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A R T I C L E S

India’s Financial Development: Measures and Analysis

BY Anuradha Guru*

Economic growth and financial development are inextricably linked. While growth provides the ability to develop fi-
nancial structures, the latter in turn facilitates higher growth through efficient allocation of limited resources of the
economy. Economists have, since the times of evolutionary economist Joseph Schumpeter, (who put the role of finan-
cial intermediation at the center of economic development through his work in 1911), stressed the connection be-
tween a country's “financial superstructure and its real infrastructure”. Raymond W. Goldsmith, in his 1969 book,
“Financial Structure and Development” noted that the financial superstructure of an economy "accelerates economic
growth and improves economic performance to the extent that it facilitates the migration of funds to the best user,
i.e., to the place in the economic system where the funds will yield the highest social return". A number of empirical
studies have proved the causal linkage between growth and financial development. Thus, well functioning financial
markets are crucial, especially for emerging market economies (EMEs), such as that of India.

India is one of the five countries classified as big emerging market economies by the World Bank. This list, besides
India, includes China, Indonesia, Brazil and Russia. These countries have made the critical transition from a develop-
ing country to an emerging market. A World Bank study predicts that by 2020 the share of these five biggest emerging
markets' in world output will double to 16.1 percent from 7.8 percent in 1992.

India, as other emerging markets, stands out due to certain characteristics. These include, India being a regional eco-
nomic powerhouses with large population, large resource base, and large markets; being a transitional society which
is undertaking domestic economic reforms and gradually but steadily adopting open door policies to replace its tradi-
tional state interventionist policies that and India, along with other emerging markets, contributing significantly to
the rising world trade. Thus, it would be instructive to look at where India stands in terms of financial development in
accordance with generally accepted measures of development and how it fairs among its peer emerging market
economies. Let us first see how best financial development of a country can be measured.

Measuring financial development

There have been attempts to measure financial development of economies using different sets of indicators. The indi-
cators traditionally used include monetary measures (such as narrow money to GDP, central bank domestic credit as
percentage of GDP, money multiplier etc), financial institutions assets to GDP, stock market liquidity, regulation and
supervision of banks, coverage and structure of deposit insurance schemes, indicators of barriers to banking access in
developing and developed countries etc. However, there was hardly an attempt made to develop a comprehensive
index of financial development.

In a recent development, the International Financial Cooperation of the World Bank Group commenced publishing a
“Doing Business Database” for over 183 countries since 2003. This Database provides a quantitative measure of regu-
lations for starting a business, dealing with construction permits, employing workers, registering property, getting
credit, protecting investors, paying taxes, trading across borders, enforcing contracts and closing a business-
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* The author is with the NSE. Views are personal.
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as they apply to domestic small and medium-size enterprises. A fundamental premise of Doing Business is that eco-
nomic activity requires good rules. This database suffers from quite a few limitations, such as, it does not measure
all aspects of the business environment that matter to firms or investors—or all factors that affect competitiveness;
it does not assess the strength of the financial system or financial market regulations, both important factors in un-
derstanding some of the underlying causes of the global financial crisis and it does not cover all regulations, or all
regulatory goals, in any economy. Thus it does not fully capture the financial development of a country. However,
this database has gained considerable attention in recent years among developing countries with hopes that a
higher spot on the list could help lure foreign investors. In 2010 database, India ranks 133 among 183 countries in
this database, falling one place from its position at 132 in 2009 database. Notably, some of the peer countries of
India rank above it- South Korea at 19, China at 89, Indonesia at 122 and Brazil at 129.

In another attempt to measure financial development, an occasional paper of the European Central Bank, brought
out in April 20091, constructs composite indices to measure domestic financial development in 26 emerging econo-
mies for 2008. The study uses 22 variables, grouped according to three broad dimensions: (i) institutions and regula-
tions; (ii) size of and access to financial markets and (iii) market performance. According to this index, South Korea
is ranked 6 among 30 countries, China 14 and India is at the position 22. This paper finds that India performed rela-
tively better as regards its financial markets and non-bank institutions, but requires improvements in the business
environment as well as bigger and efficient banks.

Recognizing that there is lack of intellectual agreement on how to define and measure financial system develop-
ment, the World Economic Forum (WEF), in September, 2008, released its first annual Financial Development Re-
port (FDR), which provides an Index and ranking of 52 of the world’s leading financial systems. The 2009 FDR re-
leased on October 8, 2009, ranks 55 countries based on over 120 variables spanning institutional and business envi-
ronments, financial stability, and size and depth of capital markets, among others and is thus one of the most com-
prehensive databases available on financial development.

For the purposes of this Report and Index, financial development is defined as the factors, policies, and institutions
that lead to effective financial intermediation and markets, and deep and broad access to capital and financial
services. In accordance with this definition, the Report recognizes various aspects of development of a financial
system, presenting them as “seven pillars” of the Financial Development Index (FDI). These are:

1. Factors, policies, and institutions: the “inputs” that allow the development of financial intermediaries, mar-
kets, instruments and services. It includes: (i) institutional environment; (ii) business environment and (iii) fi-
nancial stability.

2. Financial intermediation: the variety, size, depth, and efficiency of the financial intermediaries and markets
that provide financial services. It includes: (iv) banks, (v) non-banks and (vi) financial markets.

3. Financial access: (vii) access of individuals and businesses to different forms of capital and financial services.

One of the key design principles of the Index is the inclusion of a large number of variables relevant to the finan-
cial development of both emerging and developed economies. However, the FDI developed by the WEF, like other
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1 “Domestic Financial Development in Emerging Economies Evidence and Implications”, European Central Bank, Occasional Pa-
per Series, No 102 / April 2009
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such indices on financial development, has many limitations, both conceptual/methodological as well as in data
accuracy and availability. One of this is that there is necessarily a lag in some of the data used to calculate the
FDI, so it is important not to view it as having captured the full effects of the current financial crisis.

The FDR recognizes that limitations also exist in the light of rapidly changing environment and the unique circum-
stances of some of the economies covered. Yet, in its attempt to establish a comprehensive framework and a
means for benchmarking, it provides a useful starting point. The Report is unique in the comprehensiveness of the
framework it provides and the richness of relevant data it brings to bear on financial system development.

The FDR 2009, places most of the developed countries in the top rankings, with the United Kingdom holding the
first rank. Amongst the emerging economies, Malaysia is placed at the top rank, at position 22, followed by South
Korea and China. India is at position 38 in its overall ranking, while it was ranked 31 out of 52 countries by FDR
2008. Table below presents the rankings of India on various financial development parameters vis-à-vis other im-
portant emerging markets.

Table: Financial Development Index 2009-Rankings of select Emerging economies

Country Overall Factors, Policies and institutions Financial intermediation Financial

rank access

Institutional Business envi- Financial Banks Non- Financial Financial

environment ronment stability banks markets access

Malaysia 22 22 30 13 12 25 29 22

South Korea 23 31 16 28 22 18 20 52
China 26 35 40 23 10 12 26 30
South Africa 32 27 36 31 30 32 30 47
Brazil 34 42 47 15 35 15 37 31
Thailand 35 33 31 36 34 47 36 29
India 38 48 48 46 39 17 22 48
Russia 40 53 34 39 55 4 41 49

Though India is not ranked very high in its overall score of financial development, it is relatively well placed in
terms of development of non-banking financial services (rank 17) and financial markets (rank 22). Within the fi-
nancial markets, India fairs well in development of its foreign exchange markets and derivatives markets. Some of
the sub-indicators in which India ranks well are regulation of securities exchanges (rank 9) and currency stability
(rank 10).

However, the FDR points out the India’s institutional environment is considerably weak, placing it at rank 48, fol-
lowing its lower levels of financial sector liberalization as well as a low degree of contract enforcement. India’s
business environment is also affected by two particular challenges—an absence of adequate infrastructure and
high cost of doing business. These areas of difficulty translate into highly constrained financial access, it notes.

Strengthening the institutional environment

Taking a cue from here, we look at one of the important aspect in which the FDR points out that India is weak,
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viz. institutional environment. In the FDR’s framework, the institutional environment encompasses: (i) laws and
regulations that allow the development of deep and efficient financial intermediaries, markets, and services,
which, inter-alia, includes a country’s capital account openness and domestic financial sector liberalization.;
(ii) macro prudential oversight of financial systems, i.e overall laws, regulations, and supervision of the finan-
cial sector; (iii) quality of contract enforcement and (iv) corporate governance.

Let us first look at the status of development of financial markets. The financial markets of India can, at best,
be described as developing. While the securities markets, especially the equity derivatives markets, can boost
of being in the league of some of the developed countries in terms of regulatory framework, market capitaliza-
tion, turnover and state of the art risk management; other segments of the financial markets fall behind in a
number of ways. For instance, the corporate bond markets are practically non-existent when compared with the
mounting long term funding requirements to finance India’s corporates and infrastructure development. They
account for only 3.9% of GDP in 2008, as against 61% in Korea and 37% in Malaysia, according to ADB estimates.
The recent government committee, High Powered Expert Committee on Making Mumbai an International Finan-
cial Centre (HPEC on MIFC), has pointed that corporate bond markets are an important missing link following
which India’s financial sector has not been able to achieve the desired bond-currency-derivatives (BCD) nexus
required, so as to be able to offer a whole milieu of financial services to market participants.

As regards the banking sector, a number of reforms have been undertaken towards liberalization and banks have
shown improvements in asset quality and profitability. However, as pointed out by Governor RBI, Dr D. Sub-
barao, in a recent speech 2, commercial banking in India has not penetrated sufficiently to serve the large mass
of rural, illiterate and poor people in any meaningful way. Estimates indicate that of the 600,000 habitation
centres in the country, only about 30,000 centres are covered by commercial banks. He adds that even where
100 per cent financial inclusion is claimed, oftentimes it is inclusion only in a nominal sense. Households have
bank accounts that remain dormant; few conduct any banking transactions and even fewer receive any credit.
Thus, financial inclusion in its true sense still evades us. Also, the sector is plagued with high intermediation
costs largely on account of high operating cost.

Looking at the government securities markets, one finds that it faces difficulties such as lack of liquidity across
different maturity levels and thus lack of a benchmark yield curve. The latter is generally held to be one of the
reasons for non-development of corporate bond markets in the country.

In the insurance sector, in terms of insurance penetration (ratio of premium to GDP), at 4.6%, in 2007, India is
at par with most other emerging market economies. However, it fairs poorly with respect to insurance density
(ratio of premium to total population) at only 46.6%. The participation of low-income groups in life insurance is
still very limited.

Thus, each of the segments of the financial markets has its own set of shortcomings that need special attention.

As regards openness of capital account, India has cautiously opened up its capital account since the early 1990s,
with the thrust of policy reform being in favor of a compositional shift in capital flows away from debt to non-
debt creating flows, viz., FDI and foreign portfolio investment; strict regulation of external commercial
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2 Keynote address by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India at the International Finance and Banking Con-
ference organized by the Indian Merchants’ Chamber on ‘Banking - Crisis and Beyond’ on November 25, 2009 in Mumbai.
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borrowings, especially short term debt; discouraging volatile element of flows from non-resident Indians; and
gradual liberalization of outflows. Presently, for foreign corporate and foreign institutions, there is a reason-
able amount of convertibility; for non-resident Indians (NRIs) there is approximately an equal amount of con-
vertibility, but one accompanied by some procedural and regulatory impediments. For non-resident individu-
als, other than NRIs, there is near zero convertibility. For moving ahead on capital account convertibility, the
RBI “Committee on Fuller Capital Account Convertibility” has detailed the timing and sequencing of measures
for fuller capital account convertibility. Some of the recommendations of the committee have already been
acted upon; however, India is still not ready for full convertibility as the regulator carefully weighs the risks
and benefits of unfettered capital flows.

We now turn to look at the macro prudential oversight of the regulatory system in India. Presently there are
many regulatory agencies, apart from several ministries in the government that retain direct regulatory powers
on various segments of the financial markets. While on one hand this structure leads to major regulatory over-
laps and regulatory gaps, what is more concerning is that there is lack of any formal arrangement of coordina-
tion amongst these regulators in matters that concern more than one regulator. Also, as financial conglomer-
ates begin to dominate the Indian markets, a consolidated system of supervision becomes more important.

Regulatory coordination is now an imperative largely dictated by the recent global financial crisis. This is most
aptly articulated by President Barack Obama, in his speech while unveiling the 21st Century Financial Sector
Reforms agenda of the US Government early this year. He is quoted below:

“One of the reasons this crisis could take place is that while many agencies and regulators were responsible
for overseeing individual financial firms and their subsidiaries, no one was responsible for protecting the
whole system from the kinds of risks that tied these firms to one another. Regulators were charged with see-
ing the trees, but not the forest. And even then, some firms that posed a so-called "systemic risk" were not
regulated as strongly as others; they behaved like banks but chose to be regulated as insurance companies, or
investment firms, or other entities that were under less scrutiny.

As a result, the failure of one firm threatened the viability of many others. The effect multiplied. There was
no system in place that was prepared for this kind of outcome. And more importantly, no one has been
charged with preventing it.”

The proposal of US Government is to create an oversight council, as put forward by President Obama, as fol-
lows:

“…..And even as we place the authority to regulate these large firms in the hands of the Federal Reserve -- so
that lines of responsibility and accountability are clear -- we will also create an oversight council to bring
together regulators from across markets to coordinate and share information, to identify gaps in regulation,
and to tackle issues that don't fit neatly into an organizational chart. We're going to bring everyone together
to take a broader view -- and a longer view -- to solve problems in oversight before they can become crises.”

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In the context of India, the recently submitted report of the Government Committee on Financial Sector Reforms
(CFSR) (popularly known as the Raghuram Rajan Committee) has, inter-alia, recommended that a Financial Sector
Oversight Agency (FSOA) should be set up by statute, whose focus will be supervisory. It will monitor the function-
ing of large, systemically important, financial conglomerates; anticipating potential risks, it will initiate balanced
supervisory action by the concerned regulators to address those risks; it will address and defuse inter-regulatory
conflicts, and look out for the build-up of systemic risks.

This recommendation should be taken forward in the right earnest.

Looking at the issue of contract enforcement in India, we find an appalling state of affairs. According to the
“Doing Business database 2010”, contract enforcement in India requires 46 procedures, 1420 days (of which days
spent in trial and judgment are 1095) and the cost of the same is 40% of the claim amount. India ranks one but
last, in terms of this indicator, among 183 countries captured by the database. Some serious measures are re-
quired to come out of this abysmal situation.

On corporate governance, the latest episode at Satyam Computer Services raises several questions about the role
of three pillars of corporate governance in a firm i.e the Board of directors and independent directors; sharehold-
ers and institutional investors; and the auditors. Over and above all this, we need to ponder over the fact that in
spite of being proactive in promulgating corporate governance regulations and being touted as one of the best in
terms of corporate governance standards compared to our Asian counterparts, where does our country fail to pre-
vent such fiascoes? Satyam’s case highlights the need to make corporate governance laws more effective to
achieve more transparency and accountability. A New Companies Bill 2008 is under the consideration of the Par-
liament. It aims to improve corporate governance by vesting greater powers in shareholders. These have been
balanced by greater emphasis on self-regulation, minimization of regulatory approvals and increased and more
transparent disclosures. Will this be effective in addressing contemporary corporate governance issues in India,
remains to be seen.

In conclusion

There is unanimity in the opinion that India has come a long way on the path of development of its financial sec-
tor- deregulating, liberalising and increasing competitiveness along the way. However, there is no room for com-
placency. The imperatives of changing time, technology and needs of the economy, require us to take further
steps to build up on the financial sector’s capabilities, already achieved, in the form of the next generation re-
forms. This would help our financial markets achieve their full potential growth. The CFSR aptly summarises the
necessity of financial reforms as-

- “Financial sector reform is both a moral and economic imperative”.

The starting point for the same could be working on the lines of recommendations of two important recent gov-
ernment committee reports, viz. HPEC on MIFC and CFSR. Some of the thoughts of these committees have been
articulated above keeping the findings of the WEF’s FDR 2009 in the foreground.