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]

Financial Development and Savings in India

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. 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.

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). 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).

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.

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.

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. 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. 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.

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).