Currently, the government has a high shareholding in banks, financial institutions and insurance companies. (Annex 5.1). These institutions perform a developmental role as well as lend on commercial terms. The commercial lending subsidises developmental lending resulting in high cost of funds to commercial borrowers. The developmental role has also resulted in inefficiencies in the banking system like high employee costs and unviable branches.

In order to perform its developmental role as also to finance the fiscal deficit, the government has been preempting a significant amount of funds from the banking system. Prior to reforms in the banking sector, this was being done through high SLR requirements at low interest rates. In the post reform period although the SLR to be maintained by the banks has been reduced to 25% (as against around 38% pre reforms), the SLR rate continues to be high relative to other countries like Thailand and Indonesia where there are no SLR requirements. Moreover, though the interest rates on these securities have been increased post reforms, they are lower than the rates that the banks would have earned on lending similar amounts by way of advances. (Annex. 5.2)

As in the case of banks, the government has also been preempting a significant portion of the funds from the insurance companies and provident funds. 75% of investments of the Life Insurance Corporation of India and 45% of the investment of the General Insurance Corporation of India are required to be invested in government securities.

About 55% of the outstanding liabilities are owned by government and 45% by industry and agriculture sector combined. Further about 46% of the fund flows during 1997-98 are to the government and 54% to industry and agriculture sector combined. (Annex. 5.3 and Annex. 5.4)

As part of their developmental role the public sector banks were also required to provide employment as well as spread banking by opening branches across the country. As the public sector banks account for the bulk of the lending in the Indian banking system, this has resulted in a high cost structure.

Moreover, the productivity levels of the public sector banks are lower, relative to the private sector and foreign banks in India as also vis a vis banks in other countries with consequent impact on the lending rates. (Annex. 5.5)

Certain sectors of the economy, like small and marginal farmers and small businesses, have to be provided credit at lower rates of interest so as to ensure that their operations are viable, pending reforms in these sectors. As the commercial entities were unwilling to provide credit to these sectors, the government stipulated that the public sector banks lend 40% of their net credit to these sectors each year at subsidised rates.

These accounts are small in size and difficult to monitor. They have resulted in higher NPAs with the banking sector. Of the total NPAs as on March 31, 1998 the priority sector accounted for around 46%. With financial intermediaries unable to release the amounts locked up in NPAs on account of inadequate legal provisions there has been minimal earnings on these advances. (Annex. 5.6)

Consequent to high pre-emption of funds at low interest rates, priority sector lending with high NPAs, cross subsidies and high cost structure, the cost of funds to industry from the banking system has been high.

The major concern for the economy is the large fiscal deficit of the government on a consolidated basis. Even though a correction to the fiscal deficit/GDP ratio was seen for the central government after the initiation of economic reforms, the ratio has again slipped in 1997-98. This was due to the poor economic performance during the year leading to lower revenue collections for the government. Correspondingly, there has been a sharp rise in the total internal liabilities of the Central government as a percentage of GDP. From about 36% in 1980-81, the ratio has moved up to 50% in 1997-98. The ratio of the state government outstanding liability to GDP is seen more stable, though, it has slipped in the recent years after seeing some correction during 1995-96 and 1996-97. (Annex. 5.7)

Persistently high fiscal deficits and a high borrowing programme for the government imply the erosion of national savings and use of domestic savings for non-productive purposes. A high fiscal burden is seen to be coming in the way of an efficient financial intermediation process and the reforms in the financial sector.

Many PSUs are saddled with a large amount of debt, which places pressure on their profitability, and adversely affects the structure of the balance sheet. Many of these PSUs are operating in cyclical industries, and are affected negatively during times of business slowdown.

The accumulated interest payment on account of the disproportionately large debt considerably strains government finances. This is also proving detrimental to the sheer viability of their businesses.

5.2.3 High interest outgo

The high fiscal deficit is due to the high expenditures by the government on interest payment, which does not enhance the productive capacity of the economy. Interest payments as a percentage of total tax revenues of the centre had accounted for around 53% in 1991-92, which has risen to around 66% by 1997-98. The ratio of subsidies as a percentage to tax revenues are more stable though it has risen from 10.6% in 1991-92 to 19.81% in 1997-98.

Consequent to the preemption of mainly the interest bill from the tax revenues, the central government capital expenditure as a % of GDP have declined from 2.3% in 1990-91 to 1.2% in 1997-98 and is estimated to rise marginally to 1.3% in the budget 1998-99. The key to reduction in the fiscal deficit lies in the reduction in the interest outgo, which would also release funds for capital formation in the economy. (Annex. 5.8)

The government is borrowing at higher interest rates than in the pre-reform days. The weighted average interest rates on dated securities declined from 13.69% in 1996-97 to 12.01% in 1997-98 in view of the easy liquidity conditions. However, this was not appreciable compared to 11.4% in the beginning of the reforms period. Real interest rates on market borrowings remained at a high level of 7.1% in 1997-98; nearly the same as that in 1996-97 and much above the 1.2% in 1990-91.

Market expectations of high interest premium on longer maturity debt have triggered a policy of placing borrowings at the shorter end of the market, so as to minimise the cost of borrowings. This has led to a skewed structure of public debt towards the shorter end of the maturity structure. From only 8.6% of total debt in the less than 5 yrs maturity, this figure has jumped to 45.2%. (Annex. 5.9)

The repayment burden in the medium term horizon, ranges between Rs 20,252 crores and Rs 27,763 crores between 1999-2000 and 2003-2004. This creates pressure on interest repayments in the immediate term, without a commensurate increase in the income stream. Consequently, it necessitates further market borrowings by the government to service the debt.

5.2.4 High contingent liabilities

The outstanding guarantees have increased from Rs 90,734 crores in 1992 to Rs 1,18,204 crores in 1996. These guarantees or contingent liabilities do not form part of debt as conventionally measured. However, in the eventuality of defaults, these obligations have the potential of destabilising the fiscal system. (Annex. 5.10)

Creation of a sinking fund, the RIB-Maintenance of Value Account (MOV) to cover for the exchange loss under the Resurgent India Bonds. Under the arrangement, the government will issue non-negotiable, non-interest bearing special securities without specified maturity in favour of RBI. This will increase the RBI net credit to the government to the extent of the amount of such securities issued by the government. Therefore, the exchange loss for the government would be an operating entry and the government would not set aside cash for the purpose.

5.2.5 High public debt/GDP

A sharp rise in the public debt/GDP ratio has three major implications. First, the concomitant interest burden absorbs an increasing proportion of revenue receipts. Second, the rising level of borrowings casts an upward pressure on interest rates. This is capable of crowding out interest-sensitive investments in the short-run and adversely impact on economic growth. Third, the substantial additional borrowings also would add to the repayment burden and may result in frequent debt rollovers.

5.3 SUPPLY OF FUNDS

5.3.1 Quality of funds

The tenure of funds available in the financial system is mainly short term. The providers of long term funds, namely the pension/provident funds and the insurance companies, are mainly funding the government on account of the same being mandated by law. Hence, the main providers of debt to industry and infrastructure are the banks and financial institutions, which has resulted in inadequate availability of long term funds to these areas.

Equity is inadequate on account of the lack of depth in the domestic markets as also inadequate flows of foreign equity into the country through FDIs.

On account of the small size of the equity markets, limited floating stock in the markets, lack of adequate processes in the stock exchanges as also inadequate infrastructure, the funds in the financial system are available primarily in the form of debt.

5.4 INEFFICIENCIES IN THE FINANCIAL SYSTEM

5.4.1 High flow of savings into real assets

Although India currently has a high savings rate of around 26% of the GDP, a significant portion of the same is invested in real assets in the form of gold and real estate. This, coupled with the fact that the real estate markets in India are illiquid, results in these savings not being available for investment in productive assets. (Annex. 5.11)

5.4.2 Inadequate liquidity in debt and equity markets

In addition to the problem of limited availability of savings in real assets, there is also the problem of inefficient utilisation of funds in the financial system. This is on account of the following inadequate liquidity in the debt and equity markets, and high transaction costs of raising funds through measures like asset securitisation which results in funds being locked up in illiquid assets.

There is inadequate liquidity in the Indian capital markets on account of various issues like limited number of players, low floating stock, inadequate infrastructure as also inadequate processes in the stock exchange. This results in sub optimal utilisation of the funds that flow into the financial system

Currently, on account of high stamp duties and other transaction costs of raising funds through measure like asset securitisation, the intermediaries in the financial system are unable to roll over the funds that have been lent to various borrowers. This in turn results in a pressure on interest rates also as entities like the financial institutions are repeatedly tapping the markets to raise funds while the existing funds could have been rolled over.

5.4.3 High NPAs

A key problem faced by the financial sector intermediaries in India is the high level of non- performing assets at around Rs.57000 cr. While the NPAs with the banking system as at the end of March 1998 aggregated Rs. 45653 cr. the corresponding figure for the financial institutions was Rs. 12000 cr. (Annex. 5.12)

This is due to:

Developmental as well as commercial role of banks and financial institutions

Banks and financial institutions in India currently perform both a developmental as well as commercial role. The developmental role comprises the following

Directed credit by Banks

As part of their developmental role, the banks in India have to mandatorily lend a part of their net advances by way of priority sector credit. These loans are normally small in size as also dispersed across the country resulting in difficult monitoring of the same. Consequently, though the public sector banks have to lend 40% of their net advances by way of priority sector lending, as at the end of March 1998, these loans accounted for around 47% of the NPAs of the banking sector.

Developmental Role of the Financial institutions

The financial institutions in India were primarily set up with a developmental role. Consequently, these institutions have over the years lent to various projects with the aim of enabling the development of industry in India, although a number of these projects are not commercially viable in the current liberalised scenario.

Lack of adequate legal provisions to seize and sell assets, loans with respect to which are being defaulted upon as also the long drawn legal process

The laws relating to recoveries, foreclosures and bankruptcy are inadequate and do not permit the banks to seize and sell assets, loans with respect to which are being defaulted upon. The banks have to approach the courts for recovering their dues. The legal process however is long drawn on account of inadequate number of debt recovery tribunals as also the long time taken by these tribunals to settle cases. While banks and FIs have recovered only Rs.1.8 bn. to date from the special debt recovery tribunals since 1993, non-banking financial companies are currently not allowed to refer their cases to the debt recovery tribunals.

Inadequate prudential norms as also inadequate disclosure requirements

While the banks are required to provide for non-performing assets, the current guidelines require banks to classify the loan as an NPA only after the interest/principal on the same is past due for two quarters. This norm as also the provisioning norms are liberal vis a vis those in other Asian countries. Moreover, currently although the RBI guidelines do specify that 80% of the working capital requirement should be by way of a term loan, the amounts lent are normally rolled over without actual cash transactions. Moreover, banks in India are not required to disclose their exposures to groups / sectors.

5.4.4 Poor trading volumes

The debt market in India is characterised by poor trading volumes despite high stock of debt issued leading to poor price discovery. Compared to a total outstanding debt of about Rs. 500,000 cr. (33% of GDP), the average annual trading volume is only about Rs. 100,000 cr. or 20% of market capitalisation, which is low as compared to over 40% prevailing in other countries. Over 90% of the trading volume is in GOI securities where banks are the main players.

The number of issues in the primary market via public and rights issues have also dwindled in the last two years, primarily due to inefficient pricing by merchant bankers

5.4.5 Inadequate disclosure

Currently, the accounting standards and disclosure requirements for companies in India do not incorporate a number of details that are required by those in the developed countries like the US and the UK. (Refer table for comparison) This coupled with the accounting statements forming an integral part of the appraisal system of the financial sector intermediaries results in credit decisions being taken on the basis of incomplete disclosures, and consequent inappropriate allocation of funds. This in turn results in deterioration in the asset quality of the financial sector. (Annex. 5.13)

5.4.6 Disparities in regulation

Currently the regulation in the financial sector differs across various entities. This results in some entities having an unfair advantage over others on account of regulation and therefore unfair competition in the financial system.

5.5 SUMMARY

To sum up, major areas of concern on the supply side in the financial sector are in terms of high degree of government control of financial intermediaries, pre-emption of funds by the government, high cost of funds and poor quality of funds. On the demand side, the areas of concern are high government fiscal deficit, borrowings by government to meet unproductive outgo on interest payments, poor state of government finances and poor quality of assets due to high NPAs. With respect to the financial system, the areas of concern are illiquid markets, inadequate disclosure and disparities in regulation.

ANNEXURES

Annex. 5.1

Government Ownership of Major Banks in India

(as on March 31,1997)

Source: Published Reports

Source: Centre for Monitoring Indian Economy

Structure of the interest rates on outstanding central government securities pre and post reforms

Source: RBI Report on Currency & Finance, 1990-91 & 1996-97

Stock of funds in the system as on 31-3-98

(All figures in Rs. Crores)

CRR aggregating about 58,000 cr have been included under lending to Government.

Estimated annual flow of funds during 1997-98

(All figures in Rs. Crores)

CRR aggregating about 8,000 cr have been included under lending to Government.

Employee Productivity of Indian Public Sector Banks
vis a vis Private and Foreign Banks

Compiled on the basis of IBA publications

Total Income = Interest on Advances + Interest on Investments + Fee Based Income

Source: Compiled from IBA Publications

Productivity of Banks Abroad

* Capital per employee for all Indian banks has been estimated using networth per employee while the source for other banks is The Banker, July 1997. The above figures are only indicative and may not be strictly comparable

Compiled on the basis of IBA Publications

Sectorwise Break up of NPAs of the Public Sector Banks.

Source: Trends and Progress of Banking in India, 1997-98 (P)- provisional

Government Finances

Source: India: 1998 Macro economic Update, World Bank

Source: India: RBI Annual report. 1997-98.

Source: Ministry of Finance, budget documents, various years

Interest rates on Government Borrowings

Source: RBI Annual Report, 1997-98

Maturity Structure of Central Government Dated Securities Outstanding

Source: RBI report on Currency and Finance, 1996-97

Outstanding Guarantees (as at end-March) (Rs crore)

* 17 major states

Source: RBI Annual Report, 1997-98

Flow of Household Savings into Real Assets

P- provisional, $ tentative estimates

Source: RBI Currency and Finance - various issues

Comparison of NPAs in India with those in other countries

Source: S&P Estimates as at end 1997

(as at the end of March, Rs Cr).

Source: Trends and Progress of Banking in India, 1997-98

NA Not Applicable, # Net of provisioning and write-offs

Disclosure norms

Source: Published Sources