3.2 In the three decades following the first wave of bank nationalisation (the second wave consisted of six commercial banks in 1980), the number of scheduled commercial banks has quadrupled and the number of bank branches has increased eight-fold. Aggregate deposits of scheduled commercial banks have increased at a compound annual average growth rate of 17.8 per cent during this period (1969 to 1999), while bank credit expanded at a rate of 16.3 per cent per annum. Banks' investments in government and other approved securities recorded a growth of 18.8 per cent per annum. The increased role of bank intermediation is also reflected in its payment system activities. The total cheque clearances have gone up by 2175 times during this period, spurred by a qualitative shift from a manual to an electronic cheque clearing system.

3.3 The financial system outside the banks has also exhibited considerable dynamism. The system today is varied, with a well-diversified structure of financial institutions, financial companies and mutual funds. Financial institutions comprise all-India Financial Institutions (AIFIs), State-level Institutions (SFCs and SIDCs) and other institutions (ECGC and DICGC).² AIFIs include all-India Development Banks (IFCI, ICICI, IDBI, SIDBI and IIBI), specialised institutions (EXIM Bank, IVCF, ICICI Venture, TFCI and IDFC), investment institutions (UTI, LIC and GIC and its subsidiaries) and refinance institutions (NABARD and NHB). The setting up of some specialised financial institutions and refinance institutions during last three decades and the onset of reforms from about the early 'nineties, provided depth to the financial intermediation outside the banking sector. These developments, coupled with increased financial market liberalisation, have enhanced competition. A number of the existing financial institutions have diversified into several new activities, such as, investment banking and infrastructure financing, providing guarantees for domestic and offshore lending for infrastructure projects. Apart from the financial institutions, rapid expansion of Non-Banking Financial Companies (NBFCs) took place in the 'eighties and provided avenues for depositors to hold assets and for borrowers to enhance the scale of funding of their activities. Various types of NBFCs have provided varied services that include equipment leasing, hire purchase, loans, investments, mutual benefit and chit fund activities. More recently, NBFC activity has picked up in the area of housing finance. Financial development is also reflected in the growing importance of mutual funds. In the 'nineties, they have enabled sizable mobilisation of financial surpluses of the households for investment in capital markets. Capital markets themselves have become an important source of financing corporate investments, especially after firms were permitted to charge share premium in a flexible manner.

3.4 Sanctions as well as disbursements of all-financial institutions, including the SFCs and the SIDCs has expanded at a rate of 24.1 per cent per annum and 23.8 per cent per annum, respectively, during 1970-71 to 1999-2000. In addition, there has been a spurt in the activities of NBFCs and mutual funds over the last two decades. Deposits of NBFCs recorded an impressive growth of about 35 per cent per annum from the mid-'eighties to the middle of the 'nineties. In the 'sixties and 'seventies, the Unit Trust of India (UTI) was the only mutual fund. By 1999-2000 as many as 34 mutual funds were operating of which 7 mutual funds were set up by the public sector banks and financial institutions. Their total resource mobilisation in 1999-2000 was nearly Rs. 22,000 crore, with 78 per cent of this having been mobilised by the private sector mutual funds.

3.5 The financial development in the banking and non-bank financial sector has supported saving and investment in the economy and contributed to growth in real activity. By pooling risks, reaping economies of scale and scope, and by providing maturity transformation, financial intermediation supports economic activity of the non-financial sectors. Its influence on growth, however, needs to be examined from different viewpoints that are of potential relevance in the Indian context. Before analysing the linkage between financial development and growth, it would be necessary to know as to how financial development is measured.

3.6 There are a number of indicators for measuring financial development of an economy. Most of them relate to the asset/liability aggregates of different financial institutions. For the purpose of easy understanding and comparability, all the asset/liability aggregates are presented as ratios to GDP at current market prices.

3.7 One of the basic indicators of financial development of an economy is the contribution of finance-related activities in real GDP, i.e., the contribution of banking and insurance in GDP. The share of real GDP originating from finance related activities experienced a steady increase from 2.2 per cent during the first half of the 'seventies to 4.7 per cent during 1993-94 to 1998-99 (Table 3.1). Within the services sector, the share of finance worked out to little over 11 per cent during the 'nineties.

3.8 It may be noted that the growth of GDP originating in finance was generally higher than that of GDP ever since the mid 'seventies (Chart III.1).³ The higher growth rate of GDP from finance in comparison to total GDP, to some extent, arose from the low base of GDP from finance.

3.9 The extent and process of evolution of financial development can be gauged from the flow of funds accounts of the Indian economy, which provides information on instrument-wise and sector-wise financial flows. The data in this regard are available up to 1995-96. The financial system intermediates part of a country's total investment through financial institutions, while firms, households and the government finance a part of the investment directly through their own savings. Financial intermediaries perform the important task of moving financial resources from the units in surpluses to those which are in deficit and need finance from other units for their investments. Financial development is, therefore, to some extent reflected in the inter-sectoral movements of funds. The flow of funds accounts for the Indian economy provide information on the following six sectors of the economy: households, corporates, government, banks, other financial institutions (OFIs) and the rest of the world (ROW). Of the six sectors of the economy, household is the only sector which is in consistent surplus, while government and corporates are the deficit sectors. The deficit sectors meet their requirements mainly from the households and occasionally, and to a smaller extent from the ROW. Funds can flow from surplus to deficit sectors either directly or through banks and OFIs as intermediaries. Thus, total sources of funds or the total issues can be segregated into two distinct parts, viz., primary issues (i.e., those funds which directly flow from surplus to deficit sectors) and secondary issues (i.e., those funds which flow through the financial intermediaries, viz., banks and OFIs). Total issues which amounted to Rs. 5,877 crore in 1970-71 rose to Rs. 4,34,308 crore in 1995-96 (Table 3.2). A more interesting feature emerges from the sectoral distribution of the total claims. While the share of primary issues had registered a steady decline from 60.3 per cent in 1970-71 to 57.6 per cent in 1990-91, per contra there had been an increase in the share of secondary issues. This is indicative of the process of intermediation in the economy. This trend continued during the 'nineties as well, with the exception of 1995-96. Almost the whole of the primary issues was in the form of domestic primary issues in most years under review.

3.10 The financial deepening and widening of India as well as the role of financial development in national income and capital formation may be also seen from the various financial development ratios that can be derived from the flow-of-funds data (Table 3.3). Most of the four commonly tracked ratios exhibited upward trend during the 'seventies and the 'eighties. In the 'nineties, however, there were moderate fluctuations in some of the ratios.

3.11 The finance ratio, as the ratio of total financial claims to national income, is an indicator of the rate of financial development in relation to economic growth. This ratio exhibited generally a steady increase over the period under consideration and reached 0.5 during 1993-94 to 1995-96.⁴ The financial inter-relations ratio (i.e., the ratio between total issues to net domestic capital formation) reflects the relation between the financial structure and real asset structure. Though the ratio exhibited year-to-year fluctuation, it has averaged around 2.4 since 1990-91. The new issue ratio (i.e., the ratio of primary issues to net domestic capital formation), on the other hand, which was at a high of 1.618 in 1991-92 declined to 1.161 in 1994-95, before increasing to 1.328 in 1995-96 (Table 3.3). This ratio is indicative of the extent of dependence of the non-financial sector on its own funds in financing the capital formation. A downward movement in the ratio (as seen during 1992-93 to 1995-96) would reflect the continued role of financial intermediation in capital formation. The importance of financial intermediation by banks and other financial institutions in financing activities is also reflected in the intermediation ratio (the ratio between the financial instruments issued by the financial institutions and the financial instruments issued by non-financial units). The intermediation ratio touched a high of 0.913 in 1994-95, but declined to 0.702 in the following year.

3.12 In addition to the broad based indicators of financial development, various monetary aggregates in relation to GDP are regarded as important proxies for measuring the extent of financial development. This is particularly relevant from the well-acclaimed view that examines the role of intermediation played by banks in economic development. This is primarily reflected in the aggregate deposit /GDP ratio and M₃/GDP ratio. In particular, M₃/ GDP ratio surpassed the 50 per cent mark during the 'nineties (Table 3.4). As far as credit components are concerned (i.e., both to the Government and to the commercial sector), there had been some tapering off during the 'nineties. However, substantial pressures on liquidity (and through it on the exchange markets) emanated from the surges in capital flows in the second half of the 'nineties that got reflected in accretion to net foreign exchange assets (NFAs) of the banking sector. NFA as a proportion of M₃ had moved up on an average from 9.0 per cent in the first half of the 'nineties to 16.4 per cent in the second half of the 'nineties.

3.13 The banking system in India consists of commercial banks and co-operative banks, but it is the former which is dominant in terms of deposits, advances and investments. Commercial banks include foreign banks operating in India in addition to Indian banks in the public sector and the private sector, including Regional Rural Banks. Since 1969, the commercial banks, after nationalisation of 14 banks, have made rapid strides in all the spheres of banking operations, be it the mobilisation of deposits, deployment of credit or geographical coverage, and have accounted for most of the growth in the banking system (Table 3.5). Illustratively, while the number of scheduled commercial banks has gone up moderately, the number of bank offices in India expanded nearly eight-fold from 8,262 in June 1969 to 67,339 in March 2000, as a result of which the population per bank office improved from 64,000 to 15,000 over the same period. Both per capita deposit and per capita credit have witnessed manifold growth. While per capita deposit expanded from a mere Rs.88 in 1969 to Rs.8,247 in 1999-2000, per capita credit, over the same period, expanded from Rs.68 to Rs.4,705; the increase in both these indicators was more pronounced since the latter half of the 'eighties.

Development Financial Institutions

3.14 Development financial institutions (DFIs) were established in India to resolve a typical market inadequacy problem, viz., the shortage of long-term resources and the perceived risk aversion of savers and creditors to part with funds for long gestation projects. In view of the inadequate provision of long-term finance through banks and/or markets, many of these institutions were set up by the Government. The endorsement of planned industrialisation at the national level provided the critical inducement for establishment of DFIs at both the all-India and state levels. Besides DFIs at the national and state levels, there are also investment institutions and specialised financial institutions.⁵ These institutions provided financial assistance in the form of term loans, underwriting/direct subscription to shares/debentures and guarantees. There has been a secular increase in the disbursements of financial institutions (Table 3.6). As a percentage of GDP, disbursements by financial institutions rose from as low as 0.5 per cent in the first-half of the 'seventies to 1.4 per cent in the first-half of the 'eighties. The ratio increased further to 2.9 per cent in the first-half of the 'nineties and stood at 3.3 per cent in the second-half of the 'nineties.

Mutual Funds

3.15 Mutual funds provide households an option for portfolio diversification an d relative risk-aversion through collection of funds from the households and mak e investments in the stock and debt markets. Resources mobilised by mutual funds (UTI was the only mututal fund until 1987-88) grew at a steady rate until 1992-93; since then they showed some variations. Resources mobilised by mutual funds which was just 0.04 per cent of GDP (at current market prices) during the period 1970-71 to 1974-75 increased to 1.59 per cent during 1990-91 to 1992-93. Total resources mobilised as proportion of GDP declined to 1.12 per cent by 1994-95 but nevertheless remaine d positive. During the period from 1995-96 to 1996-97, there was a net outflow of funds from mutual funds, especially UTI, as a result of which the ratio turned negative. From 1997-98 onwards, the ratio agai n turned positive and stood at 1.13 per cent during 1999-2000 (Table 3.7).⁶

Non-Banking Financial Companies

3.16 Non-banking financial companies (NBFCs) have emerged as an important part of the Indian financial system. These companies have grown rapidly in the second-half of the 'eighties and the first-half of the 'nineties. The regulated deposits of NBFCs increased from an average of 0.12 per cent of GDP during the period from 1970-71 to 1974-75 to 0.30 per cent during the period from 1985-86 to 1989-90 (Table 3.8).⁷ They witnessed a steady growth thereafter to 0.45 per cent of GDP during 1990-91 to 1992-93. During the period 1993-94 to 1996-97, they experienced a sharp rise from 2.02 per cent of GDP to 3.90 per cent. In recent years, however, deposits with NBFCs have witnessed a decline.⁸

3.17 The trend in the growth in total deposits with NBFCs as a percentage of aggregate deposits exhibited more or less similar trend, rising from a low of 0.71 per cent of bank deposits during the period from 1970-75 to 1.18 per cent during 1990-93. During the period from 1993-94 to 1996-97, deposits with NBFCs experienced a sharper rise from 5.02 per cent of commercial bank deposits to 9.47 per cent. Recent years have, however, witnessed relatively lower ratios. This could be attributed partly to the setting up of a strong regulatory and supervisory framework and partly to changes in the definition of deposits as indicated at footnote 8.

3.18 Financial development and growth has been a crucial subject of public policy for long. As early as in the 19^th century, a number of economists stressed the importance of financial development for the growth of an economy.⁹ The banking system was recognised to have important ramifications for the level and growth rate of national income via the identification and funding of productive investments. This, in turn, was expected to induce a more efficient allocation of capital and foster growth. A contrary view also prevailed at the same time suggesting that economic growth would create demand for financial services. This meant that financial development would follow growth more or less automatically. In other words, financial development could be considered as a by-product of economic development.

3.19 The issue of sources of finance gains importance in this context. The preferred modes of finance get to a substantial extent determined by the level of financial development, institutional practices, legal structures and other country-specific features. For instance, in the absence of a well-developed stock market, the traditional treatment about the availability of choice between banks and stock markets as providers of liquidity at the short-end and the long-end would be of limited relevance for countries. In certain other cases, the stock-markets might not be efficiently functioning and could create a wedge between the preferred financing hierarchy of the firms and the one that could support accelerated growth of corporate investment and output. If the markets are competitive, complete and well functioning, financing choices would be rendered irrelevant by the sheer efficiency of the markets. However, in practice, the instances of financial markets having developed and matured to such an efficient state are few and far between. As such, given the market imperfections, financial development becomes a crucial determinant of the growth, with links being provided through the processes of saving and investment as also the choices that economic units exercise between the alternate sources of financing investment.

3.20 It is important to note in this connection the several functions that a financial system is expected to perform. First, in the presence of informational asymmetries, financial markets could still develop in order to facilitate trading and hedging of risks. Risk mitigation and economising on information acquisition and processing reduce uncertainty and enable resources to flow towards most profitable projects. Such a situation would raise the efficiency of investments and the rate of growth. Secondly, by acting as an efficient conduit for allocating resources, the financial system enables an improvement in technical progress. Technological innovations take place when entrepreneurs exploit the best chances of successfully imitating technologies in their production processes and introducing new products. Over time, as skills develop, and as the economy experiments with adaptations of the existing technologies, and creates a base for research and development of new technologies, growth rates are likely to move upward. This is particularly valid in financial systems that are more effective at pooling the savings of individuals and permitting continuous upgradation of technologies for promoting growth on a sustained basis. Finally, to the extent that financial development leads to the creation of financial infrastructure and enables better and more efficient provision of goods and services, costs of transactions would be lower, with positive spillover on economic growth.

3.21 These possibilities may not be in evidence in many developing economies where distortions in the financial systems impact the growth process adversely and result in dead-weight loss. In a number of developing economies, interest rate ceilings, high reserve ratios and directed credit programmes are generally noticed. Such requirements though necessitated by the initial conditions, limit the degrees of freedom for the conduct of monetary and financial policies.

3.22 The recent growth literature, building on 'learning by doing' processes, assigns a special role to finance. Finance is seen as a crucial factor of production like knowledge and the influence of institutional arrangements in regard to finance on growth rates has often been forcefully emphasised. These models offer important insights on the impact of financial development on economic growth which are of relevance to the Indian context (Box III.1).

3.23 One of the basic channels of influence of financial development on growth is the saving rate. The primary mode through which this occurs is financial savings and in particular, intermediated financial savings. In fact, a distinction should be made between the determinants of the capacity to save and the willingness to save.¹⁰ While the capacity to save is dependent on the level and growth of per capita income, the willingness to save is influenced by a number of financial variables, such as, rate of interest and financial deepening. However, the effect of interest rate on saving in developing economies is not clear, partly because of the presence of either administered interest rates or some rigidities in the working of interest rate mechanism. After all, a change in interest rate could cause a variation in the portfolio composition of the household sector's saving without perceptible impact on the total quantum of saving. Financial deepening, on the other hand, is capable of increasing the total quantum of saving. The Indian saving experience during the period 1970-71 to 1998-99 was marked by a simultaneous secular increase in the rate of Gross Domestic Saving (GDS, as a percentage of GDP at current market prices) and the rise in the rate of financial saving of the household sector and private corporate sector (Table 3.9). During the 'nineties, household financial saving has emerged as the single most important contributor to GDS. The performance of the corporate sector improved during the 'nineties, while the public sector experienced a notable downturn in its saving performance. Given the fairly high public sector deficits in relation to GDP during the 'nineties, the public sector had to make a draft on household saving in general and household financial saving in particular. The implications of this development for growth and macroeconomic balance are important, both from the point of view of closing the potential output gap and promoting financial stability.

3.24 The criticality of financial saving is better appreciated from the structural composition of the GDS. Since the early 'nineties, there has been a downward drift in the share of physical saving, which had been partly compensated by the household sector financial saving. Within household sector financial saving, contrary to experiences of disintemediation in a number of developed economies, bank deposits turned out to be the most popular abode of saving. The share of net bank deposits (i.e., net of liabilities) increased from 9.8 per cent during 1985-86 to 1992-93 to 16.3 per cent during 1993-94 to 1998-99 (Table 3.10). This apart, contractual savings like those in Life Insurance Funds, and Provident and Pension Funds emerged as important financial assets in the household sector's portfolio. Contractual saving can raise the potential saving of the economy. In particular, it has the potential of activating the capital market and performing the role of social security (Box III.2).

3.25 While there is some evidence that financial development has led to improvement in the saving rate of the Indian economy, the question nevertheless remains as to how much of the increase in saving has got translated into higher growth. The answer to the question is rather mixed. There is some evidence of a unidirectional causality from growth to finance.¹¹ However, using more recent data it is found that there is a distinct feedback effect from saving to growth as well.¹² In other words, while higher growth may lead to higher saving, there is also a possibility of saving-induced growth in the Indian economy. Hence, the channel of impact from finance to saving and therefrom to growth could be the link behind the relationship between financial development and economic growth in India.

3.26 The role of stock markets as a source of economic growth has been widely debated. It is well recognised that stock markets influence economic activity through the creation of liquidity. Liquid financial market was an important enabling factor behind most of the early innovations that characterised the early phases of the Industrial Revolution. Recent advances in this area reveal that stock markets remain an important conduit for enhancing development. Many profitable investments necessitate a long-term commitment of capital, but investors might be reluctant to relinquish control of their savings for long periods. Liquid equity markets make investments less risky and more attractive. At the same time, companies enjoy permanent access to capital raised through equity issues. By facilitating longer-term and more profitable investments, liquid markets improve the allocation of capital and enhance the prospects for long-term economic growth. Furthermore, by making investments relatively less risky, stock market liquidity can also lead to more savings and investments.

3.27 Over the years, the stock market in India has become strong. The number of stock exchanges increased from 8 in 1971 to 9 in 1980 to 21 in 1993 and further to 23 as at end-March 2000. The number of listed companies also moved up over the same period from 1,599 to 2,265 and thereafter to 5,968 in 1990 and 9,871 in March 2000. The market capitalisation at BSE as a percentage of GDP at current market prices also improved considerably from around 28 per cent in the early 'nineties to over 45 per cent at the end of the 'nineties, after witnessing a fall in certain intervening years (Table 3.12). In 1998, India ranked twenty-first in the world in terms of market capitalisation, nineteenth in terms of total value traded and second in terms of number of listed domestic companies.¹³ Though the Indian stock market was founded more than a century ago, it remained quite dormant from independence in 1947 up to the early 'eighties, with a capitalisation ratio (market capitalisation to GDP) of only 4 per cent. However, the patterns of demand for capital have undergone significant changes during the last two decades and improved stock market activity. It may be recalled that till the 'nineties, institutional term-lending acted as the primary source of industrial finance in India. Financial institutions raised money through Government-guaranteed bonds at low rates of interest, which, in turn, lent funds at concessional rates of interest. This system provided corporates a cushion to absorb the relatively high risk of implementing new projects. This, in turn, discouraged the corporates to raise risk capital from equity markets. On this account, the debt market segment, which is sensitive to 'economic information' also remained underdeveloped and illiquid. With the onset of the reforms process in the 'nineties, institutions had to raise resources at market related rates. At the same time, the market has witnessed the introduction of several new customised bonds at maturities tailored to suit investor needs and with market-driven coupons. Along with this development, a number of measures were initiated to reform the stock markets, which helped to improve the overall activity in the stock market significantly. The turnover ratio increased from a low of 6.7 per cent at the beginning of the 'nineties, to reach 35.1 per cent in 1999-2000, excepting certain years of relative inactivity.

3.28 Over the years, the Indian capital market has experienced a significant structural transformation in that it now compares well with those in developed markets. This was deemed necessary because of the gradual opening of the economy and the need to promote transparency in alternative sources of financing.

The regulatory and supervisory structure has been overhauled with most of the powers for regulating the capital market having been vested with the Securities and Exchange Board of India (SEBI).

3.29 Banks have traditionally been the dominant entities of financial intermediation in India. This is reflected in the predominance in the share of banks in the aggregate financial assets of banks and financial institutions, taken together. The relative share of banks, which stood at nearly three-fourths in the early 'eighties, came down gradually over a period of time, and has hovered around the two-thirds mark since the 'nineties (Chart III.2). While this meant that financial institutions have gained in terms of shares in financial assets, it also implies that there is considerable potential for market financing to grow.

3.30 Given the predominance of bank-based finance in India, questions arise about the advantages and disadvantages of bank-based financial systems vis-à-vis (stock) market-based financial systems. The banking system avoids some of the information-deficiencies associated with the securities markets. Put differently, banks perform screening and monitoring functions on behalf of investors, which, left to themselves, can be undertaken only at a high cost. As a consequence, resource allocation and credit availability are considered to be superior under a bank-based as opposed to a market-based financial system. On the contrary, lower transaction costs in the absence of intermediation, may favour market-based sources of finance.

3.31 Experiences of the two most successful industrialised countries - Germany and Japan -reveal that the dominance of bank-based system has been the most successful financial vehicle for late industrialisation. While the institutional arrangements underlying bank-based systems vary, the basic contours are that banks establish long-term relationships with industrial companies, often reinforced by cross-holdings. For example, in Japan, banks had preferential access to transaction deposits of the firms, while the firms had secured access to loans from the banks, especially in situations of cyclical downturns. This ensured a steady supply of long-term finance to the firm, irrespective of the phase of cyclical fluctuation and built up a synergy between investment and growth. On the other hand, in countries, such as, the US and the UK, financial markets have played an important role in the development of these economies. A cross-country comparison reveals that both bank-based and market-based systems are in vogue (Box III.3).

A major shortcoming with existing comparisons of market-based versus bank-based financial systems is that they focus on a very narrow set of countries with similar levels of GDP per capita, so that the countries have very similar long-run growth rates. In order to statistically test this proposition, Demirgic-Kunt and Levine (1999), using a database of 150 countries, have attempted to illustrate the relationships between financial structure and economic development. The following illustrative list (Table 3.13), classifying countries according to the structure and the level of financial development exemplifies the point.

Thus, a comparison of financial systems across different income groups reveals several clear patterns. First, banks, other financial intermediaries and stock markets become larger, more active and more efficient as countries become richer. Thus, financial sector development tends to be greater at higher income levels. Secondly, an analysis of differences in financial structure across different income groups demonstrates that size measures of financial structure do not follow a clear pattern, as countries become richer.

3.32 A tentative measure of the significance of stock markets relative to the banking system is the ratio of market capitalisation to assets of scheduled commercial banks. During the 'seventies and the 'eighties, this ratio remained significantly low, with a high of 21.3 per cent in 1970 (Table 3.14).

3.33 With the establishment of the SEBI as an autonomous body for regulation and promotion of capital markets (with focus on simplification of issue procedures, enhancement in disclosure standards and greater investor protection), the role of stock markets has gained prominence. As a result, the relative importance of stock markets vis-à-vis banks has increased significantly in the 'nineties. The ratio of market capitalisation to assets of scheduled commercial banks which was 28.4 per cent in March 1991 increased sharply to 85.2 per cent in March 1996. It came down to 55.3 per cent in March 1999, only to increase to 79.3 per cent in March 2000.¹⁴

3.34 An important aspect of the process of financial development has been the role of the Government. In many developing economies the Governments traditionally played a significant role in fostering financial development. While in some cases this led to an administered interest rate regime, leading to market inefficiencies, Governments in many developing countries had to contend with financial markets that are characterised by significant informational asymmetries, moral hazard and adverse selection problems. For these reasons, a free-market equilibrium might not have the efficiency characteristics which are typically associated with market equilibria in the goods market. More importantly, the nascent accounting frameworks and inadequate legal mechanisms for redressal necessitate a role for the Government to remedy these imperfections.

3.35 The overarching concerns of the Government in fostering financial development have been in evidence as reflected in the regulations and administrative mechanisms that have been evolved in respect of credit and capital markets. Direct intervention was particularly highlighted with the nationalisation of 14 commercial banks in 1969. However, over time, the relationship between fiscal and financial institutions and banks have developed in a way that required prudential regulations and capital strengthening to be set in place. Predominant Government ownership of financial system also involved quasi-fiscal activities that added to the contingent liabilities of the government. However, the coexistence of government and private financial institutions and enhancement in private participation in the existing public sector financial institutions has afforded an opportunity to restructure the financial system, enhance competition, cut costs of intermediation, improve quality of customer services and ultimately support growth in an economy.

3.36 The extent to which fiscal factors could influence the financial system depends upon the existing fiscal position and the policy stance of the Government. Unlike in the 'seventies, the fiscal situation in India in the 'eighties was characterised by significant imbalances contributing to rising fiscal deficit and accumulation of debt. However, much of the debt was incurred on relatively low coupon rate basis. The maturity profile of debt also was somewhat long. The revenue account of the centre turned into deficit beginning 1979-80. The State Governments began to experience revenue gaps since 1987-88. The combined GFD/ GDP ratio of the Central and State Governments, which averaged 9.4 per cent during the five-year period ending 1989-90 and stood at 10.0 per cent in 1990-91, after declining to 6.4 per cent by 1996-97, reverted to 9.9 per cent by 1999-2000.

3.37 The combined debt/GDP ratio of Central and State Governments had touched a high of 61.7 per cent of GDP in 1990-91. Since then, there has been some progress in reducing debt ratios, albeit, marked by a regress in 1999-2000 on account of exogenous factors. On the expenditure side, the total expenditure of central and state governments which averaged 27.3 per cent of GDP in the first half of the 'eighties and 30.1 per cent of GDP in the second half of the 'eighties, declined to 25.2 per cent of GDP in the 1996-97 with rationalisation of expenditure. Although this ratio increased to 28.5 per cent of GDP in 1999-2000, there was an overall containment of expenditure in recent years, brought about mainly by cuts in capital expenditures and rise in interest payments (Table 3.15). However, the development of the Government securities market and introduction of innovative Government debt instruments was rendered possible as a matter of deliberate policy action on the part of the Government.

3.38 The saving-investment gap for the public sector had risen to 8.7 per cent of GDP in 1990-91 and reflected a large draft on household savings. Some improvement followed as the public sector savings averaged 1.8 per cent during 1996-97 to 1998-99. The gap was reduced to 5.3 per cent in 1996-97 and was sustained at this rate, mainly on account of reductions, albeit moderate, in the rate of capital formation. However, in 1998-99, public sector saving dipped significantly due mainly to large deficit of administrative departments. The continuance of domestic saving-investment gap of such a magnitude contributes to macroeconomic imbalances, places pressure on domestic interest rates and creates uncertainty in pursuing the objectives of financial sector strengthening and stability.

3.39 The growth of the gilt market, with the help of Government intervention, has facilitated financial growth by providing (i) possible benchmark interest rates to the markets, (ii) instruments with a wide array of maturity to the market players to enable them to tailor their asset-liability management, and (iii) tools for monetary management in the form of open market operations in Government securities. The development of the gilt market in the 'nineties has led to increasing integration of various market segments with benchmark interest rates increasingly emerging in short term securities, such as, the 91-day Treasury bills. What is interesting is that in the recent period, the call money rate has shown modest co-movement with the 91-day Treasury bill yield.

3.40 The relationship between finance and growth, as noted earlier, could have manifold forms a priori. Finance may influence growth and growth may drive finance. There could be positive feedback between them, or they could even be independent as well. The available cross-country evidence on the relationship provides interesting empirical patterns (Box III.4).

3.41 While cross-country evidence is useful, an assessment of the relationship in the case of any one country would be relatively difficult, especially when the country in question is undergoing structural transformation. Furthermore, mere correlations between various indicators of finance and economic progress may not be of much use because of the strong time trend inherent in both these sets of indicators. Any contemporaneous correlation between indicators of financial development and growth of an economy should, therefore, be interpreted with caution. While finance is one of the ingredients of growth, it is not the only one. In fact, in the absence of complementary inputs like the formation of human capital, the knowledge-based technological innovations and macroeconomic stability, growth may not be sustained even with a liberal supply of finance.

3.42 Notwithstanding the above qualifications, it is of interest to look into the relationship between finance and growth in isolation and examine the causality pattern between the relevant indicators. If the economic progress is measured by rate of growth of real GDP and rate of expansion of real broad money is taken as an indicator of financial development, then there is evidence of a two-way causality between them. This is done through a bivariate Vector AutoRegression (VAR) model with real GDP growth and real M₃ growth (deflated by GDP deflator) over the period 1971-72 through 1999-2000. It has been found that while the F-statistic value for deleting lagged values of real M₃ growth in the real GDP growth equation is significant at 10 per cent, the same for deleting lagged values of GDP growth in the real M₃ growth equation is significant at 5 per cent level (Table 3.16). These results would indicate a two-way causality between finance and growth. Similar results are also obtained between GDP growth and growth of real bank claims (i.e., total of commercial and co-operative banks' credit to commercial sector and their investment in Government securities deflated by GDP deflator). The F-statistic values for deleting lagged values of growth of real bank claims in the real per capita GDP growth equation are also significant at 5 per cent and the same for deleting lagged values of GDP growth in the growth of real bank claims equation are significant at 10 per cent level, indicating a bi-directional causality between finance and growth.¹⁵

7. Shaw, G.S., (1973), Financial Deepening in Economic Development, New York, Oxford University Press.

3.43 These causality results are, however, reduced-form evidence. In the absence of any structural model, the finding that finance and growth have bi-directional relationship between them may have to be interpreted only in terms of predictive content of each of the variables. That is to say, in the Indian case, past values of financial development seem to have good predictive content about future economic growth. Similarly, past values of growth are likely to have information about future financial development. But it must be noted that the evidence of a symbiotic relationship between financial development and growth in India is in line with the experience of a number of developing economies, where finance and growth have been found to have a close association.

3.44 In appreciating the nature of relationship between finance and growth in India, it should be noted that financial development in India has been by and large a state-induced activity. Thus, starting with bank nationalisation to various stipulations on bank lending with emphasis on 'social banking', the very thrust of financial development was consciously to encourage growth via availability of adequate credit at reasonable (at times concessional) rates of interest to areas where commercial considerations may not allow for imminent disbursal of credit. Sharp bank branch expansion strategy turned out to be successful in increasing the scale of lending, since banks could raise necessary deposit resources. Availability of finance encouraged growth, and over time, growth, in turn, facilitated financial development. This virtuous circle between growth and finance seemed to have borne fruit in India, essentially to satisfy the need for diversification of financial assets holdings as the size of holdings has gone up. For this reason, it is important to track the indicators of stock market-based financial development in the primary market as well as the secondary market. As growth rate improves and is sustained, the new capital issue market is expected to gain importance. In this case, therefore a priori it could be expected that the direction of causation would run from growth to finance. However, the effect would be felt with long lags, with possible bunching effects corresponding to upswings in the phases of activity. The channels of influence between secondary market activity and growth would be largely guided by the extent of liquidity in the system. Towards this end, using higher frequency data, the causality pattern between stock-market capitalisation and GDP growth for the second half of the 'nineties (April 1995 through March 2000) has been examined. Using deseasonalised data for stock market capitalisation and wholesale price index for manufactured products (1993-94 = 100), an index of stock market capitalisation in real terms has been constructed. Taking the deseasonalised index of industrial production - manufacturing (1993-94 = 100) as a measure of activity variable, a bivariate VAR model was constructed between annualised growth rates of market capitalisation (in real terms) and industrial production for April 1995 though March 2000. It has been found that while the lagged values of industrial growth are insignificant in the equation for growth in market capitalisation (in real terms), the lagged values of growth in market capitalisation are significant in the equation for industrial growth. In other words, there is a unidirectional causality from market-based financial development to industrial growth. While market-based sources of finance have high predictive power for explaining growth, past growth need not be an indicator of future availability of finance in the capital market. This has important policy implications for the economic relationships that the stock market supports. A case can be made for the provision of adequate liquidity in the context of the growth-inducing macroeconomic and structural management of the economy.