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ROLE OF STATE-OWNED FINANCIAL INSTITUTIONS IN INDIA: SHOULD THE GOVERNMENT DO OR LEAD? Urjit R.

Patel* Infrastructure Development Finance Company Limited Mumbai, India April 2004 World Bank, International Monetary Fund and Brookings Institution Conference on Role of State-Owned Financial Institutions Washington, D.C., April 26-27, 2004 Abstract The importance of a sound financial sector in efficient intermediation of resources is generally accepted. A case for government intervention in the sector might also be made in the initial stages of a countrys development, given systemic failures in achieving certain economic goals. The paper argues that, in the case of India, this role is now redundant; the public sector should no longer be directly intermediating resources. There remain, however, certain aspects of the financial sector (which have merit good characteristics) where the government might be required to catalyse developments; these are what may be termed its market completion role. These interventions should essentially be for establishing enabling mechanisms that facilitate financial transactions. *Correspondence: Urjit R. Patel, IDFC, Ramon House, 2 nd Floor, 169 Backbay Reclamation, Mumbai 400 020, India; e-mail: urjitpatel@idfc.com. I would like to thank Saugata Bhattacharya for collaborating on work that forms the basis of this paper. Disclaimer: The opinions presented in the paper are those of the author and not necessarily of the institution to which he is affiliated.
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The Agricultural Infrastructure and Credit Fund, the Small and Medium Enterprise Fund, and the Industrial Infrastructure Fund will be operational shortly. All the three funds will, without compromising the norms of financial prudence, provide credit at highly competitive rates, which is expected to be 2 percentage points below the Prime Lending Rate (PLR).

Interim Budget, India, 2004-05. 1. INTRODUCTION A deep and efficient financial sector is necessary for optimal allocation of resources. Governments have been involved in the financial sectors in intermediation, if not directly owning intermediaries of many countries, even currently developed ones, during various stages of their growth. In many countries, Development Financial Institutions (DFIs) have been major conduits for channeling funds to particular firms, industries and sectors during their development. Many studies (more recently, Allen and Gale [2001] and Levine [1997]) have identified the importance of DFIs in the South Korean and Japanese process of industrialisation. In some developed countries, such as Germany, especially in the post Second World War era, this (command) mode of financial intermediation has been used in national reconstruction as well. In many developing countries, there has traditionally been a strong presence of the government in the sector, usually through a combination of either owning these entities or indirectly by mandating credit allocation rules. This followed a line of thinking emanating from the works of Gerschenkron [1962] and Lewis [1955] that advocated a development role for state-owned intermediaries. Arguably, compelling arguments have been made for this involvement in the initial stages of a countrys development. It is in the financial sector that market failures

are particularly likely to occur.1 In addition, the significant asymmetries of information characterising the sector, as well as the commercial unviability of lending to most pioneering or small scale projects, generate a bias in bank loan portfolios away from areas deemed vulnerable but are identified as thrust areas for development. As a result, governments had often established development oriented intermediaries to nurture infant industries and have also occasionally resorted to bank expropriations and nationalisations if the need was felt to advance social goals like expanding the reach of banking; in other words, addressing market failures. Even in countries that did not have a high level of direct government ownership of financial intermediaries, the involvement of governments in intermediation has been significant. Reflecting the erstwhile predominance of the public sector in most areas of economic activity, the government involvement in the financial sector had been devised to implicitly assume counter-party risks. This cover had been adequate in the past given the relative simplicity of transactions then prevalent. As economic activity became increasingly commercially oriented, however, the government dominated financial systems of most developing countries became ill-equipped to tackle the changed profile of risks arising from the increased complexity of transactions. Nor did there exist the robust clearing systems needed to support new financial products, or the accounting and hedging mechanisms to deal with the significant counter-party risks that now permeated the system. The consequence was a large increase in both institution-specific as well as systemic moral hazard, manifest in repeated bailouts and recapitalisations.
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over the past half a decade have provided numerous examples of these failures spanning geographical areas as well as various types of economic systems. 3

Worldwide experience suggests that in the case of public sector institutions, the owner the government typically lacks both the incentive and the means to ensure an adequate return on its investment (La Porta, et al. [2000]). Political decisions, as opposed to rate of return calculations, are often important in determining resource allocation. In many instances, as well as across a wide spectrum of countries, this involvement has led to fragility of the financial sector, occasionally resulting in macroeconomic turbulence as well. One thread of explanations for this stems from the political theories advanced, for instance, by Kornai [1979], Shleifer and Vishny [1994] and others. Directed lending to projects that might be socially desirable but not privately profitable is not likely to be sustainable in the long run. These weaknesses go beyond the normal crises that have characterised the financial sector and have been explored in detail in Patel [1997b]. A conflict of interest arises between development goals of the government directed credit flows and the absence of commercial discipline that gradually percolates the lending process. The issue of incentives is especially relevant in Indias financial reforms, particularly given the current importance of government owned financial entities that cover almost all segments. India is one of a number of countries whose intermediaries have been used by the government to allocate and direct financial resources to both the public and the private sector. Government ownership of banks in India is, barring China, the highest among large economies. 2 Beside the standard problems of the financial sector that result from information asymmetry and agency issues, moral
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and Mihaljek [2001] outline the characteristics of financial systems that are dominated by government ownership of intermediaries. 4

hazard might be aggravated3 in countries like India with high government involvement

because both depositors and lenders count on explicit and implicit guarantees. 4 The high degree of government involvement gives rise to a belief of depositors and investors that the system is insulated from systemic risk and crises by engendering a sense of confidence, making deposit runs somehow unlikely, even when the system becomes insolvent. While selective regulatory forbearance might be justified as a measure designed to balance the likely panic following news of runs on troubled institutions, a blanket guarantee by government makes forbearance difficult to calibrate and has the effect of sharply increasing system-wide moral hazard. Depositors, borrowers and lenders all know that the government is guarantor. Since, for all intents and purposes, all deposits are covered by an umbrella of implicit government guarantees, there is little incentive for due diligence by depositors, which further erodes any semblance of market discipline for lenders in deploying funds, as witnessed most recently in the case of cooperative banks in India. The regularity of sector restructuring packages (for steel and textiles and proposed most recently for telecom), on the other hand, diminishes incentives for borrowers for mitigating the credit risk associated with their projects. Just as importantly, India now has a banking sector whose indicators (in terms of standard norms like profitability, spreads, etc.) are prima facie more or less
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distinguish the term aggravated from enhanced, considering the former as a parametric shift of the underlying variables as opposed to a functional dependence in the case of the latter. More explicitly, increasing moral hazard enhances the incentives of banks to accumulate riskier portfolios, whereas an aggravated moral hazard results in a failure to initiate corrective steps to mitigate the enhanced hazard, for example, increasing requirements of capital, proper risk weighting, project monitoring, etc. 4 In this regard, Indias decision not to provide deposit insurance, ex post, to non-bank financial intermediaries was commendable. 5

comparable to international peer group standards. This sector is also complemented by relatively well developed capital markets which are playing an increasingly important role in the resource requirements of commercial entities. The paper draws heavily on recent papers (Bhattacharya and Patel [2002], Bhattacharya and Patel [2003b] and Patel and Bhattacharya [2003]). It argues that the useful role of public sector financial institutions in resource intermediation in India is now very limited. After a brief sketch of the status of the sector, Section 2 highlights the infirmities and weaknesses of the system engendered by the high degree of involvement of the government in the sector. Section 3 is a critical look at the areas which are often claimed to be the residual (but legitimate) domain of intervention by the government, and examines the merits of the arguments advanced. Section 4 concludes. 2. THE FINANCIAL SECTOR IN INDIA AND CURRENT INFIRMITIES From independence to the end of the 1960s, Indias banking system consisted of a mix of banks, some of which were government owned (the State Bank of India and its associate banks), some private and a few foreign. The political class felt that private banks, which concentrated mainly on high-income groups and whose lending was security rather than purpose oriented, were not sufficiently encouraging widening of the entrepreneurial base, thereby stifling economic growth. Hence, it was decided to nationalise 20 large private banks in two phases, once in 1969 and again in 1980, with the objectives of promoting broader economic goals, better regional balance of economic activity, extending the geographic reach of banking services and the diffusion of economic power. Significant financial deepening has taken place over the three
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decades since the seventies (see Table 1 below). The M3/GDP ratio has increased from 24% in 1970-71 to 70% at present, and the number of bank branches have increased eight fold over the same period, with much of the expansion in rural and semi-urban areas, which now account for 71% of total branches.
Table 1: Decadal indicators of financial deepening 1970-71 1980-81 1990-91 2000-01 2002-03 M3 / GDP 24% 39% 47% 63% 70% Bank branches / 000 population 0.02 0.05 0.07 0.07 0.07 Source: RBI Report on Trend and Progress of Banking in India, various issues.

After a hiatus of two decades, private banks were allowed to be established in 1993, but their share in intermediation, albeit increasing, continues to be low. The largest growth in savings since 1997-98 has been in bank deposits, which now account for half of financial savings. 2.1 Public sector involvement in the Indian financial system Banking intermediaries continue to dominate financial intermediation (see Appendix 1 Table A1.1 and Patel [2000] for a detailed exposition). Much of this segment is publicly owned and accounts for an overwhelming share of financial transactions (see Table 2 below for a thumbnail view). Appendix 1 Figure A1.1 also shows that the extent of government ownership of banks in India is quite high compared to international levels. The Reserve Bank of India (RBI), moreover, has a majority ownership in the State Bank of India (SBI), the largest Public Sector Bank (PSB).
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Table 2: Share of public sector institutions in specific segments of the financial sector Public sector (%) Private (%) Total (Rs. bn) Scheduled Commercial Banks (SCBs) 75.6 24.4 16,989 Mutual Funds (MFs) 48.2 51.8 1,093 Life Insurance 99.9 -- 2,296 Source: RBI Report on Trend and Progress in Banking 2002-03; Annual Reports of SEBI (2002-03) and IRDA (2001-02). Banking and mutual fund data are at end-March 2003. Insurance data is end-March 2002. Definition of shares: SCBs: Total assets. Private banks include foreign banks. MFs: Total Net Assets of domestic schemes of MFs (public sector includes UTI). Insurance: Life insurance Policy Liabilities. Public sector insurance includes LIC and SBI Life.

The shortcomings of the banking system in India are now relatively well known. There have also been efforts, predominantly through a regulation-centric approach, to tackle these issues. There is also a move to transform the major DFIs 5 into entities approximating commercial banks. But there remains another large section of intermediaries that has not attracted requisite attention: specifically, the large government-sponsored Systemically Important Financial Institutions (SIFIs). 6 A very serious lacuna in the oversight framework is the inadequate attention that has been devoted to the role of market discipline for SIFIs like Life Insurance Corporation of India (LIC) and Employees Provident Fund Organisation (EPFO). A particular cause of concern is the opacity of the asset portfolios of LIC and EPFO, a shortcoming which is especially serious in the case of the latter. LIC, as of March 2003, had investible funds of Rs. 2,899 bn (which, to provide perspective, was 11.9% of GDP in 2002-03)7. The book value of LICs socially oriented investments mainly comprising of government securities holdings and social sector investments at end-March 2003 amounted to Rs. 1,882 bn, i.e., 71% of a
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India, DFIs are a sub-group of intermediaries termed All India Financial Institutions (AIFIs). classification of SIFIs is somewhat different from the governments view, enunciated in the RBIs Monetary and Credit Policy, April, 2003, which referred to large intermediaries, including banks like SBI and ICICI Bank.
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total portfolio value of Rs. 2,650 bn (10.9% of GDP) 8. A staggering 87% of this portfolio comprises of exposure to the public sector. Compared to the LIC, the EPFOs accounts are, simply, opaque. Cumulative contributions to the three schemes of the EPFO, i.e., Employees Provident Fund (EPF), Employee Pension Scheme (EPS) and Employees Deposit Linked Insurance (EDLI), up to the end-March 2002, amounted to Rs. 1,271 bn (5.1% of GDP). Total cumulative investments of these three schemes were Rs. 1,390 bn (5.6% of GDP), with the EPF being the largest scheme. The EPFO does not come under the purview of an independent regulator, with oversight resting on three sources: Income Tax Act (1961), EPF Act (1952) and Indian Trusts Act (1882). More importantly, the involvement of the government in intermediation is much wider than mere ownership numbers indicate; its ambit stretches across mobilisation of resources, direction of credit, appointments of management, regulation of intermediaries, providing comfort and support to depositors and investors, as well as influencing lending practices of all intermediaries and the investment stimuli of private corporations. These practices include treating banks as quasi-fiscal instruments, the consequent pre-emption of resources through statutory requirements, directed lending, administered interest rates applicable for selected savings instruments, encouraging imprudent practices like cross-holding of capital between intermediaries, continual bailouts of troubled intermediaries, control and manipulation of smaller intermediaries like
7 The

Industrial Development Bank of India (IDBI) Report on Development Banking in India, 2002-03, Appendix Tables 117-119. 8 Social sector investments include loans to State Electricity Boards, housing, municipalities, water and sewerage boards, state Road Transport Corporations, roadways and railways. These, however, account 9

cooperative banks, weak regulatory and enforcement institutions, unwarranted levels of government controlled deposit insurance, etc (Buiter and Patel [1997]). A set of indices to quantify the extent of this involvement was developed in Bhattacharya and Patel [2002]9. Figure 1 below (here updated from the paper) shows that after having declined almost secularly till 1995-96, the degree of involvement has risen fairly sharply after 1997-98.
Figure 1: Index of Density of Government Involvement in the Financial Sector (IDGI-F) in India

One of the arguments previously advanced to justify government ownership of many intermediaries was related to concerns about systemic stability. The argument went that an implicit government net of comfort and support to both depositors and lenders deterred the prospect of financial runs. Till 2001-02, the explicit component of this support had translated into a cumulative infusion into banks of Rs. 225 bn. The government has also engineered many other indirect forms of bailouts. Financial interventions in the Unit Trust of Indias 10 (UTI) US-64 scheme are
for about a fifth of the socially oriented investments portfolio, with the balance accounted by government and government guaranteed securities. 9 Appendix 2 provides a description of the Index construction methodology. 10 Indias largest mutual fund.
80 90 100 110 120 130 140 199091 1991-

92 199293 199394 199495 199596 199697 199798 199899 199900 200001 200102

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examples. Following the recommendations of an Expert Committee constituted after an earlier payments crisis in 1998, the government decided to exempt for three years the US-64 from a 10% dividend tax (deducted at source) that other equity mutual funds were required to pay. Data on dividend income distribution and the dividend tax for US-64 for 1999-2000 indicate foregone tax revenue of around Rs. 2 bn. Under the Special Unit Scheme of 1999, the Government of India (GoI) did a buyback of PSU shares at book value, higher than the then prevailing market value, effectively transferring Rs. 15 bn to investors. After the second US-64 payments crisis in 2001, under a Repurchase Facility covering 40% of the assets of US-64, investors were allowed to redeem up to 3000 units at an administratively determined price, with the GoI making up the gap between this price and the NAV of a unit. Eight Public Sector Banks offered liquidity support to UTI in the event of large-scale redemptions. Recognising the unviability of this support and a high probability of an ultimate default on these loans, however, these banks have sought comfort through government guarantees to help in easy provisioning against the loans and avoiding violation of norms of lending without collateral. Even more than the actual losses to the exchequer, these implicit safety nets create an insidious expectation of government support to investors, weakening their commercial judgment. 2.2 Weaknesses characterising the Indian financial system Certain structural characteristics and institutional rigidities evident in India further weaken mechanisms for prudent de-risking of portfolios. The absence of effective bankruptcy procedures leading to a lack of exit opportunities for both intermediaries and the firms that they lend to, force intermediaries to roll-over existing
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sub-standard debt or convert them into equity, thereby continually building up the riskiness of their asset portfolio. The use of intermediaries by the government in diverting funds, for purposes that are not entirely commercially motivated, reinforces the decline in the quality of assets. A prominent reason is an attempt by government to boost investment, both by direct spending and indirectly via credit enhancements, like guarantees, partially to counter low private investment. In combination with the frequently observed tunnelled structure of many corporations (Johnson, et al. [2000]), which facilitates connected lending and diversion of funds between group companies, institutional rigidities (especially weak foreclosure laws) and regulatory forbearance (including inadequate disclosure requirements of investments and other

lending practices), the outcome is a disproportionate build up of the riskiness of intermediaries asset portfolios. 2.2.1 Incentive distortions arising from public ownership of intermediaries In the process, the incentive structures that underlie the functioning of intermediaries are blunted and distorted to the extent that they over-ride the safety systems that have nominally been put in place. The large fiscally-funded recapitalisations of banks in the early and mid-nineties may be rationalised as being designed to prevent a system-wide collapse at a time when the sector had been buffeted by the onset of reforms and it had not had time to develop risk mitigation systems. Moreover, the overall reforms were designed to enhance domestic and external competition, as a result of which past loans to industry were bound to get adversely affected, impacting these banks balance sheets. The nascent state of capital markets at that time might also have been seen as a hindrance in accessing capital, especially
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capital without large attached risk premia. The impact of this support, though, has been considerably reduced, if not eliminated, by the series of ongoing bailouts, with seemingly little by way of (binding) reciprocating requirements imposed on intermediaries to prevent repeats of these episodes. It needs to be recognised that the only sustainable method of ensuring capital adequacy in the long run is through improvement in earnings profile, not government recapitalisation or even mobilisation of private capital from the market. A singular aspect of financial sector reforms in India has been that, while the look and feel of organisations associated with intermediation has altered, the focus of the changes has revolved around the introduction of stricter sector regulatory standards. Caprio [1996] argues that regulation-oriented reforms cannot deliver the desired outcome unless banks are restructured simultaneously; this includes introduction of measures that empower banks to work the new incentives into a viable and efficient business model and encourage prudent risk-taking. These mechanisms are also meant to inter alia mitigate the legacy costs that continue to burden intermediaries even after restructuring. Some of these costs, in the Indian context, apart from the consequences of public ownership discussed above, are well known: weak foreclosure systems and legal recourse for recovering bad debts, ineffective exit procedures for both banks and corporations, etc. In addition, during difficult times, fiscal stress is sought to be relieved through regulatory forbearance; there are demands for (and occasionally actual instances of) lax enforcement (or dilution) of income recognition and asset classification norms. A multiplicity of economic regulators, most of them not wholly
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independent, deters enforcement of directives (see Bhattacharya and Patel [2001] for an analysis of the way regulators have looked at financial market failures). 11 Other than structural changes in corporate resource raising patterns, commercial lending is inhibited inter alia due to distortions in banks cost of borrowing and lending structures arising from interest rate restrictions. Continuing floors on short-term deposits and high administered rates on bank deposit-like small savings instruments (National Savings Certificates, post office deposits, etc.) artificially raise the cost of funds for intermediaries. Lending constraints relate to various PLR related guidelines for Small Scale Industries (SSIs) and other priority sector lending. This constellation of factors has made treasury operations an important activity in improving banks profitability.12 Over and above the regulatory oversight of the RBI, the role of government audit and enforcement agencies like the Comptroller and Auditor

General (CAG), Central Vigilance Commission (CVC), Central Bureau of Investigation (CBI), etc. in audits of decisions taken by loan officers at banks undermines normal risk taking associated with lending (see Banerjee et al. [2004]).13 The outcome of this environment is lazy banking 14; banks in India seem to have curtailed their credit creation role. Outstanding assets of commercial banks in government securities are, as of March 5, 2004, much higher (just over 46%) than the
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instance, cooperative banks have been lax in implementing RBI notifications on lending to brokers. 12 Declining interest rates increased trading profits (in securities) of PSBs in 2001-02 more than two and a half times that of the previous year and accounted for 28% of operating profits (RBI Report on Trend and Progress of Banking in India, 2001-02, Table II.14). 13 Loan officers have complained about being harassed, if not penalised, for having taken on good credit risks, whereas risks not warranted by sound commercial practices have often been foisted on by the political owners of these institutions. 14 A term coined by one of the current Deputy Governors of the RBI. 14

mandated SLR (25%).15 As Figure 2 below shows, a large fraction of bank deposits are being deployed for holding government securities. This ratio, as is evident, has been increasing steadily over the last seven quarters and, more pertinently, has persisted over the last two quarters despite a strong economic rebound and, presumably, a consequent increase in demand for credit.
Figure 2: Cumulative (quarter-wise) SLR securities investment - deposit ratio of SCBs (in %)
Sources: RBI Handbook of Statistics, 2002-03 and Weekly Statistical Supplements Note: Q4 2003-04 figures are as of March 5, 2004.

Note that this phenomenon is actually rational behaviour by banks given the incentive structure described above. In deciding on a trade-off between increasing credit flows and investing in government securities, the economic, regulatory and fiscal environment is stacked against the former. An unintended consequence of the increasingly tighter prudential norms that banks will be forced to adhere has been a
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is also noteworthy that 51% of the outstanding stock of central government securities at end-March 2002 was held by just two public sector institutions: the State Bank of India and the Life Insurance Corporation of India (sourced from Government of India Receipts Budget, RBI Report on Trend and Progress and investment information on LICs website).
40% 50% 60% 70% 80% Q1 Q2 Q3 Q4

2001-02 2002-03 2003-04

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further shift in the deployment of deposits to government securities and other investments that carry a comparatively lower risk weight 16. 3. RESIDUAL ROLES OF GOVERNMENT IN INTERMEDIATION IN A MARKET ECONOMY: A CRITICAL LOOK Given the scenario described in the previous section, primarily driven through distorted incentives, of public sector involvement described above, there is a robust case for the government to exit from actual intermediation. This section is a critical look at the functions which are often claimed to be the residual (but legitimate) domain of intervention by the government, and examines the merits of the arguments advanced. We need to emphasise that even though the paper analyses the specific activities that are claimed to be the residual arenas of government involvement in a commercial environment, it in no way provides a blanket endorsement of these actions in India. The paper adapts an institution-specific framework explored in Rodrik [2002]

formulated in the context of general economic development as a touchstone for this analysis. Rodrik groups the shortcomings and required actions related to market driven reforms into four components, viz., (i) market stabilisation; (ii) market regulation; (iii) market creation; and (iv) market legitimisation. This paper relates to the last two aspects, but primarily through the lens of a fifth component that we add and explore in this paper, namely, market completion. Table 3 below provides a schematic layout as an organising scaffold for drawing together the threads of various aspects of the role of
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were advised in April 2002 to build up an investment fluctuation reserve (IFR) of a minimum 5% of their investments in the categories Held for Trading and Available for Sale within 5 years. As at end-June 2003, total IFR amounted to only about Rs. 100 bn (i.e., 1.7% of investments under relevant categories). While 12 banks are yet to make any provisions for IFR, 20 have built IFR up to 1% but only 65 have IFR exceeding 1% (RBI Mid-term Credit and Monetary Policy, 2003). 17 PSBs have IFRs of 2% or more (RBI Report on Trend and Progress, 2002-03). 16

the government in creating new markets that are necessary for facilitating transactions as well as deal with issues that are a corollary of a move towards commercial orientation of economic activity.
17 Table 3: Matrix of institutional processes in the reform of the financial sector Institutions role Objective Mapping to the Indian (financial) context Addressing specific shortcomings Market stabilisation Stable monetary and fiscal management. Profligate fiscal environment. Pre-emption of resources by government. Efficacy of central bank functions. Market regulation Mitigating the impact of scale economies and informational incompleteness. Regulatory forbearance. Public ownership of institutions. Appropriate prudential regulation. Imposition of market discipline. Transparency and information disclosure. Market creation Enabling property rights and contract enforcement. Public ownership of institutions. Enforcing creditor rights. Effective dispute resolution mechanisms. Market legitimisation Social protection; conflict management; market access. Profligate fiscal environment. Regulatory forbearance. Public ownership of institutions. Mixing social and commercial objectives (e.g., rural branch requirements for banks).

Appropriate insurance for depositors. Capital markets enforcement. Effective redressal of investor grievances. Market completion Spanning states of nature. Shallow or non-existent markets. Lack of institutions and products to mitigate specific (market-making) risks that hamper formation of markets. Inadequate old-age income safety nets. 18

3.1 Facilitating transactions and deepening markets Given the significant information asymmetries that normally characterise capital markets and, consequently, the specific risks that individual intermediaries (or even groups) might not be able to bear, there are often inefficiencies in market transactions or the inability of institutions to catalyse certain specialised economic activities. Market institutions that minimise transactions cost, often in the nature of a quasi-public good, may not necessarily emerge as a rational collective outcome of the individual players involved. These activities usually share characteristics of public merit goods. The government has an important role in developing institutions that serve as platforms for correcting market deficiencies and failures as well as facilitating transactions and increasing market liquidity, as well as improving clearing and settlement systems. Dealing with the commercial consequence of the new set of risks, however, demands the presence of specialised institutions. Debt markets in developed countries now serve both as a complement to intermediaries loans to corporations as well as for innovating structured financial instruments. In India, on the other hand, the fragmented nature of debt markets had entailed significant counter-party risk, thereby becoming a barrier to market integration and further hindering the formation of benchmark yield curves. This resulted in large and distorted spreads on rates of interest on debt instruments. As a consequence, the market disciplining effect of capital markets on intermediaries loans, especially to corporations, has tended to be mitigated. The RBI, recognising the need for a financial infrastructure for clearing and settlement of government securities, forex, money and debt markets (thereby bringing in efficiency in the transaction settlement process and insulate the financial system from shocks emanating from operations related issues), initiated a move to establish the
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Clearing Corporation of India (CCIL), with the SBI playing a lead role. CCIL was incorporated in October 2001. CCIL takes over and mitigates counterparty risks by novation17 and multilateral netting. The risk management system at CCIL includes a Settlement Guarantee Fund (SGF) composed of collaterals contributed by the members, liquidity support in the form of pre-arranged lines of credit from banks, and a procedure for collecting initial and mark-to-market margins from the members to ensure that the risk on account of members outstanding trade obligations remains covered by their respective contributions to SGF. The core activities of the Securities Trading Corporation of India (STCI) comprise participation, underwriting, market making and trading in government securities. It was sponsored by the RBI (jointly with PSBs and AIFIs 18) with the main objective of fostering the development of an active secondary market for Government securities and bonds issued by public sector undertakings. In the equity markets, an important component of the governments reform

programme in the 1990s consisted of creating three new institutions the National Stock Exchange (NSE), National Securities Clearing Corporation (NSCC) and National Securities Depository Limited (NSDL) to facilitate the three legs of trading, clearing and settlement. The first of these has been the most successful, and was in fact the progenitor of the other two. Promoted in 1993 by some AIFIs (at the behest of the government), as an alternative to the incumbent Stock Exchange, Mumbai (BSE), the NSE has since become a benchmark for operations characterised by innovation and transparency. The NSE has
17 Novation

is the original contract between the two counterparties being replaced by a set of two contracts between CCIL and each of the two counterparties, respectively. 18 These comprise the DFIs, Investment Institutions like LIC and UTI, other Specialised Financial Institutions and Refinance Institutions (NABARD and the National Housing Bank, NHB). 20

overtaken the BSE in terms of spot transactions and has spearheaded the introduction of derivative instruments, where it now accounts for 95% of trades. The NSCCL, a wholly owned subsidiary of NSE, was incorporated in August 1995. It was constituted with the objectives of providing counter-party risk guarantees and to promote and maintain, short and consistent settlement cycles. NSCC has had a troublefree record of reliable settlement schedules since early 1996, having evolved a sophisticated risk containment framework. To promote dematerialisation of securities, the NSE, IDBI and UTI set up NSDL, which commenced operations in November 1996, to gradually eradicate physical paper trading and settlement of securities. This got rid of risks associated with fake and bad paper and made transfer of securities automatic and instantaneous. Demat delivery today constitutes 99.99% of total delivery-based settlements. A point worth noting has been the inherent profitability of many of these institutions. Volumes at the NSE, both in the spot and derivatives segments, have increased significantly in recent times. The annual compound growth in turnover at NSE over 1995-96 to 2002-03 was 73.1%19, and is likely to have significantly increased in the current fiscal year. The government (indirectly, through the sponsoring financial institutions) stands to increase its returns from the volumes evident in these markets (not to mention the service taxes that directly accrue to it). 3.2 Catalysing niche economic activities As the government begins to open up areas of economic activity that had hitherto been the exclusive domain of government to the private sector, many processes and institutions have to develop that can mitigate and allocate the attendant risks through
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appropriate financial structures, innovative products, resource syndication and project facilitation. Without these institutions, the probability of private sector operations not succeeding increases, leading to the political risk of re-nationalisation of at least some of these activities. In addition, individual initiatives depend upon a critical mass being attained in certain supporting areas, which we analyse in the sub-sections below. 3.2.1 Exim financing Although commercial banks in developed markets have the capability of financing (and re-financing) most trade related transactions, there remains even in developed countries a residual role for a state-sponsored Exim bank for underwriting sovereignrelated risks, as well as advancing matters that are strategic in nature, apart from the traditional role in building export competitiveness. In developing countries, in addition, there might not be commercial banks with sufficiently diversified portfolios of assets that can adequately cover the forex risks that are necessarily an adjunct of trade financing.

The Export-Import Bank of India (Exim Bank) was established in 1982, for the purpose of financing, facilitating, and promoting foreign trade of India. It is the principal intermediary for coordinating institutions engaged in financing foreign trade transactions, accepting credit and country risks that private intermediaries are unable or unwilling to accept. The Exim Bank provides export financing products that fulfill gaps in trade financing, especially for small businesses, in the areas of export product development, financing export marketing, besides information and advisory services 20. As Indian corporations increasingly invest in foreign countries, there is also a need for political risk insurance, the mantle of which might also be assumed by this institution.
19 NSE 20 The

Factbook 2002-03. Exim Banks role in export promotion, besides extending lines of credit, consists of educating exporters about market potential, banking facilities, payment formalities, etc., which has a bearing on the country risk they might face. 22

Exim Banks loan assets have risen from Rs. 20.3 bn in 1993-94 to Rs. 87.7 bn in 2002-03 (an increase of 340%), and its guarantee portfolio from Rs. 7.5 bn to Rs. 16.1 bn (113%) over this period. Indias manufacturing exports, over this period, has increased from Rs. 685 bn to about Rs. 2,290 bn (234%). 3.2.2 Infrastructure and project financing Universally considered a pivot for economic growth, infrastructure has been one of the two large segments that has traditionally been under the rubric of the state in India (the other, as we have discussed, being the financial sector). The gradual recognition of the inefficiencies inherent in public provision of utility services, as well as the inability of the exchequer to cope with the large investments needed to upgrade, refurbish and build assets, made the Indian government amenable to introducing private participation in the sector (in the early 1990s). Bhattacharya and Patel [2003a] had previously detailed the necessity of developing sound regulatory structures in emerging economies for encouraging private investment in infrastructure. The unique requirements of project finance necessary for financial closure of private infrastructure projects had been recognised early on, but, of itself, this was soon found to be insufficient. After years of effort, and initial failure in most sectors in India, the importance of sound policy and regulatory frameworks to complement specialised financial products and markets was understood. As an outcome of this understanding, the Infrastructure Development Finance Company (IDFC) was established to lead private capital into commercially viable infrastructure projects. Apart from its responsibility in structuring finances for infrastructure to lower the cost of capital, IDFC was tasked with rationalising the existing policy regimes in sectors as diverse as electricity, telecom, roads, ports, water &
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sanitation, etc. Its policy advocacy initiatives in the telecom and civil aviation sectors are good examples of the success in developing sectors, in contrast (and addition) to merely financing individual projects. IDFC has also made an impact in bringing in funds into projects through innovative financial products like take-out financing and the use of various risk-guarantee instruments, as well as financing structures such as the annuity method for road projects. These initiatives have had the effect of orchestrating a significant quantum of private investment into infrastructure projects. 3.3 Channels and instruments for social objectives The original rationale for nationalisation of banks in India, as well as the establishment of DFIs, was the failure of existing private sector intermediaries to extend

the reach of banking to rural and remote areas, as well as perceived inadequacies in channelling credit to what were then deemed as critical areas of industrialisation. Although understandable, and even recommended, in a specific context, the justification for a continuation of these policies has been largely eroded. For some of these objectives, India already has specialised intermediaries the National Bank for Rural Development (NABARD), Small Industries Development Bank of India (SIDBI), State Finance Corporations (SFCs), etc. These institutions have quite obviously failed to live up to their mandates, given the periodic exhortations by the government and supplementary mechanisms that are proposed to be instituted to advance their stated objectives. 21 We look at individual components of these objectives and argue that using bank intermediaries to achieve them is sub-optimal.
21 There

is a proposal in the Interim Budget 2004-05 for a Fund for small scale enterprises, but the objective and disbursement mechanisms of this fund are not clear. 24

3.3.1 Intermediating rural financial resources Rural banking is rife with inefficiencies. Commercial banks, especially PSBs, have an inordinately large presence in rural and semi-urban areas. While only 33% of their deposits are sourced from (and 21% of credit is disbursed in) these areas, a full 71% of their branches are located there (see Appendix 1 Table A1.2). RBI licensing conditions for new private sector banks stipulate that, after a moratorium period of three years, one out of four new branches has to be in rural areas, thereby adding significantly to operating costs in an intensely competitive environment. This is despite the prevalence of a large network of post offices that is the predominant channel for small savings, as well as specialised Regional Rural Banks (RRBs), cooperatives and other intermediaries working through NABARD. India had around 155,000 post offices at end-March 2002, including about 139,000 in rural areas. 22 The Post Office Savings Bank, operated as an agency for the Ministry of Finance, besides being a conduit for National Small Savings (NSS) schemes, also offer money order and limited life insurance schemes. The ambit of these outlets, many already operating in partnership with commercial banks and insurance companies, can be further expanded in rural areas to address credit delivery shortcomings (the problematic aspect of rural intermediation). Although, to the best of our knowledge, an exploration of the potential of a re-organised post office network in India as the main channel of delivery of rural credit has not been done, an instructive report is that of the Performance and Innovation Unit of the British government, whose post office organisational structure is similar to Indias (PIU [2000]). Rural banking needs might be narrower in nature and alternative credit delivery mechanisms which might be better suited and more cost effective may be considered.
25

The other side of the coin is the reported shortcomings of credit delivery through institutions like NABARD, which is validated through the casual empiricism of a periodic refrain of the government to disburse funds to the agricultural sector at administratively mandated rates of interest.23 Not only are lending decisions of individual banks distorted (through the implicit cross-subsidies), financial sector reforms are systemically undermined through these administrative directives. The success of operations of certain Self Help Groups (SHGs) and micro credit institutions (SEWA being a prime example) has also demonstrated the viability and higher sustainability of these alternative channels. The use of minimum subsidy bidding to achieve some of the governments social objectives might be more cost-effective.

3.3.2 Lending to priority sectors As seen above, the dilution of the credit creation role of banks have raised concerns about under-lending. This worry is especially high for agriculture and small scale industries. According to RBI guidelines, banks have to provide 40% of net bank credit to priority sectors, which include agriculture, small industries, retail trade and the selfemployed. Within this overall target, 18% of the net bank credit has to be to the agriculture sector and another 10% to the weaker sections. Commercial banks have been consistently unable to attain these targets, and the expedient of channeling the shortfalls to the Rural Infrastructure Development Fund (under NABARDs administrative ambit) has led to concerns about its relatively non-transparent procedures of disbursement and the potential of future Non Performing Assets (NPAs). One of the arguments for mandating lending to the priority sectors at interest rates lower than market rates is an administrative mitigation of the higher risk premiums for the
22 India

Post Annual Report 2002-03.

26

(supposedly) inherently risky nature of this lending. An outcome of this risk is the level of NPAs. While credit appraisals for small firms are definitely more difficult, the argument of potentially high NPAs in priority sector advances may need to be nuanced (even if just a little) in light of the numbers on the sector-wise origins of NPAs of PSBs, as of endMarch 2003. While the share of priority sector NPAs in the total is about 47% 24 for PSBs, their total loans outstanding to the priority sector (as a percentage of total loans) at endMarch 2003 was about 43%25. At the same time, the high NPAs of DFIs remain a pointer to the perils of administrative mandates in advancing social goals as well as reliance on state government-guaranteed lending.26 3.3.3 Social security nets The provident fund system is the most important component of the social security net, but covers a meager 11 million persons, all of them in the organised sector. An important component of the Employee Provident Fund (EPF) Scheme of the EPFO (discussed earlier) is the administratively determined markup for the returns provided on deposits into the EPF, justified on the basis of providing an adequate livelihood for pensioners and others on limited fixed incomes. It is estimated that the average real annual compound rate of return over the period 1986-2000 was 2.7% (Asher [2003]). One of the worries, apart from concerns about investment efficiency, is the sustainability of this method. The average markup between the returns provided by the EPF and 10-year Government of India securities since 1995-96 has been 120 basis
23 For

instance, the recent directive to banks in December 2003 to disburse farm credit at 2% below their respective Prime Lending Rates (PLRs). 24 RBI Statistical Tables Relating to Banks in India, 2002-03, Table 7.2. 25 RBI Report on Trend and Progress in Banking, 2002-03, para. 3.93. This includes transfers to RIDF, SIDBI, etc. 26 Net NPAs of DFIs were 18.8% of advances in 2002-03 (RBI Report op. cit). 27

points27. The various tax exemptions that are granted to these deposits throughout the life of these deposits make the effective rate of return even higher. A back-of-theenvelope calculation in Patel [1997a] indicated that the EPS was actuarially insolvent and the EPFOs reluctance to make public its actuarial calculations does little to assuage this conclusion. Other than issues of sustainability, there remain concerns of these and other National Small Savings (NSS) schemes regarding the distortive effects on the yield curve (term structure of interest rates). As Table A1.1 shows, small savings outstanding accounted for over 15% of GDP in 2002-03, dwarfing all other intermediaries but banks.

3.4 Deposit insurance to enhance systemic stability Other than instituting a sound regulatory mechanism and facilitating efficient and seamless transactions, a major aspect of the governments role in imparting stability to the financial system is the constitution of an appropriate safety net for depositors. The current system has a built-in bias which leans towards using taxpayer funds to finance bank losses, thus undermining even limited market discipline and encouraging regulatory forbearance. India has a relatively liberal deposit insurance structure, compared to international norms (Demirguc-Kunt and Kane [2001]). Depositors in India do not have to bear coinsurance on the insured deposit amount and the ceiling insured amount (Rs. 100,000) is five times the per capita GDP, high by international standards. This encourages some depositors to become less concerned about the financial health of their banks and for banks to take on additional (and commercially non-viable) risks. The Deposit Insurance and Credit Guarantee Corporation (DICGC) came into existence in 1978 as a statutory body through an amalgamation of the erstwhile separate Deposit Insurance Corporation (DIC) and Credit Guarantee Corporation (CGC). DICGC
27 The

rate of return on the EPF scheme has been set at 12% per annum from 1989-90 onwards, till July 2000

28

extended its guarantee support to credit granted to small scale industries from 1981, and from 1989, the guarantee cover was extended to priority sector advances. However, from 1995, housing loans have been excluded from the purview of guarantee cover. As of 200102, about 74% of the total (accessible, i.e., excluding inter-bank and government) deposits of commercial banks was insured28. Banks are required to bear the insurance premium of Re 0.05 per Rs. 100 per annum (depositors are not charged for insurance protection). The issues raised by an overly generous deposit insurance structure have been recognised by the government. Some of the major recommendations of the 1999 Working Group constituted by the RBI to examine the issue of deposit insurance are withdrawing the function of credit guarantee on loans from DICGC and instituting a risk-based pricing of the deposit insurance premium instead of the present flat rate system. A new law, superceding the existing one, is supposedly required to be passed in order to implement the recommendations. 4. CONCLUSION Despite the institution of market reforms in India since the early nineties, government interests in the financial sector have not diminished commensurate to its withdrawal from most other aspects of economic activity. The continuing presence is too large to be justified solely on considerations of containing systemic risk. There might have been justifiable reasons for government ownership of intermediaries in the early years of Indias development, but these have now been rendered redundant, and possibly even damaging. India now has a relatively well developed intermediation network, with intermediaries that are becoming increasingly commercially oriented. The raison detre of the Development Finance Institutions (DFIs)
from when they have been progressively reduced to the current 9%. 29

is also now obsolete, with the continuing development of project finance skills of banks and the maturing of capital markets. A combination of directing resources of intermediaries in fulfilling a quasi-fiscal role for government, extra-commercial accountability structures and regulatory forbearance (arising out of an implicit overarching guarantee umbrella) has mitigated the essential corrective effect of market discipline in both lending and deposit decisions.

Coupled with persisting government involvement in intermediation and an implicit support scaffold, this has resulted in an aggravation of the problems of moral hazard that is a normal feature of financial systems. A cycling analogy is the most apt to describe the outcome of these deficiencies. The set of actions that increasingly aggravate moral hazard, through visible and invisible props to keep the edifice from falling, is like riding a bicycle without brakes down a hill attempting to stop or intensifying pedalling will lead inexorably to a wreck. The prudent escape is to look for a soft spot to crash to minimise damage and then get the brakes repaired. India is unlikely to suffer a full-blown systemic crisis, witnessed in different contexts in various countries. Its financial sector inefficiencies are likely to simply simmer, with occasional payments crises, like the one at the dominant mutual fund over the last five years. However, the cumulative inefficiencies and grim fiscal outlook, with the concomitant regulatory forbearance that public involvement inevitably entails, are certain to retard Indias transition to a high growth trajectory. The persistent unease with the state of the system, it can be speculated, arises from the recognition that the perceived
28 DICGC

Annual Report 2001-02.

30

safety of intermediaries is due more to the social contract between the government and depositors than underlying robustness in the health of the sector. The system of intermediation will not improve appreciably in the absence of any serious steps towards changing incentives blunted by public sector involvement (of which ownership is an important aspect). To sharpen these incentives, outright privatisation may not be sufficient, but it is necessary. It is the first step to a true relinquishing of management control, which remains far beyond the scope envisaged in the Banking Companies (Acquisition and Transfer of Undertakings) Bill tabled in Parliament in 2002 (and still languishing), designed to reduce government holding in nationalised banks to 33%, but allowing them to retain their public sector character by maintaining effective control over their boards and restricting the voting right of non-government nominees. Attempts to shed commercial risks of investors, borrowers and depositors (through implicit bailout and other means of accommodating fragility) will almost certainly lead to economic ones during slowdowns, creating a new kind of instability. Old habits, unfortunately, die hard. There has re-emerged in official thinking an ambiguity about the perceived role of financial institutions as a tool of financial policy. On the one hand, there is an extensive restructuring of the DFIs underway, through mergers and redefinitions of their statutory status. Yet, on the other, various aspects of financial sector reforms are either being rolled back (directives for lending to target groups) or are not being addressed (artificially high rates of interest for small savings schemes). Various decisions that strengthen the DFI model including directed disbursements at lower than market interest rates, use of public sector intermediaries for interventions in capital markets, etc. have recently been taken. More than anything else, the cardinal mistake is
31

to confuse outcomes with mechanisms and processes. Both, after a brief period of increasing emphasis on commercial viability, are again becoming target driven. Given the increasing integration of financial markets, there is also a need to shift reform focus from individual intermediaries to a system level. An important component in this shift is enhancing intermediaries ability to de-risk their asset portfolios. Undoubtedly, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act of 2002 is a crucial step forward in addressing bad loans, but, on

its own, it is limited in scope and even this is beset by various legal challenges. Establishing asset reconstruction companies, even under private management, will serve only to tackle the overhang of existing bad assets they per se do little to correct the distortions in incentives that are intrinsic to large parts of the system. There, however, remain some aspects of intermediation that are in the nature of public goods. One is the establishment of specific platforms for facilitating transactions. Another is to catalyse certain economic activities that are in the nature of testing waters or else are pioneering financial services. The government has constituted diverse bodies to fulfill these roles; it is worth noting that the most successful among these have been institutions that have had no direct intermediation functions. The state might have other legitimate social objectives like extending the reach of intermediation in rural and remote areas and providing social security nets; these, though, would be better achieved through the use of existing networks like post offices rather than commercial banks.
32

References Allen, F. and D. Gale, 2001, Comparative financial systems: A survey, Mimeo., New York University. Asher, M. G., 2003, Reforming Indias social security system, Mimeo., National University of Singapore, May. Banerjee, A. V., S. Cole and E. Duflo, 2004, Banking Reform in India, paper presented at the Inaugural Conference of the India Policy Forum, New Delhi, March. Bhattacharya, S. and U. R. Patel, 2001, New regulatory institutions in India: White Knights or Trojan Horses?, forthcoming in volume of Conference Proceedings on Public Institutions in India: Performance and Design , Harvard University (revised version: May 2003). Bhattacharya, S. and U. R. Patel, 2002, Financial intermediation in India: A case of aggravated moral hazard?, Working Paper No. 145, SCID, Stanford University, July; (revised version forthcoming in volume on Proceedings of Third Annual Conference on the Reform of Indian Economic Policies, Stanford University, (ed) T. N. Srinivasan). Bhattacharya, S. and U. R. Patel, 2003a, Markets, regulatory institutions, competitiveness and reforms, Working Paper No. 184, SCID, Stanford University, September. Bhattacharya, S. and U. R. Patel, 2003b, Reform strategies in the Indian financial sector, forthcoming in the Proceedings volume of IMF-NCAER Conference on Indias and Chinas Experience with Reform and Growth, New Delhi, November. Buiter, W. H. and U. R. Patel, 1997, Budgetary aspects of stabilisation and structural adjustment in India, in Macroeconomic Dimensions of Public Finance, Essays in Honour of Vito Tanzi, M. Blejer and T. Ter-Minassian (Eds.) (Routledge, London). Calomiris, C. W. and A. Powell, 2000, Can emerging market bank regulators establish credible discipline?, National Bureau of Economic Research Working Paper No. 7715, May. Caprio, G., 1996, Bank regulation: the case of the missing model, Paper presented at Brookings - KPMG Conference on Sequencing of Financial Reform, Washington, D.C. Demirguc-Kunt, A. and E. J. Kane, 2001, Deposit insurance around the world: Where does it work?, Paper prepared for World Bank Conference on Deposit Insurance, July. Gerschenkron, A., 1962, Economic backwardness in historical perspective: A book of essays, Harvard University Press. Hawkins, J. and D. Mihaljek, 2001, The banking industry in the emerging market economies: Competition, consolidation and systemic stability, Overview Paper, BIS Papers No. 4, August.

Kornai, J., 1979, Resource-constrained vs. demand-constrained systems, Econometrica, vol. 47, pp. 801-819.
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La Porta, R., F. L. de-Silanes and A. Shleifer, 2000, Government ownership of banks, Mimeo., Harvard University. Levine, R., 1997, Financial development and economic growth: Views and agenda, Journal of Economic Literature, vol. XXXV, pp. 688-726. Lewis, W. A., 1955, The theory of economic growth, London. Patel, U. R., 1997a, Aspects of pension fund reform: Lessons for India, Economic and Political Weekly, vol. XXXII (No. 38, September 20-26) pp. 2395-2402. Patel, U. R., 1997b, Emerging reforms in Indian banking: International perspectives, Economic and Political Weekly, vol. XXXII (No. 42, October 18-24) pp. 2655-2660. Patel, U. R., 2000, Outlook for the Indian financial sector, Economic and Political Weekly, vol. XXXV (No. 45, November 4-10), pp. 3933-3938. Patel, U. R. and Bhattacharya, S., 2003, The Financial Leverage Coefficient: Macroeconomic implications of government involvement in intermediaries, Working Paper No. 157, SCID, Stanford University. Performance and Innovation Unit Report, 2000, Counter revolution: Modernising the post office network, UK Government Cabinet Office, June. Rodrik, D., 2002, After neo-liberalism, what?, Mimeo. Harvard University, June. Shleifer, A. and R. Vishny, 1994, Politicians and Firms, Quarterly Journal of Economics, vol. 109, pp. 995-1025.
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APPENDIX 1
Table A1.1: Comparative profile of financial intermediaries and markets in India (Amounts in Rupees billion, and numbers in parentheses are percentage of GDP) 1990-91 1998-99 2002-03 Gross Domestic Savings 1,301 3,932 5,500 (24.3) (22.3) (24.0) Bank deposits outstanding 2,078 7,140 13,043 (38.2) (40.5) (50.1) Small Savings deposits, PPFs, outstanding etc 1,071 3,333 3,810 (20.0) (19.1) (15.4) Mutual Funds (Assets under management) 253 858 1,093 (4.7) (4.9) (4.2) Public / Regulated NBFC deposits 174* 204 178 (2.4) (1.2) (0.7) Total borrowings by DFIs (outstanding) -- 2108 901 (12.0) (3.5) Annual Stock market turnover (BSE & NSE) 360& 15,241 9,321 (5.6) (79.0) (35.8) Stock market capitalisation (BSE & NSE) 845& 18,732 11,093 (15.8) (97.1) (42.6) Turnover of Government securities (excluding repos) through SGL (monthly average) -- 310 2,287 (1.8) (9.0) Annual turnover as % of stock market turnover -- 24% 276% Volume of corporate debt traded at NSE (excluding Commercial Paper) -- 9 58
Legends: *: denotes figures at end-March 1993. &: Pertains only to BSE. --: Not comparable.

Table A1.2: Current trends in banking in urban and non-urban areas (as on March 31, 2003)
No. of bank branches Deposits (Rs. bn)

Credit (Rs. bn) C-D Ratio (%) Scheduled Commercial Banks Urban centres (including metros) 19,379 29% 8,619 67% 5,998 79% 70% Metro centres 8,664 13% 5,719 45% 4,745 62% 83% Top 100 centres 15,066 23% 7,603 61% 5,758 75% 74% Non Urban centres 38% Semi urban centres 14,813 22% 2,405 19% 847 11% 35% Rural centres 32,244 49% 1,763 14% 748 10% 42% All India 66,436 12,787 7,592 59% Regional Rural Banks (RRBs) 14,462 (21%) 498 (4%) 221 (3%) 44% Source: Culled from RBI Banking Statistics Quarterly Handout, March 2003. Note: Percentages for RRBs in parentheses represent shares relative to those for all India Scheduled Commercial Banks.

35 Figure A1.1: Country comparison of government ownership of banks


86 79 68 52 44 31 30 25 18 15 1000 12 13 23 32 49 62 21 55 82 78 93 83 95 50 2 8 9 16 77 49 20 1 96 17 5 50 0% 25% 50% 75% 100% China India Russ ia Brazil Indonesia Thailand Argentina Me xico Ge rm any Sw itzerland Japan Aus tralia USA Singapor e

Government banks Domestic private banks Foreign Banks

Source: BCG presentation, CII Banking Summit, 2003.

36

APPENDIX 2 METHODOLOGY OF CONSTRUCTION OF THE INDEX OF DENSITY OF GOVERNMENT INVOLVEMENT IN THE FINANCIAL SECTOR (IDGI-F). This appendix is an enumeration of the constituent groupings of the Index of Density of Government Involvement in the Financial Sector (IDGI-F) and an associated weighting system. The weights are uniform, being simply +1 or 1 depending on the appropriate definition of the respective series vis--vis the definition of impact on involvement. I. Constituents of IDGI-F A. Share of public sector banks (PSBs) and financial institutions (FIs) in total financial intermediation. 1. Share in resource mobilisation (as a sum of the following): a. Net demand and time liabilities of public sector banks (as % of financial savings). b. Resources mobilised by DFIs through bond issues (as % of financial savings). c. Premia of LIC / Amounts mobilised by UTI (as % of financial savings). B. Lending practices and use of funds. 2. Investments in government securities by banks and financial institutions (as % of their incremental lendable resources). 3. Excess deposits deployed by PSBs in priority sectors (as % of Net Bank Credit, in excess of minimum prescribed norms). C. Trends in the governments pre-emption of financial resources. 4. Share of public investment in overall investment (e.g., 7.7 percent out of 26.8 percent in 1995-96 and 6.9 percent out of 23.7 percent in 2001-02).
37

5. Public sector saving - investment gap (as % of GDP). 6. Public sector fiscal / resource gap (a proxy for Public Sector Borrowing Requirement (PSBR), as % of GDP). 7. Outstanding explicit liabilities of the (central and state) governments (as % of GDP). 8. Outstanding contingent liabilities (guarantees and other off-balance sheet items) of the (central and state) governments (as % of GDP). II. Methodology for construction of the IDGI-F The IDGI-F is a simple weighted average of the rates of change of synthetic (sub-index) constituent series. These synthetic sub-index series are constructed using the (observed) rates of change of the constituent variables (detailed above), with the values of variables of the individual series each being normalised to 100 in 1990-91.

RURAL AGRI- MARKETING IN INDIA - WITH SPECIAL REFERENCE TO AGRICULTURAL PRODUCE IN INDIA ABSTRACT

Around 700 million people, or 70% of India's population, live in 6,27,000 villages in rural areas. 90% of the rural population is concentrated in villages with a population of less than 2000. Rural marketing is as old as the civilization. Surplus of agro products are exchanged in earlier days in the barter system. The introduction of currency, transport, and communication has increased the scope of rural market. This paper discusses the present scenario of rural marketing especially rural produce, and its importance, current trends, and highlights certain problems related to rural marketing. Further it highlights the improvements that make the rural marketing system most effective. ----------------------------------------------------------------------------------------------------RURAL AGRI - MARKETING IN INDIA - WITH SPECIAL REFERENCE TO AGRICULTURAL PRODUCE IN INDIA RURAL MARKETING Rural marketing facilitate flow of goods and service from rural producers to urban consumers at possible time with reasonable prices, and agriculture inputs/ consumer goods from urban to rural. Marketing as a function has started much earlier when civilization started but not recognized as marketing. All economy goods are marketed in terms of goods and services (Barter system). Now money is being practiced as a good exchanging medium. The market may be a street, or a small town/ metropolitan city, Developments in infrastructure, transport, and communication facilities has increased the scope of the rural market. Environment The difference between rural and urban markets on the basis of various socio economic factors, most dominant among them being the source of income, the frequency of receipt of income, the seasonal nature of income and consumption. Rural markets are small, non- contiguous settlement units of village relatively low infrastructure facilitates, low density of population, their life styles also being different. Rural consumers are mostly farmers whose income receipts are dependent on the vagaries of nature. Agri-Marketing Rural population has been increased about 74% of the total population; the demand for products and services has increased a lot in rural areas. Green revolution in the North and white revolution in the West has brought about a new prosperity in the lives of rural people. Government emphasis on rural development has caused significant changes in the rural scenario. Moreover, the special attention given for infrastructure development through the successive Five-year plans has improved the buying and consumption pattern of rural people. The Rural Agro Products: The rural agro-products are

* Fruits & Vegetables * Grains * Flowers Rural sale products * Milk & poultry products * Handicrafts and Hand loom products * Tribal village products like tamarind, Lac, soapnut etc The peculiar characteristics of agricultural produce are: * * * * * * Bulkiness Perishability Wide varietal differences Dispersed production Processing needs for consumption Seasonality

GROSS CROPPED AREA BY 1997 CROP WISE PERCENTAGE GIVEN BELOW


CROP SUGGER CANE COTTON RICE WHEAT OTHER CEREALS PULCESS OIL SEEDS OTHERS TOTAL PERCENTAGE AREA 2 4 22 13 19 13 15 12 100

More than 40 % of the gross cropped area under non- food grains is under oilseeds. Principally groundnut and rapseed and mustered, cotton and sugar cane area the other major non- food grain crops. VEGETABLES (share in production)
CROP TOMATO ONION BRINJAL CAULIFLOWER OKAR PEAS POTATO CABBAGE OTHER TOTAL % 0F TOTAL PRODUCTION 8 8 9 6 6 3 25 6 29 100

FRUITS

The major fruits share in total fruit production


Fruit name BANANA APPLE CITRUA MANGO GUVA OTHERS Percentage of fruit Production 27 2 8 23 3O 37

India is the largest producers of mangos and banana in the world, and top ten producers of apples and pineapples. Other fruits, guava, sapota, papaya etc. Area under fruits which was estimated to 1.45 millions hectares in 1970-71 grow slowly and gear up after 1991-92 to 2.8 million hectares. DAIRY India is the largest milk producer and processing of milk was largely in the cooperatives sector. NATIONAL DAIRY DEVELOPMENT BOARD PLAN ESTIMATION FOR YEAR 2010
Year 1999 6 lack liters per day sale 9.11 lack litters per day procurement 174 ml per consumption per day Year 2010 34 lack litters per day 71 Lack lit per day 230 ml per consumption per day

Rural marketing depends on agricultural produce, the production is seasonal and the consumption is spread out equalization of demand and supply has to be done. In addition, the raw agricultural produce as marketed by farmers has to be processed by many middlemen This include collection and assembling, financing, grading and standardization, storage, transportation, wholesaling and retailing these functions performed by village merchants, commission agents, wholesalers, processors etc. These people seek returns commensurating with their investments of capital, time and labour. As a result, the middlemen get more share of the price than the producers. TYPES OF RURAL MARKETS HAATS /SANDIES (mostly for weekly market for all commodities) MANDIS (mostly for all types of grains) COMMODITY SPECILISED MARKETS Nasik for onions and Grapes market, Nagpur for Orange market, Delhi for Apples market, Salem{TN} for Mangoes, Farkka market for potato market and Calcutta / Assam for tea market. REGULATED MARKETS

There are more than 5000 primary and Secondary Agricultural produce wholesale assembling markets functioning in the country. These markets are meant for the farmers to take their produce for sale. These markets facilitate formers, immediate cash payments. The directorate of state Agricultural Marketing Board or Registrar of cooperative marketing societies is controlling these markets. The market is run by an elected committee comprising of members from the farmers community, commission agents/wholesalers and some government nominees from Directorate of state agriculture / cooperative societies. COOPERATIVE MARKETING Another major improvement for rural producers is the formation of cooperative societies. Farmer's common interest helped to increase the incomes of the farmers and avoid exploitation of the middlemen. There are about five lack cooperatives working but very few cooperative societies in selected areas like Dairy, sugar, oilseeds, Mahagrape in Maharastra, tomato growers in Punjab etc. succeeded in cooperative processing industry. Problems in Rural Marketing The rural market offers a vast untapped potential. It is not that easy to operate in rural market because of several problems and also it is a time consuming affair and it requires considerable investments in terms of evolving appropriate strategies with a view to tackle the problems. The problems are. * * * * * Underdeveloped people and underdeveloped markets Lack of proper physical communication facilities Inadequate Media coverage for rural communication Multi language and Dialects Market organization & staff

Underdeveloped people and underdeveloped markets The agricultural technology has tried to develop the people and market in rural areas. Unfortunately, the impact of the technology is not felt uniformly through out the country. Some districts in Punjab, Haryana or Western Uttar Pradesh where rural consumer is somewhat comparable to his urban counterpart, there are large areas and groups of people who have remained beyond the technological breakthrough. In addition, the farmers with small agricultural land holdings have also been unable to take advantage of the new technology. Lack of proper physical communication facilities Nearly 50 percent of the villages in the country do not have all weather roads. Physical communication to these villages is highly expensive. Even today, most villages in eastern part of the country are inaccessible during monsoon season. Inadequate Media coverage for rural communication

A large number of rural families own radios and television sets there are also community radio and T.V sets. These have been used to diffuse agricultural technology to rural areas. However the coverage relating to marketing is inadequate using this aid of Marketing. Multi language and Dialects The number of languages and dialects vary from state to state region to region This type of distribution of population warrants appropriate strategies to decide the extent of coverage of rural market. OTHER FACTORS INFLUENCING MARKETING Natural calamities and Market conditions (demand, supply and price). Pests and diseases, Drought or too much rains, Primitive methods of cultivation, lack of proper storage facilities which exposes grain to rain and rats, Grading, Transport, Market Intelligence (up to date market prices to villagers), Long chain of middlemen (Large no. of intermediaries between cultivator and consumer, wholesalers and retailers, Fundamental practices (Market Dealers and Commission Agents get good part of sale of receipts). MAJOR LOSERS IN AGRICULTURAL MARKETING Small and marginal farmers , 75% villagers are illiterates or semiliterate, they facing difficulties like proper paper procedures for getting loans and insurance. The farmers facing high interest rates for their credits (Local money lending system). Most of the credit needed for agricultural inputs like seeds, pesticides, and fertilizers. THE MAJOR WEAKNESS AND CHALLENGES IN THIS SECTOR * * * * Traditional mind not to react new ideas. Agricultural income mostly invested in gold ornaments and weddings. Low rural literature. Not persuading new thinking and improved products

EMERGING TRENDS IN MARKETS ON LINE RURAL MARKET (INTERNET, NICNET): Rural people can use the two-way communication through on line service for crop information, purchases of Agri-inputs, consumer durable and sale of rural produce online at reasonable price. Farm information online marketing easily accessible in rural areas because of spread of telecommunication facilities all over India. Agricultural information can get through the Internet if each village have small information office COST BENEFIT ANALYSIS IN THIS SECTOR Cost benefit can be achieved through development of information technology at the doorsteps of villagers. Most of the rural farmers need price information of agriproduce and inputs. If the information is available farmers can take quick decision

where to sell their produce, if the price matches with local market farmers no need to go near by the city and waste of money & time it means farmers can enrich their financial strength. NEED BASED PRODUCTION Supply plays major role in price of the rural produce, most of the farmers grow crops in particular seasons not through out the year, it causes oversupply in the market and drastic price cut in the agricultural produce. Now the information technology has been improving if the rural people enable to access the rural communication, farmers' awareness can be created about crops and forecasting of future demand, market taste. Farmers can equates their produce to demand and supply, they can create farmers driven market rather than supply driven market. If the need based production system developed not only prices but also storage cost can be saved. It is possible now a days the concept of global village. MARKET DRIVEN EXTENSION Agricultural extension is continuously going through renewal process where the focus includes a whole range of dimensions varying from institutional arrangements, privatization, decentralization, partnership, efficiency and participation. The most important change that influences the extension system is market forces. There is a need for the present extension system to think of the market driven approach, which would cater the demands of farmers. AGRO- PROCESSING INDUSTRY India is the second largest producer of fruits and vegetables in the world with an annual production of more than 110 million tonnes of fruit and vegetable only 1.3 percent of the output is processed by the organised sector commercially, the reason higher consumption in fresh form. However, as the packaging, transportation and processing capacities increase, the market for processed fruits and vegetables is projected to grow at the rate of about 20 % per annum. 100 % export oriented units (EOU) and Joint venture units required improving the processing industry. KISAN MANDI There is a need to promote direct agricultural marketing model through retail outlets of farmer's co-operatives in urban areas. The direct link between producers and consumers would work in two ways: one, by enabling farmers to take advantage of the high price and secondly, by putting downward pressure on the retail prices. RECENT DEVELOPMENTS IN TAMILNADU Many remote villages now connected to main roads and link roads with the help of innovative technique of grass root development by the people for the people of the people. "Uzhavar sandhai" the another development of rural farmers reducing middle men and also cost to the benefit of urban society. The Innovative " Uzhavar sandhai"

The recent changes in agricultural produce sale by farmers in Uzhavar sandhai leads to direct selling vegetables and other commodities to urban needs. Government of Tamilnadu started Uzhavar sandhai all over the state for the purpose of direct selling their produce to urban needs, not only selling of rural produce but also exchange of their ideas each others. Procurement Prices / Support Prices These prices are more than minimum prices, which facilitates government bulky procurement for Public Distribution System and maintains buffer stock levels. Farmer has little control over prices, which are determined by the broad factors of, supply and demand market at large. SUGGESTIONS FOR SOUND AGRICULTURAL MARKETING IN INDIA * Suitable structure of support prices for various farm commodities adjusted from time to time. * Adequate arrangement of agricultural produce on support price if the price falls below the level. * Regulated infrastructure of markets and warehouses, which ensure fair prices * Rural roads must be compliment and coordinate with railways, nearest waterways (port), airports if possible. * The efficient marketing is predominantly influenced by efficient distribution system it means products such ultimate consumer in the quickest time possible at minimum cost. * The development of communication systems appropriate to rural market may cost up to six times as much as reaching an urban market through established media, need rural communication facilities. * The state marketing board or federation or market committees also the producers, traders and sellers have necessarily to be consulted as they have the principle interest towards it s use. * The arrivals of various products such as Food grains Vegetables Dairy products Flowers etc. need speedy transport. * Public weighing machines one in each rural market to ensure correct weightment both for farm and non-farm arrivals. Storage godowns and an office also required. * For storage facilities the government should not depend on private agencies to store food grains (National commission on Agriculture recommended). * Rural markets need more number of godowns and ancillary platforms for packaging places, market office cum information cell, bank and post office. * Rural marketing is the nerve center of a rural economy, rural markets are the channels for the movements of goods and services as well as to promote cultural integration. * Agricultural technology must reach all over the country, irrespective of size of land holding. * Improve physical communication facility to nook and corner of the country. * Land reforms need effectively implemented, because the land is basic asset of rural people. * Rural communication must be in regional language and dialects.

* The existing marketing staff must be increased and adequate training must be given. * Extending of financial support for modernization of the agro-processing units is also needed. * Processing units should utilise fully capacity. * There is need to find out markets for agro-processed products within and out side of the country. * The proper packaging technology must be improved. CONCLUSION Considering the emerging issues and challenges, government support is necessary for the development of marketing of agricultural produce. The government may adjust suitable budget allocations to rural infrastructure plans, and proper supervision for effective plan implementation. The core areas like transport, communication, roads, credit institutions, crop insurance for better utilization of land and water at appropriate level. The rural people and markets will definitely develop rural income and reduce poverty, on the whole countries economy will boost at an expected level. MANAGE an extension management institution may provide extension services to rural people in crop information, price information, insurance and credit information by using various media. MANAGE may recommend / advice to central and state governments on suitable infrastructure development, current problems in rural markets and problem solving techniques. REFERENCES 1. Marketing of Agricultural inputs by Manohar Lal Jalan., Published by Himalaya Publishing House (Delhi). 1988. 2. Agricultural Price Policy in India by Raj Kumar Singh., Published by Print well Publishers (Jaipur). 1990. 3. Communication and Rural Development by J.B. Ambekar Yadav. Published by Mittal Publications (New Delhi). 1992. 4. Development of Agricultural Marketing in India by Dr. Rajagopal Published by Print well (Jaipur). 5. Marketing Management by Philip kotlar. 1992. 8th edition. 6. Rural Marketing by T.P.Gopal Swamy published by Wheeler publishings (New Delhi) 1998. 7. CMIE report 97 8. Indian agrl. Journal of agril.economics vol. 54

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