whichallocate and distribute raw materials to small industries and provide somehire-purchase finance, and State Small Industries Development Corporations(SSIDCs) whose main activities are to establish and manage industrialestates. Table 1.4 shows the major financial institutions providing fundsto industry.

1.18 An important feature of the system for industrial finance in Indiais the participation of major investment institutions in consortium financ-ing with other all-India financial institutions. The Unit Trust of India(UTI), Life Insurance Corporation of India (LIC), and General InsuranceCorporation (GIC), work closely with other all-India financial institutionsto meet the financial requirements of the industrial sector. In order tofacilitate the application process for financial assistance, the modalitiesof the consortium finance have been streamlined. The institutions haveintroduced common application forms, the "lead" institution concept and theProject Financing Participation Scheme. Proposals for project assistanceare now submitted in a common application form to one of the institutionswhich forwards copies to the other institutions. The "lead institution"

-10-

appraises the project in association with the other participating institu-

tions and sanctions assistance after the sharing of assistance is decided in

inter-institutional meetings.

1.19 The following sections discuss the functioning of the major institu-

tions providing finance for industry, looking at: (a) the structure of

their capital and ownership, (b) their rationale and major activities, and

(c) their outstanding features.

Table 1.4: Institutional Finance for Industry

(Rs Billion)Financial Assistance 1981/82 Total

Institution Abbr. Sanctioned % Disbursed Assets (1982)(Rs billion)

Industrial DevelopmentBank of India IDBI 13.3 /a 37.2 10.4 43.31

Industrial FinanceCorporation of India IFCI 2.4 6.7 2.0 7.54

State Financial Corporations (18) SFCs 5.9 16.5 4.0 14.23

Industrial Credit andInvestment Corporation ICICI 4.1 11.5 2.8 10.37

Industrial ReconstructionCorporation of India IRCI 0.6 1.7 0.4

National and State Industrial NIDCDevelopment Corporations (26) SIDC 3.0 8.4 2.1

Life Insurance Corporation LIC 1.4 3.9 0.9 70.91 /b

Unit Trust of India UTI 1.3 3.6 0.7 4.95 /b

General Insurance Corporation GIC 0.9 2.5 0.5

Export Import Bank of India EXIM 2.9 8.0 2.1 2.6

Total 35.8 100.0 25.9

/a Excludes refinance to SFCs and SIDCs.Tr In 1980.

Source: Report on Currency and Finance, RBI.

All-India Financial Institutions

1.20 Industrial Development Bank of India (IDBI) - IDBI has been respon-sible for coordinating term finance institutions for industry since 1964.The IDBI was established in response to the perceived need for an apexinstitution which would coordinate the operations of the industrial financeinstitutions which, although quite large in number and diversity, did notadequately meet the requirements of medium and long-term finance nor ofrendering promotional services to the industry. Founded as a subsidiary ofthe RBI, it holds an interest of 50% in the Industrial Finance Corporationof India (IFCI). It is the largest development bank in India and formalcoordinator of other term-financing institutions. It provides financing toSFCs and SIDCs through refinance and bills discounting facilities and equityparticipation and refinances commercial banks. It also finances industrydirectly and provides technical and administrative assistance through estab-lishment of and support to Technical Consultancy Organizations (TCOs).

1.21 During the last five years there has been a marked shift in thecomposition of assistance in favor of small and medium enterprises underIDBI's indirect schemes (refinance of industrial loans and rediscounting ofbills for sale of indigenous machinery on defined basis). Direct assistancewhich formed 37% of total assistance in 1978/79 gradually declined to 27% in1982/83. This shift was allowed by improved conditions in the capitalmarkets and greater participation by GIC and UTI in consortium financing.In 1982/83 assistance sanctioned by IDBI was distributed as follows: directproject finance (22%), underwriting and direct subscriptions (1.6%),refinance of industrial loans (49%), rediscounting of bills (21%), softloans (1.7%), subscription to shares and loan of financial institutions(2.6%), and others (2.1%).

1.22 In 1982/83, IDBI's total fund requirements for disbursement ofassistance, repayment of borrowings, and interest and dividend paymentsamounted to RS 18.8 billion. Internal generation of funds met 47.1% of therequirement, and the balance was covered by market borrowings (27.8%),borrowings from RBI (16.5%), increased COI share capital (1.6%), and others(7%).

1.23 The Industrial Credit and Investment Corporation of India (ICICI)was founded in 1955 and is owned and financed mainly by the private sector.Participation in its capital are from commercial banks, insurance companies,local limited companies, private persons, and various foreign insurance andlimited companies. It promotes private enterprises in three ways; firstly,it offers medium- and long-term loans, share and debenture underwriting,equity participation, loan guarantees and provision of managerial and tech-nical assistance to enterprises; secondly, it lends heavily to non-traditional sub-sectors such as chemicals and petrochemicals, electricalequipment and electronics and mechanical engineering, and thirdly, itprovides the most important institutional source of foreign exchange financ-ing for private industry, accounting for over three-fourths of foreignexchange financing by all of the institutions. There are no firm limits onthe size of an enterprise ICICI is prepared to assist, nor is there a maxi-mum or minimum limit on the investment it will make. In addition, toindustrial finance, ICICI also lends for rural development projects.

-12-

1.24 ICICI has the strongest financial position of all the institutionsproviding industrial finance. In 1982/83 internal generation of funds met44.2% of requirements, the balance being provided by market borrowings(53.6%) and borrowings from GOI/RBI/IDBI (2.2%). Overdues as a percentageof aggregate outstanding assistance were 2.6Z, the lowest of all theinstitutions in the consortium (compared with 4.8% for IDBI, 4.3% for IFCIand 19.1% for SFCs).

1.25 Industrial Finance Corporation of India (IFCI), was founded in 1948,with its ownership held jointly by public and private sector institutions.Participating in its capital are the IDBI (50%), scheduled banks,cooperatives, other banks, insurance companies, investment trusts, etc. Itlends and invests only in limited private and public sector companies orcooperatives engaged in manufacturing, shipping, mining, hotels and power.IFCI's assistance is available for setting up new industrial projects andalso for the expansion, diversification or modernization of existing ones.Assistance may take the form of long-term loans, underwriting and subscrib-ing to equity, preference and debentures issues, and guarantees. In1982/83, IFCI financed 46% of its fund requirements from internalgeneration, 11% from GOI/IDBI lending and 43% from other market borrowing.

1.26 The Industrial Reconstruction Corporation of India (IRCI) wasfounded in 1971 originally to provide financial and technical assistance forreconstruction and rehabilitation of sick industrial enterprises in WestBengal; however, in recent years, it has expanded its operations beyond WestBengal. IDBI holds 50% of its capital, the balance being provided by IFC,ICICI, the State Bank, the nationalized banks and the Life InsuranceCorporation of India.

1.27 IRCI was the only organization dealing mainly with "sick" industrialunits, but did not have the power to bring about structural changes eitherin the management or finances of the assisted units. In 1982/83 internalgeneration of funds contributed to 12.6% of IRCI's fund requirements, bondissued raised 12.5%, and the balance was met by borrowings, subsidies, andincentives from Government. In July 1984, a new bank was formed, theIndustrial Reconstruction and Development Bank of India (IRDBI), which willtake over the operations of IRCI. IRDBI will be an independent organizationlike IDBI and will have power to revive, liquidate, sell and order mergersof industrial units assisted by it. In order to avoid the financialproblems of IRCI (low internal generation of funds and very high level ofoverdues), IRDBI will embrace a wider spectrum of industries.

1.28 Export-Import Bank of India (EXIM BANK) was established in 1982 tostrengthen the institutional framework for encouraging the export of non-traditional products. It finances, facilitates, and promotes foreign tradeof India and coordinates the work of institutions engaged in financingexports and imports. EXIM BANK started its operations with an authorizedcapital of Rs 2 billion, which can be increased to Rs 5 billion. As onDecember 31, 1983, its resources comprised paid-up capital of Rs 1 billion,long-term loans of Rs 450 million from GOI and Rs 1,250 million from theRBI, and Rs 1,522.76 million due to IDBI on transfer of export loans. In1983, the Bank also raised Rs 530 million in the domestic bond market and

-13-

two Euro-dollar loans aggregating US$50 million. During 1983 the Bank'scommitments aggregated Rs 3,138 million.

Investment Companies Providing Industrial Finance

1.29 The Life Insurance Corporation of India (LIC) was founded in 1956 bythe nationalization and merger of about 250 independent life insurancesocieties. Its main purpose is to carry on life insurance business, but hasgradually developed into a specialized all-India financial institution. Itplays an important role in the capital market of the country and is one ofthe two largest and most successful institutional investors in India. Bylaw, it must invest 25% of its funds in Government securities and a further25% in "approved" securities. It also invests in infrastructuralfacilities, housing and industry. LIC is the most important institutionunderwriting equity and debenture issues for the industrial sector.

1.30 Apart from underwriting and purchasing corporate securities, LICfinances private industry through subscriptions to the shares and bonds ofindustrial financial institutions and also provides finance to corporateenterprises in the form of direct loans. A notable feature of LIC's long-term assistance to industry has been its rising share of loan assistanceas against underwriting and direct subscription. In 1981/82, 76.5% of LIC'stotal assistance to industry was in the form of loans, while the remaining23.5 was in subscriptions. However, although LIC direct financing toindustry has grown considerably, loans sanctioned by LIC constitute onlyabout 1% of total private corporate capital formation.

1.31 The General Insurance Corporation (GIC) was formed when the manage-ment of general insurance businesses in India was taken over by theGovernment in 1971 and subsequently nationalized in 1973. According toGovernment guidelines, 70% of annual additions to investible funds have tobe invested in "socially-oriented" sectors. Such investments includeCentral and State Government securities, bonds and debentures of publicsector undertakings and also loans on soft terms to State Governments andother agencies engaged in housing and urban development. Total investmentsof the GIC stood at Rs 12.8 billion in 1982. About one-half was invested inGovernment and other approved securities, one-third in shares anddebentures, term loans and deposits with companies, and the balance in loansto banks on participation certificates and bills rediscounting schemes.

1.32 Unit Trust of India (UTI), was founded in 1964 and in 1976 becamean associate institution of IDBI. It is the largest mutual fund in India.Initial ownership was split as follows: RBI 50%, LIC 15%, State Bank ofIndia 15%, and other banks and financial institutions 20%. Beyond theinitial capital, UTI raises funds by the sale of small denominations(units). The yield from these units, which is market-based, is tax free upto Rs 5000. UTI encourages savings by middle and low-income groups, andchannels these funds to industrial development. It thus enables smallsavers to invest in industry without exposing their savings to undue risk.The UTI is a major underwriter of public shares and debenture issues, andhas emerged as an important institutional holder of corporate securities inthe industrial securities market vis-a-vis the other financial institutions.

-14-

The establishment of the UTI has enlarged the market for industrialsecurities.

1.33 UTI's investible funds reached Rs 8.7 billion at the end of 1982/83,of which 81.3% were placed in the industrial corporate sector. In 1982/83,UTI provided Rs 1.3 billion in direct assistance to the corporate sector,55% in the form of privately placed debentures and the balance in the formof underwriting, direct subscriptions, firm allotments and rights issues.

State Level Industrial Finance Corporations

1.34 State Financial Corporations (SFCs), have been established incapital cities of 18 federal states; most of them as a result of the StateFinancial Corporation Act of 1951. Their shareholders are the respectivefederal State governments, the IDBI, credit cooperatives, insurancecompanies, investment trusts and private shareholders. Private ownershipcannot exceed 25% of SFCs total capital. SFCs obtain additional capital bytaking deposits from the public, borrowing from State governments and theRBI, and refinancing loans with IDBI. External resources accounted for 66%of total funds required in 1982/83, 63% of which was provided by IDBIthrough refinancing and 26% were borrowed from GOI and RBI. The assistanceof SFCs to industrial units is mainly through: (a) offering loans foracquisition of fixed assets; (b) guaranteeing for loans received byindustrial undertakings from scheduled banks or State Cooperative Banks;(c) guaranteeing deferred payments dues from any industrial concern inconnection with purchase of capital goods; and (d) underwriting the issuesof stocks, shares, bonds or debentures of industrial units.

1.35 A disquieting feature of SFCs' operations has been the growing levelof overdues. Total overdues, which were Rs 0. 92 billion in March 1977 andRs 1.75 billion in March 1979, have increased to Rs 2.25 billion in March1981, and Rs 2.67 billion in March 1982. By comparison disbursement ofassistance in 1981/82 was Rs 3.15 billion. Overdues therefore constitute19% of total loans outstanding. The recovery performance varies widelyamong the SFCs. During the past two years, several SFCs have beenimplementing measures to improve the recovery position, with encouragingresults. As a result, the share of overdues to total loans outstandingdeclined from 27% in March 1981 to 23% in March 1982 and 19% in March 1983.

1.36 The persistence of major problems in most SFCs calls for remedialaction. The following are some areas of SFCs' operations which should beaddressed: (a) high turnover of staff at management levels: (b) inabilityto attract and retain experienced professional staff; (c) inadequate manage-ment information systems; (d) major deficiencies in appraisal procedures;(e) weak supervision and collection procedures, and (f) high growth inoperations not supported by adequate organizational structures to appraise

-15-

and supervise operations and provide appropriate technical assistance toborrowers .l/

1.37 The Industrial Development Corporations, which exist both at thefederal level (NIDC) and at the State level (SIDC) are not exclusivelyfinancial institutions. Their original aim was to promote those industriesnecessary to fill gaps in the industrial infrastructure. To achieve this,the institutions were provided with financial resources and technical andcommercial know-how. Unfortunately, the NIDC has not lived up to expecta-tions and has remained as an agency of the Ministry of IndustrialDevelopment, merely undertaking investigations of publicly-owned industrialprojects. The SIDCs, on the contrary, have recorded sustained growth intheir operations. The main activities carried out by SIDCs are: (a)granting financial assistance to medium-scale industrial units in the formof loans, guarantees and underwriting or directly subscribing to shares anddebentures; (b) promoting industrial development through preparing techno-economic surveys and feasibility studies, identifying projects, and select-ing and training entrepeneurs; (c) administering various State Governmentincentive schemes; (d) developing industrial areas, constructing sheds andproviding infrastructural facilities; and (e) promoting joint sectorprojects in association with private promoters. Because of this record,IDBI has extended refinance assistance to SIDCs since 1976, and at present25 SDICs are eligible for refinance assistance. External sources accountedfor 65% of total fund requirements in 1982/83 and IDBI provided 49% ofexternal funds mobilized. The aggregate sanctions of SIDCs recorded analmost three-fold increase from Rs 0.98 billion in 1978/79 to Rs 2.97billion in 1982/83.

1.38 As in the case of SFCs, the arrears position and poor recoveryperformance are major concerns. Total outstanding arrears at the end of1982/83 was Rs 648 million, 34% higher than the year before. There werewide variations in the recovery rates of SIDCs, with Gujarat achieving 71%while Assam only achieved 6.2%. Ten SIDCs had recovery rates which rangedbetween 40% and 50%.

1.39 The National Small Industries Corporation Limited (NSIC), agovernment-funded institution, established in 1955, promotes the developmentof small industrial units.2/ It only extends financial assistance throughits hire-purchase operations. It provides services such as: (a) securingcontracts from the Central Government Stores Purchasing agencies;(b) exporting products of small industries; (c) training industrial workersand supervisors in its Prototype Development and Training Centers;(d) constructing and managing industrial estates; (e) supplying imported

1/ For more details on SFC's operations and problems refer to "ProjectPerformance Audit Report. First IDBI/SFC Project", World Bank June 1984(Unpublished internal document).

2/ Defined as small business (up to 50 workers) which use electricity,and larger businesses (up to 100 employees) which do not use electricityand have a capital of less than Rs 750,000.

-16-

and indigenous machinery and equipment on easy installments under its hire-purchase scheme; (f) distributing scarce raw materials and other componentsat comparatively less expensive rates than suppliers' credits; and(g) refinancing various schemes of the State Small Industries DevelopmentCorporations (SSIDCs). Besides its headquarters in Delhi, it has regionaloffices in Bombay, Madras and Calcutta and sub-offices in other majorcities. The NSIC is wholly owned by the Union Government. It supplementsits financial resources through borrowings and grants from the GOI, and byforeign credits and loans from banking institutions. Although NSIC doesmake a significant contribution to the promotion of small industry, its roleas financier is rather small because of inadequate financing and lowreplicability of its hire-purchase operations due to inadequate projectappraisal and low recovery of principal and interest.

1.40 The development finance institutions occupy an important place inindustrial planning and promotion. The seven all-India institutions 1/together account for about three-fourths of the assistance sanctioned by allterm financial institutions, including SFCs and SIDCs. The State levelinstitutions (SFCs and SIDCs) also occupy an important role in industrialpromotion but are much weaker institutions in terms of human, financial andadministrative resources. In order to strengthen these institutions, stateGovernments should study the possibility of restructuring them to reduceduplication of activities and to improve their administration and finances.

E. AGRICULTURAL FINANCING INSTITUTIONS

1.41 A thorough review of agricultural finance will not be attempted heredue to the diversity of institutions and complexity of the system. Thus,only a brief description of the system and of its major institutions will bemade to indicate the linkages with the rest of the financial system. Chart2 shows the complexity of the existing institutional set up for ruralfinance. In addition, this section will analyze major issues in agricul-tural finance.

1.42 India has followed the "multi-agency" approach in providing ruralfinance. Under this approach, cooperative, commercial, regional banks andother field level institutions provide rural finance and are supported byCentral and State Governments and national level institutions such as theReserve Bank of India, the National Bank for Agriculture and RuralDevelopment, the National Cooperative Development Corporation and theIndustrial Development Bank of India. The field level institutions whichprovide credit to individual borrowers are: (a) primary agriculturalcooperative credit societies providing both short-term and medium-termcredit to their members; (b) primary cooperative land development banks orbranches of State cooperative land development banks providing long-termcredit to their members; (c) branches of commercial banks, and (d) branchesof Regional Rural Banks (RRBs). Of the total agricultural credit outstand-ing at the end of June 1980, cooperatives accounted for 59.4%, commercialbanks for 38.8% and RRBs for 1.8%.

1/ IDBI, ICICI, IFCI, IRCI, LIC, UTI, and GIC.

CHART 2

AGRICULTURAL RNANCE

state d Deveo_nt

(coop wteflhm) (Coop insfttAlcns) nk(C)BksFM

j DCCO ICCP (coop insMvor)g

I I I I I iSNCDC~~~~~~~ I I

(PAC) Soite

PAa [lSl DO Fcwr & I

LII IJE Z E ZI~PLM twlb bwvImji ,mu,

Leg.l 9ttbc Bav l- ?&aW

Short-Tean CmML _ . Sr- OeD

-18-

National Bank for Agricultural and Rural Development (NABARD)

1.43 NABARD is the apex institution in the field of credit for agricul-ture and other rural economic activities such as small-scale industries,cottage and village industries, handicrafts and other crafts. It was set upin 1982 to coordinate agricultural credit and provide loans and refinanceassistance to the financial institutions operating in the sector. It hastaken over the entire undertaking of the former Agricultural Refinance andDevelopment Corporation (ARDC) as well as the Reserve Bank's functions inthe sphere of coordination and refinancing of rural credit. NABARD willprovide the same refinance facilities which were available from ARDC tocommercial banks, RRBs, State Land Development Banks (SLDBs) and StateCooperative Banks (SCBs). In addition, the refinance assistance previouslygiven by the Reserve Bank will be provided to RRBs and SCBs. Thus, it isempowered to provide short, medium, and long-term assistance.

1.44 In addition to its role as refinancing agency in the sector, italso: (a) provides institution building facilities; (b) coordinates therural financing activities of all the institutions involved; (c) monitorsand evaluates agricultural development projects it has refinanced and(d) invests in share capital or securities of institutions concerned withagriculture and rural development.

The National Cooperative Development Corporation (NCDC)

1.45 NCDC was established in 1962 to promote and finance projects andprograms carried out by agricultural and agro-industrial CooperativeSocieties. NCDC is authorized to advance loans, provide grants andsubsidies, and participate in the share capital of cooperative enterpriseswith inter-State activities. NCDC has promoted projects involving grainstorage, sugar factories, oil extraction, ginneries, spinning mills, dis-tribution of fertilizer, etc., marketing of agricultural produce and tradeof consumer goods in rural areas. Its role is not limited to that of aninvestment financing institution, but includes technical and managerialsupport to the subproject investors during the course of subprojectimplementation and in the operational phase. NCDC has, over the years,acquired considerable experience in the implementation of agro-processingprojects on the technical as well as managerial level.

1.46 In contrast to NABARD's sole responsibility at the national levelfor refinancing agricultural credit to cooperative and commercial banks,NCDC specializes in project lending. NCDC lends through some of the samefinancial intermediaries which NABARD refinances (SCBs and SLDBs), but itsloans are used for investments by Cooperative Societies and not individualfarmers, and the number of subloans is much smaller than NABARD's. NCDC'sfunds consist of grants and loans from GOI, retained earnings, and borrow-ings from the market. Unlike NABARD, it is not entitled to refinance itsloans through the Reserve Bank.

Cooperative Credit System

1.47 The cooperative credit system provides short, medium and long-termfinancing. The cooperative credit structure for short- and medium-term

-19-

credit is a three-tier federal structure with a State Cooperative Bank (SCB)at the apex level in each State, the Central Cooperative Bank (CCB) at thedistrict level in each State and the Primary Cooperative Societies (PCS) andPrimary Agricultural Credit Societies (PACS) at the base. State LandDevelopment Banks (SLDBs) are the apex cooperative institutions engaged inlong-term lending for agriculture. Together with commercial banks they arethe only sources of formal long-term credit to individual farmers. SLDBsfunction through branches or affiliated Primary Land Development Banks(PLDBs) providing development loans for periods up to 15 years, mostlyrefinanced by NABARD.

1.48 The financial performance of the various types of cooperativesvaries significantly. While SCBs ad SLDBs are generally profitable and havelow overdues, the Primary Cooperatives and Credit Societies show weakfinances and large overdues. Furthermore, while the State and Centralcooperative banks have been able to mobilize deposits to contribute a largeproportion of their working funds, the Primary Agricultural Credit Societieshave failed in promoting and mobilizing savings from their members.Deposits in SCBs make up for about 60% of their working capital and ownfunds finance 12%. The CCB's own funds constitute 16% of working capitaland deposits make up about 50%. In contrast, the PACS depend on borrowingsfrom other financing agencies to fund about 74% of their working capital.The PACS are plagued with financial difficulties of which the most importantis the high percentage of overdues to loans outstanding, which stood atabout 44% as of June 1981. Table 1.5 provides some major indicators of theperformance of the cooperative movement in India.

Issues in Agricultural Finance

1.49 The main issues in agricultural finance are (a) poor loan recoveryand high overdues; (b) high cost of agricultural credit; and (c) prolifera-tion of institutions. These problems will only be solved by undertaking arehabilitation program which includes (a) restructuring of institutions;(b) upgrading and strengthening field level staff; (c) improving managerialand supervising capacity; and (d) reducing political interference in loanrecovery efforts.

1.50 During the 1970s, the volume of short, medium, and long-terminstitutional credit disbursed to farmers grew substantially, practicallytripling in nominal terms and increasing annually by 4.5% in real terms.However, the ability of the rural credit administration to handle thisexpansion, while maintaining adequate quality control, has grown much moreslowly. Overstrained managerial capacity, inadequate and poorly trainedfield level staff and lack of effective procedures for supervision, monitor-ing and evaluation of credit disbursements have resulted in extremely poorloan recovery and high overdues. Political interference by state govern-ments in loan recovery efforts have exacerbated this problem. Overdues havebeen particularly high for long-term credit, hovering around 50% for thelast several years. Both commercial and cooperative banks are affected, butthe latter have suffered more acutely since their loan portfolios have beenconcentrated on agricultural lending, particularly for private wells. Manycooperatives have been forced to restrict lending and sizeable state govern-ment subsidies are needed to keep them solvent. The impact of these

-20-

constraints is evident in the virtual stagnation in the growth of realcredit since the start of the Sixth Plan. The need to begin what will bea slow process of rehabilitation is urgent. It is essential that steps betaken to upgrade and strengthen field level staff while improving coordina-tion between credit institutions and other agencies related to creditoperations.

1.51 According to the 1981 Report of the Committee to Review Arrange-ments for Institutional Credit for Agriculture and Rural Development(CRAFICARD), the principal reasons for overdues are: (a) failure to tie uplending with productive investments; (b) neglect of/or absence of effortsfor marketing arrangements and linkage of credit recovery with sale ofproduce; (c) defective loan policies, including untimely loan disbursements,underfinancing/over-financing and unrealistic scheduling of loan repayment;(d) misapplication of loans; (e) ineffective supervision; (f) apathy andindifference of management to take coercive measures for recovery; and(g) lack of responsibility and sense of discipline of borrowers.l/ Aprimary cause, however, of persistently high levels of overdues has been therapid expansion of lending in response to pressures to achieve mandatedcredit distribution targets.

Table 1.5: Progress of Cooperative Credit Movement in India(1982/83 figures in Rs billion)

SCBs CCBs S/CLDBs PACS PCBs

Number (in Units) 28 340 19 94,000 1,281Owned Funds 4.73 8.25 3.52 8.80 3.93Deposits 21.17 31.84 n.a. 3.81 22.78Working Capital 38.95 62.41 28.45 n.a. n.a.Loans Issued 41.90 45.08 4.26 /a 22.91 n.a.Loans Outstanding 29.06 43.05 20.47 7a 31.08 18.08Loans Overdue 1.83 13.30 2.85 7r 13.09 n.a.

/a Long-term loans7T Includes interest overdue

n.a. - not available

Source: National bank for Agriculture and Rural Development (NABARD) andReserve Bank of India.

1/ A 1974 RBI study on Overdues of Cooperative Credit Institutionsreached similar conclusions.

-21-

1.52 Another issue in agricultural finance is the current inadequatespread between the costs of agricultural lending and the revenues from theseoperations. Financial intermediaries face very high administrative costswhile lending to a multitude of small beneficiaries which are not covered byappropriate rate spreads. Agricultural lenders have to rely on Governmentsubsidies or cross-subsidize their agricultural credit operations from otherprofitable activities. Since interest rates are regulated by theGovernment, this problem will only be resolved by a thorough revision of thestructure of interest rates, particularly of those rates which affectagricultural lending.

1.53 Another weakness of the agricultural credit system which has to beaddressed is the proliferation of institutions, many of which are finan-cially not viable, and which overlap in their functions and objectives. Arestructuring of the agricultural cooperative credit system would bebeneficial. In addition further establishment of new institutions shouldonly be authorized after careful consideration of financial viability.

F. FINANCE COMPANIES

1.54 The private sector as well as the Government raise funds on thestock market. As in other countries, India's financial system also hasnon-banking financial intermediaries which compete with banks in the mobi-lization of deposits and in credit allocation. So far these companies havenot played an important role in influencing the direction of savings andinvestment or in mobilizing financial flows. The major types of financialcompanies are: hire-purchase finance companies, leasing companies, invest-ment companies, housing finance companies, loan companies or financecorporations, and mutual benefit financial companies. They are mainlyengaged in financing industry by advancing loans, in financing hire-purchaseoperations, providing leasing facilities, trading in shares and securitiesand investing in securities in general. Some also function as merchantbankers (for example the brokerage system is very well developed for companydeposits, and this has been a unique feature of the Indian markets since1860). As in the case of non-financial companies, financial companies areonly allowed to accept deposits from the public with short-term maturities(up to 3 years), thus they do not operate in the long-term financial market.

1.55 There are also some investment companies and unit trusts whichmobilize savings and invest them in industrial securities with the objectiveof providing a good return to savers while reducing risks throughdiversification. Of these companies only Unit Trust of India has a largerole in the Indian financial system. Recently, since 1983 several privateunit trusts or mutual funds have been set up in India. Their success willdepend on management capabilities, sources of finances, cost of finance anddeployment possibilities. The Government is currently contemplating therelaxation of legislation concerning mutual funds aimed at accelerating thepace of growth of the capital market, increasing competition, and providinga wider choice to investors. Mutual funds would not only mobilize largerresources for development but would also provide the basis for increasedactivity in secondary security markets.

-22-

C. STOCK AND SECURITIES MARKET

1.56 The stock market in India is regulated under the Securities Contract(Regulation) Act of 1956. At present there are twelve Stock Exchangesrecognized by the Government which offer an organized market for shares anddebentures of joint stock companies and for gilt-edged securities. TheBombay Stock Exchange is the leading stock market in India with the largestnumber and paid-up value of listed stocks. The stock market is composed ofthe new issue market, which is a primary market for raising new capital andthe stock exchange which forms the secondary market for stocks and othersecurities.

1.57 The private sector as well as the Government raise funds on thestock market. A very interesting and hardly known fact about the Indianstock market is the overwhelming importance of Government securities in itsvolume of operations as compared to industrial securities. During 1971-72to 1977-78, new funds mobilized through the issue of government and semi-government securities accounted for 93% to 97% of total new funds mobilized,the balance was for funds for the private corporate sector.l/ This propor-tion has been reduced somewhat in recent years due to increased activity inthe private capital market since 1980. This compares with the U.K. wherethe government securities market is also larger than the industrialsecurities market (private capital market).

1. Government Securities Market

1.58 As indicated above, the Government Securities market is the largestsegment of the India capital market. Government securities are issued bythe Central Government, State Government, and semi-Government authoritieswhich include local government authorities, autonomous institutions likeport trusts, state electricity boards, public sector enterprises, and othergovernment agencies, such as the All-India and regional financialinstitutions. Central and State Government securities outstanding stood atRs 219.6 billion at end-March 1982, with the Central Government accountingfor 84.6%. The annual net market borrowings by the Government haveincreased significantly over the last decade, increasing from Rs 2.3 billionin 1970/71 to Rs 28.0 billion in 1980/81 (equivalent to 32% of householdfinancial savings). These large Government borrowings from the market (asopposed to from the banking system) allowed India to finance a large propor-tion of its Government deficit without increasing inflationary pressures.

1.59 Ownership of Government securities is concentrated in institutionalinvestors which hold about 95% of total Government securities outstanding.In March 1982 the RBI held 23% of outstanding securities, scheduled banks44%, LIC 11% and Provident Funds 15%. The secondary market for Governmentsecurities operating in the stock market is very narrow since institutionalholders tend to keep the issues until maturity. Commercial banks, thelargest holders, can buy as many securities as they want, but cannot sell

1/ "Financial Markets and Institutions", L.M. Bhole, Bombay, 1982,Tata-McGraw Hill, Chapter 15.

-23-

securities beyond a limit due to Statutory Liquidity Reserve (SLR) require-ments which will be analyzed later in Chapter 4. RBI's holdings allow it toact as the regulator of market prices and that explains the price stabilitywhich characterizes Indian Government securities.

1.60 Interest rates on Government securities are not aligned with otherrates in the financial market. Rates are lower than on bank deposits,privately issued securities or company deposits. The main reasons for largeholdings of Government securities despite low rates are: the compulsion ofcertain institutional investors to buy these securities (SLR requirements)and their liquidity and safety. Individuals and other non-institutionalinvestors, such as trusts and joint-stock companies have maintained verysmall holdings. Ownership by individuals.is estimated at only 1% of totalGovernment securities outstanding.

2. Private Capital Market

1.61 In India the private capital market does not constitute a majorinstrument to mobilize savings and channel them into investment. This isbecause the stock market as well as the new issue market attract an insig-nificant proportion of household savings. Recently, the Government hasintroduced fiscal and financial measures aimed at encouraging the flow offunds into investment in shares. Resource mobilization through the capitalmarket has improved substantially during the past few years in response tothese policies which have affected both the demand and supply side of themarket. The corporate sector was encouraged to step up its efforts to raiseadditional resources from the capital markets by certain measures such asliberalization of industrial policy and allowing industrial firms to raisetheir debt-equity ratio up to 2:1. In addition, measures such as increasingthe rate of interest of convertible and non-convertible debentures andrecent improvement in industrial performance and corporate financesincreased the interest of savers. Another measure which has increased thesavers' interest in non-convertible debentures is the authorization tocompanies issuing such debentures to have a buy-back arrangement.l/ Thefurther simplification of procedures relating to investment by non-residentsof Indian nationality/origin and repatriation of sale proceeds of suchinvestments also had a positive influence in the capital market.

1.62 Table 1.6 shows the significant increase in capital market activitywhich has occurred since 1980. Despite this overall increase in capitalmarket activity, the mobilization of resources by the private corporatesector from this market is small when compared to household financialsavings or to the capital needs of the sector. The "Rangarajan Report"2/

1/ Under this scheme, companies can buy back non-convertible debenturesat par from any debenture holder whose holding does not exceed Rs 40,000and who has held the debentures for a period of at least one year. Thiswas one of the recommendations made by the Working Group on Secondarymarket for Debentures with a view to providing liquidity to investmentin non-convertible debentures short of creating an authentic secondarymarket.

-24-

estimates that in 1980/81, only 6.8Z of financial savings of the householdsector were directly mobilized by the corporate sector either as securitiesor company deposits. It can therefore be assumed that there exists a size-able growth potential in the Indian capital market which will be tapped onlyby (a) improving the attractiveness of the instruments to the savers,(b) reducing the costs of intermediation and of floating of new issues,(c) strengthening the infrastructure of the capital market, encouraging thedevelopment of a secondary market, and (d) improving productivity and finan-cial performance of the corporate sector itself. The Study Group listsvarious measures aimed at achieving this objective which, if implemented,would go a long way in widening the base of the capital market.

Table 1.6: Private Corporate Capital Issues to Public(in Rs million)

12 Months Equity & Total as a % of NetEnded June Preference Debentures Total Financial Savings /a

1979 733 384 1117 1.71980 1036 779 1815 2.81981 1705 913 2618 3.11982 1765 3772 5537 5.71983 2532 4867 7399 6.3

/a This proportion would increase substantially if we were to includecompany deposits as instruments of the capital market.

Source: Center for Monitoring the Indian Economy, Economic Outlook, June1983, and CSOs Quick Estimates dated January 27, 1984.

1.63 In the same vein, the Mehta/Honavar study 1/ also made severalrecommendations on policy and organizational changes which would increasethe attractiveness of the capital markets to both savers and corporations.The main recommendations are: (a) simplify procedures for transfer of sharesand reduce time spent between purchase and actual transfer of stock,(b) develop a secondary market for debentures, (c) authorize buy backarrangements of certain percentage of the debentures issue (sinceimplemented), (d) allow banks to invest a portion of their statutoryliquidity reserves on securities issued by private companies and not only inapproved Government securities.

1.64 What is not very clear is whether further increases in the capitalmarket will result in a diversion of funds from the banking system to capi-tal market instruments or whether the effect will be to increase financial

2/ Also known as the "Report of the Study Group on Financing of PrivateCorporate Sector in the Sixth Five-Year Plan".

1/ "Some aspects of the Indian Capital Market," S.S. Mehta andR. M. Honavar, Mimeo, 1982.

-25-

savings relative to saving through physical asset formation. The design andimplementation of policy changes would be very much related to thisquestion. The ideal policy should allow a shift from tangible to financialassets since this would facilitate a more efficient allocation of savingsbetween competing uses by subjecting them to the discipline of the money andcapital market. Funds could then be channeled into the most productiveuses. Policy changes should further aim at increasing the returns tofinancial assets relative to physical assets and at reducing their invest-ment risk. In addition, policies which affect returns on financial assetsshould allow the growth of all different types of financial assets.

1.65 However, currently investors prefer deposits or are forced to investin approved securities rather than in typical capital market instruments.Several measures could be taken to accelerate the development of the capitalmarket such as those mentioned above plus: (a) changing tax policies whichnow make it more attractive for firms to borrow than issue equity;(b) reducing the cost of capital issues which is estimated at about 7% ofthe total issue; 1/ (c) amending legislation of Provident Funds to allow aproportion of them to flow into corporate securities; (d) reviewing taxexemption policies to provide appropriate incentives among different typesof financial assets.

1.66 Following this line of argument, the recent Rangarajan Study GroupReport highlighted the existing bias against equities as compared to lowrisk assets like bank deposits and UTI units which enjoy a deduction underSection 80L of the Income Tax Act. It also indicated that the bias againstequities could be neutralized by exempting dividend income from taxation ona similar basis as that enjoyed by interest on deposits and income from UTIunits.2/

1/ The cost of raising capital on the market in some cases has reached20% or more of the issue amount. The items responsible for the highissue costs are expenses on advertising, conferences, printing andsupply of issue stationary, conveyance and foreign tours. Other costsare subject to statutory ceilings such as underwriting commission (3%)and brokerage fees (1.25%). Strong competition among merchant bankershave reduced management fees to about 0.5% of the issue amount.

2/ The 1983/84 Budget removed the bias towards bank deposits by cancell-ing the exemption for income tax purposes.

-26-

CHAPTER II

MACROECONOMIC DIMENSIONS OF THE FINANCIAL SYSTEM

A. EVOLUTION OF THE FINANCIAL SYSTEM: ANALYSIS OF VARIOUS INDICATORS

2.1 This section presents information on the size, growth and composi-tion of assets of financial institutions for the period 1950 through 1980.The eleven most important types of financial institutions--RBI, commercialbanks, cooperative banks, post office savings system, development banks,ARDC (NABARD), Unit Trust of India, Provident Funds, life insurancecompanies, finance companies and other insurance companies--are differen-tiated in Table 2.1.

2.2 There are various indicators which can be used to describe theevolution of the financial system. Here we will first look at the growthand composition of assets of the financial system itself, and then we willanalyze the evolution of the financial assets in the economy and will com-pare with similar data for other countries.

2.3 The assets of financial institutions (deflated by the CDP deflator)grew by 7.22% per annum in the 30-year period between 1950 and 1980, ascompared to the growth of CDP of only 3.7%. Growth was not uniformthroughout the period, fluctuating between 4.5% per annum in 1960-65 and10.7% in 1975-80. Furthermore, there does not appear to be a strong cor-relation between the growth of assets of financial institutions and that ofGDP. Another interesting fact that emerges from the figures is that in theperiod since 1968, characterized by tighter government control of the finan-cial system, particularly of commercial banks, the system grew by 8.5% perannum, faster than the long-term growth rate of 7.2%. This occurredprimarily because of expansion of the banking system into rural areas andincrease in branches. The data show the increased "financialization" of theIndian economy and suggest that an increased role of the public sector onthe financial system does not necessarily retard its development. Thesetrends are depicted in Chart 2.1.

Table 2.1. Assets of Financial Institutions

(In Billions of Rupees)

PostOffice unit

Reserve Coinrcial Cooperative Saving Developent ARDC Trust Provident Life Ins. Finance Other TotalBank Banks Banks System Bnk (NAMED) of India Funds Coanies Comanies Insurance Assets

1950 16.54 12.50 2.03 0.63 0.11 1.42 2.88 0.23 36.421951 16.74 13.29 2.20 0.69 0.11 1.60 3.23 0.27 38.131952 15.72 12.19 2.23 0.89 0.11 1.83 3.52 0.29 36.781953 15.46 12.33 2.55 1.00 0.18 2.25 3.78 0.32 37.871954 15.61 13.77 2.89 1.21 0.21 2.69 3.63 0.35 40.361955 17.11 15.84 3.51 1.56 0.39 3.19 3/83 0.37 45.801956 19.16 17.36 4.22 1.91 0.50 3.80 4.14 0.44 51.531957 20.53 1.931 5.88 2.08 1.83 4.52 4.65 0.93 0.50 60.231958 21.74 21.52 7.21 2.25 1.95 5.20 5.05 0.97 0.53 66.421959 23.11 24.78 8.97 2.46 2.13 5." 5.54 1.03 C.58 74.591960 24.97 26.16 10.88 2.85 2.40 7.05 6.22 1.10 0.65 82.281961 26.44 26.63 12.86 3.22 2.70 8.22 6.96 0.95 0.73 88.711962 28.18 29.67 14.74 3.40 3.06 9.50 7.84 1.00 0.83 98.231963 30.77 33.18 17.49 3.66 3.56 0.10 11.06 8.80 1.02 0.91 110.551964 33.01 37.86 20.35 4.08 4.00 0.11 12.88 10.05 1.10 1.02 124.451965 36.12 41.71 23.16 6.12 4_03 0.11 0.25 14.86 10.95 1.19 1.13 139.631966 40.15 49.47 25.95 6.70 5.52 0.11 0.27 17.05 12.38 1.32 1.32 160.241967 43.29 53.66 29.79 7.15 6.39 0.14 0.35 19.59 13.89 1.45 1.46 177.111968 45.18 60.65 35.88 7.78 6.49 0.32 0.50 22.34 15.55 1.50 1.63 197.821969 51.16 68.71 41.50 8.41 7.25 0.63 0.67 25.86 17.45 1.56 1.89 225.091970 56.05 82.49 48.69 9.12 7.84 1.02 0.92 29.93 19.54 1.64 2.19 259.431971 64.23 94.28 55.19 9.88 9.05 1.27 1.05 35.08 22.09 1.74 2.45 296.191972 69.58 110.85 61.72 10.37 10.45 2.23 1.25 40.24 25.10 1.70 2.74 336.231973 84.37 137.70 68.65 11.31 12.06 3.10 1.52 46.27 28.76 1.86 3.07 398.761974 95.25 163.57 78.99 11.62 14.56 4.20 1.49 54.14 32.37 2.01 3.43 461.631975 109.32 200.33 87.67 11.66 18.46 5.69 1.67 64.84 36.42 2.26 3.84 542.16 11976 122.04 259.12 103.78 14.34 22.23 7.55 1.93 76.00 41.63 2.40 4.30 655.321977 141.n 314.70 118.83 15.23 28.68 9.43 2.55 89.00 47.25 2.62 4.81 774.87 1978 160.46 398.77 134.42 16.78 36.36 11.41 3.45 105.1 54.21 2.76 5.38 929.101979 192.86 485.24 150.55 18.53 46.31 13.94 4.35 122.6 61.77 2.99 6.02 1105.16 11980 228.38 582.33 180.66 20.83 58.39 17.28 4.95 142.5 70.91 3.23 6.74 1316.201981 265.66 22.68 75.45 21.38 5.52(est) 80.8(est.)

Notes on Table "Assets of Finncial Institutions"

Reserve Bank: Data taken frm DFWs IFS, various issues. Data is as of Deceuber of each year.

Comircial Banks: Data taken from RBI's "Statistical Tables Relating to Banks in India', annual various. Data is as of December of each year.

Cooperative Banks: Data for 1948-1978 from RBI's "Statistical Statesents relating to Cooperative Ikoveimnt in India". 1979-1980 estinstes basedon partial data from "Report of Trends and Progress in Banking" (RBI). Data is as of June of following year.

ot Office Savings Syatm: DI's IFS various issues. Data is as of December of each year.

Development Banks: 1948-1977 data from VW's IFS end R8I's "Report on Currency and Finance (RCF) as reported by R. Goldadthl/; 1977-1980 datataken directly from RCF. Data is as of )brch of following year.5Liculture and Rursl Develoncent Bank (ARDC1: 1963-1980 data taken from various ARDC's Annual Reports. Data is as of June of following year.Unit Trust of India CUrl): 1948-1977 Ulri's Annual Reports and RC as reported by R. Coldsmith]/; 1978-1980 data from D3I' "Report on

Development Banking in India". Data is as of Decamber of each year.

Provident Funds: 1948-1977 saken from Goldsmith-/; 1978-1980 extrapolated based on increases in assets from flow of funds figures.Data is as of NArch of following year.

Life Insurance Cnsmanies: 1950-1980 taken from Annual Reports of LIC. Data is as of lbrch of following year.

Other insurance: 1950-1970 taken from Goldsmith1 1

; 1970-1980 etitmted applying 1950-1970 growth rate.

Finance Comanies: Partial date based on data collected by BI for largest Finance and Investment companies. 1957-1970 from RBI's"Financial Statistics of Joint Stock Companies". 1970-1980 RBI's "Performance of Financial and Investment Companies"(Various RBI Bulletins). Data is as of March of following year.

1/ Table 3-17, R. Goldsamith "The Financial Development of India 1860-1977" (book published in 1983).

-28-

Graph 2.1

rc,;wth @;4 Fin a n C I Ass ets * I8,, CDpI' ;n conn*or,t 19'7C prios'

11 - -

'7 7

IDn~~~~~~~~~~~~

4

r 0 r I

jf<frjGrow&th arf As-,-t- Tm(iper Growth a=f GDP

2.4 The ratio of assets of financial institutions to GDP has increasedgradually from 38X in 1950 to 73X in 1975, then quickly to 103% by 1980,marking an extensive financial deepening of the economy. The driving forcebehind this increase has been the significant increase in the assets of thecommercial banks since the late 1960s as a consequence of: (a) the policyof social control and nationalization of the major commercial banks whichwidened the scope of the commercial banks to increase their exposure inrural areas and in other previously unbanked regions; and (b) the sig-nificant increase in foreign private remittances during the second half ofthe 1970s (please refer to footnote on page 58). The introduction of theLead Bank scheme 1/ and the development of regional rural banks have also

1/ The Lead Bank scheme was introduced in 1969 with the dual objectivesof mobilizing deposits on a massive scale and of stepping up lending toweak sectors of the economy. Under the scheme individual scheduledbanks are entrusted with the responsibility of locating growth centers,assessing deposit potential and identifying credit gaps in specificregions; and in concert with other banks and credit agencies operatingin those regions to evolve a coordinated program of credit deploymentfor each district.

-29-

been major forces in the rapid increase of deposits in commercial banks.There has been a reversal of the 1950-1965 trend of relative decline in theimportance of commercial banks in the financial system and as a consequencethe share of commercial banking in the total assets of the financial systemincreased from 29.9% in 1965 to 44.2% in 1980. The emergence of new finan-cial intermediaries such as development banks, a large number of cooperativebanks, the Unit Trust of India, and others, has also been a key factor inthe growth of the financial system.

Table 2.2: Composition of Assets of Financial Institutions(in %)

1950 1955 1960 1965 1970 1975 1980

RBI 45.4 37.4 30.3 25.9 21.6 20.2 17.4Commercial Banks 34.5 34.6 31.8 29.9 31.8 37.0 44.2Cooperative Banks 5.6 7.7 13.2 16.6 18.8 16.2 13.7Development Banks 0.3 0.9 2.9 3.0 3.0 4.5 5.7Life Insurance Companies 7.9 8.4 7.6 7.8 7.5 6.7 5.4Provident Funds 3.9 7.0 8.6 10.6 11.5 12.0 10.8Other 2.4 11.0 5.6 6.2 5.8 3.4 2.8

Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Total Assets as Z of GDP 38.1 44.6 54.8 57.9 64.4 73.2 102.7

Source: Table 2.1 and National Accounts Statistics.

2.5 Other development in the financial system which may account for partof the increase in the share of financial assets to GDP is the "layeringeffect" which occurs when the transfer of funds from the saver to theultimate borrower is not direct but takes place through one or severalfinancial intermediaries which relend the money, thus creating a duplicationof financial claims. The pyramidal structure of the Indian financial systemmakes it suitable for financial layering. The three-tier structure ofgovernment administration at the Center, State and local levels andsimilarly that of cooperative institutions are suitable illustrations inthis context. In India's agriculture sector, the active primary agricul-tural credit societies (PACSs) borrow funds from central cooperative banks(CCBs) which themselves borrow part of their funds from State cooperativebanks (SCBs). In turn, the SCBs raise funds from refinancing facilities ofthe NABARD which is financed by the Reserve Bank and the Indian Government.The "layering effect" is the result of the percolation of finance from theapex to lower level and inflates the total magnitude of flows.

2.6 This effect can be measured by the layering ratio, which is definedas the proportion of inter-institutional issues among financial institutionsto the issues to non-financial sectors. There are not recent estimates ofthis ratio for India. The most recent data available placed the layering

-30-

ratio at 0.28 in 1970/71 indicating the increasing importance of intra-financial claims.l/ Netting out layering would slow down the growth of thefinancial system but in the absence of more detailed information on intra-financial flows it is not possible to specify the extent of the reduction.

2.7 This rapid growth of the financial system, both in real terms and asa proportion of GDP, also witnesses to its success in providing financialassets sufficiently attractive to compete with holdings of physical capital,such as precious metals and real estate, as stores of wealth. Despite thissignificant financial deepening, there is still substantial scope forimprovement since financial savings still account for only about 30% oftotal savings in the economy.

B. FINANCIAL DEVELOPMENT RATIOS

2.8 The data presented earlier showed the significant "financialization"of the Indian economy which occurred since 1950/51. The financial develop-ment of a country can also be measured by the following ratios: (a) theFinance Ratio, which indicates the relationship between financial develop-ment and economic development and is measured by the ratio of total finan-cial claims to national income; (b) the Financial Interrelations Ratio whichestablishes the relationship between the financial system and the funding ofinvestment and is measured by the ratio of total financial claims to netphysical capital formation; (c) the New Issue Ratio is an indicator of theextent to which the non-financial sector directly finances investment asmeasured by the ratio of primary issues (those claims created by non-financial sectors) to net physical capital formation; and (d) theIntermediation Ratio which indicates the proportion of financial transac-tions in the economy which take place through financial institutions. It isusually measured as the proportion of claims issued by financial institu-tions to the issues of non-financial sectors. Here it is measured as theratio of issues of financial institutions to total financial issues toclarify its meaning. Trends in these ratios are shown in Table 2.3.

I/ "Structure and Trends in the National Balance Sheet of India,"T. R. Venkatachalan and Y. S. Sarma, Journal of Income and Wealth, April1977.

-31-

Table 2.3: Selected Ratios of Financial Development

1951/52- 1956/57- 1961/62- 1966/67- 1969/70- 1974/75- 1977/78-1955/56 1960/61 1965/66 1968/69 1973-74 1976/77 1980/81

Finance Ratio (Z) 4.9 10.8 14.1 13.8 15.5 23.4 26.9

Financial Inter-relations Ratio 0.63 0.85 0.98 0.93 1.10 1.21 1.50

New Issue Ratio 0.46 0.58 0.67 0.63 0.62 0.70 0.87

Intermediation Ratio 0.27 0.32 0.32 0.33 0.44 0.42 0.42

Source: 1951/52-1973/74 "Chartbook on Financial and Economic Indicators," RBI.1974/75-1976/77 "Flow of Funds in the Indian Economy, 1970/71-1976/77," RBI.1977/78-1980/81 "Report on Currency and Finance," (Various Issues), RBI.

2.9 The Finance Ratio increased from 4.9Z in 1951-56 to 14.1% in 1961-66and 26.9% in 1977-81, clearly indicating the increasing role and importanceof the financial superstructure in the Indian economy since independence.l/In 1977-81, financial claims in the economy amounted to over one-fourth ofnational income, compared to just about one-twentieth during the First Planperiod. The evolution of this ratio supports earlier figures presented onthe growth of the assets of the financial system and of the increasing roleof financial assets in household savings.

2.10 The evolution of the Financial Interrelations ratio (FIR) alsopoints out the increasing role of the financial system in channeling fundsin the economy. The FIR shows an upward trend almost throughout the wholeperiod between 1951/52 and 1980/81. The FIR has been above unity since1969-74 indicating that the growth in financial claims issued was higherthan the growth in investment. The performance of this ratio reflects theincreasing role of the financial system in mobilizing surplus funds avail-able in the economy and allocating them among the needy sectors. In short,it is an indicator of the larger role played by financial institutions inmobilizing funds for economic development.

2.11 The New Issues ratio, indicative of the extent to which the non-financial sectors directly financed investment, also shows a rising trendover the years. The ratio jumped from 0.46 in 1951-56 to 0.87 in 1977-81.Other important financial ratio is the Intermediation ratio which indicatesthe relative importance of the claims issued by financial and non-financialinstitutions. This ratio, also defined as secondary issues to total issues,

1/ The finance ratio relates to financial flows and national income whilethe ratio of assets of financial institutions toGDP shown in Table 2.3is measured based in stock figures.

-32-

showed that the proportion of claims issued by financial institutions tototal claims increased from 0.27 in 1951-56 to 0.44 in 1969-74, indicatingan increase in the importance of indirect financing in the Indian economy.The shift to higher levels of indirect financing and thus to a higher degreeof intermediation through financial institutions is typical of the develop-ing phase of less developed countries. The slight decline in the inter-mediation ratio since 1974 reflects a higher utilization of direct financingby non-financial sectors in the last few years, particularly by theGovernment which has stepped up the issuing of securities to tap householdsector savings directly.

2.12 In summary, the evolution of the financial ratios follow trendswhich are to be expected in developing countries: an increase in the impor-tance of financial institutions in the economy and of financial flows inrelation to economic activity, thus reflecting the fact that the financialsystem has increasingly facilitated the transfer of funds from the surplusto the deficit sectors. This transfer is effected either by direct claimsissued by non-financial deficit sectors or indirectly through financialintermediaries, both of which have grown considerably in India. The expan-sion of financial assets can be attributed to the expanding role of thepublic sector investment and the active role of the financial institutionsin widening and deepening the financial system in terms of the range offinancial instruments and magnitude of funds traded.

C. FLOW OF FUNDS

2.13 Table 2.4 presents data on the evolution of the financial balancesof major sectors in the Indian economy presented as a percentage of GDP.Households and Rest of the World (ROW) are the main surplus sectors financ-ing the Government and Private Corporate Business (PCB) which are the maindeficit sectors. These two deficit sectors complement their investmentrequirements by direct borrowing from Households and ROW and indirectlythrough financial intermediation.

2.14 In the period 1970/71 to 1980/81, the Household sector was the onlysurplus sector in the domestic economy since ROW, traditionally a surplussector, recorded deficits. In several years during this period, capitalaccount transactions on balance of payments effected between resident unitsand non-resident units, including the international organizations, wereunfavorable. The financial deficit of the Government increased from 1.8% ofGDP in 1951-56 to 4.4Z in 1961-66 and 6.7% in 1977-81. Similarly, thedeficit of the Private Corporate Sector also increased from 0.8% of GDP in1951-56 to 1.6% in 1961-66 and 1.7% in 1977-81. These deficits were mostlyfinanced by the Household Sector which recorded very high levels of finan-cial surplus in the 1970s (4.8% in 1970-77 and 7.4% in 1977-81), and lent tobanking, other financial institutions, Government and Private CorporateBusiness sectors in the form of currency and deposits, contractual savings(insurance and provident funds), small savings and trade debt.

-33-

Table 2.4: Financial Balances

(Financial Surplus or Deficit as a percentage of GDP)

1951/52- 1956/57- 1961/62- 1966/67- 1970/71- 1977/78-1955/56 1960/61 1965/66 1969/70 1976/77 1980/81

Banking 0.1 0.2 0.3 0.3 0.3 0.9

Other FinancialInstitutions n.s. n.s. n.s. n.s. n.s. 0.2

Private CorporateBusiness -0.8 -1.2 -1.6 -1.1 -1.0 -1.7

Government -1.8 -4.4 -4.4 -4.1 -4.6 -6.7

Rest of the World 0.3 2.6 2.0 1.9 -0.1 -1.1

Households 1.8 2.8 3.3 2.5 4.8 7.4

Sectors Not ElsewhereClassified -0.4 0.0 -0.4 -0.5 -0.6 -0.6

Source: Reserve Bank of India.

2.15 Table 2.5 shows the flow of funds by major type of instrument forselected sectors and periods. The structure of sources of funds for the twolargest deficit sectors (Government and Private Corporate Business) isshown, as well as that of uses of funds of the Household Sector. Throughoutthe years, a large proportion of sources of funds for the Government wasprovided by Treasury Bills, other securities and loans and advances. Themix, however, fluctuated between periods, with some periods in which borrow-ings from financial institutions were considerable and others in whichfinancing by issuing Treasury Bills and other securities was predominant.Small savings and Provident Funds have also been a steady, although not verylarge, source of funding for the Government. In the case of the PrivateCorporate Sector, borrowings from financial institutions constitute thesingle most important source of finance which fluctuated between 84.5% in1966-70 and 49.5% in 1970-74. The data also shows the decline in paid-upcapital as a source of funds and that of debentures (although it improvedsomewhat in 1977-81 and has continued to improve since then). During the1970s, trade credit was also an important source of fund for the privatecorporate sector. An interesting development in the early 1980s has beenthe increase in the proportion of corporate securities in the total sourcesof funds for private corporate business. In 1981-83 corporate securitiesaccounted for 8.4% of funds for private business, significantly higher thanlevels experienced in the 1970s.

-34-

Table 2.5: Flow of Funds of Selected Sectors(as a percentage of sectoral flow)

1966/67- 1970/71- 1974/75- 1977/78-1969/70 1973/74 1976/77 1980/81

Sources of Funds

Government 100.0 100.0 100.0 100.0

Treasury Bills 10.0 23.2 6.7 20.8Other Securities 16.8 27.4 19.1 24.9Borrowings 42.0 19.4 40.6 15.2Small Savings 7.8 12.4 6.5 9.6(of which households) (5.4) (6.8) (1.8) (6.1)

Provident Funds 6.7 7.9 6.7 5.3Other 16.7 9.7 20.4 24.2

Private Corporate 100.0 100.0 100.0 100.0

Paid-up capital 12.1 11.1 7.7 8.6Debentures 5.1 2.2 -0.5 1.9Deposits 2.8 2.2 2.8 4.4Borrowings 84.5 49.5 61.9 54.9Trade Credit -4.6 15.8 11.2 14.0Other 0.1 19.2 16.9 16.2

Uses of Funds

Households 100.0 100.0 100.0 100.0

Cash 17.4 19.3 9.6 13.4Bank Deposits 34.4 39.3 55.4 46.3Government Securities

& Small Savings 4.1 2.5 0.5 6.1Loans/Deposit to Private

Corporate 5.3 3.0 2.3 1.9Provident Funds 21.7 18.4 19.9 17.4Shares/Debentures -0.6 3.2 1.1 2.6Other 17.7 14.3 11.2 12.3

Source: Reserve Bank of India

2.16 The Household sector deploys its loanable funds by holding theprimary issues of non-financial sectors or the secondary issues of financialinstitutions. The bulk of the Households' financial surpluses are kept withbanks and other financial institutions and such placements have steadilygrown both relatively and in absolute terms. Important shares of thesurpluses are also maintained as cash (presumably mostly for transactionpurposes) and provident funds. Lower shares are invested in Government

-35-

securities, small savings and shares and debentures reflecting a dissatis-faction with yields offered. In 1977-81 an improvement is shown in theproportion of household funds which were deployed in these assets, but theystill constitute only about 8.7% of its household funds. Further improve-ments have probably occurred in 1981-83 due to higher yields and lowerinflation rates. Direct financing from Households to Government and PrivateCorporate Sector accounts for only about 11% and 13% respectively of theirtotal sources of funds, the balance being provided by ROW and the financialsystem through loans and advances or investment in securities. This isconsistent with a larger role of the financial sector in the mobilization offunds in the Indian economy which has been indicated in earlier paragraphs.

D. ROLE OF THE FINANCIAL SYSTEM IN THE MOBILIZATION OF SAVINGS

2.17 Savings Trends. Since the mid-seventies, the Indian economy hasexperienced very high saving rates relative to its low per capita income.India's saving rates are high in comparison to other low-income countriesand are more comparable with those of middle income countries. There hasbeen an almost continual increase in the saving rate, which averaged 15.6%in 1965-70, 20.5% in 1970-80, and 22.6% in 1980-83. The acceleration andmaintenance of the savings rate at relatively high levels has been closelylinked with income growth--the elasticity of gross domestic savings withrespect to real income exceeds 2.0. The increase in the proportion of netdisposable income to net domestic product partly explains the rising savingrate, but other factors have contributed as well, including the significantfinancial deepening of the Indian economy since Independence, and in thesecond half of the 1970s, the strong growth in production (especially inagriculture) and the significant increase in workers' remittances. Theincreasing share of the secondary and tertiary sectors in the Indian NDP,which have higher marginal propensities to save, was also an importantfactor.

2.18 The Household sector, which comprises, not only individuals, butalso all non-Governmental and non-corporate enterprises such as soleproprietorships, partnerships, and such non-profit organizations ascharitable and educational institutions and trusts account for over three-fourths of the net savings in the economy. The share of household savingson net savings has not declined while India's savings rate has increased,indicating that this high savings scenario is primarily related to higherhousehold savings. About 80% of the increase in the savings rate in theperiod between 1970/71 and 1978/79 has been due to higher household savings.Savings of the household sector accounted for 13.9% of net domestic product(NDP) in 1980/81, up from 5.2% in 1950/51, 6.3% in 1960/61 and 9.3% in1970/71. Savings in the form of both financial and physical assets haveincreased, however the increase has been more marked in the case of finan-cial savings which now account for 7.2% of NDP, compared to 0.7% in 1950/51.Therefore, higher saving rates in the Indian economy since the mid-seventieshave been accompanied by higher levels of financial savings.

-36-

Table 2.6: Gross Domestic Savings 1965/66-1982/83(As a Z of GDP at c.m.p.)

Estimates1965-70 1970-75 1975-80 1980-83 1980/81 1981/82 1982/83

Domestic Savings 15.6 18.4 22.6 22.6 22.8 22.5 22.3

Households 11.6 13.5 16.4 16.3 17.2 15.6 16.0(financial)/a (3.0) (4.2) (6.1) (6.8) (6.7) (6.5) (7.1)

Private Corporate 1.4 1.8 1.5 1.9 2.0 1.9 1.8Public 2.6 3.2 4.7 4.4 3.6 5.0 4.5Non-Dept. Entep. (0.7) (1.1) (1.5) (1.9) (1.4) (2.1) (2.3)General Government (1.9) (2.0) (3.2) (2.4) (2.2) (2.9) (2.2)

/a These figures do not fully reflect the scale of financial intermediation,as they show only the net increases in the financial assets of the sectorafter deducting the increases in its financial liabilities.

Source: CSO, National Accounts Statistics, 1983, and Quick Estimates datedFebruary 27, 1984.

Table 2.7: Trends in Savings

As a Percentage of Net Domestic Product As a % of Net Domestic SavingsNet

Domestic Other Household Finan- Total House-Savings Household Savings Savings cial Savings hold Savings

Financial Physical Total

1950/51 7.0 0.7 4.5 5.2 1.8 10.0 74.31955/56 10.0 4.3 4.0 8.3 1.7 43.0 83.01960/61 9.3 3.2 3.1 6.3 3.0 34.4 67.71965/66 11.2 4.7 3.5 8.2 3.0 42.0 73.21970/71 12.0 3.9 5.7 9.3 2.7 32.5 77.51975/76 15.4 5.6 5.8 11.4 4.0 36.4 74.01976/77 17.6 6.3 6.8 13.1 4.5 35.8 74.41977/78 17.1 6.5 6.7 13.2 3.9 38.0 77.21978/79 19.6 7.3 8.1 15.4 4.2 37.2 78.61979/80 17.4 6.6 6.8 13.4 4.0 37.9 77.01980/81 16.7 7.2 6.6 13.9 2.8 43.1 83.2

Source: National Accounts Statistics, Central Statistics Organization.

2.19 The major causal force in the increase in net financial savings ofthe household sector has been the increased role of financial institutionsin the Indian economy. This process started in the early 1950s, butaccelerated after 1968 with the nationalization of most of the bankingsystem followed by the introduction of the Lead Bank scheme and regionalrural banks. This brought about a tremendous expansion in banking servicesby opening branches in previously unbanked rural and urban areas. Other

-37-

factors spurring the growth in financial savings, particularly during the1970s, were: (a) the significant increase in foreign remittances; (b) theincreased real return to savings due to the combined effect of higher inter-est rates and general price stability that characterized the period 1975-79;(c) the growing monetization and commercialization of the economy; and(d) the increase in household income due to economic development.

2.20 The household sector's saving pattern is better understood by afinancial instrument-wise analysis of the flow of its savings. This disag-gregation facilitates the task of explaining the reasons behind the increasein financial savings. The evolution of the structure of financial savingsby main instruments is depicted in Table 2.8.

Table 2.8: Structure of Net Household Financial Savings (as Percentages)

1955/56- 1960/61- 1965/66- 1970/71- 1975/76-1959/60 1964/65 1969/70 1974/75 1979/80 1980/81

Currency 28.1 26.7 25.3 20.4 17.5 19.0

Net Deposits 10.7 17.8 23.4 34.1 39.1 42.5

Shares and Debentures 13.3 14.3 11.2 3.8 3.4 5.1

Net Claims onGovernment 19.0 1.4 -7.8 -3.5 4.1 0.3(memo: gross claims) (n.a.) (9.2) (0.3) (1.6) (4.9) (3.7)

Life Insurance Funds 9.1 12.7 14.0 12.5 10.2 9.8

Provident Pension Funds 19.8 27.1 33.8 32.8 25.7 23.3

Total Financial Assets 100.0 100.0 100.0 100.0 100.0 100.0

Source: Central Statistical Organization (February 1983 Data).

2.21 One part of household savings is held in the form of currency tosatisfy households' demand for liquidity due to transactional, speculativeand precautionary motives. However, the single largest form of financialassets held by the household sector since the early seventies is saving inthe form of deposits, of which more than three-fourths are deposits withcommercial banks (as will be documented later). Other significant forms ofsavings are accretions to Life Insurance funds and provident funds, althoughthey now constitute a smaller proportion of household savings in comparisonto earlier years. The claims on government are another form of householdsaving and their major components are accruals under small savings, specialbearer bonds, compulsory deposit schemes and direct investment in Governmentsecurities. The remaining savings of the household sector are in the formof investments in shares and debentures, in units of the Unit Trust of Indiaand trade credit extended by the household sector to the corporate sector.

-38-

2.22 There has been a significant change in the composition of financialsavings since the 1950s. The financial instrument which has shown thelargest increase in its share as a component of financial savings of thehousehold sector has been net deposits, which include deposits in commercialbanks, other financial institutions and in non-financial institutions(including company deposits). The factors behind the increase in netdeposits are: (a) the deepening of the financial system due to the intro-duction of the Lead Bank scheme and Regional Rural Banks which openedbranches in areas of the country which were previously unbanked, therebyexpanding the financial infrastructure; (b) the significant increase inforeign remittances, both in absolute terms and as a proportion of totalfinancial savings, which occurred particularly since the mid-seventies;l/and (c) the increase in interest rates to arrest severe competition fromalternative saving instruments. In the absence of details on the uses offoreign remittances, it is not possible to determine precisely the extent towhich incoming remittances are converted into financial savings or are putto alternative uses. Nonetheless, it seems reasonable to assume, as the RajCommittee Report on Savings did,2/ that at least initially, foreign remit-tances would get reflected almost entirely in an increase in householdfinancial savings, particularly in the form of currency and bank deposits.Net deposits constitute the largest type of financial asset held by thehousehold sector. Table 2.10 disaggregates total deposits by majorcomponents: commercial bank deposits, cooperative bank deposits and companydeposits.

2.23 The share of deposits on commercial banks to total deposits out-standing has remained at about 83%-84% throughout the 1970s, indicating thatthe bulk of the increase in financial savings which occurred during theperiod has been directed to commercial banks. Deposits in cooperativebanks, also part of the public sector institutional machinery, make up for7.8% of total deposits, down from 9% in 1970/71. The decline in depositsin cooperative banks has been offset by an increase in the share of companydeposits.3/ Although only small amounts flow to the private corporatesector in the form of direct company deposits, they increased by a healthy31% in 1979/80 and 21% in 1980/81, faster than bank deposits. These companydeposits flow to both financial and non-financial companies. The proportionof deposits flowing to non-financial companies (mainly large industrialfirms) fluctuated between 4.8% and 5.9% in the seventies. It is interesting

1/ Foreign remittances increased from Rs 1.4 billion in 1973/74 to Rs21.3 billion in 1980/81. In the same period, foreign remittances as aproportion of gross financial savings and Bank deposits increased from3.9% to 18.2% and from 9.4% to 39.6%, respectively.

2/ "Capital Formation and Savings in India 1950-51 to 1979-80, "Report ofthe Working Group on Savings, Ministry of Planning, February 1982.

3/ Indian companies are allowed to accept deposits from the generalpublic as long as total deposits are kept below 25% of the capital ofthe firm.

-39-

to note, however, that they increased by 47.3% in 1980/81, the last yearfor which data are available.

Table 2.9: Structure of Total Deposits Outstanding(as of end of March)

1970/71 1975/76 1977/78 1978/79 1979/80 1980/81

Total Deposits(in Rs billion) 71.1 167.9 262.7 321.1 381.6 457.7

Distribution (in %)

Total Deposits 100.0 100.0 100.0 100.0 100.0 100.0Commercial Banks 83.0 84.3 84.6 84.1 83.2 83.0Cooperative Banks 9.0 8.2 7.6 7.7 7.7 7.8Company Deposits 8.0 7.5 7.9 8.2 9.1 9.2

of which: Depositson non-financialcompanies 5.9 4.8 5.0 5.0 4.8 5.9

Note: Deposits on Post Office Savings Banks have been excluded because theyare considered under "net claims on government" for flow of fundspurposes.

Source: Report on Currency and Finance; Reserve Bank of India Bulletin,October 1982 and April 1975; RBI.

2.24 The importance of claims on Government in financial savings alsohas increased since the mid-seventies. This came about because theGovernment had to borrow additional resources from the public and had to tapa larger proportion of household savings in order to finance higher invest-ment expenditures and Government deficits. These moves explain the increasein the share of gross claims on Government in the total financial assets ofthe household sector to 4.9% in 1975-80 and 3.7% in 1980/81.

2.25 The Government effected this increase in a series of measures.First, the increase in the households "claims on Government" was due to theintroduction of securities offering higher returns, such as a new six-yearnational savings certificate (1981), and a more aggressive effort in col-lecting "small savings" by the Postal Savings Bank, which was allowed toincrease the interest rate on five-year Post Office time deposits from 10.5%to 11.5% in March 1983. Second, to encourage the absorption in the finan-cial system of illegal funds circulating in parallel channels, ten-yearSpecial Bearer Bonds (SBBs) with an annual interest rate of 2% were offeredin 1981. Total subscriptions to SBBs amounted to Rs 9.6 billion; the amountpurchased by the household sector was equivalent to about 6%-7% of new grossfinancial savings. Third, the Government also introduced National SavingsCertificates (NSCs) in 1981/82 with the attractive terms of 12% interest and

-40-

six years maturity. The share of NSCs rose from 2% of household financialsavings in 1980/81 to 4.6% in 1981/82. Fourth, in 1982/83 the Governmentintroduced two long-term bonds, Capital Investment Bonds and Social SecurityCertificates; but the public response to these instruments has not been asstrong as for NSCs. Despite this recent increase in net claims on theGovernment, it is quite clear that the Government has been unable to securea major share of the increase in financial savings directly. Financialmediation through banks, other financial institutions, Life Insurance Fundsand Provident Funds played an important role in the transfer of householdfinancial savings into public sector spending.

2.26 The data on Table 2.8 also indicate a decline in the importance ofshares and debentures to total financial assets of the household sectorduring the 1970s as compared with the 1950s and 1960s. The issuing ofshares and debentures as a source of corporate funding declined as a conse-quence of a larger reliance on company deposits and on funds from financialinstitutions to finance operations. The revival of company deposits isexplained by the large spread between bank borrowing and lending rates whichallow companies with good financial records to take deposits directly fromthe public by paying higher returns than banks and still reduce their costof funds. The recent difficulty of obtaining sufficient funds directly fromthe financial institutions in a timely manner, due to reduced availabilityand cumbersome procedures, is also behind this larger use of companydeposits.

2.27 As was already stated in Section G of Chapter I, capital marketactivity has increased since 1980, encouraged by recent Government policymeasures, such as allowing industrial firms to raise their debt-equity ratioto 2:1, increases in the rate of interest of convertible and non-convertibledebentures, authorization to include buy-back clauses on issues of non-convertible debentures, and new measures to attract investments by non-resident Indians (Table 1.6). Despite this increase in capital marketactivity, its contribution to private corporate sector resources is smallwhen compared with household financial savings or the sector's needs. Thesizable growth potential in the Indian capital market will only be tappedby: (a) improving the attractiveness of the instruments, (b) reducing thecost of intermediation and of floating of new issues, (c) strengthening theinfrastructure of the capital market, (d) encouraging the development of asecondary market, and perhaps most important (e) improving the productivityand financial performance of the corporate sector itself. As in the case ofthe public sector, the private corporate sector has also relied very heavilyon financial mediation to make use of larger household financial savingsavailable.

2.28 Households have been very conservative in choosing financial assets.They have preferred the financial instruments issued by the Government(national saving certificates, post office savings schemes, other smallsavings deposits, and to a lesser degree, securities), banking and otherfinancial institutions to shares, debentures and company deposit schemes ofthe private corporate sector. The reason for this is that the public isvery averse to risks. The ineffectiveness of the stock exchanges inproviding an active market for a large number of corporate securities andthe overall poor performance of industry contribute to this lack of interest

-41-

in investment in industrial securities. Furthermore, it appears that thehousehold sector prefers to hold its savings in the form of financial assetswhich: (a) are relatively liquid; (b) have low transaction costs; (c) aresimple to understand; and (d) earn a return comparable to that on privatelending, which involves high transaction costs and is not very liquid.

2.29 A large proportion of savings has gone to bank deposits because theyoffer returns that are higher than those of Government and industrialsecurities. Industrial securities do not offer yields high enough tocompensate for the risks involved in comparison to Government securities orbank deposits. Another reason for the small development of the stockmarkets relates to the low number of issues that are available to theinvestors, since only a small number of cmpanies list their stocks in themarkets. The private corporate sector has to improve its profitability inorder to offer higher returns and sufficient capital appreciations andencourage investors to hold its financial instruments. At present only asmall number of well-known profitable companies are successful in placingtheir securities in the market. The securities market mobilizes only asmall part of the household sector's financial savings, the major part beingmobilized by the banking system, social security institutions and pensionfunds.

Table 2.10: Returns on Selected Financial Assets(% per annum)

StateAverage of GOI Government Industrial Commercial Companymonths securities securities securities Bank deposits

Redemption Redemption Ordinary Deposit ratesyield yield shares (1 to 3 years) (3 years)

1973-74 5.18 5.63 5.59 6.00 8.5 - 13.01974-75 5.67 5.78 -- 6.75 - 7.50 9.5 - 16.01975-76 5.79 5.98 5.43 8.00 9.5 - 16.51976-77 5.73 6.02 6.14 8.00 11.0 - 16.01977-78 5.82 5.85 6.47 6.00 11.0 - 16.51978-79 5.84 5.79 5.66 6.00 10.5 - 15.01979-80 5.87 5.72 5.83 7.00 10.5 - 15.01980-81 6.36 5.87 5.88 7.50 - 8.50 13.0 - 15.51981-82 6.76 6.04 5.51 8.00 - 9.00 13.0 - 15.5

(--) = Not availableSource: Reserve Bank of India, Report on Currency and Finance, Various Issues.

E. INTER-COUNTRY COMPARISON OF FINANCIAL SYSTEM DEPTH

2.30 An estimate of financial assets outstanding is also provided by thesum of broad money and total securities outstanding (public and privatesector issues). This measure of financial system development is a bettergauge for inter-country comparisons because it is based on aggregatemonetary statistics which tend to be more accurate and uniform. On thecontrary, the aggregation of financial assets as done in Table 2.1 is more

-42-

cumbersome. Since country data and definitions are not entirely consistent,the figures presented in Table 2.11 are only illustrative of relativedegrees of financial system depth.

2.31 The data show that India's financial development compares favorablywith those of other developing countries, including some upper middle incomedeveloping countries. The following are some of the factors which mayaccount for India's "deeper" financial system: (a) an inflation rate lowerthan that of other developing countries which have eased the task ofproviding adequate returns thus discouraging asset holders to shift fromfinancial assets into physical assets; (b) a large proportion of Governmentfinance which flows through the financial system (the Government utilizesprovident funds, small savings and about one-third of commercial bankdeposits almost directly to finance its expenditures and in addition itborrows from the financial system and issues securities); (c) a financialsystem which allows only a very small number of activities to foreign banksthereby increasing financial intermediation through domestic financialinstitutions; and (d) large forced savings programs, such as providentfunds.

Table 2.11: Total Financial Assets in Selected Countries (1980)(Financial Assets/GNP in percentages)

Industrial Countries Upper Middle Income Low/Lower Middle Income

Canada 189 Chile 77 India /a 69United Kingdom 133 Greece 84 Philippines 48United States 220 Korea 51 Thailand 58Japan 240 Venezuela 63 Indonesia 18France 100 Mexico 41 Ivory Coast 29Netherlands 78 Brazil 40 Nigeria 56

/a Data for 1980/81.

Source: International Finance Corporation, "Selected Indicators of FinancialSystem Depth," Draft Mimeo, Capital Markets Dept. India datacalculated directly from RBI and Ministry of Finance information.

2.32 Another interesting area for international comparison is thedevelopment of the securities market. Table 2.12 shows data on the shareof the securities markets in GNP for selected countries including India.The data indicate that India's capital markets are very underdeveloped whencompared to those in other lower and lower middle income developingcountries. The comparison with upper middle income developing countries iseven less favorable. This proves that there is a tremendous potential inIndia to develop and widen the capital markets. This will probably requiresome major changes in regulation (paragraphs 1.62 and 1.63). Increasedcapital market activity is important because it would increase competitionin the financial system and bring additional resources for corporateinvestment.

-43-

Table 2.12: Capital Market Development in Selected Countries(securities outstanding as a Z of GNP)

India Thailand Nigeria Philippines Kenya

1980 7.6 /a 16 11 18 211981 7.0 Th 14 12 17 19

/a 1979/807T 1980/81

Source: IFC, Capital Market Dept. for all data excluding India. Data forIndia estimated from (a) RBI data on Government securities outstanding;and (b) Ministry of Finance estimates on corporate securities.

-44-

CHAPTER III

CREDIT ALLOCATION

A. COMPREHENSIVE PICTURE

3.1 Table 3.1 presents a comprehensive picture of credit outstanding bymajor type of financial institution and economic sector as of 1982. At theaggregate level, commercial banks account for the largest share of totalcredit outstanding (47.9%), followed by cooperative credit societies (14.2%)and Life Insurance Corporation (6.6%). With regards to the sectoral alloca-tions of credit, 37.0% of all credit outstanding was given to industry(excluding power), 20.8% to agriculture and 12.3% to trade activities.

3.2 The data also indicates the relative importance of the variousfinancial institutions in individual borrower sectors. For instance, in thecase of industry, credit from commercial banks account for 63.0% of totalcredit outstanding, while the share of the three all-India development banks(IDBI, IFCI, ICICI) amounted only to about 12% and that of SFCs and SIDCs toabout 7.2%. These institutions (ICICI, IDBI, IFCI, SFCs, SIDCs), togetherwith LIC and UTI still provide the bulk of term financing for industry sinceonly about 14% of commercial bank credit to industry is provided as termloans.l/

3.3 In the case of agriculture, commercial banks are also the mostimportant institutions providing credit. Commercial banks account for 35.5%of credit outstanding to agriculture as compared to 21.4% and 14.4% providedby cooperative credit societies and land development banks, respectively.NABARD accounted for 15.5%.

3.4 Unfortunately, comparable data is not available for previous yearsand therefore it is not possible to analyze trends in the overall lendingoperations of the system. This can however be done for scheduled commercialbanks which account for the largest share of total credit outstanding(50.2%) and which lend to almost all economic sectors.

B. DEPLOYMENT OF CREDIT BY SCHEDULED COMMERCIAL BANKS

3.5 The pattern of bank credit changed substantially over the lastfifteen years as a consequence of: (a) the nationalization of major commer-cial banks in 1969; (b) larger borrowing by the public sector; (c) largerproportion of food procurement being financed by commercial banks; and (d)efforts to increase lending to priority sectors and under-privileged and

1/ Term financing to industry by commercial banks is probably largersince the 14% figure does not include rollovers.

Table 3.1: Co2 rehenaive Picture of Lendine Ope'rations of banka and Financial Institutions 1982 (a)

TotalRe. toName of Institutions Agriculture Industry Power Transport Trade Rousing Others crores total

Reserve lank of India 1,391 2,154 -- - 25 - 6 3,576 5.8Scheduled Coiercial Banka 4,588 14,471 277 1,164 7,619 151 1,549 29,769 47.9Industrial Dev. lank of India - 1,037 630 - -- - 2,348 4,015 6.5Industrial Finance Corp. of India - 671 14 - - 44 729 1.2Industrial Credit & InvestmentCorp. of India - 1,044 4 -- -- -- 9 1,057 1.7Life Insurance Corp. of India 299 741 1,413 81 - 873 718 4,125 6.6General Ins. Corp. of India - 75 -- -- 36 61 172 0.3Unit Trust of India - 288 37 4 - -- 189 518 0.8Export-Import lank of India - 220 - --- -- 220 0.3Induntrial ReconstructionCorp. of India - 108 -- 108 0.2National Industrial Dev. Corp. - 2 - -- -- -- - 102 -National Small IndustriesCorporatin (b) - 40 -- -- -- -- -- 40 0.1Kbadi * Village IndustrieaCommission (b) - 341 - - -- - __ 341 0.5Indian Dairy Corporation (d) - 123 -- - - -- 123 0.2Agricultural Refinance A Dev.Corporation (ARDC) (d) 1,995 - -- - __ __ __ 1,995 3.1Agricultural Finance Corp.of India (c) 20 - -- -- - - -- 20 --Rural glectrification Corp. - - 1,122 - -- -- - 1,122 1.8State Industrial DevelopmeDntCorporations (b) - 540 8 -- __ __ 125 673 1.1State Financial Corporations - 1,121 8 -- - - 490 1.619 2.6Shipping Development FundComittee - -- -- 778 -_ __ - 778 1.3National Film DevelopmentCorp. - -- -- -- -- -- 13 13Housing Dew. Finance Corp. - 2 -- -- -- 56 1 59 0.1Rousing & Urban Dev. Corp. - -- -- -- -- 329 - 329 0.5Cooperative Credit Societies 2,762 -- 6,082 8,844 14.2State Land Dev. Banks (c) 1,855 -- -- -- -- -- - 1,855 2.9Total 12,910 22,978 3,463 2,027 7,644 1,445 11,635 62,102 100.0I to Total 20.8 37.0 5.6 3.3 12.3 2.3 18.7 100.0

Source: CHIE, basic Statistics Relating to the Indian Economy, Vol. I; All India, August 1983.

(a) It should be noted that different institutions have different accounting years. Data taken here relate to theirtheir respective year ending in 1982. Data relating to Scheduled Coumercial Banks relatres to June 1982.

(b) Estimated by CHISE

(c) Data relate to 1980.

(d) From July 12, 1984 the ARDC was renamed as Rational Bank for Agricultural and Rural Development (NABARD) to vhichall the functions of ARDC vere transferred. Data covered here are however for ARDC for its years ending June 1982.

- 46 -

GRAPH 3.1

Aggregate Lending of FinobniCl InstitutionsOutstondgs IFCI 729

in 1982{ / /// \ ~~~~~~GIC 172

Schodulod UT // #§a1 0r lCommorcbl / iFh"iBtuttionl wise om A DC -- 4995

Sources *29,79 -9DFC rro

// MC-0op, -SIDCs 67c3

Oth*, 0B c 8.844706 @/ ; t

EXIM 9ak 220 HUDCO 329

Total Rs 62,102 crores

,~~~~~,1Industry \644

Sector-wise 22,978

Lendings * Tron sport

Othprs / Housingftr (.~~~~~~~~1445~

* Estimnotd by CMIE

-47-

neglected sectors. Table 3.2 contains data on the composition of creditdeployment by sector for selected years between 1968 and 1983. The datareveal an almost steady increase in the share of priority sector lending.l/Priority sector lending on aggregate accounted for 35.7% of gross bankcredit as of March 1983, compared to 14.0% in June 1969. Banks were ini-tially asked to ensure that the total lending to priority sectors shouldreach a level of not less than one-third of total outstanding credit byMarch 1979. More recently, the Government has set a target that by 1985,40% of bank credit should be channelized to priority sectors. Based on pasttrends, it appears that the target will be met. In addition to the overalltarget of lending to priority sectors, a sub-target has been made for lend-ing to agriculture which should be extended at least 40% of the advances topriority sector. This would mean that the agricultural sector would receiveat least 16% of total advances by 1985. Another important target is thatthe ratio of credits to deposits of rural and semi-urban branches of banksshould be not less than 60%.

3.6 Of the total amount of credit extended to the priority sectors,outstanding as of March 1983, agriculture and small-scale industriesreceived 42.9% and 36.4% respectively, the balance being allocated to theother priority sectors such as, road and water transport operations, retailtrade and small business, professional and self-employed persons, andeducation. The rise in the share of priority sector lending over the yearsbrought about a reduction in the relative shares of wholesale trade (otherthan for food procurement) and of medium and large industries. This gradualprocess of shift in sectoral distribution of credit represents the successof Government policies directed at structural changes in the composition ofbank credit to make it available to sectors previously not able to borrowfrom the commercial banking system.

1/ At present, priority sectors broadly include: (a) agriculture;(b) small scale industry; (c) industrial estates; (d) road and watertransport operators; (e) retail trade and small businesses;(f) professionals and self-employed persons; (g) education; and(h) housing loans to weaker sections.

-48-

Table 3.2: Sectoral Deployment of Gross Bank Credit(in percentages)

March June June June March March March1968 1969 1972 1976 1980 1982 1983

1. Food Procurement 3.6 6.5 10.2 18.8 9.9 7.3 8.6

2. Priority Sectors n.a. 14.0 n.a. 24.2 31.7 36.6 35.7Agriculture 2.2 5.2 6.8 9.4 13.0 15.8 15.3Small-scale industry 6.9 7.9 12.1 10.5 12.4 13.4 13.0Other n.a. 0.9 n.a. 4.3 6.3 7.4 7.4

3. Medium & Large Industry 60.1 n.a. 45.5 43.4 38.9 38.3 38.4

4. Wholesale Trade 17.7 n.a. 4.2 7.0 9.0 7.6 6.8

5. Other n.a. 79.5 n.a. 6.6 10.5 10.2 10.5

6. Gross Bank Credit 100.0 100.0 100.0 100.0 100.0 100.0 100.0

of which: Export Credit n.a. 7.2 n.a. 8.4 7.7 6.2 5.0

Source: RBI, Report on Trends and Progress of Banking in India, various issues.RBI, Report on Currency and Finance.

3.7 An important question is whether the expansion of priority sectorlending significantly distorts the allocation of credit, reducing itsavailability to more productive activities, particularly for medium andlarge industry in the private sector. Table 3.3 shows trends in the ratiosof bank credit to industry to gross domestic capital formation of manufac-turing and of bank borrowings of medium and large public limited companiesto their inventories for selected years between 1960/61 and 1978/79.Although such data do not allow one to conclude whether or not bank fundswere sufficient, they do allow one to compare the situations before andafter the expansion of priority sector lending. With regard to bank creditto industry, the data do not show any significant difference in the propor-tion of gross domestic capital formation financed by the banking systembefore and after the expansion of priority sector lending, thereby suggest-ing that industry does not seem to have been significantly affected by theintroduction of the new policy. This is partially due to the fact thatsmall-scale industry is considered priority. Nevertheless, the data formedium and large public limited companies also indicate that, excluding theperiod 1967/68-1969/70, there is no major difference in the proportion ofbank borrowings to inventories before and after the expansion. The increasein the proportion of Bank borrowing going to finance inventories of largeborrowers such as that in 1967-70 was one of the reasons to tighten therequirements of the credit authorization scheme (CAS).

-49-

Table 3.3: Trends on Credit to Industry

Financing as % ofBank Credit to Bank Borrowing as Z of GAF Large, Public &

Industry as % of Inventories of Medium & Private Ltd. CompaniesGDCF Manufacturing Large Public Ltd. Companies Internal External /a

1960/61 n.a. 47.4 n.a. n.a.1961/62 n.a. 48.8 55 451962/63 n.a. 51.9 49 511963/64 16.9 51.9 54 461964/65 10.9 54.6 46 541965/66 13.8 57.7 43 571966/67 13.0 60.8 41 591967/68 17.4 63.1 42 581968/69 n.a. 64.9 50 501969/70 n.a. 64.2 53 471970/71 n.a. 61.8 55 451971/72 n.a. 58.4 56 441972/73 16.9 53.3 70 301973/74 27.1 51.0 50 501974/75 9.5 48.0 46 541975/76 20.9 52.4 43 571976/77 11.2 53.7 43 571977/78 18.4 57.7 40 601978/79 16.2 58.4 41 59Average 16.0 55.8 n.a. n.a.

/a Data obtained from CMIE. GAF stands for Gross Asset Formation

Source: Calculated based on data from:RBI, Studies on Company Finances, Various Issues.RBI, Report on Trends and Progress on Banking in India, Various Issues.CSO, National Accounts Statistics.

3.8 Although further work on this area is required, the partial dataavailable suggest that the expansion of credit to priority sectors whilereducing the proportion of bank credit provided to medium and large industryrelative to total credit, has not significantly reduced the amount of realcredit available to the sub-sector from the banking sector. For instance,Bank credit outstanding to medium and large industry grew by 5% p.a. in realterms between March 1968 and June 1982 while the real GDP of registeredmanufacturing increased by 4.2% p.a. during the 1970s. The substantialincrease in bank deposits during the 1970s made this possible by permittingbanks to continue servicing the needs of non-priority borrowers whileincreasing their lending to priority sectors.l/ Nonetheless, during periods

1/ In 1980/81, bank deposits amounted to 31.6% of India's net domesticproduct as compared with 15.5% in 1970/71 and 20.2% in 1975/76.

-50-

of tight credit or slow deposit growth, credit to medium and large industrycan be significantly affected as credit to all borrowers is not distributedproportionally. When faced with periods of tight credit, industry hassought alternative sources of finance such as suppliers' credit, directdeposit from the public and borrowing from the capital markets.Nonetheless, these alternative sources of funds are limited and aregenerally only available to the most successful companies. Since 1980Indian private industry has been permitted to tap capital markets moreaggressively due to changes in Government policies which were describedearlier in the paper. However, the capital markets in India remain smalland further measures will be required in order to reduce rigidities whichhamper their development.

3.9 Data on trade credit to medium and large industry provided by smallindustry also show increases during periods of tight credit. Therefore,although Bank credit to medium and large industry may be restricted, theseindustries are able to partially finance their needs by slowing payments toancillaries and other small-scale suppliers, a development which is itselfdisruptive, thereby neutralizing the intended reduction in credit. Industryhas also supplemented its financing needs by accepting deposits fromhouseholds (also known as company deposits) and by borrowing from institu-tional sources (IDBI, ICICI, SFCs, LIC, etc.) in a larger scale.

3.10 Table 3.4 presents data on the distribution of bank credit toindustry according to ownership. The data show that excluding 1981 whenlarge amounts of bank credit were channelled into the oil sector to financeimports and exploration, the share of the public sector in total credit toindustry remained stable at about 10% since 1973. This finding contradictsthe general view of an apparent preference by the banks and RBI to financepublic sector industry at the expense of the private sector. Nonetheless,the expansion of credit to the oil sector in 1981 was mostly accommodatedthrough a reduction of credit to private industry for working capital. Morerecent data would be required to determine whether 1981 marks a departurefrom the steady trend of the 1970s or if it just reflects a one-time changein the trend resulting from efforts to adjust the Indian economy to thesecond oil shock of 1979 as rapidly as possible.

3.11 Another emerging trend shown in Table 3.4 is the gradual reductionin the share of industrial credit to private sector companies. This prob-ably results from an increase in priority sector lending to small scaleindustry, which is mostly reflected as credit to partnerships, proprietaryconcerns, joint families and individuals.

-51-

Table 3.4: Distribution of Bank Credit Outstanding to IndustryAccording to Ownership

(as of June of each year in percentages)

1973 1975 1977 1979 1981

Total Credit to Industry 100.00 100.00 100.00 100.00 100.00

Public Sector 10.0 11.5 9.8 9.6 15.1Center & State Undertakings 7.9 11.4 8.5 8.9 13.8Other Government 2.1 0.1 1.3 0.7 1.3

Private Sector 89.4 87.0 89.8 90.0 84.5Companies 65.4 62.2 61.8 62.7 56.2Partnerships, Individuals 24.0 24.8 28.0 27.3 28.3& Others

Cooperatives 0.6 1.5 0.4 0.4 0.4

Source: Banking Statistics: Basic Statistical Returns, various issues, RBI.

C. DEPLOYMENT OF CREDIT BY TYPE OF OWNERSHIP

3.12 Another important change in credit deployment by commercial bankssince the nationalization of 1969 is the increase in the share of credit tothe public sector in relation to total credit. Credit outstanding to thepublic sector increased from 13.4% in December 1972 to 29.5% in June 1977,declining thereafter to 24% in June 1981 as shown in Table 3.5.1/ Credit tothe cooperative sector maintained its small relative importance (about 2% oftotal credit), while the private sector, particularly companies, experienceda significant reduction in its share. This highlights the increasing roleof the financial system, particularly the banking sector, in financingpublic sector expenditures. In addition to providing credit to theGovernment, the banking system invests a large proportion of funds (about36% of total deposits) in Government and Government approved securities,therefore a large proportion of commercial bank resources are channelledinto the public sector.

3.13 The data presented in Table 3.5 also show that the bulk of theincrease in public sector borrowing came from Central and State Governmentundertakings, while the decline in the share of the private sector mostlyaffected companies which experienced a reduction in their share of totalcredit outstanding from 52.5% in 1972 to 36.0% in 1981. This reduction inthe share of private sector companies in total bank credit outstanding is aconsequence of: (a) meeting priority sector lending targets and(b) enlarging the role of the banking system in financing expenditures ofpublic sector enterprises. The table also shows that the share of the

1/ Including borrowing by public sector enterprises.

-52-

public sector in total credit outstanding peaked at 29.5% in 1977 and hasdeclined thereafter, indicating a reversal of the trend observed in theearly 1970s. This development is welcome because it releases bank funds forfinancing private sector investment and consumption.

Table 3.5: Distribution of Outstanding Credit of Scheduled CommercialBanks According to Ownership

(in percent as of June of each year /a)

1972 1973 1975 1977 1978 1979 1980 1981

Public Sector 13.4 18.3 20.2 29.5 28.8 28.0 28.3 24.0

Central GovernmentUndertakings 7.8 11.2 12.4 21.6 21.1 20.1 20.0 16.7

State Government 1.0 1.7 2.4 2.5 2.1 2.4 1.8 1.8State Government

Undertakings 2.2 2.9 3.7 4.1 4.5 4.5 4.6 3.9Quasi-Government Bodies 2.4 2.5 1.7 1.3 1.1 1.0 1.3 1.6

Coop Sector 1.9 1.7 1.9 1.7 1.9 1.9 1.7 1.9

Private Sector 84.7 80.0 77.9 68.8 69.3 70.1 70.0 74.1

(of which companies) (52.5) (48.1) (46.8) (39.8) (38.5) (37.4) (36.2) (36.0)

TOTAL 100.0 100.0 100.0 100.0 100.0 100.0

/a Data for 1972 are December figures.

Source: Banking Statistics: Basic Statistical Returns, Various Issues, RBI

D. TERM-STRUCTURE OF BANK CREDIT

3.14 Another important development in the Indian banking system duringthe 1970s was the increase in the proportion of term lending to total creditoutstanding. In December 1980, 22.2% of total credit outstanding was termlending as compared to 11.9% in December 1972. Data shown in Table 3.6indicates that this trend is related to the expansion of priority sectorlending, a large proportion of which was made as term lending, even in 1972.The data show that industry and trade, the two major non-priority sectors,have the lowest percentages of term lending, 13.9% and 4.5%, respectively,as compared to 63.4% for agriculture, 85% for transport operators and 54.8%for personal loans. While the proportion of term lending by commercialbanks has increased considerably, this should not be regarded as an increasein term transformation by the system because there has been a parallelchange in the structure of deposits. Time deposits as a proportion of totaldeposits in commercial banks increased from 54.6% in 1969 to 81.3% in 1984.

-53-

Table 3.6: Proportion Term-lending to Total Credit Outstanding(in percentages)

Dec. 1972 June 1978 Dec. 1978 Dec. 1980

Agriculture 41.9 50.5 51.8 63.4

Industry 10.8 13.3 12.7 13.9(Small-scale) n.a. (16.4) (16.3) (18.1)

Transport Operations 66.7 81.7 79.9 85.0

Personal and ProfessionalServices 39.0 46.9 43.8 46.3

Trade 2.1 2.5 1.6 4.5

Personal Loans 33.3 72.1 59.5 54.8

Others 11.5 26.1 25.3 28.3

TOTAL 11.9 17.8 17.8 22.2

Source: RBI, "Banking Statistics: Basic Statistical Returns," VariousIssues.

E. CONCLUDING NOTES ON CREDIT DEPLOYMENT

3.15 The Indian Government intervenes extensively in the allocativeprocess both by directing the commercial banks to lend to priority sectorsand by establishing specialized institutions such as development banks tomake priority loans. It believes that without its intervention, some sec-tors would receive less credit than indicated by social priorities, whileother sectors with lower priority would receive too much. While the inter-vention has succeeded in diverting credit into desired channels, its impactin terms of economic growth and efficiency in the use of resources is notclear. There is a need for further studies to assess the impact of thesepolicies on economic efficiency and to determine its costs and benefits.Such studies could also respond to the following questions with regards tothe efficiency of credit deployment: Do the banks lend enough in aggregate?Do they allocate their credit appropriately between different sectors in theeconomy? Do they lend enough to particular borrowers? Do the benefits ofcredit allocation regulations exceed their costs in terms of refusal ordelays in granting credit for productive activities?

3.16 The comparison of credit shares allocated to specific sectors withrespect to their contributions to gross national product shows that theshares of credit to priority sectors are, by and large, below their con-tributions to production. For instance, agriculture contributes nearly 40%of the gross national product through its share on total bank credit is only

-54-

about 12%. However, this is a crude yardstick for assessing the efficiencyof credit allocation, and should not be used by itself to support the expan-sion of priority sector lending. The important questions are whether thefunds given to priority sectors are being used productively or not, andwhether there are alternative non-priority activities with higher produc-tivity that are not being financed.

3.17 The inclusion of any item in priority sector has two advantages,(a) priority in allocation of credit; and (b) concessions in terms andconditions (including interest rates). These advantages sometimes conflictwith the objectives of monetary policy.l/ Since priority sectors, foodprocurement, exports, and some public sector activities are usually exemptedfrom higher lending rates and during periods of overall credit restraintthey do not seem to be affected by credit squeezes, the burden of adjustmentfalls on other segments of the private sector such as medium and largeindustry. In order to conduct effective monetary control while providingadequate credit to all sectors during periods of credit restraint, measuresshould be taken to spread the burden of adjustment as evenly as possible.

3.18 The analysis of credit deployment has shown a trend toward increasedbank exposure to priority sectors of the economy and at longer maturities.This should be monitored very closely to avoid an escalation in the propor-tion of overdue loans. For instance, there are reports on the low andgradually deteriorating ratio of recovery to total credit with respect todirect agricultural advances which may be indicative of unsound lendingpolicies and/or procedures. Similar ratios should be estimated for alltypes of lending to allow the implementation of timely corrective measuresif required. An overall deterioration in the ratios would indicate that RBItargets for priority sector lending may be too ambitious and may be forcingbanks to relax their loan appraisal methods in order to achieve the targets.This would also mean that a large amount of resources are being locked up inbad loans.

1/ See the following study by RBI: "Monetary Policy in India: Issues andEvidence"; A. Singh, S.L. Shetty. T. R. Venkataraman, RBI OccasionalPapers, Vol. 3, #1, June 1982.

-55-

CHAPTER IV

SELECTED INSTRUMENTS OF MONETARY AND CREDIT POLICY

4.1 India has a very complex system of credit and monetary policiesdesigned to channel credit to priority sectors, groups and/or regions,sometimes at subsidized rates of interest, and to regulate the overallvolume of credit and money in the economy. Monetary policy is broadlyguided to achieve price stability through the regulation of money supplyand bank credit. As in most developing countries, two sets of controlinstruments are used in India: general credit controls and selective creditcontrols. The general credit control techniques are open market operations,Bank rate and variable reserve requirements. The following types of selec-tive credit policies are implemented in India: (a) differential rediscountrates; (b) guidelines on credit floors or minimum proportion of total creditor total deposits which must be lent to specific priority borrowers(analyzed in the previous chapter); (c) credit ceilings on non-prioritylending or on the aggregate volume of loans (such as the CreditAuthorization Scheme); (d) extraction of a large proportion of funds ofnon-specialized depository institutions (such as commercial banks) throughreserve requirements, to be channeled to the Government or toGovernment-owned specialized financial institutions; and (e) extensiveintervention in the determination of borrowing and lending interest rates.These policies are complemented by fiscal policy instruments such as taxexemptions and deductions.

4.2 In addition, the RBI has a policy of selective credit control toregulate the flow of bank credit for purchase of specific commodities. Thecommodities covered are: (i) foodgrains; (ii) selected major oilseeds andproducts; (iii) raw cotton and Kapas; (iv) sugar/gur/Khandsari; and(v) cotton textiles. The objective is to prevent speculative holding ofessential commodities. The main instruments of selective credit controlare (a) minimum margin for lending against the value of specifiedsecurities; (b) ceiling on the level of credit; and (c) minimum rate ofinterest on advances. Since the control has to be exercised to prevent thefinancing of speculative activities in the selected commodities without, atthe same time, affecting normal operations of production, the regulation isnot uniform for all borrowers.

4.3 This paper will not attempt to review each of these instruments ofmonetary policy but will look at those selected policy instruments whichhave considerable effect on the mobilization of savings and the allocationof credit.l/ Since the previous chapter dealt extensively with prioritysector lending targets, the analysis here will focus on reserve

1/ A good review of recent developments in monetary policy in India canbe found in "Monetary Policy in India: Issues and Evidence"; A. Singh,S.L. Shetty. T.R. Venkataraman, RBI Occasional Papers, Vol. 3, #1,June 1982.

-56-

requirements, the workings of the Credit Authorization Scheme and the struc-ture of interest rates.

A. RESERVE REQUIREMENTS

4.4 Scheduled banks are required to hold minimum balances with theReserve Bank as a proportion of their liabilities in India. Before 1962,banks were required to hold as liquid assets no less than 20% of totalliabilities, inclusive of balances to be held on account of cash reserverequirement (CRR). In 1962, through an amendment of the Banking RegulationAct, this requirement was raised to 25%, exclusive of required cashbalances, which at that time were at a level of 3%. Thus the reserverequirements were divided into two: (a) the cash reserve ratio which isa minimum cash balance which the banks have to hold with the RBI; and(b) the statutory liquidity ratio (SLR) which is an asset requirement tobe held by each bank against its liabilities. The liquid assets eligiblefor meeting this requirement are the following: gold, cash, unencumberedapproved securitiesl/ and balances with the RBI and with other banks. TheCRR is an instrument of credit control in the strict sense of the term sinceit affects the availability of reserves with the banking system and affectsthe total volume of credit.2/ The SLR is more a means of allocating fundsbetween the public and the private sector than an instrument of creditcontrol.

4.5 According to the RBI, the rationale for the introduction of the SLRwas exclusively of monetary nature: the desire to eliminate the possibilityof banks offsetting the effect of increases in reserve requirements (in theCRR) through liquidation of holdings of Government securities. It appearsthat the initial intention of the SLR was to enhance the ability of the RBIto control overall liquidity. The statutory liquidity ratio has beenincreased in successive stages from its initial level of 25% to its presentlevel of 36%.3/ These further increases in the ratio have been based on twoadditional considerations: (a) an attempt to reduce banks' discretionarypower to provide credit to the private sector; and (b) the use of the SLR as

1/ "Approved" securities are those debt obligations issued and guaranteedby the Union or State Government or issues of specified agencies,including institutions like IDBI and ICICI, bearing governmentguarantee.

2/ The CRR is currently 8.5% of bank deposits. In addition, the RBI hasinstructed commercial banks to impound 10% of the growth in depositsfrom November 12, 1983 which is expected to block Rs 2.5-3 billion ofbank funds every six months as incremental cash reserve ratio.According to RBI, this measure was taken to wipe out continued excessliquidity in the system with a view of ensuring a better match betweensources and uses of funds. Adequate credit monitoring should preventany undesirable reduction in the flow of credit for productive purposes.

3/ The RBI raised the SLR from 35% to 35.5% effective July 28, 1984 and36% effective September 1, 1984.

-57-

an instrument for supporting the Government's market borrowing program andincreasing resources for Plan purposes at a cost substantially lower thanthe rate charged by banks on advances to borrowers. The SLR has increasedparallel to the expansion of public sector borrowing requirements. Itcurrently stands at 36% but since December 1979 the RBI is empowered toraise the SLR up to 40% if so required. The SLR affects credit creation byreducing the amount available for lending but does not have a deflationaryimpact on the money supply (unlike the cash reserve ratio).

Table 4.1: Deployment of Total Resources by Commercial Banks

March March March March March June June June1951 1956 1961 1966 1969 1976 1980 1982

Credit/DepositRatio 61.8 71.6 75.6 77.6 78.3 75.6 66.1 65.7

Investment/Deposit Ratio 37.8 36.4 32.0 27.5 24.3 32.1 35.4 36.8Total /a 99.6 108.0 107.6 105.1 102.6 107.7 101.5 102.5

/a Variations from 100.0 are due to operations with RBI, such as borrowing,discounting and changes in balances.

Source: RBI, "Report on Trends and Progress in Banking," various issues.

4.6 Table 4.1 shows that in the early 1950s bank holdings of Governmentand other approved securities were in excess of reserve requirements. Banksinvested well over one-third of aggregate deposits in Governmentsecurities,l/ a situation that changed in the early 1960s due to the com-bined effect of better business opportunities for increased lending and arelative decline in the yield of Government securities as compared toreturns on bank loans. The data for the 1950s contradict the general viewthat commercial banks hold Government securities merely because they aredirected to do so by the RBI. Only in recent years does the ratio appearsto be just about the prescribed level, having stayed higher in earlieryears. During the slack season in business demand for advances, Governmentsecurities provide the banks with an alternative asset to hold. The recenttendency for holdings of Government securities to hover around theprescribed SLR level suggests that the SLR limits are quite high; and thatbanks do not find it very profitable to invest a larger proportion of theirresources in those assets. The increase in the differential between banklending rates and yields on Government securities is probably the major

1/ Government securities are defined in a broad sense to include otherGovernment approved investments, such as subscribing in long-termcapital issues of term-finance institutions, etc.

-58-

cause of this latter development (Table 4.2). Nonetheless, the scheduledcommercial banks are the major holders of Government securities, holdingabout 45% and 55% of outstanding interest bearing loans of the Central andState Government, respectively (March 1980 data).

Table 4.2: Comparison of Government Securities Yieldsand Interest Rates on Bank Loans

(in %)

Government Interest on SpreadSecurities Yield Bank Loans (2) - (1)

(1) (2)

1952 3.69 4.22 0.531955 3.72 4.57 0.851958 4.17 5.08 0.911960 4.07 5.74 1.671965 5.32 7.60 2.281970 5.00 8.80 (est) 3.801975 6.34 14.10 (est) 7.761980 6.71 13.20 (est) 6.491982 7.59 13.50 (est) 5.91

Source: IMF, International Finance Statistics and RBI, Report onCurrency and Finance, various issues and Banking Statistics,various issues.

4.7 The SLR reallocates funds to the public sector at lower cost thanthe market rate of bank loans in a non-inflationary manner. Compared totaxation, another non-inflationary source of funding for governmentexpenditures, it is easier to administer and politically less controversial.It does have, however, several drawbacks. One negative aspect is thatbeyond a certain limit, it reduces the effectiveness and flexibility of themonetary authority in controlling credit expansion. This occurs because ahigh SLR coupled with the need to meet credit requirements of the privatesector limit RBI's ability to use alternative instruments of credit control.Another negative aspect of the SLR is that by creating a captive market forGovernment securities yielding lower returns than alternative securitiesfrom the private sector, it hinders the development of a truly competitivesecurity market. Furthermore, it fails to give correct price signals to theGovernment on the real cost of credit and probably reduces the interestbanks can pay on deposits. Finally, since return to borrowers are lowerthan market rates it is a hidden tax. The existence of SLR and a "captive"market guarantees funding to the public sector but does not provide adequatesignals on the real cost of funds which should be used to discount thevarious public expenditure alternatives.

-59-

B. CREDIT AUTHORIZATION SCHEME

4.8 The Credit Authorization Scheme (CAS) was introduced by the RBI inNovember 1965 as one of the measures to align bank credit in accordance withPlan priorities. It subjects large individual credit proposals to thescrutiny of the RBI to ensure that they conform to the requirements of itscredit policy. Under the scheme, scheduled banks are required to obtainauthorization from the RBI before releasing any fresh credit limit above acertain amount (initially Rs 10 million, presently Rs 40 million)l/ tocertain single parties, or any limit that would take the total credit limitsenjoyed by such parties (from the banking system as a whole) to such amount.In 1970, the focus was widened to cover credit appraisal by the scheduledcommercial banks to impose financial discipline on the large borrowers. TheRBI introduced a comprehensive set of norms for credit appraisal with thepurpose of assisting banks in the proper assessment of credit requirements.This reduced the flexibility banks had in appraising and justifying addi-tional credit limits. In May 1971, the Scheme was further extended toinclude term credit. Provision of term credit to any single party beyondRs 2.5 million (currently Rs 5 million) from the banking system as a wholerequires previous RBI authorization.2/ In 1973, advances to public sectorundertakings, including State Electricity Boards and also advances againstthe guarantees of Central and State Governments were brought under thesystem.

4.9 As Table 4.3 shows, the CAS predominantly affects working capitalrequirements though it also affects term lending and sale of machinery ondeferred payment basis. As of June 30, 1982, credit limits under the CASstood at Rs 159.1 billion and affected 1251 parties of which 204 were ofthe public sector and accounted for 52.6Z of the total credit limits. Thesharp reduction in the number of parties affected in 1976 was due to anincrease in the cut-off point for the CAS from Rs 10 million to Rs 20million. The increase, in July 1982 of the cut-off point to Rs 30 millionfor private sector enterprises reduced the number of parties subject to CASas of June 30, 1983 to 897. The recent increase in the cut-off point toRs 40 million for all enterprises should reduce the number of partiesaffected even further.

4.10 In 1975 and 1979, the CAS was further modified following the recom-mendations of the Tandon (1974) and Chore (1979) Committees 3/ which wereset up to provide guidelines to banks on the provision of credit par-ticularly to large borrowers. Among the more important recommendations were

1/ On October 20, 1983 the cut-off point under the CAS was raised fromRs 30 million to Rs 40 million.

2/ Term credit is defined as loans repayable over a period of more thanthree years.

3/ Report of the Study Group to Frame Guidelines for Follow-up of BankCredit, (Tandon Report), RBI 1975; and Report of the Working Group toReview the System of Cash Credit, (Chore Report), RBI, 1979.

-60-

a set of norms for holdings of inventories and receivables designed to curbexcessive inventory holdings by corporate business. The main objective wasto prevent the misuse of bank credit and other resources for speculativehoarding purposes.

Table 4.3: CAS: Distribution of Credit Limits

Number ofParties Credit Limits Credit Limits Limits for

(in thousands) (in Rs billion) as a X of Working CapitalAs onJune 30 Public Public Credit Out- as a % of

of: Total Sector Total Sector % Public standing /a Total Limits

1973 1392 130 58.6 20.2 34.4 92.5 90.31974 1622 166 67.0 24.8 37.1 83.7 89.41976 851 154 84.8 44.4 52.4 73.9 89.71978 979 178 106.4 57.8 54.3 65.8 89.21980 1093 192 130.3 71.3 54.7 58.8 88.21982 1251 204 159.1 83.7 52.6 52.8 89.21983 897 188 170.5 103.8 60.9 n.a. n.a.

/a This is provided only for illustrative purposes since it compares CAS' normativecredit limits with figures on actual credit outstanding. Firms only borrow thefull extent of their credit limits sporadically (if ever) during the year, andpeak borrowing seasons vary from industry to industry.

Source: RBI, "Report on Currency and Finance," Various Issues.

4.11 The Tandon Committee proposed the following three approaches toworking capital financing by banks and also recommended that to avoidhardships on borrowers, a start should be made with method (i) and a move tohigher stages should be made thereafter.

(i) banks should determine the working capital gap (i.e., totalcurrent assets less current liabilities other than bank borrowings) andfinance 75% of this gap. The balance would be covered by long-term funds(owned funds plus term loans). This method of lending would bring undersome control, those cases involving adverse current ratios, and raise theratios to better than 1:1;

(ii) the borrower should provide a minimum of 25% of total currentassets from long-term funds (i.e., owned funds plus term borrowings). Afterallowing for a level of credit for purchases and other liabilities, bankswould provide the balance. The total amount of current liabilities, includ-ing bank finance, would not exceed 75% of current assets. This mode oflending would give a minimum current ratio of 1.33:1; and

(iii) the third method would be the same as (ii) above but wouldexclude core current assets from total current assets on the theory thatcore current assets should be financed from long-term funds. This methodwould further strengthen the current ratio, to reach a level of 1.8:1.

-61-

4.12 The main recommendation of Chore Committee is that banks shouldadopt method (ii) of lending and this has been made applicable to borrowershaving working capital limits of Rs 5 million and above from the bankingsystem. Thus, all medium and large units should maintain a minimum currentratio of 1.33:1. Borrowers not able to comply with this requirementimmediately are to be given "working capital term loans" (WCTL) carved outof the existing working capital limits, repayable within five years. WCTLwill carry a rate of interest, at least as high as the rate for cash creditand banks may, at their discretion, charge a higher rate of interest notexceeding the ceiling rate to encourage early liquidation of WCTL. Further,penal rates of interest can be charged in the event of any default in therepayment of WCTL.

4.13 Thus the Chore Committee proposals seek to impose the discipline ofthe current ratio of 1.33:1 rather rigorously on all medium and large units.No distinction has been made between infant units and others. The liquidityconstraints that new units and others with ongoing projects may face, have,however, been recognized and banks have been authorized to make suitablerelaxation depending on the merits of the case, in consultation with term-lending institutions. Exporting units also are subject to this discipline,though discretionary powers have been given to banks to relax in suitablecases. Only sick units have been exempted from the norm. By and large, alllarge and medium units having credit limits of Rs 5.0 million and more fromthe banking system have to abide by the norm.

4.14 Despite the fact that the Tandon/Chore norms do provide someflexibility, they have been criticized on various grounds: (a) theguidelines are not flexible enough to hold good throughout the year and ina constantly changing economic environment (the composition of size ofinventories varies throughout the year and between years subject to fluctua-tions in economic activity); (b) the classification of industry into 15groups does not make allowance for relevant individual characteristics suchas variances in financial strength, market circumstances and managementstrength; (c) the recommendations are also too restrictive since they try toenforce two separate types of control: restrictions on inventory holding byindustry and trade and by type of inventory, and limits on the extent ofbank finance in total working capital.

4.15 In practice credit authorization can take up to six months from thedate the request is made to a commercial bank until the RBI approval,thereby causing delays in credit allocation which may arrive too late tocorrect for situations which call for deviations from norms and limits. Onaverage, authorizations take from one to three months. Situations such asbunched receipt of raw materials, strikes, lockouts and other interruptionsin production, transport delays, power shortages and accumulation offinished goods due to lack of shipping space for exports, are common inIndia. Industry should not be penalized for those developments. Oneresponse to this kind of criticism has been that firms tend to exaggeratetheir credit requirements to protect themselves from such unforeseen eventsand in anticipation of perceived credit restrictions. This argument,however, undercuts the whole rationale for the credit authorization schemeand of credit allocation schemes in general.

-62-

4.16 The CAS has recently been reviewed by the Marathe Committee whosemajor recommendations were reviewed and approved by the RBI Board in October1983. As a result, the Reserve Bank has increased the banks' discretion todeploy credit under CAS, even without RBI's prior clearance. The RBI listedspecific situations in which this could be done. Borrowers have to meetfive conditions, including a minimum current ratio of 1.33:1, in order to beeligible for preferential treatment. For instance, the banks could giveclearance in cases where the estimates and projections regarding production,sales, chargeable current assets, other current assets, current liabilities(other than bank borrowings) and net working capital conform to past trendsand norms. The RBI also indicated that the banks are permitted to use theirdiscretion only where the projected current ratio is not below 1.33:1(except under exempted categories) and any fall in it from a higher level inthe past to the projected level is on account of permissible activitiesl/indicated by the RBI and not due to any diversion of funds outside thecompany. Banks are also allowed to release funds without RBI permission tothose borrowers who have been submitting quarterly operating statementsregularly for the past six months within the stipulated time, and undertaketo do so in the future. Banks can now release up to 75% of the new limitsrequested in the case of export oriented manufacturing assets and up to 50%to other borrowers. These discretionary powers should speed up release offunds to some borrowers but the proposals will go through the normal processof RBI scrutiny. If, as a result of the scrutiny, the credit limit sanc-tioned is found to be excessive, the RBI can direct banks to take correctiveactions. This relaxation is welcome because it will reduce undue interrup-tions to productive activity.

4.17 One reason for the existence of the CAS is to enhance credit controland planning by the RBI. Indian banking largely operates on the cash creditsystem under which banks have no control over the level of advances and nonotice is required for drawing up to limits that may remain unutilized forlong periods. As such, banks are not able to plan their credit operations.The Tandon and Dehejia Committees 2/ suggested that the credit limits shouldbe bifurcated into a loan and cash credit. The loan would comprise theminimum level of borrowing which the borrower expects to use throughout theyear, known as "core current assets" while the cash credit part would meetthe fluctuating requirements. The RBI initially accepted the need for achange in the credit system, but then reversed its position when the ChoreCommittee in 1979 recommended against shifting from cash credit to loan orbill financing thus reducing even further the likelihood of a change in thesystem.

4.18 Unless the importance of cash credit system is reduced, it is veryunlikely that the RBI will further liberalize or eliminate the CAS. The CAS

1/ Permissible activities are: expansion of existing capacity,diversification, fuller utilization of capacity and rise in workingcapital requirements because of abnormal price increases.

2/ Report of the Study Group on Bank Credit (Dehejia Committee), RBI, 1968.

-63-

allows the RBI to have a tighter control on monetary developments. Beforethe implementation of the Tandon norms, the total credit limits sanctionedby the banking system exceeded total deposits (before deducting reserverequirements). The Tandon Committee also found that in June 1974 the actualutilization of credit limits was only 57% thus in effect 43% of the creditlimits sanctioned remained unutilized. As a result of changes to CAS thissituation has changed in recent years.

Table 4.4: Credit Limits and Aggregate Deposits(in Rs billion)

Dec. Dec. Dec. Dec. June June Dec.1972 1973 1974 1975 1978 1980 1980

Total Deposits 87 105 122 147 233 334 370

Total Credit Limits 106 122 134 157 219 270 298of which under CAS n.a. (65) (68) n.a. (106) (130) n.a.

Deposit/Credit LimitRatio 0.82 0.86 0.91 0.94 1.07 1.24 1.24

Source: Reserve Bank of India.

4.19 The RBI should review the CAS taking into consideration the intendedpurposes of the scheme and the extent to which it is required to pursuethose objectives. The allocative aspect of the CAS may have been necessaryin 1965 when the scheme was initially implemented, but with the present veryspecific priority sector lending targets, it seems to be redundant. Withrespect to the credit control aspect, it seems that a reduction in this rolewill only be possible through a shift from cash credit to loan credits.Nevertheless, even now the existence of the CAS is based on the assumptionthat businesses use credit lavishly or for unproductive purposes. Sincecredit is not a grant but a loan with very high financial costs (interestrates as high as 18%) and since efficient management of firms calls formaintaining working capital requirements (and borrowings) at the operation-ally minimum level, the rationale beyond the assumption does not appear tobe very convincing.

4.20 Two additional aspects of the CAS require further scrutiny: (a) therationale for subjecting public sector enterprises to CAS control; and(b) the scope for reducing the role of the RBI, which currently acts as thehead office of commercial banks for CAS purposes, to that of overseer.Banks would still be required to follow certain norms, at least initially,and the RBI would monitor the implementation through random checkups withouthaving to approve all requests for credit extension under the scheme.

-64-

C. INTEREST RATE POLICY

1. Introduction

4.21 The level and structure of interest rates in India is administra-tively fixed by the Government. Bank interest rates are not determined bycompetitive market forces, but are largely resultant of policy decisions.Interest ceilings are also imposed in the least controlled end of the finan-cial market which comprises company shares, debentures and deposits.

4.22 Interest rates can perform three basic functions when allowed tofind their equilibrium market levels through the interaction of the forcesof supply and demand: (a) contribute to mobilize an adequate level ofsavings by acting as the price which influences the choice between presentand future consumption; (b) act as efficient rationing devices for theallocation of scarce resources between alternative investments; and (c)provide a social discount rate for saving and investment decisions. Sincemost interest rates in India are administratively fixed by the Governmentthese basic functions are not fully performed. On the contrary, interestrate policy has been designed to achieve the following objectives: (a)support activities of particular sectors through lending at preferentialrates; (b) finance the Government's considerable borrowing requirements ascheaply as possible; (c) provide framework for macroeconomic stability; and(d) encourage the mobilization of financial savings. Thus, interest ratesdo not necessarily act as rationing devices for the allocation of scarceresources between alternative investments. This role is being performed bythe Government through other mechanisms such as priority sector lending andoverall credit policy which are generally less efficient for this purpose.Furthermore, the pursuit of an interest rate policy which attempts to sup-port these four sometimes conflicting objectives has the potential formisallocation of resources by promoting activities in preferred sectors(including some public investments) which may not otherwise be economicallyviable.

4.23 Interest rates are affected by Government policy both directly andindirectly. As a major borrower, the Government regulates the rate ofinterest on its securities, small savings schemes, etc., and, as an impor-tant lender, determines the rates of interest on the loans and advances itgives directly and indirectly for a wide array of activities, institutionsand individuals, both in the public and private sectors. The Governmentuses various policy instruments to control and regulate the structure ofinterest rates. The RBI regulates the rediscount rate (Bank rate) andinterest rates on bank deposits and bank credit, the Controller of CapitalIssues fixes interest rates on debentures and preference shares, theGovernment and RBI dictate interest on Government securities, and finallythe Government (Ministry of Finance) fixes on-lending rates for loan andadvances for Government-related activities performed by State Governments,Ports, Development Banks and other public sector institutions. In addition,the Government sets the wide range of rates applicable to the various tiersof cooperative societies and development institutions. Some of these ratesalso vary from State to State being subject to State legislation.

-65-

2. Structure of Interest Rates

4.24 The structure of interest rates in India is very complex since mostrates in the organized market are to some degree subjected to Governmentcontrol. Rates are differentiated on a large variety of criteria such as:the size of loans, maturity, source of funds, activity or purpose of theloan, group or sector to which the borrower belongs, or region where themoney is allocated. Tables 4.5 and 4.6 show the evolution, in nominalterms, of the structure of major types of interest rates in India. Thetables are by no means comprehensive.

4.25 An analysis of the data highlight the following features of India'sinterest rate behavior. First, there is a trend toward increasing nominalinterest rates. This upward adjustment in nominal rates probably reflectsthe scarcity of capital and higher inflation rates. Real rates, on thecontrary, have shown wide fluctuations with negative deposit rates during 8of the past 13 years and positive lending rates almost throughout the periodsince 1970/71 (excluding 1973-1975).l/ Second, short-term rates on depositsare lower than those on longer-term deposits. This follows the expectedpattern: higher interest has to be offered to savers to encourage them tolend at longer maturities. Third, loan rates of interest are generallyhigher than rates on deposits. Therefore, the inversion of deposit and loanrates which occurs in many LDCs is not a widespread phenomenon in India,although it occurs in some instances where financial institutions acceptdeposits with higher interest rates than their lowest loan rates of similarmaturities. This reduces the institution's profitability by reducing thespread between average deposit rates and average lending rates.

4.26 Fourth, term lending rates are lower than those for short-termloans. This runs counter to what would be expected in a freely operatingmarket: higher rates on longer maturities. Rates on term lending are keptlow with a view of promoting long-term investment. Some authors indicatethat this reversal in the rates tends to reduce funds available for long-term investment by financial institutions which find short-term lending moreprofitable. This phenomenon is not apparent in India because of the exist-ence of specialized financial institutions and credit allocation policieswhich direct funds for specific purposes and maturities. Institutions suchas IDBI, ICICI, NABARD, etc. which have to lend a considerable proportion oftheir portfolio at long maturities are able to do so because they areallowed to float securities in the "captive market" created by the SLR towhich commercial banks are subjected. In addition, cooperative societiesare permitted to pay higher rates to depositors and lend at lower ratescompared to commercial banks, operating on a smaller spread supported byGovernment subsidies and/or concessional finance from the Reserve Bank.

1/ Real rates are analyzed in more detail in paragraphs 4.38 to 4.40.

- 66 -

Table 4.5

INTEREST RATES - SHORT TERN COMECIAL MIING RATES(in percent)

1971/71 1975/76 1976/77 1977/78 1978/7? 1979/81 19861/8 198t/82 1982/83

I Bank late 5.0/6.6 9.6 9.6 91. 9.1 91. 9.0 1I.$ 116.11 Treasery Dill Rate 3.1/3.5 4.6 4.6 4.6 4.6 4.6 4,6 4.6 4.6

III Call money Rate(a) State Bank of India

- Schedsled anks 9.5/12.15.5 15.5 15.5/15.0 15.1 15.1/18.1 15.1/19.4 18.5 18.5- Cooperative hnks 7.5/8.5 14.5 14.5 14.5/13.5 13.5 13.5 (4) (a) (a)

(b) Othe Major Scheduled Ceomrcial Banks- ombay 6.38 11.55 13.84 9.28 7.57 8.47 7.12 9.96 8.78- Calcutta 6.91 11.12 11.71 7.17 7.96 8.51 9.28 9.81 8.91- adras 6.45 9.73 11.17 9.82 8.10 8.56 9.42 9.38 6.35

IV Bazaar Bill Rate- Dolea 15.1 21.6 n.A na n.a n.a n.a n.a n.a

Hadi Rate- State Bank of India 9.5 14.1/16.5 14.1/16.1 na na n.a n.a n.a n.a

V Ceowrcial Bank Raes(a) Deposit Ratn- Ceiling

- I Year 6.1 9.1 89. 8.1/6.1 6.1 7.1 7.5 9.1 9.1- 3 Years 6.5 9.6 9.6 9.1n.5 7.5 8.5 16.3 16, 11.1- 5 Years 7,25 1.6 116. 1161/9.0 9.1 10.1 10.0 10.1 11.6

(b) Key Lending RatesCeiling- Ceneral (b) 16.5 16.5 16.5/15.1 15.6 19.1 19.4 19.5 19.5- Experts - 11.5 11.5 11.5/11.0 11.0 11.1 12.5/17.5 12.5/17.5 12.5/17.5- Foed Procurenwnts - 12.1 1210 12.1/11.0 11.$ 11.6 12.51 12.51 12.51- On deferred Payents - 81 8.1 8.1 81 89. 89.65 8.65 9.65

Wineion- Ceneral - 12.5 12.5 12.5 12.5 12.5 13.5 (c) (C)- Selective Controls - 14.1/15.1 14.1/15.1 14.1/15.1 14.0/15.1 15.5/18.5 17.5/19.5 17.5/19.5 17.5/19.5

(a) Effective July 1980, the rates cbarged on dnad leans are sane as those applicable to general categories of borrowers for sinilaradoance.

(b) The ceiling on lending ratm was withdrawn in January 1976 but was reintroduced from March 1976.(c) In the revised internt rate structure vhich beca effKctive from March 2, 1981, no general lending rote was fixed bit a broad

fraeort of internt rate was provided with fixed rate on certain type of advancn and ceiling rates on ether type of advances.llb n r ceiling rates were prescribed, the rate of internt fixed for the prteeding advance woeld serve as fleo rate for advaocesin that category.

loorce: Reserve Ink nof India - lepsot on Currentcy and Finance 1982/93 and preoviss issen.

- 67 -

Table 4.6

INTEREST RATES - LONG TERN RATES(in percent)

1970/71 1975/76 1976/77 1977179 1979/79 1979/18 1996/81 1991/82 ISW83

Tern Lending Institutlns

Primge Lending RatesIDII 8.5 11.1 11.1 11.0 11.1 11.6 14.1 14.1 14.1IFCI 9.0 12.1 11.6 11.0 11.6 11., 14.6 14.6 14.6ICICI 6.5 11.0 11.6 11.1 11.1 11.1 14.1 14.1 14.6

IdI - 8.5 8.5 8.5 8.5 8.5 9.15 9.15 12.5SFC 7.5/11.5 8.1/14.5 8.6/15.5 9.6/15.5 8.0/t5.5 8.6/15.5 12.6/16.1 11.3/14.1 12.5/17.1

(ratn charged to small scale Industries) 7.1/9.5 .6/11.1 8.1/11.6 8.0/11.1 8.1/11.6 8.1/11.1 12.1/14.5 12.5/14.0 12.5/14.5

UTI Dividend alte 8.1 8.75 9.6 9.1 9.6 11.1 11.5 12.5 13.5

Corporate Borrowing Rate(a) Preference - Ceiling 9.5 11.t 11.1 11.1 11.1 11. 11. 13.5 13.5(b) Debenturn - Ceiling 9.1 16.5(a) 11.5(a) 10.5(a) 16.5(a) 11.5(b) 13.5(b) 13.5(b) 13.5/15.1(b)

(c) 1 year - 9.6/13.5 9.15.6 9.0/15.1 9.6/13.5 9.6/13.6 9.6/13.5 9.6/13.5 9.6/15.1(d) 2 years - 10.1/14.5 16,0/16.1 11.1/15.5 9.5/14.1 9.5/14.1 11.1/14.5 10.1/14.5 9.5/15.1(e) 3 years - 9.5/16.5 11.6/16.6 11.6/16.5 16.5/15.0 16.5/15.6 13.6/15.5 13.1/15.5 16.5/15.5(1) 5 years - 9.1/16.1 12.0/16.1 11.5/16.1 12.1/16.1 11.5/16.1 15.1/16.6 15.1/16.1 14.1/t5.1

(c)

Industrial SecuritiesOrdinary Shares 5.53 5.43 6.14 6.47 5.66 5.93 5.88 5.51 5.86Dbentores - Running Yield 7.31 8.39 9.55 8.89 nJ ma. na. e. 1a.

gCvernment SecuritlsShut - teor(1 - 5 years) 3.8/4.3 5.2/6.0 5.2/5.5 5.1/5.5 S.1/5.4 4.7/5.7 4.7/6.1 5.3/6.4 5.6/8.5Medium- tern(5 -15 ears) 4.3/4.8 5.5/6.1 5.4/5.9 5.4/5.9 5.5/6.2 5.7/6.3 5.8/6.8 5.8/7.1 6.3/7.8Lrng - tern(15 fears and ever) 4.8/5.5 6.1/6.4 6.1/6.4 6.1/6.4 6.1/6.7 6.2/6.9 6.4/7.5 6.5/8.1 6.5/9.1

(a) Effective September 12 1974 and for a term exceding 7 years. 11 percent for a ten Ins thin 7 years.

(b) Interest on 'Rights' debentvres iusd by public limited companies to agmet their long-trm working capital roqiruoets had beenfixed at the rate of 16.5 prcent opts 7 years mturity and 11 percent on the maturity period from 8 to 12 years as per quidelinnisseed by government in Septeber 1978. The ceiling en internt on public isset of debentures as raised from It to 12 percent fromOtoeer 190 and further to 13.5 prcent from March 2,1981. From April 17,1982 while the existing ceiling on interest rate of 13.5percent was imintained for issne of convertible debentorn, the ceiling rate ws raised to 15 percent in the cas of isun-cvertibledebentures.

(c) The acceptannce of deposits for periods more than 3 years hs ben prohibited effetive fron April 1,1M bet companiesare permitted to retain such deposits accepted prier to April 1,1978 till maturity.

Seorce : Reserve Bank of India - Report on Currency and Finance 1982/83 and proievus isswn.

-68-

4.27 Fifth, deposit and lending rates are subjected to either floors orceilings (sometimes to both) which account for the complexity of thestructure. There is a significant spread between ceilings and minimuminterest rates and between interest rates for preferred and non-preferredactivities. Finally, Government securities yield less than privatesecurities due not only to their lower risk, but also to the existence of acaptive market for Government securities which constraints upward movementof interest rates on Government approved securities.

3. Commercial Bank Rates

4.28 Since the early 1950s, commercial bank rates moved progressivelyfrom being market rates to being administered rates. In 1964 the RBI movedto set the deposit rates offered by banks directly and imposed a ceilingrate on general advances. Prior to that, there was no control over thegeneral level of lending rates although minimum lending rates wereprescribed on loans secured by sensitive commodities. In January 1970, theceiling on general advances was withdrawn. In the period from January 1970to June 1973 there was no explicit control over the rate on generaladvances, although a minimum lending rate continued to be specified againstcommodities subject to selective credit controls. In June 1973, the RBIimposed a minimum lending rate on general advances. The minimum lendingrate on general advances has remained in effect. Established initially at10%, it was raised since to 13.5%. In March 1976 the RBI re-imposed theceiling on advances to discourage usury practices by certain banks.Currently, therefore, for general lending purposes, banks are operatingwithin the confines of a minimum lending rate of 13.5% and a ceiling rate of18%. Lower rates are available under the Differential Rate of InterestScheme which directs banks to lend at least 1% of their loan portfolio at 4%rates of interest to small businessmen, small farmers, selected tribes andscheduled castes, and for activities in backward regions. Intermediaterates between 4% and 13.5% (generally clustered around 10-12%) are alsoavailable for some types of exports, food procurement, and deferredpayments.

4.29 India has a very complex interest rate structure which needs to berationalized in order to raise the efficiency of financial intermediation.The Government's rationale for this complex structure is the need to promotecertain priority sectors. However, a comparison of average rates of inter-est on loans to different sectors shows that while there is a differencebetween average on-lending rates to different sectors, the spread is verysmall. For instance, in June 1978 the average lending rate for agricultureand allied activities was 12.5% as compared to 13.9% for retail activitiesand 12.9% for total credit outstanding. In addition, up to 1978 the averagecost of credit to priority sectors was quite close to the average cost tonon-priority sectors. This has been changed in recent years with a wideningspread between average onlending rates to different sectors. In 1981 theaverage lending rate to priority sectors was 13.6% as compared to 15.8% fornon-priority sectors and 14.9% for total credit.

4.30 While the data are incomplete and more recent data show a widerspread between lending rates to different sectors, it still is not clearthat such a complex interest rate structure is required to promote specificactivities. The analysis of data on credit outstanding by interest rate and

-69-

sector also indicates that preferential interest rates are available toselected borrowers in all sectors, regardless of their activities or purposeof the loan. Therefore, the complex interest rate structure appears tofavor certain borrowers who are able to obtain low rates, but does notnecessarily contribute to the promotion of priority sectors as a whole.Since India also has a very detailed credit allocation policy in addition toa complex set of interest rates, the interest rate structure could besimplified without significantly altering the direction of credit. While itis important to promote the development of previously neglected sectors, itis also important to recognize the costs and limitations of such efforts.

4.31 A rationalization of interest rate structure would bring aboutseveral benefits: (a) it would reduce administrative cost to banksassociated with the complex interest rate structure; (b) it could lead to anoverall reduction in interest rates since the new structure should aim atreducing the spread between ceiling and minimum interest rates with somecategories being charged higher rates and others experiencing a reduction;and (c) it would reduce the potential negative effects of interest subsidiesand extensive cross-subsidization, such as: reduction in the aggregatesupply of credit and inappropriate technology choice because of biases infactor prices in favor of capital and against labor.

Table 4.7: Average Rates of Interest on Scheduled CommercialBank Outstanding Credit: A Sectoral Comparison /a

(percentage rates per annum)

Outstanding as of June ofEconomic Activity 1975 1976 1977 1978 1980 /b 1981

Agriculture and Allied 13.8 13.5 13.3 12.5 12.6 12.7Small-scale Industry 14.1 14.0 13.9 13.1 13.9 14.5Transport Operators 14.0 14.5 13.9 12.7 12.4 12.7Personal & Professional Service 14.7 14.6 14.0 13.5 14.7 15.2Retail Trade 15.3 15.2 15.1 13.9 15.4 16.2

Priority Sectors 14.1 14.0 13.8 13.0 13.4 13.6Non-priority Sectors 14.1 13.8 13.7 12.9 15.0 15.8

Total Credit Outstanding 14.1 13.9 13.7 12.9 14.4 14.9

/a Relates only to accounts with credit limits over Rs 10,000 which accountfor about 86% of total credit outstanding.

lb Refers to December 1980.

Source: 1975-1977: K.V. Ravindranath, "Rates of Interest on Commercial BankCredit" (calculated based on data published in Banking Statistics,Vol. 6), Prajnan, April-June 1981.1978, 1980, 1981: Calculated from RBI's Banking Statistics,various

-70-

4.32 Table 4.8 shows the distribution of credit according to interestrate range in 1980. While the average lending rate was 13.6%, the interestrate range varied from 4% to 19.5%, indicating a significant spread inlending rates. A rationalization of the structure should aim at reducingthe spread without reducing the profitability of banks. This can beaccomplished by a reduction in ceiling rates together with an increase inconcessional rates, particularly those under the DRI Scheme and others topreferred customers.

Table 4.8: Distribution of Loans and Advances of ScheduledCommercial Banks According to Interest Range

(June 1980)

Interest Rate Percentage to Total

6% and less 1.66.01 to 9% 1.89.01 to 10% 1.910.01 to 11% 23.811.01 to 12% 5.612.01 to 13% 8.313.01 to 14% 8.114.01 to 15% 13.715.01 to 16% 6.216.01 to 17% 14.717.01 to 18% 13.818.01% + 0.5

Average Lending Rate 13.6%

Source: Statistical Tables relating to Banks in India,1980, RBI.

4.33 Any attempt to rationalize interest rates should take into con-sideration the need to maintain a reasonable spread between average lendingrates of financial institutions and average cost of funds. Commercial bankspay an average 7.5% to depositors and get an average 13.5% on lendingthereby operating on a 6% spread. This spread is high when compared to thatin other countries (a typical spread is 3%) but is necessary to cover bank-ing costs including the cost of maintaining a large proportion of its port-folio in low-yield assets. Discounting the effect of the SLR and CRR, thespread between average lending rates and financial cost of funds is reducedto 2.5%-3%.1/ This spread is just enough to cover administrative costs andallow a small return on assets.

1/ Calculated based on: zero return on 3% maintained as CRR, 8% returnon additional 4% maintained as CRR, 6.25% average return on 35% kept asSLR and 13.5% average return on lending (58% of total deposits).

-71-

4.34 In addition to revising the structure of interest rates, theGovernment could also contemplate the possibility of gradually delegatingthe responsibility of setting interest rates to the commercial banks on thebasis of cost of funds and expected benefits and risks. The large number ofbanks in India should allow the formation of a truly competitive market.

4. Differential Rate of Interest Scheme (DRI)

4.35 This scheme was introduced by public sector banks in 1972. Underthis scheme, loans are provided to low-income beneficiaries, for startingany income-generating viable project at a concessional interest rate of fourpercent per annum. Progress under this scheme has been impressive and banksare already meeting the target of 1% of total advances. As of June 1981,the number of DRI accounts stood at 2.7 million and the amount of loansoutstanding on these accounts was Rs 2.25 billion, for an average loanamount of Rs 844. The performance in terms of loan utilization andrepayment, however, has not been very successful. The National Instituteof Bank Management has recently completed a study of the DRI schemel/ whichindicates the need for remedial actions. Some measures suggested are:(a) raise the income limits for eligibility; (b) raise the interest ratefrom the current 4% to 7% or 8% to encourage banks to have a more activerole in loan preparation; supervision and follow up; (c) increase the amountof the loans to at least Rs 2000 so that it can be used for income-generating activity; and (d) provide indirect financing, i.e., throughcooperatives, development corporations, etc. (this would facilitate creditadministration, supervision and recovery).

5. Nominal vs Real Interest Rates

4.36 Considerable disagreement exist in the economic literature over theinfluence exerted by interest rates on the volume of savings and investment.Nevertheless, the available empirical evidence tend to suggest that there isa positive relationship between savings and interest rates, especially whenrates become positive in real terms after having been maintained at substan-tially negative real levels by administrative action.2/ The role of inter-est rates in the mobilization of savings may be completely offset if nominalinterest rates do not increase proportionately to inflation. However,determining the true "real" rate of interest is a problematic exercise sinceit should be based on expected inflation and not on short-run changes of anyparticular price index. A "second best" solution to the problem is toestimate real interest rates by using as an adjustment factor the weightedaverage of current and past annual averages of an inflation index such as

1/ "Impact of Differential Rate of Interest Scheme", O.P. Chawla, K.V.Patel, N.B. Shete, National Institute of Bank Management, Bombay, 1983.

2/ For evidence on India see "Interest Rate Policy in India," M.J. Fry,1981; "Innovations in Banking: the Indian Experience, Part I,"C. Rangarajan, 1978; "Public Investment, Crowding Out and Growth: ADynamic Model Applied to India and Korea," V. Sundarajan and S. Thakur,IMF Staff Papers, December 1980.

Table 4.9 Nominal and Real Interest Rates of SelectedFinancial Instruments

Actual Deposit Rate Leading Rates Govmt. 2Inflation Expected 1 , One Year Gen.-Ceiling General-Min. Term-Lending Securities-

(Change in WPI) Inflation- Nom Real Nom Real Nom Real Nom Real Nom Real

1970/71 5.5 5.1 6.0 0.9 n.a. n.a. n.a. n.a. 8.5 3.2 4.1 -1.01971/72 5.6 4.7 6.0 1.2 n.a. n.a. n.a. n.a. 8.5 3.6 4.5 -0.21972/73 10.0 6.4 6.0 -0.4 n.a. n.a. n.a. n.a. 8.5 2.0 4.7 -1.61973/74 20.2 11.5 6.0 -4.9 n.a. n.a. 10.0 -1.3 9.0 -2.2 4.8 -6.01974/75 25.2 16.9 6.75 -8.7 n.a. n.a. 11.0 -5.0 10.25 -5.7 5.3 -9.91975/76 -1.1 12.1 8.0 -3.7 16.5 3.9 12.5 0.4 11.0 -1.0 5.6 -5.81976/77 2.1 8.8 8.0 -0.7 16.5 7.1 12.5 3.4 11.0 2.0 5.4 -3.11977/78 5.2 6.8 8.0 1.1 16.5 9.1 12.5 5.3 11.0 3.9 5.3 -1.41978/79 0.0 3.4 6.0 2.5 15.0 11.2 12.5 8.8 11.0 7.4 5.3 1.81979/80 16.7 6.8 7.0 0.2 18.0 10.5 12.5 5.3 11.0 3.9 5.2 -1.51980/81 18.7 11.5 7.5 -3.6 19.4 7.1 13.5 1.8 14.0 2.2 5.4 -5.51981/82 9.0 11.7 8.5 -2.9 19.5 7.0 13.5 1.6 14.0 2.1 5.9 -5.21982/83 (est.) 2.5 9.2 9.0 -0.2 18.0 8.1 12.5 3.0 14.0 4.4 6.2 -2.7

1/ Expected inflation is calculated from a distributed lag on current and past inflation rates (WPI, annual increase).The weights are: 0.333 for t; 0.267 for t-l; 0.200 for t-2; 0.133 for t-e and 0.067 for t-4. Weights were arbitrarilyselected based on ratio 5:4:3:2:1.

2/ Average rate for short-term securities (1 to 5 years) estimated by simple arithmetic average of rate on 5-yearsecurity and rate on 1-year security.

SOURCE: RBI Report on Currency and Finance, various issues.

NOTE: All rates are pre-tax.

-73-

the Wholesale Price Index.1/ Table 4.9 shows nominal and real interest ratefor selected financial assets in the last few years. The pattern thatemerges is comparable for both short and long-term instruments. Changes innominal rates (administered by the RBI) are less frequent and volatile thanthe adjustment factor which fluctuated between 16.9% in 1974/75 and 3.4% in1978/79.

4.37 While lending rates have generally been positive in real terms,_deposit rates have fluctuated more widely. Real deposit rates ranged from2.5% in 1978/79 to minus 8.7% in 1974/75. Government securities have t[adi-tionally yielded very low returns with negative real yields almostthroughout the 1970s -- with the exclusion of 1978/79, a year of very p1winflation. India t--oes not have serious interest rate problems although itshould adjust yields on Government securities to close the existing gap withreturns on other financial assets. Despite this the overall level of inter-est rates in India does appear to encourage mobilization of savings andresources.

4.38 While India has generally maintained positive real interest rates,temporary upsurges in inflation have caused real interest rates to turnnegative sporadically. Negative real interest rates are not a significantcause for concern in India because the phenomenon is temporary (recentupsurges in inflation were promptly brought under control) and also becausethe rates turned only slightly negative excluding the period 1973-1975. Apolicy of constant adjustment of interest rates to reflect short-termchanges in inflation and allow for continuous positive real rates could havepotential disruptive effects on economic activity. This could happenbecause price fluctuations in India very much reflect the vagaries of natureand its effects on agricultural performance, therefore a policy ofcontinuous adjustment in interest rates would lead to undesirably sharpfluctuations in nominal rates. The current policy of frequent but smallrevisions of interest rates is a more sensible approach. This policy hasallowed the expansion and deepening of the Indian financial system despitesome inflationary spurts. Nevertheless, as indicated earlier, some aspectsof interest rate policy in India have the potential for misallocatingresources and should be corrected.

1/ The weighting is arbitrarily assigned at the ratio 5:4:3:2:1, currentto previous four years, respectively.

- 74 -

REFERENCES

1. V.A. Avadhani (1978), Studies on Indian Financial System, JarcoPublishing House, Bombay.

2. V.V. Bhatt, Ed. (1981, 2 Volumes), Readings in Finance andDevelopment, Economic Development Institute, World Bank, Washington,DC.

3. L.M. Bhole (1982), Financial Markets and Institutions--Growth,Structure, Innovations, Tata McGraw-Hill Publishing Company, Ltd.,New Delhi.

4. Central Statistical Organization, GOI (February 1983 and previousissues), National Accounts Statistics, New Delhi.

5. Centre for Monitoring the Indian Economy (various, annual), BasicStatistics Relating to the Indian Economy, Bombay.

6. O.P. Chawla, K.V. Patel, N.B. Shete (1983), Impact of DifferentialRate of Interest Scheme, Bombay.

7. W.L. Coats and D.R. Khatkhate, Eds. (1980), Money and MonetaryPolicy in Less Developed Countries, Pergammon Books, New York.

8. M. J. Fry (1981), Interest Rate Policy in India, Unpublished Mimeo.Paper, IMF, Washington, DC.

9. R. Goldsmith (1983), The Financial Development of India 1960-1977,Oxford University Press, Oxford.

10. Indian Banks' Association (various, annual), Financial Analysis ofBanks, Bombay.

11. Indian Investment Centre (1980), Specialized Financial Institutions,New Delhi.

12. Indian Investment Centre (1983), Non-resident Indians, An InvestmentGuide, New Delhi.

13. Industrial Development Bank of India (various, annual), Report onDevelopment Banking in India, Bombay.

14. M. Long (1983), Review of Financial Sector Work, FinancialDevelopment Unit, Industry Department, World Bank, Washington, DC

15. Dr. H.R. Machiraju (1978), Some Aspects of the Corporate SecuritiesMarket, Management Development Institute, New Delhi.

16. P. Mampilly (1978), Innovations in Banking: The Indian Experience,Part II - Cost and Profitability of Commercial Banking, IndianInstitute of Management, Ahmedabad.

17. S.S. Mehta and R.M. Honavar (Unpublished draft, 1982), Some Aspectsof the Indian Capital Market, 1982.

18. A. Pinell-Siles, V.J. Ravishankar (1982), The Financing ofInvestment in India, 1975-85, Sources and Uses of Funds Approach,World Bank Staff Working Paper No. 543, Washington, DC

19. Ct Rangarajan (1978), Innovations in Banking: The IndianExperience, Part I - Impact on Deposits and Credit, Indian Instituteof Management, Ahmedabad.

20. D.C. Rao (Dec. 1980), The Structure of Corporate Finance and SomeRelated Policy Issues, Occasional Papers, Reserve Bank of India,Bombay.

21. J.C. Rao (1981), Financing of Manufacturing Enterprises in India,UNIDO Consultant, Limited pub., United Nations.

22. K.V. Ravindranath (April-June 1981), Rates of Interest on CommercialBank Credit, Prajnan, New Delhi.

23. Reserve Bank of India (various issues), Annual Report, Bombay.

24. , (bi-annual, various issues), BankingStatistics (Basic Statistical Returns), Bombay.

25. Reserve Bank of India (various, monthly), Bulletin, Bombay.

26. , (February 1982), Capital Formation and Savingin India 1950-51 to 1979-80, Report of the Working Group on Savings,Reserve Bank of India, Bombay.

27. , (1978), Chart Book on Financial and EconomicIndicators, Bombay.

28. , (August 1975), Flow of Funds in the IndianEconomy 1966-67 to 1971-72, RBI Bulletin, Bombay.

29. , (March 1980), Flow of Funds in the IndianEconomy 1970-71 to 1976-77, RBI Bulletin, Bombay.

30. , (1983), Functions and Working; Reserve Bankof India, Bombay.

31. , (various issues), Occasional Papers, Bombay.

32. , (1978), Report of the Committee on Functioningof Public Sector Banks, Bombay.

33. , (1975), Report of the Study Group to FrameGuidelines for Follow-up of Bank Credit, Bombay.

34. Reserve Bank of India, (1982), Report of the Working Group on theRole of Banks in Implementation of New 20-Pont Programme, ReserveBank of India, 1982.

- 76 -

35. , (1979), Report of the Working Group to Reviewthe System of Cash Credit, Bombay.

36. , (annual, various issues), Report on Currencyand Finance, Bombay.

37. , (annual, various issues), Report on Trend andProgress of Banking in India, Bombay.

38. , (various, annual), Statistical StatementsRelating to the Cooperative Movement in India, Bombay.

39. , (annual, various issues), Statistical TablesRelating to Banks in India, Bombay.

40. A.N. Shanbhag (1982), In the Wonderland of Investment, JarcoPublishing House, Bombay.

41. S.L. Shetty, Ed. (1979), Framework for a National Credit Plan,National Institute of Bank Management, Bombay.

42. A. Singh, S.L. Shetty, T.R. Venkatachalan (Vol. 3, No. 1, June 1982,Supplement to RBI Occasional Papers), Monetary Policy in India:Issues and Evidence, RBI, Bombay.

43. K.N. Subrahmanya (1982), Modern Banking in India, Deep & DeepPublishers, New Delhi.

44. T.R. Venkatachalan and Y.S. Sarma (April 1977), Structure and Trendsin the National Balance Sheet of India, Journal of Income andWealth, New Delhi.

45. T. Timberg (Unpublished draft, 1979), Informal Credit Markets inIndia, World Bank, Washington, DC

46. S. Van Wijnbergen (1983), Interest Rate Management in DevelopingCountries, World Bank Staff Working Paper #593, Washington, DC.

47. V. Sundarajan and S. Thakur (December 1980), Public Investment,Crowding Out and Growth: A dynamic Model Applied to India andKorea, IMF Staff Papers, Washington, DC.

48. R. Vishwanathan (1982), Industrial Finance, S. Chand & Co., NewDelhi.

49. World Bank (June, 1984, unpublished internal document) ProjectPerformance Audit Report, First IDBI/SFC Project, Washington, DC.

World Bank An Analysis of Developing NEWCountry Adjustment

Publicatlons Experiences in the 1970s: Low- Compounding and Discountingof Related Income Asia Tables for Project Analysis

Christine Wallich (with a Guide to TheirInterest Staff Working Paper No. 487. 1981. 43 Applications)

pages (including references). Second Edition, Revised andStock No. WP 0487. $3. Expanded

Adjustment Experience and Aspects of Development Bank J. Price GittingerGrowth Prospects of the Semi- Management Project planners and analysts will findIndutrthl Countries Willia Dia od ad V c this book a convenient and time-sav-Frederick Jaspersen Raghamvan amon and * ing reference for the preparation andStaff Working Paper No. 477. 1981. 132 Deals exclusively with the manage- decianal tables for I percent through 50pages (including 3 appendixes). ment of development banks. The book percent show the compounding 50torStock No. WP 0477. $5. is divided into eight sections, each for I and for I per annum, the sinking

dealing with one aspect of manage- fund factor, the discount factor, theAdjustment in Low-Income ment of its problems, and of the var- present worth of an annuity factor,Africa ious ways of dealing with them. and the capital recovery factor. TheRobert Liebenthal EDI Series in Economic Development. The first edition of this book underwentStaff Working Paper No. 486. 1981. 62 Johns Hopkins University Press, 1982. seven printings in ten years and waspages (including bibliography). 2nd printing, 1983. 311 pages. translated into Arabic, Chinese,Stock No. WP 0486. $3. LC 81-48174. ISBN 0-8018-2571-7, Stock French, and Spanish. This new edi-

No. 1H 2571, $29.95 hardcover; ISBN 0- tion-with narrow-interval compound-Aggregate Demand and 8018-2572-5, Stock No. IH 2572, $12.95 ing tables added for higher interestMacroeconomic Imbalances in paperback. rates, updated project examples, aguide to using simple electronic calcu-Thailand: Simulations with the Capital Accumulation in lators to perform the computationsSIAM 1 Model Eastern and Southem Africa: A discussed, and an annotated bibliog-Wafik Grais Decade of Setbacks raphy increases the proven usefulnessStaff Working Paper No. 448. 1981. 132 Ravi Gulhati and Gautam Datta of its predecessor, both in the class-pages (including 3 appendixes). room and at the project site.Stock No. WP 0448. $5. in capital accumulation in eastern and May 1984. About 208 pages.

southern Africa. This phenomenon is ISBN 0-8018-2409-5. Stock No. BK 2409.examined in twenty-eight statistical ta- $10.95.

NEW bles. The authors sample sixteen coun- Translations of this new edition will betries and rely on expert observations to available in 1985. Still available are theexplore the proximate causes of the following translations of the first edition:

Alternative Mechanisms for setbacks. French: Tables d'interets composes et d'ac-Financing Social Security World Bank Staff Working Paper No. 562. tualisation. Economica, 4th printing,Parthasarathi Shome and Lyn 1983. 74 pages. 1979.Squire ISBN 0-8213-0169-1. Stock No. WP 0562. ISBN 2-7178-0205-3, Stock No. IB 0542,Reviews, clarifies, and evaluates theo- $3. $6.retical literature about the effect of so- Capital Market Imperfections Spanish: Tablas de interes corpuesto y decial security on capital accumulationrf scuntopr T alas de proyectosdand labor supply. Analyzes empirical and Economic Development descuento para evaluacion de proyectos.studies using U.S. data, the impact of Vinayak V. Bhatt and Alan R. Roe EdItoNal Tecnos, 1973; 4th printng, 1980.pay-as-you-go financed and fully Staff Working Paper No. 338. 1979. 87 ISBN 84-309-0716-5, Stock No. lB 0526.funded social security schemes, and tsages (including footnotes). $6.characteristics of optimal social secu- Stock No. WP 0338. $3.rity systems. This study provides astarting point for everyone interestedin the relevance of existing theories for The Changing Nature of Export A Conceptual Approach to thefinancing social security in developing Finance and Its Implications Analysis of External Debt ofcountries. for Developing Countries the Developing CountriesStaff Working Paper No. 625. 1983. 62 Albert C. Cizauskas Robert Z. Aliberpages. Staff Working Paper No. 409. 1980. 43 Staff Working Paper No. 421. 1980. 25ISBN 0:8213-0292-2. Stock No. WP 0625. pages (including 3 annexes). pages (including appendix, references).$3. Stock No. WP 0409. $3. Stock No. WP 0421. $3.

NEW Staff Working Paper No. 632. 1984. 144 Growth and Structuralpages. Adjustment in East AsiaDevelopment Finance Stock No. WP 0632. $5. Parvez HasanCompanies, State and Privately Staff Working Paper No. 529. 1982. 42Owned: A Review NEW pages.David L. Gordon ISBN 0-8213-0102-0. Stock No. WP 0529.An informative guide to the function Economic Liberalization and S3.and design of development finance Stabilization Policies in Interest Rate Management incompanies as they are set up in devel- Argentina, Chile, and Developin Countries: Theooping countres. Case histones high- Uruguay: Applications of the De pig rylight the differences among these com- Monetary Approach to the and Simulation Results forpanies-their institutional structure, B o South Koreamanagement style, financial perfor- Balance of Payments Sweder van Wijnbergenmance, and other features. Looks at Edited by Nicolas Ardito Barletta, Examines the claim that higher tmethe problems of resource mobilization Mario I. Blejer, and Luis Landau deposit rates raise output and lowerand strategies to overcome them. Twenty-eight leading intemational inflation in the short run, and increaseStaff Working Paper No. 578. 1983. 84 economists and regional specialists re- growth through their favorable impactpages. view the salient characteristics of the on savings rates. It concludes that thisISBN 0-8213-0226-4. Stock No. WP 0578. monetary approach to the balance of theory depends heavily on the as-$3, payments, examine the variations in sumption that portfolio shifts into time

its application, and evaluate its suc- deposits come out of unproductive as-Development Prospects of cesses and failures. Emphasizes the sets, providing less intermediationCapital Surplus Oil-Exporting empirical evidence and dynamic as- than the banking system. Impact ofCountries: Iraq, Kuwait, Libya, ects a nd c osts. Provid es an important changes in time deposit rates on infla-Qatar,Sau di Araq,biwat, UAE thexamination of economic policies and tion, capital, capital accumulation andQatar, Saudi Arabia, UAE their effects in a region that looms medium term growth are discussed,Rudolf Hablutzel large in current deliberations about in- and empirical relevance is demon-Staff Working Paper No. 483. 1981. 53 ternational indebtedness and finance. strated through simulation runs with apages (including statistical tables). June 1984. About 240 pages. macroeconomic model of South Korea.Stock No. WP 0483. $3. ISBN 0-8213-0305-8. $17.50 paperback. World Bank Staff Working Paper No. 593.

1983. 52 pages.Developments in and Prospects Energy Prices, Substitution, ISBN 0-8213-0188-8. Stock No. WP 0593.for the External Debt of the and Optimal Borrowing in the $3Developing Countries: 1970-80 Short Run: An Analysis ofand Beyond Adjustment in Oil-Importing International Adjustment inNicholas C. Hope Developing Countries the 1980sStaff Working Paper No. 488. 1981. 70 Ricardo Martin and Marcelo Vijay Joshipages (including 2 annexes, references). Selowsky Staff Working Paper No. 485. 1982. 57Stock No. WP 0488. $3. Staff Working Paper No. 466. 1981. 77 pages.

pages (including footnotes, references). ISBN 0-8213-0062-8. Stock No. 0485. $3.

NEW Stock No. WP 0466. $3.

Exchange Rate Adjustment NEWDomestic Resource under Generalized CurrencyMobilization in Pakistan: Floating: Comparative Analysis Links between Taxes andSelected Issues among Developing Countries Economic Growth: SomeNizar Jetha, Shamshad Akhtar, Romeo M. Bautista Empirical Evidenceand M. Govinda Rao Staff Working Paper No. 436. 1980. 99 Keith MarsdenFouses on the relationship between pages (including appendix). Reviews the experience with growthtaxation and the three main compo- Stock No. WP 0436. $3. and taxation in twenty developing andnents of savings. Emphasizes tax re- developed countries, spanning a wideform with a view to raising additional A General Equilibrium spectrum of incomes. Do countriesrevenues and encouraging household Analysis of Foreign Exchange with lower taxes experience moreand business savings. Proposals for tax Shortages in a Developing rapid expansion of investment, pro-reform take account of equity consid- Economy ductivity, employment, and govem-erations and the need to keep ta.x-in- Kecnmyl Devs am eMlad ment services? This provocative paperduced distortions in the allocation of Kemal Dervis, Jaime de Melo, and sheds new light on this and other keyresources to a minimum. Highlights Sherman Robinson questions especially relevant to devel-appropriate policies on current ex- Staff Working Paper No. 443. 1981. 32 opment economists. It also examinespenditures, subsidies, user charges, pages (including references). the mechanisms by which fiscal poli-public enterprise pricing, self-financing Stock No. WP 0443. $3. cies may affect growth rates.of investment by public enterprises. Staff Working Paper No. 605. 1983. 48Includes three annexes that examine pages.direct taxes, indirect taxes, and tax Prices subject to change without notice ISBN 0-8213-0215-9. Stock No. WP 0605.changes in Pakistan's 1983/84 budget. and may vary by country. $3.

NEW The Policy Experience of Private Bank Lending toTwelve Less Developed Developing Countries

Municipal Accounting for Countries, 1973-1978 Richard O'BrienDeveloping Countries Bela Balassa Staff Working Paper No. 482. 1981. 60David C. Jones Staff Working Paper No. 449. 1981. 36 pages (including appendix, bibliography).This manual is based on British prac- pages (including appendix). Stock No. WP 0482. $3.tices and terminology of municipal ac- Stock No. WP 0449. $3Pcounting, modified to suit the needs of Private Capital Flows toother countries, especially those lack- The Political Structure of the Developing Countries anding a core of appropriately trained ac- New Protectionism Their Determinations:countants. Provides the basic princi- Douglas R. Nelson Historical Perspective, Recentples of municipal accounting for those Dwith little or no bookkeeping experi- Staff Working Paper No. 471. 1981. 57 Experience, and Futureence and proceeds through successive pages (including references). Prospectslevels of difficulty to some of the most Stock No. WP 0471. $3. Alex Flemingadvanced concepts currently in use, Staff Working Paper No. 484. 1981. 41including the pooling of loans. An im- pages.portant feature is the multitude of NEW Stock No. WP 0484. $3.practical applications and examples offorms and records. Private Direct ForeignA joint publication of the Chartered Price Distortions and Growth Investment in DevelopingInstitute of Public Finance and Ac- in Developing Countries Countriescountancy and the World Bank. Ramgopal Agarwala K. Billerbeck and Y. YasugiJune 1984. About 900 pages. Sixteen informative tables trace the Staff Working Paper No. 348. 1979, 101ISBN 0-8213-0350-3. Stock No. BK 0350. distortion in prices of foreign exchange pages (including 2 annexes).$30. and other factors affecting the growth Stock No. WP 0348. $5.

of developing countries. Based on sta-The Nature of Credit Markets tistics from thirty-one developingin Developing Countries: A countries. NEWFramework for Policy Analysis Staff Working Paper No. 575. 1983. 78Arvind Virmani pages. Savings Mobilization throughStaff Working Paper No. 524. 1982. 204 ISBN 0-8213-0242-6. Stock No. WP 0575. Social Security: The Case ofpages. $3. Chile, 1916-1977ISBN 0-8213-0019-9. Stock No. WP 0524. Christine Wallich$5. Pricing Policy for Development Describes the savings mobilization po-

The Newly Industrializing Management tential in Chile and in five Asian pro-Developing Countries after the Gerald M. Meier grams. Some sort of social securityOil Crisis Presupposing no formal training in program functions in almost all devel-

economics, it explains the essential oping countries. Programs are oftenBela Balassa elements of a price system, the func- costly, whether measured in relationStaff Working Paper No. 437. 1980. 57 tions of prices, the various policies to GNP, government expenditure,pages (including appendix). that a govemment might pursue in govemment revenue, or the wage bill.Stock No. WP 0437. $3. cases of market failure, and the princi- This paper compares the successful

ples of public pricing of goods and systems.Notes on the Analysis of services provided by government en- Staff Working Paper No. 553. 1983. 109Capital Flows to Developing terprises. It also provides the would-be pages.Nations and the "Recycling" practitioner with an appreciation of the ISBN 0-8213-0123-3. Stock No. WP 0553.

Problem ~~~~~~~~underlying logical structure of cost- 5Problem benefit project appraisal. To give sub-Ralph C. Bryant stance to the applied and policy di- Short-Run Macro-EconomicStaff Working Paper No. 476. 1981. 67 mensions, many of the readings arepages. drawn from the experience of develop- Adjustment Policies in SouthStock No. WP 0476. $3. ment practitioners and relate to such Korea: A Quantitative Analysis

important sectors as agriculture, in- Sweder van WijnbergenNotes on the Mechanics of dustry, power, urban services, foreign Staff Working Paper No. 510. 1981. 182Growth and Debt trade, and employment. The principles pages (including 3 appendixes).Benjarnin B. King outlined are therefore relevant to a ISBN 0-8213-0000-. Stock No. WP 0510.Benjamin B. King ~~~host of development problems. IB -2300'.SokN.W 50A practical model to explore the way hohs H .opkins U rstPess. $59in which capital inflow from abroad af- The pohns Hopkins Universaty Press. 1983.fects economic growth. 272 pages (including bibliography and in-The Johns Hopkins University Press, 1968. LCe2-71. ISN088-031Stc69 pages (including 4 annexes). No. JH 2803, $35 hardcover; ISBN 0-LC 68-8701. ISBN 0-8018-0338-1, Stock 8018-2804-X, Stock No. IH 2804, $12.95 Prices subject to change without noticeNo. IH 0338. $5 paperback. paperback. and may vary by country.

State Finances in IndiaA three-volume set of papers that ex-plores a range of issues relating to thenature of intergovernmental fiscal rela- loeItions in India. "'The primary source for wVVri Debt TablesVol. 1: Revenue Sharing in India mediwm- and long-term En-Oew o 9 l lChristine WallichVol. 11: India-Studies in State Fi- external debt of manynances developing counrtries."Christine WallichVol. III: The Measurement of Tax Ef- Suhas Ketkar, Asia-Pacificfort of State Governments, 1973-1976 Economust and Vice President,Raja J. Chelliah and Narain Sinha Marine Midland Bank, N.A.Staff Working Paper No. 523. 1982. vol.1, 85 pages, vol. II, 186 pages, vol. III, 85pages. Often the only reliableISBN 0-8213-0013-X. vol. 1, Stock No. tWP 1523, $3, vol. II, Stock No. WP source of information for2523, $5, vol. III, Stock no. WP 3523, $3. countries for which data

is hard to come by ... Used quantitatively formacroeconomic detail as well as qualitatively in

Structural Adjustment Policies reports discussing the debt picture. I find thein Developing Economies projected servicing payments a strong feature."Bela BalassaStaff Working Paper No. 464. 1981. 36 Economist, Republicpages. 0464. $3. National Bank of New York

Structural Aspects of Turkish World Debt Tables, 1983-84 EditionInflation: 1950-1979 The World Bank's invaluable reference Also available for the first time..M. Ataman Aksov guide to the external debt of develop-_Staff Working Paper No. 540. 1982. 118 ing countries. Essential planning tool Summary Reportpages. for economists, bankers, country risk Debt and the DevelopingISBN 0-8213-0098-9. Stock No. WP 0540. analysts, financial consultants and all World Current Trends$5. those interested in the global system Wol:CretT nd

of trade and payments. Provides data and Prospectson the external debt of 103 developing Includes an overview and summary ta-

Thailand: An Analysis of countries augmented by information, bles from the 1983-84 edition.Structural and Non-Structural where available, on major economic 1984. 64pages.Adjustments aggregates plus indicators used to ana- SokNAme Drud, Wafik Grais, and lyze debt and creditworthiness. Shows Stock No. BK 0319, $6.50.Dusan Vujovic statistical tables by country, including Companion computerized datafigures for external public debt out-Staff Working Paper No. 513. 1982. 93 standing, commitments, disburse- basepages (including appendix). ments, service payments, and net bor- Includes all debt infornation given inISBN 0-8213-0023-7. Stock No. WP 0513. rowings. Reports on private the unabridged volume, and, where$3. nonguaranteed debt of 19 countries. available, offers continuous historical

Gives aggregate position of 13 major series for 1970-82 and projected debt-borrowers-countries with disbursed service payments for 1983-92. Write for

Trends in Rural Savings and and outstanding medium- and long- sample purchase agreement.Private Capital Formation in term total debt in excess of $13.5 bil (9-track, phase-encoded, recordingIndia lion at the end of 1982. Includes pen- density 1600 bpi)Raj Krishna and G.S. odic supplements as fresh data are re- Stock No. IB 0500, $5,000 (service bur-Raychaudhun c98e. eaus for reselling to their clients); StockWorld Bank Staff Working Paper No. 382. 1984. 328 pages. No. IB 0667, $2,000 (banks and commer-1980. 43 pages (including 2 tables, 3 ap- Stock No. BK 0315 $75 (annual subscrip- cial corporations); Stock No. IB 0666, $500pendixes, references). tion) (universities and libraries).Stock No. WP 0382. $3. _

The World BankPublications Order Form

SEND TO: YOUR LOCAL DISTRIBUTOR OR TO WORLD BANK PUBLICATIONS(See ihe other side of this form.) P.O. BOX 37525

WASHINGTON, D.C. 20013 U.S.A.

Date

Name Ship to: (Enter if different from purchaser)

Title Name

Firm Title

Address Firm

City State_ Postal Code Address

Country 'Telephone I ) City State - Postal Code

Purchaser Reference No. Country Telephone I-)

Check your method of payment.Enclosed is my El Check OI International Money Order El Unesco Coupons OI International Postal Coupon.Make payable to World Bank Publications for U. S. dollars unless you are ordering from your local distributor.

Charge my Cl VISA O MasterCard O American Express O Choice. (Credit cards accepted only for orders addressedto World Bank Publications.)

Credit Card Account Number Expiration Date Signature

O Invoice me and please reference my Purchase Order No.

Please ship me the items listed below.

Customer InternalStock Number Author/ Title Routing Code Quantity Unit Price Total Amount S

All prices subject to change. Prices may vary by country. Allow 6-8 weeks for delivery.

Subtotal Cost STotal copies Air mail surcharge if desired ($2.00 each) S

Postage and handling for more than two complimentary items ($2.00 each) S

Total S .-9ORD-0053 Thank you for your order.

Distributors of World Bank Publications

ARGENTtNA GERMANY, FEDERAL REPUBUC KUWAIT SRI LANKA AND THE MALDIVES

Carlos Hirch, SRL OF MEMRB Lake House Bookshop

Galena Guemes UNO-Verag P.O. Box 5465 P 0. Box 244

Flonda 165, 4th Floof-Ofc. 45Y465 D5300 Bonn I Kuwait I00, Sir Cuttampalam A. Gardiner

1333 Buenos Aires SMmckstase MALAYSIA Mawatha

AUSTRALIA, PAPUA NEW GRECE University of Malava Cooperative Colonbo 2

GUINEA, FJI, SOLOMON MEMRB Bookshop, Luiuted Snka

ISLANDS, AND VANUATU 24. Ippodamou Sbeet P 0. Box 1127, jalan Pantai Baru SWEDEN

Info-Line Athens-I 1635 Kuaba Lumpur For single titles:

Overseas Docrument Delvery HONG KONG, MACAU MEXICO ABCE Fntzes Kungl. Hovbokhandel

Box 506. GPO HONG 2000 Ltd MEXIC Regenngspgatan 12, Box 16356Svdnev, NSW 2001Asia 200 Ltd. INFOTEC

Sydney, NSW 2001 6 Fl. 146 Pnnce Edward Road, W, San Lorenro 153-11 Col. del Valle S-103 27 StockholmAusbrahia Kowloon Deleg Benito Juarez For subsaiption ordrs:

BAHRAIN Hong Kong 03100 Mexico City Wennergren-Wibiams AB

.UEMRB INDIA MOROCCO Box 300UP.O. Box 22103 UBS Publishers Distnbutors Ltd. MEMRB S9104 25 StockholmManama Town 317 Post Box 7015 2 Rue Mobere Racine SWITZERLAND

BANGLADESH New Deltu 11002 Casabbanca LAbrane Pahvot

Micro Industnes Development 10 First Man Road THE NETHERLANDS 6 Rue Grenus

G.PO0. BOX Sc Gandhi Nagar Medical Books Europe. BV (MBE) Case postal 381

Dhaka. Bangalore 560009 Noorderwal 38, CH 1211 Geneva 11

BELGIUM Apeemav Chambers, P.O. BOX 736 7241 9L Lochem TANZANIA

BELGIUM 5 Wallace Sreet NIGERIA Oxfori Univesty PrtssPublations des Nations Uni Bombiv 400X01 Univesty Prss Limuted P. O. Box 5239

Av du Rol 202 Thr Crowns Buwldng jerncho Dar es Salaam

10bO Brusselb 8,-B, Chownnghee Lane Pnvate Mail Bag 5095 THAILAND

BRAZIL Calcutta 7016 bdan Central Depa ent Store

Pubcacoes Tecnicas Internaconaus 7188, I(CA), Swarup Nagar NORWAY 306 Silom RoadLtda. KPmpu 20B002 Tanum Kair Johan, A.S bangkok

Rua Peixoto GoPude, S Sivaganga Road P. 0. Box 1177 TRINIDAD & TOBAGO

01409 Sao Paulo, SP Nungambk Sentrum Systensabt Studies Unit

CANADA Madras 600034 Oslo 1 55 Eastern Main Road

Le D5 Amtseur INDONESIA PAWUSTAN Curepe

C.P. bS, 1b01 Ampere Street Pt Indira Linited Mirza Book Agency Trinidad, West Indies

boucherville, Quebec J4B S (I. Sam Ratulangt 37 65, Sh&hrah-e-Quiad-e-Azan TUNSIA

CHILE Jakarta Pusat P 0. Box No 729 Societe Tunusienne de Diffusion

Editonal Renacimiento PO BOx 181 Lahore 3 ; Avenue de Carthage

Santirallores 3IRELAND PANAMA TunisSantiago TDC Publshers Edicones LLbreria Cultural TURKEY

COSTA RICA 12 North Frederick Srett Panamena, S.A. Haxt Kitpevi A S

Librena Treos Dubbn I , Av 7. Espana 16 469. Istikial Caddess

Cale 11-13 Panama ZoneI Bevoglu-istanbulAv. Femnandez Guell ITALY BvguItnuSan Jose Licosa Conmissmnauira Sanoni SPA PERU UGANDA

Via Lanumnora 45 Editorial Desrollo SA Uganda Bookshop

CYPRUS 50121 Florence Aputado 3824 Atn.. rMarin-Luther Gaiwango

MPM0 B JAPAN Lima PO. box7145

PNO.cBosx 203BEastem Book Service (EBS) PHIUPPINES Kampala37-3, Hongo 3-Chome, Bunko-ku National Book Store UNITED ARAB EMIRATES

DENMARK 113 701 Rizal Avenue MEMRB

SamfundsLbttertur Tokvo MetroManila P. O Box 6097

Rosenoerns Alle 11 JORDAN PORTUGAL Shish

DK-1970 Copenhagen V MEMRB Livrana PortugL UNITED KINGDOM AND

EGYPT, ARAB REPUBUC OF P.O Box 3143 Rua Do Camo70-74 NORTHERN IRELAND

Al Ahmam Jabal 1200 Lisbon Micromfo Ltd.

GalStreet Amman SAUDI ARABIA P. 0. Box 3

KENYA Jant Book Store Alton, Hampshre GU 34 2PG

FINLAND Atnca Book Sevce (E.A.) Ltd. P. O. Box 3196 United Kingdom

Akateeminen Kirjakauppa P 0 Box 45245 Riyadh 11471 VE?{EZUELA

P0. Box 128 Na0robi SINGAPORE, TAIWAN, BURMA Librena del Este

SFink01 KOREA, REPUBUC OF Infomation Publications Private. Ltd. Aptdo. 60.337

HeLsinki 10 Pan Korea Book Corporation 02416 Ist Fl., Pei-Fu Industral Bldg., Caras 1060-A

FRANCE P 0 Box 101. Kwangwhamun 24 New Industreal Road WESTERN SAMOA

Wortd Bank Publications Seoul Smspport Wesley Bookshop

66 Avenue d'lena SPAIN Apa

75116 Pans Mundi-Prensa Libros, S.A.

Castelo 3728b01 Madrid

The World B3ank

Headquarters European Office Tokyo Office1818 H Street, N.W. 66, avenue d'lIna Kokusai BuildingWashington, D.C. 20433, U.S.A. 75116 Paris, France 1-1 Marunouchi 3-chome

Telephone: (202) 477-1234 Telephone: (1) 723-54.21 Chiyoda-ku, Tokyo 100, JapanTelex: WUI 64145 WORLDBANK Telex: 842-620628 Telephone: (03) 214-5001

RCA 248423 WORLDBK Telex: 781-26838Cable Address: INTBAFRAD

WASHINGTONDC

SS§N 0253-2115/IS0N 0-3213-0564-6