Flow of Funds Accounts of the Indian Economy: 2008-09 and 2009-10^*

This article presents the Flow of Funds accounts for the two fiscal years, 2008-09 and 2009-10, along with revised/updated data for 2007-08. Over this period the Indian economy slowed down from a high growth rate of over 9 per cent to 6.7 per cent during 2008-09 even as financial markets came under pressure under the indirect effects of the global financial crisis. Coordinated fiscalmonetary policy actions facilitated a quick recovery to a growth rate of 8.4 per cent in 2009-10. Reflecting these developments, aggregate financial claims issued by all the sectors, as a ratio to national income, declined from an average of around 59 per cent during 2003-04 to 2007-08 to 53 per cent in 2008-09 but recovered to around 65 per cent in 2009-10. The decline in the total financial claims issued in 2008-09 was primarily reflected in the private corporate business sector followed by the rest of the world sector and other financial institutions sector. Claims issued by the banking sector declined during 2008-09 and 2009-10, mainly reflecting the unwinding of Market Stabilisation Scheme balances. The resource gap of the private corporate sector narrowed in 2008-09 as investment declined more than savings. As a consequence of fiscal stimulus measures, the net savings of the public sector turned into dis-savings in 2008-09 which deteriorated further in 2009-10. The household sector remained the financial surplus sector. Household financial savings (net of depreciation) declined from 12.9 per cent in 2007-08 to 11.3 per cent during 2008-09 but recovered substantially to 14.5 per cent in 2009-10. The shares of bank deposits and Government securities in total financial claims issued by all the sectors increased while that of non-Government securities (including Mutual Funds) declined during 2008-09 against the backdrop of financial market uncertainty. In 2009-10, the share of non- Government securities in total financial claims improved significantly. The finance ratio, the financial interrelations ratio and the new issues ratio, declined in 2008- 09 but recovered in 2009-10 to somewhat above trend. The movement in these ratios showed that the pace of financial deepening which slowed down in 2008-09 had largely recovered in 2009-10.

I. Introduction

The Flow of Funds (FOF) accounts show the transactions in financial instruments between the major sectors of the economy on a ‘from whom-towhom basis’. In the extant system of compilation of the FOF accounts, the Indian economy is divided into six major sectors – Banking, Other Financial Institutions (OFI), Private Corporate Business (PCB), Government, Rest of the World (ROW) and Households. The transactions between sectors are also classified under nine major categories of financial instruments viz., currency and deposits, investments, loans and advances, small savings, life fund, provident fund, trade debt, foreign claims not elsewhere classified (NEC) and other claims NEC.

A few conceptual and methodological issues relating to the Flow of Funds that are pertinent for the subsequent analysis in this article, are set out in Box 1.

This article presents the FOF accounts for the years 2008-09 and 2009-10 along with revised/updated data for 2007-08. The real and financial sectors of the Indian economy witnessed rapid and contrasting changes over this period. Underlying these changes were the indirect effects of the global financial crisis, as a consequence of which, the growth rate of the Indian economy slackened to 6.7 per cent in 2008-09 from over 9 per cent in each of the previous three years even as domestic financial markets came under pressure. The policy response to the crisis took the form of coordinated fiscal, monetary and debt management operations beginning mid-September 2008. With the growth rate picking up smartly to 8.4 per cent in 2009- 10 and financial markets remaining orderly, a calibrated exit from the accommodative monetary policy stance began in October 2009 in the face of incipient inflationary pressures. Evidently, these developments were reflected in the changes in the resource gaps as well as the flow of funds across the different sectors of the Indian economy viz., banking, other financial institutions (including non-bank financial companies and mutual funds), private corporate business, Government, households and rest of the world, as subsequent analysis would show.

Box 1
Some Conceptual and Methodological Issues Relating to Flow of Funds

Conceptually, the Flow of Funds Accounts and the National Accounts of an economy are intrinsically related. The gap between the real investment (capital formation) and the savings of a sector, as given by the National Accounts, corresponds to the difference between the changes in the financial liabilities and financial assets of that sector, as given by the Flow of Funds accounts. In other words, if the real investment by a sector is more than its savings, it would imply that this sector, on the whole, borrows financial resources from other sectors (or increases its net financial liabilities) to fund its real resource gap. On the other hand, if real investment is less than the savings of a sector, it would imply that this sector, on the whole, provides financial resources to other (deficit) sectors (or increases its net financial assets). Thus, the Flow of Funds Accounts show the sectoral and instrument-wise pattern of financing/investing the shortfall/ surpluses of savings over real investment.

In the Flow of Funds accounts, the sources (i.e. change in financial liabilities) and uses of financial funds (i.e. change in financial assets) are shown separately for each sector. The financial transactions in respect of the Rest of the World (ROW) sector in the Flow of Funds accounts are, in contrast to those of the other sectors, reported from the standpoint of that sector (and not of the ‘domestic’ economy, as in the case of the Balance of Payments). Therefore, the credits and debits in the Balance of Payments are treated conversely in the Flow of Funds Accounts. Moreover, as per the extant format, the sources of funds in the ROW sector in the Flow of Funds correspond to the financial flows towards that sector, and reflect (a) an increase in financial liabilities and (b) a reduction in/liquidation of financial assets. Similarly, uses of funds by the ROW sector in the Flow of Funds accounts correspond to financial flows away from that sector and reflect (a) an increase in financial assets and (b) a decline in financial liabilities (say, through repayment of loans) (Please see Statement 5). As such, the financial claims of the ROW sector in the Flow of Funds accounts (as shown in Table 2, for instance) are obtained by netting the decline in financial liabilities (under uses of funds) from the increase in financial liabilities (under sources of funds). This is in contrast to the other sectors in the Flow of Funds accounts in which their respective financial claims correspond directly to their total sources of funds.

The difference between the sources and uses of funds of all the ‘domestic’ sectors (i.e. other than the ROW sector) corresponds to their saving-real investment gaps. As such, the sum of the saving-real investment gaps of the ‘domestic’ sectors is the current account deficit/surplus in the Balance of Payments, which is the standard macroeconomic identity. In the Flow of Funds accounts, the difference between the sources and uses of funds of the ROW sector corresponds to the current account balance in the Balance of Payments, but with the opposite sign since financial transactions of the ROW sector are, as indicated earlier, shown from the standpoint of the latter sector.

Three specific issues relating to the compilation of National Accounts and Flow of Funds Accounts in India may be highlighted. First, for the purposes of compiling data on savings and investment as part of the National Accounts, the Central Statistics Office classifies the Indian economy into the private corporate, public and household sectors, with banking and other financial institutions subsumed under the private corporate sector and the public sector, depending upon the nature of their ownership. This is in contrast to the classification of the economy adopted under the Flow of Funds accounts under which banking and other financial institutions are shown as separate sectors (irrespective of their ownership) and the private sector actually refers to the private corporate business sector. Consequently, data on savings and investment of the banking and other financial institutions sectors are not separately available from the National Accounts. The definition/coverage of the ROW sector and the household sector is, however, the same in National Accounts and Flow of Funds. Secondly, quite apart from the afore-mentioned differences in sectoral classification, the saving-investment gap, as obtained from the National Accounts, could vary from the financial surplus/deficit (i.e. the difference between the change in financial assets and the change in financial liabilities), as obtained from the Flow of Funds accounts, owing to, inter-alia, different sources of compiling the data. Thirdly, the National Accounts show investment in valuables (gold, silver, etc) – which has increased significantly in recent years – as a separate category under investment (capital formation) and do not provide its allocation across the private corporate, public and the household sectors. Consequently, in order to obtain the saving-investment gap for the economy as a whole, investment in valuables is added to the sum of the savinginvestment gaps of the private corporate, public and the household sectors, which, after adjusting for errors and omissions, reflects the balance in the current account of the balance of payments (rest of the world sector), as shown in Table 1.

It may be also mentioned that, drawing upon some of the recommendations of the High Level Committee on Estimation of Saving and Investment (Chairman: Dr. C. Rangarajan), a few changes in the methodology of compilation of the FOF accounts have been effected in respect of the years under review. Consequently, the FOF accounts for these years may not be strictly comparable with the accounts published earlier. The changes in the compilation methodology and some of the assumptions made in the compilation pertain mainly to the insurance sector and the cooperative sector. In the case of the insurance sector, thus far, the information that was received from the responding insurance companies were blown-up using the ratio of global/population paid-up capital to the sample paid-up capital, in order to generate the flows for the entire sector. In the current estimates, the balance sheet information of all insurance companies as provided by the Insurance Regulatory and Development Authority (IRDA) has been used. Secondly, data on flows relating to some of the cooperative banks were received from NABARD which were used to supplement the estimates based on the Statistical Statement Relating to Cooperative Movement in India released by NABARD. Earlier, the flows relating to the cooperative banks were entirely estimated/extrapolated based on the Statistical Statement issued by NABARD, which continues to be dated.

Finally, a Working Group on Flow of Funds (Chairman: Shri D.K. Mohanty, Executive Director, RBI) which has been constituted by the RBI, is examining a gamut of compilation issues keeping in view the evolving financial sector developments as well as the international experience. The Working Group is expected to submit the Report shortly.

The article is organised as follows: Section II begins with a summary of the channels through which the global financial crisis and the policy response impacted the Indian economy. It then provides an overview of the changes in the saving-investment (or resource) gaps as well as the net financial claims issued by the different sectors to finance these gaps over the three years before proceeding to a more detailed sectoral analysis. Section III discusses the instrumentwise financial flows. Select indicators of financial development estimated from flow of funds are analysed in Section IV. Section V sums up the findings of the article. Statements 1 to 6 present the instrumentwise FOF accounts for each of the sectors. The annual inter-sectoral flows are summarised in Statement 7. Instrument-wise financial flows are summarised for each year separately in Statement 8.

II. Sectoral Trends in Flow of Funds

As prelude to the flow of funds analysis, the underlying mechanics of the impact of the global financial crisis and the policy response during 2008-09 and 2009-10 are briefly recapitulated below. The global financial crisis has, in fact, reignited the interest in using the flow of funds framework to distil the impact of monetary policy on the financial decisions of different sectors of the economy. Most of such studies have, however, been conducted in the context of advanced economies where flow of funds data are compiled at quarterly frequency (Box 2).

Box 2
Analysis of Monetary Policy Transmission in a Flow of Funds Framework

The flow of funds framework provides a useful analytical basis to study monetary policy transmission mechanism. In this context, empirical studies have usually assessed the impact of a monetary policy shock on the net funds raised/lent by different sectors of the economy in a VAR model using quarterly flow of funds data. A snapshot of some of the studies in this regard is provided here.

A seminal paper by Christiano et al (1996) in the case of the US economy found that following a contractionary monetary policy shock, net funds raised by the private corporate sector increased for around one year. Subsequently, the slowdown in growth induced by the tightening of the monetary policy stance caused the net funds raised by the private corporate sector to decline. The initial increase in the net funds raised was attributed to rigidities/frictions (say, on account of contracts) in adjusting nominal expenditures by the firms even as cash flows decline as a result of falling sales and increase in inventories. On the other hand, net funds raised by the household sector was found to remain unchanged (immediately) after a contractionary monetary policy shock; this reflected the nuances of ‘a limited participation model’ which generally assumes that the ability of households to adjust their financial portfolios is limited i.e. households are assumed to make their financial decisions before they can observe current (monetary policy) shocks. Government borrowings, however declined, albeit by a small amount, after a contractionary monetary policy shock. This counterintuitive result was attributed to the increase in personal income taxes, net of transfers (although the reason for the increase in personal income tax receipts was not very clear).

Bonci and Columba (2008) in their study on Italy, however, found results different from that of Christiano et al (1996): following a contractionary monetary policy shock, they found (i) no evidence of nominal expenditure rigidities in respect of private firms; (ii) households do adjust their financial portfolios relatively quickly; and (iii) public sector borrowings increased largely as a result of automatic stabilisers and the lower tax receipts following the growth slowdown on account of the monetary policy stance.

Bonci’s study (2011) on the Euro area, also found results similar to that in Italy and different from that in the US. A monetary policy shock was found to have a negligible effect on the net funds raised by firms as these reduced their acquisition of financial assets and/or drew on their own liquidity and inter-company loans, as bank loans become costlier. According to the study, absence of significant rigidities in nominal expenditures of firms in the Euro area, in contrast to that in the US, was attributable to the size of the firms: the larger average size of the firms in the US enabled to them to raise debt more easily in the face of deteriorating business conditions after a monetary policy shock. Households were found to reduce the issuance of new financial liabilities quickly after a monetary policy shock, which enabled them to increase their net lending to other sectors. Two years after the shock, households were found to increase net borrowings as private consumption recovered. Credit (net loans) from banks to households and firms were found to decline after a monetary policy shock. Loans from non-bank sectors (especially to households) were found to increase after the monetary policy shock, attributable to say, availability of pre-committed credit lines (at the pre-shock lower rate), at least in the short run.

Gamerio and Sousa’s study (2010) on Portugal found that, in response to a contractionary monetary policy shock, net funds raised by non-financial corporations as well as households increased. The finding in respect of the non-financial sector which was similar to that of the US and different from that of Italy and the Euro area, was indicative of the constraints imposed by extant contracts that prevented the firms from immediately adjusting their level of inventories. The increase in the net funds raised by the household sector largely reflected consumption smoothing behavior.

In the Indian context, Flow of Funds data are compiled only on annual basis. One of the earlier studies using flow of funds data in a macro model was by K. Sen et al (1996) but this related to the pre-reform period 1970 to 1989. They found, inter-alia, that there was little portfolio adjustment by households and commercial banks in response to changes in interest rates but that increases in the rate of return on household assets, and a reduction in the government’s access to household savings, had a clear positive impact on investment and output in the short run. Moore and Green (2008) analysed the flow of funds and portfolio behaviour of Indian banks from 1951 to 1994 (again, largely in the pre-reform period) in an Almost Ideal Demand System (AIDS) framework. They found that an increase in the CRR increases the banks’ demands for all assets except loans, as the banks expect further increases in CRR. Furthermore, the main impact of liberalisation was to increase bank holdings of government debt and loans at the expense of excess reserves and company securities (which includes the debt of public sector financial institutions).

References:

1. Bonci R (2011), ‘Monetary Policy and the Flow of Funds in the Euro Area’, Eurpena Central Working Paper No.1402, December

2. Bonci R and F. Columba (2008), ‘Monetary Policy Effects: New Evidence from the Italian Flow of Funds’, Applied Economics, Vol.40.

3. Christiano L.J; M. Eichenbaum and C. Evans (1996), ‘The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds’, The Review of Economics and Statistics, Vol.78(1), February.

4. Gameiro I.M. and J. Sousa (2010), ‘Monetary Policy Effects on the Flow of Funds of Non-Financial Corporations and Households in Portugal’, Banco de Portugal Economic Bulletin, Summer.

5. Moore T and C.J. Green (2008), ‘Flow of Funds and the Impact of Financial Controls on Bank Portfolio Behaviour: A Study of India’, The European Journal of Finance, Vol.14(7), October.

6. Sen K, T. Roy, R. Krishnan and A. Mundlay (1996), ‘A Flow of Funds Model for India and Its Implications’, Journal of Policy Modelling, Vol.18(5).

Impact of the Global Financial Crisis and the Policy Response on Flow of Funds – A Brief Snapshot

The contagion of the global financial crisis spread to India through the financial, real and confidence channels. The adverse impact of the slump in global demand on India’s trade sector reflected the real channel. Notwithstanding the absence of direct exposure of Indian banks and financial institutions to the failing international institutions or troubled assets, the finance channel operated in two ways viz., (i) as a result of the drying up of global liquidity, Indian nonfinancial corporates shifted their demand for funds to the domestic banking sector. The corporates also started withdrawing their investments in domestic money market mutual funds which, in turn, adversely impacted their (substantial) investment in non-bank financial companies, causing the latter institutions to come under redemption pressure; and (ii) the reversal of capital inflows – partly reflected in the sell-off in the equity market by Foreign Institutional Investors (FIIs) – and the conversion of domestic funds into foreign currency by corporates to meet their external obligations, put downward pressure on the Rupee. Responding to contain the undue volatility in the Rupee, the RBI’s forex market operations, further siphoned off domestic liquidity. The third channel – the confidence channel – operated through the spread of general and heightened risk aversion in the financial markets and the banking system which impacted lending activities.

As a response to the financial crisis, the monetary policy stance changed track and turned accommodative in the second half of 2008-09 which was reflected in the steep reduction in the Cash Reserve Ratio (CRR) and the Liquidity Adjustment Facility (LAF) interest rates. Some unconventional measures were also launched such as an exclusive refinance window as also a special purpose vehicle for supporting non-banking financial companies, and expanding the lendable resources available to apex finance institutions for refinancing credit extended to small industries, housing and exports. A fiscal stimulus programme to revive the economy was also set in motion which resulted in a sharp increase in the overall borrowings of the government. In order to manage the government borrowing programme in a non-disruptive manner, an auction-based Open Market Operations (OMO) programme was launched in February 2009. Unwinding of the sequestered Government balances in the Market Stabilisation Scheme (MSS) account with the RBI through redemptions and buy-backs of Government securities as well as transfer of funds to the normal Government cash account with the RBI, also helped to buttress domestic liquidity and maintain orderly conditions in the financial markets. As growth began reviving and inflation started taking root, a calibrated exit from the accommodative monetary policy stance began in October 2009, with the termination of most of the unconventional monetary policy measures, and subsequently with increases in the CRR and LAF interest rates. Fiscal policy, however, remained generally accommodative in 2009-10, as reflected in further increases in the fiscal and primary deficits of the Central Government vis-a-vis the previous year.

Evolution of Saving-Investment Gaps of Different Sectors

Evidently, macroeconomic and financial developments impacted not only on the savings and investment (capital formation) of the different sectors of the economy, and thus, on their resource gaps/ surpluses (as obtained from the National Accounts), but also on the pattern of financing these resource gaps or the deployment of surpluses in financial assets (as reflected in the Flow of Funds accounts).

Reflecting the impact of the global financial crisis, the private corporate sector’s saving-investment gap, as a ratio to national income, halved in 2008-09 owing to a sharper decline in net investment than net savings (Table 1). In contrast, the saving-investment gap of the public sector more than doubled in 2008-09 largely reflecting the impact of fiscal stimulus measures which turned the net savings of that sector in 2007-08 into dis-savings in the following year. The household sector surplus declined in 2008-09 , largely resulting from the adverse impact of macroeconomic conditions on financial saving, even as saving in physical assets increased sharply. The decline in household surplus and the sharp increase in the resource gap of the public sector more than offset the decline in the resource gap of the private corporate sector. Taking into account investment in valuables, and adjusting for errors and omissions, the saving-investment gap of the economy or in other words, the current account deficit, thus, increased during 2008-09.

In 2009-10, the saving-investment gap of the private corporate sector increased as investment pickedup faster than saving, with the policy induced improvement in macroeconomic conditions. The resource gap of the public sector increased further, reflecting the continuance of fiscal stimulus measures. The household sector surplus increased significantly largely reflecting additional savings under life insurance. The increase in household surplus more than offset the increase in the resource gaps of the private corporate and public sectors. However, taking into account the acceleration in investment in valuables, and adjusting for errors and omissions, the overall resource gap of the economy or the current account deficit widened further in 2009-10.

An Overview of the Flow of Funds across the Sectors

Reflecting the general slowdown, the pressure on domestic liquidity, capital outflows and the generalised risk aversion wrought by the global financial crisis, the aggregate funds raised by all the sectors (i.e. their total financial claims) declined sharply by around 29 per cent in 2008-09 (Table 2). As a ratio to net national income at current prices, total financial claims issued by all the sectors declined significantly from 86.2 per cent in 2007-08 to 53.0 per cent in 2008-09. With the revival of growth and normalisation of financial conditions, facilitated by coordinated policy actions, aggregate funds raised by all the sectors, however, picked up to around 65.0 per cent of net national income in 2009-10, and was placed even higher than the average of around 59.0 per cent during the five-year period 2003-04 to 2007-08.

The decline in the total financial claims issued in 2008-09 was primarily reflected in the private corporate sector followed by the ROW sector and other financial institutions sector. The decline in the financial claims of the ROW sector largely mirrored the depletion of the foreign exchange assets of the RBI as part of its forex market operations during 2008-09. The claims of the banking and household sectors also declined in 2008-09 but that of the government sector increased, reflecting the increase in overall borrowings necessitated by the fiscal stimulus measures. Even so, the share of the banking sector in total claims issued in the economy increased to around 34 per cent in 2008-09, above the average of around 28 per cent during 2003-04 to 2007-08.

In 2009-10, while claims issued by the private corporate sector, the other financial institutions sector and the ROW sector recovered substantially, claims issued by the government sector declined somewhat even as the fiscal stimulus programme continued. Claims issued by the banking sector, on the other hand, declined further. Compared to the five-year (2003-04 to 2007-08) average, the composition of total claims issued during 2009-10 showed that while the shares of private corporate business and other financial institutions had increased substantially that of the ROW sector continued to remain much lower. Moreover, the share of the claims issued by the government sector in 2009- 10 remained somewhat below the five-year average, that of the banking sector slipped well below the average. Against this backdrop, the sector-wise changes in the flow of funds are discussed next.

Private Corporate Business Sector

The net savings of the private corporate business (PCB) sector which had increased sharply and persistently since 2004-05, declined in 2008-09 as the growth slowdown and subdued financial market conditions impacted sales and profitability (Table 1). Likewise, investment of the PCB sector also declined in 2008-09, but more sharply than net savings. Consequently, the overall resource gap declined during 2008-09, and this was broadly reflected across the sources of funds from the different sectors (Table 3). The reduction in the funding by the banking sector mirrored the slackening of non-food bank credit as well as the substantial build-up of fixed deposits of the PCB sector with the banks, in the context of financial market uncertainties and the sluggish investment environment during 2008-09. Strained financial market conditions also had an enervating impact on the flow of funds between the PCB sector and other financial institutions. While the PCB sector withdrew its financial investments in other financial institutions (such as money market mutual funds), other financial institutions reduced their shares (as part of the paid-up capital) in private nonfinancial companies, apart from reducing their lending to this sector. On net basis, therefore, funding by other financial institutions declined over the previous year. Similarly, foreign investment and foreign currency loans towards the PCB sector declined sharply during 2008-09. With the improvement in the macroeconomic environment in 2009-10, net savings of the private corporate sector increased and, in fact, exceeded the level of 2007-08 in absolute terms. Investment also recovered substantially – even though it remained lower than that in 2007-08 – causing the resource gap to widen. Significant changes were evident in the financing of the resource gap. Net funding from the banking system in absolute terms increased substantially largely on account of the slower pace of bank deposit build-up by the PCB sector during 2009-10, even as the growth rate of non-food bank credit remained more or less unchanged over the year. Furthermore, with the turnaround in the finances of other financial institutions such as mutual funds and insurance companies, these institutions increased their lending as well as contributions towards the paid-up capital of the PCB sector. At the same time, the PCB sector enhanced their financial investment in other financial institutions. Consequently, on net basis, funding by other financial institutions in absolute terms did not show much change over the previous year. Foreign investment in the PCB sector recovered substantially in 2009-10 as macroeconomic conditions improved.

Government Sector

With the Government final consumption (nominal) expenditure increasing sharply in 2008-09 (19.9 per cent) and 2009-10 (25.8 per cent) on account of the Sixth Pay Commission arrears and fiscal stimulus measures and tax revenues adversely impacted by the growth slowdown, the Government net savings in 2007-08 turned into dis-savings in 2008-09 which exacerbated in 2009-10 (Table 1). Public sector investment was also stepped up during 2008-09 as part of the stimulus programme which led to an increase in the resource gap. In 2008-09, both the banking and the OFI sector enhanced their financing of the Government sector in absolute terms reflecting their preference for low-risk investment avenues (Table 4). In 2009-10, while the financial deficit of the government sector increased somewhat over the previous year, net funds raised from the banking and OFI sectors declined. On the other hand, funding by the household sector increased sharply reflecting the turnaround in Government provident funds and small savings collections.

Rest of the World Sector

The net financial claims (increase in liabilities minus decrease in liabilities) issued by the ROW sector declined sharply from around `3,738 billion in 2007-08 to around `272 billion in 2008-09, which reflected the reduction in RBI’s holdings of foreign currency assets as part of its market operations to stem the excessive volatility in the exchange rate (Table 2 and Statement 5). Largely mirroring – rather the impetus for – the changes on the liabilities side, the net financial assets of the ROW (increase in assets minus decrease in assets) which had declined substantially in 2008-09 on account of a reduction in foreign investment and foreign currency loans to the private corporate business sector, recovered to some extent in 2009-10. As alluded to earlier, the share of net financial claims of the ROW sector in total financial claims in 2009-10 remained lower at 5.6 per cent as compared with 10.1 per cent, on average, during 2003- 04 to 2007-08 when the domestic economy had witnessed a surge in capital inflows.

Household sector

The household sector in India has always been a surplus sector (net lender) with the banking sector generally receiving most of the surplus funds followed by the OFI sector (Table 5). The financial surplus of the household sector declined in 2008-09 but recovered substantially in 2009-10. While the share of the banking sector in the total surplus of the household sector increased that of the OFI sector declined in 2008-09 largely reflecting the household preference for bank deposits given the uncertain financial environment and the slackening of life insurance premium and redemptions of mutual funds. With the improvement in the macroeconomic environment and the turnaround in life insurance premium, small savings and provident fund collections in 2009-10, the shares of other financial institutions and the Government sector in the household surplus improved significantly. Even so, the share of the Government sector in household sector financial surplus in 2009-10 remained much lower and those of the banking and other financial institution sectors were placed higher than their average respective shares during 2003-04 to 2007-08.

Banking Sector

The reduction in the total claims issued by the banking sector during 2008-09 mainly reflected (a) the decline in deposits of the Government sector with the RBI and (b) decline in overseas borrowings by commercial banks (Statements 1, 1.1 and 1.2). The decline in Government deposits with the RBI was primarily on account of the injection of liquidity in the domestic market through the unwinding of MSS balances in the Government account. The reduction in Government balances with the RBI partly offset the sharp increase in ‘other liabilities’. At the same time, deposits flows of commercial banks picked up during the year as the net outflow of deposits of the OFI sector (mainly Provident Funds and Mutual Funds) was more than made up by the sharp increase in deposits of the PCB sector, reflecting the slack in their investment activities.

In 2009-10, the aggregate financial claims issued by the banking sector declined further despite a sharp increase in borrowings and substantial issuance of Certificates of Deposits (CDs) by scheduled commercial banks. The CDs were largely subscribed by mutual funds. A circular flow of funds between banks and mutual funds was, in fact, manifest in the substantial investment of banks in the liquid/short-term debt schemes of mutual funds and the provision of funds by mutual funds to banks through the Collateralised Borrowing and Lending Obligation (CBLO) and market repo routes as well as via investment in CDs.¹

The reduction in financial claims of the banking sector in 2009-10 was, nevertheless, largely due to (a) the sharp decline in RBI’s other liabilities (net); (b) further unwinding of MSS balances and (c) further reduction in foreign currency borrowings by commercial banks.

Other Financial Institutions (OFI) Sector

Total financial claims issued by the OFI sector declined substantially in 2008-09 mainly due to the net outflows from the mutual funds which came under redemption pressure as well as decline in borrowings from commercial banks (Table 2 and Statements 2, 2.1 and 2.2).

The Indian insurance industry witnessed a slowdown in 2008-09. Life insurance business (in terms of first year premium) grew by 10.1 per cent (23.9 per cent in 2007-08). This reflected moderation in the growth rate of unit linked premium which led to a decline in its share in total premium to 40.9 per cent in 2008-09 (46.1 per cent in 2007-08). The fair value change in life funds turned negative on account of the subdued Indian equity market during the year.

There was, however, a turnaround in 2009-10 in the total financial claims issued by the OFI sector mainly driven by the reversal in flows (i.e., net inflows) in the mutual funds sector. Furthermore, the insurance sector witnessed a turnaround in 2009-10 with the life insurance premium income registering a growth of 19.7 per cent. The unit-linked premium income growth was higher at 27.4 per cent resulting in an increase in its share in total premium to 43.5 per cent.

III. Instrument-wise Financial Flows

The indirect impact of the global financial crisis was evident in the use of financial instruments during 2008-09. While the shares of currency and deposits and investment in Government securities in total claims issued increased, reflecting their inherent lowrisk/ risk-free character, non-Government securities including mutual funds were divested in the aggregate on account of acute financial stress and the prevalence of generalised risk aversion (Table 6). Loans and advances, notwithstanding a decline in absolute terms, accounted for a larger share of total claims in 2008-09. In the following year, with the progressive normalisation of financial market conditions, while the share of currency and deposits in total claims declined, that of non-Government securities (including mutual funds) increased. Investment in Government securities, continued to account for a higher share of total claims issued in 2009-10 vis-à-vis the average of 2003-04 to 2007-08, even though it was lower than that in 2008-09. An increase in life funds and some improvement in small savings collections were also evident in 2009-10.

IV. Select Indicators of Financial Development

The FOF accounts are useful for understanding the extent of financial deepening and widening in the economy through the various ‘financial development’ ratios derived from the flow-of-funds data. These ratios include the finance ratio, the financial interrelations ratio and the new issue ratio (Table 7).²

The trends in these ratios since 2001-02 are given in Chart 1 to provide a historical perspective in the movement of these ratios. The finance ratio, the financial inter-relations ratio and the new issues ratio had moved upwards even as the economy clocked a growth rate of over 9 per cent during three consecutive years 2005-06 to 2007-08, indicative of the robust pace of financial development (Table 7). All the three ratios declined during 2008-09 as the economy lost momentum and financial markets came under pressure under the indirect impact of the global financial crisis. With the coordinated policy actions taking effect, all the three ratios picked up once again in 2009-10 and, in fact, were placed somewhat above their respective averages during 2003-04 to 2007-08

V. Summing Up

The Flow of Funds accounts reflected the changes in the Indian macroeconomic and financial environment which transited from a robust state in 2007-08 to a period when overall growth and private sector investment slumped and financial markets came under pressure under the indirect impact of the global financial crisis in 2008-09, but recovered fairly quickly in 2009-10 as coordinated fiscal-monetary policy actions took effect. The key features of the flow of funds over this period were as follows:

• Aggregate financial claims issued by all the sectors, as a ratio to national income, declined in 2008-09 but recovered in 2009-10, and were, in fact, placed above the average during 2003-04 to 2007-08.

• The decline in the total financial claims issued in 2008-09 was primarily reflected in the private corporate business sector followed by the rest of the world sector and the other financial institutions sector. The claims of the government sector increased, reflecting the increase in overall borrowings necessitated by the fiscal stimulus measures.

• The claims of almost all sectors, particularly, the other financial institutions (including insurance and mutual funds), recovered substantially in 2009-10. The financial claims of the government sector declined only marginally as the fiscal stimulus programme continued.

• The claims of the banking sector, however, declined further in 2009-10 which resulted, inter-alia, from the unwinding of the MSS balances.

• The resource gap of the private corporate business sector narrowed in 2008-09 as investment declined more than net savings. This was reflected across the major sources of funding the resource gap particularly the rest of the world sector (mirroring the slackening of foreign investment and borrowings) and banks. In 2009-10, as macroeconomic conditions improved, the higher financial deficit of the private corporate business sector was funded largely by the banking and the rest of the world sectors.

• As a consequence of fiscal stimulus measures, the net savings of the public sector turned into dissavings in 2008-09 which deteriorated further in 2009-10. Increase in government investment in 2008-09 widened the resource gap. Banks were the major source of funding the Government’s resource gap. The share of the household sector in financing the resource gap increased substantially in 2009-10 as reflected in robust collections under small savings and provident funds.

• The household sector remained the financial surplus sector. The financial surplus of the household sector declined somewhat in 2008-09 but increased in 2009-10 in line with their financial savings. A major chunk of household financial surplus was invested in bank deposits. In 2009-10, the share of household financial surplus channelised towards other financial institutions increased with a turnaround in their financial position.

• The shares of bank deposits and Government securities in total financial claims issued by all the sectors increased while that of non-Government securities (including Mutual Funds) declined during 2008-09 against the backdrop of financial market uncertainty. In 2009-10, the share of non- Government securities in total financial claims improved significantly.

• The finance ratio, the financial inter-relations ratio and the new issues ratio declined in 2008-09 but recovered in 2009-10 to somewhat above trend. The movement in these ratios showed that the pace of financial deepening had largely recovered in 2009-10.