Project on Indian Financial Market - Module: 1
Financial Development and Economic Growth in India
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Fiscal Policy and Financial Development

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.

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.

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. 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.

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.

The growth of the gilt market, with the help of Government intervention, has facilitated financial growth by providing:

1. possible benchmark interest rates to the markets,

2. instruments with a wide array of maturity to the market players to enable them to tailor their asset-liability management, and

3. 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.