Did Financial sector reforms in India lead to expansion of credit?

This is a nice paper from IMF economists  Poonam Gupta,  Kalpana Kochhar and  Sanjaya Panth.

They say a couple of interesting things on India’s financial system and economy:

  • First, even after 20 years of liberalization, banking system is dominated by public sector banks (PSB)
  • Second, credit to private sector has not increased much. Despite lower SLR , PSBs continue to allott larger share of assets to investments in government bonds (G-secs).
  • Moreover, the investment in G-sec rises with rise in fiscal deficit. Implying that PSBs kind of take it upon themselves to fund the fiscal deficit.
  • Hence, state ownership of banks leads to effective crowding out of credit to private sector .
  • Then PSBs do not hold higher G-secs for risk management. The reasons are incentive system in PSBs where a high risk loan turning into default could lead to government enquiry. Also perhaps there is moral suasion coaxing PSB officials to hold higher bonds to finance fiscal deficits.

Amazing paper by all means!! 🙂

The authors say paper is related to 3 strands of literature:

The first strand is the literature on the effects of financial liberalization on financial deepening, e.g. a recent paper by Tressel and Detragiache (2008). It uses data for 90 some countries over the period 1973-2005 to see if financial reforms resulted in financial deepening, defined as an increase in bank credit to the private sector as percent of bank assets. They find that the evidence is very context dependent, differing over the long run and shorter horizons, for developing and developed countries, and across countries with different political institutions. Overall, they find that the effect is positive for developing countries in the short run, and is stronger for countries that have political institutions that offer stronger protection of property rights. Our results suggest that the effect of financial liberalization on the availability of credit to the private sector may also depend on the state ownership of banks and the size of the fiscal deficit.

The second strand is the literature on the role of government-owned banks in the financial sector. Influential papers from this strand of literature include La Porta, Lopez-de-Silanes and Shleifer (2002) and the papers by Hauner (2008, 2009). La Porta et al (2002) discusses the two broad views about government participation in financial markets. One view, called the “development” view, holds that in economies with underdeveloped institutions, private entities could not be relied on to raise adequate amounts of capital or to allocate it efficiently for industrialization and growth. Under such circumstances, it is imperative for the government to set up and control banks to achieve these objectives in a direct manner. The alternate view, called the “political” view, considers that the state ownership of banks politicizes resource allocation and because of agency problems and soft budget constraints, lowers economic efficiency. Using cross-country data, La Porta et al find higher government ownership of banks to be associated with slower subsequent development of the financial system, lower economic growth, and in particular lower growth of productivity, and conclude that the political view is closer to the mark. Our results support the main findings of La Porta et. al. and Hauner by suggesting that government ownership and the size of the fiscal deficit may, together, also limit the impact of financial liberalization on financial development.

Our paper also  relates to the literature on the evolution of the Indian banking sector post liberalization and on the characterization of the public sector banks in India, e.g. Banerjee, Cole and Duflo (2004) and Cole (2004). Banerjee et al (2004) shows that Indian firms are credit constrained, and characterize the Indian public banks as “lazy”, in the sense that they do not lend adequately to the private sector and the lending decisions of their managers are based primarily on past turnovers and outlays of the borrowers rather than their current or expected profitability. This “lazy” behavior on the part of the bankers is also reflected in their preference to overinvest in government securities, especially in the states where, for various institutional reasons, it might be particularly difficult and costly to scrutinize the private sector applications for credit. Our paper adds to these findings by focusing on changes in the specific regulations pertaining to asset allocation, and comparing the response of  public and private banks to these changes.

All emphasis is mine.

The authors add this paper provides ideas on why despite many years of reform, credit constraint remains a problem in India.

It also adds an interesting channel to the India’s fiscal deficit problem. Earlier papers have shown how fiscal deficit leads to inflation etc. Even this crowding out has a different channel now. Earlier we would say as government deficit is large it will take majority of the domestic savings leading to crowding out. Now, it seems govt owned banks are using these savings to park most monies in G-sec indirectly leading to private sector crowding out.

Insightful paper really. It has some nice tables at the end summarising the key reforms in India’s financial system.

THis is also a different kind of paper like this earlier one by Viral Acharya et al. In this economists said that PSBs fared batter in the 2007-09 crisis not because of lower risks. Infact, they had a higher risk profile and were saved because of perception of government support. They even show PSBs which had higher risk also got government support making the public belief stronger. This leads to moral hazard problem.

So, IMF economists paper say PSBs hold higher G-secs which should mean lower riskier portfolio. But the Acharya et al paper says PSBs have higher risks (though their measure needs to be understood better). How does one assess this divergence? As IMF study is a more long term based whereas Acharya et al is more crisis period based, so there will be diffeernces.May be we need to divide the IMF study in phases to understand the whole thing better. 

But still, both these papers give you a different take on PSBs.

2 Responses to “Did Financial sector reforms in India lead to expansion of credit?”

  1. SRINIVASAN Says:

    WELL SHOT BY THE AUTHOR. AND A WELL CATCH BY THE BLOGGER… KEEP POSTING.. I M INTERESTED IN YOUR POST….

    WELL.. WELL… PSB KEEPS WAVING THE DEFAULT BILLS EVERY TIME TO TAX PAYER… SO ITS ALL BURDEN TO THE TAX PAYER… DIRECT TAX ON GDP WOULD GO DOWN WHEN PSB STILL FOLLOWS THIS…. ULTIMATELY THERE WOULD ALSO BE A INDIAN CRISIS ALSO…. A GUESS FROM ME…

  2. India’s FinMin questioned over LIC’s food coupon scheme « Mostly Economics Says:

    […] this blog pointed to this nice research which shows how Indian Public Sector Bank executives are not aggressive in giving private sector […]

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