ROLE OF STATE-OWNED FINANCIAL INSTITUTIONS IN INDIA:SHOULD THE GOVERNMENT “DO” OR “LEAD”?Urjit R. Patel*Infrastructure Development Finance Company LimitedMumbai, IndiaApril 2004World Bank, International Monetary Fund and Brookings InstitutionConference on Role of State-Owned Financial InstitutionsWashington, D.C., April 26-27, 2004AbstractThe importance of a sound financial sector in efficient intermediation of resourcesis generally accepted. A case for government intervention in the sector might also be madein the initial stages of a country’s development, given systemic failures in achievingcertain economic goals. The paper argues that, in the case of India, this role is nowredundant; the public sector should no longer be directly intermediating resources. Thereremain, however, certain aspects of the financial sector (which have merit goodcharacteristics) where the government might be required to catalyse developments; theseare what may be termed its “market completion” role. These interventions shouldessentially be for establishing enabling mechanisms that facilitate financial transactions.*Correspondence: Urjit R. Patel, IDFC, Ramon House, 2nd Floor,169 Backbay Reclamation, Mumbai 400 020, India; e-mail: urjitpatel@idfc.com. I wouldlike to thank Saugata Bhattacharya for collaborating on work that forms the basis of thispaper.Disclaimer: The opinions presented in the paper are those of the author and not necessarilyof the institution to which he is affiliated.1“The Agricultural Infrastructure and Credit Fund, the Small and Medium Enterprise Fund, andthe Industrial Infrastructure Fund will be operational shortly. All the three funds will, withoutcompromising the norms of financial prudence, provide credit at highly competitive rates,which is expected to be 2 percentage points below the Prime Lending Rate (PLR)”.– Interim Budget, India, 2004-05.

1. INTRODUCTIONA deep and efficient financial sector is necessary for optimal allocation ofresources. Governments have been involved in the financial sectors – in intermediation,if not directly owning intermediaries – of many countries, even currently developedones, during various stages of their growth. In many countries, Development FinancialInstitutions (DFIs) have been major conduits for channeling funds to particular firms,industries and sectors during their development. Many studies (more recently, Allenand Gale [2001] and Levine [1997]) have identified the importance of DFIs in theSouth Korean and Japanese process of industrialisation. In some developed countries,such as Germany, especially in the post Second World War era, this (command) modeof financial intermediation has been used in national reconstruction as well. In manydeveloping countries, there has traditionally been a strong presence of the governmentin the sector, usually through a combination of either owning these entities or indirectlyby mandating credit allocation rules. This followed a line of thinking emanating fromthe works of Gerschenkron [1962] and Lewis [1955] that advocated a “development”role for state-owned intermediaries.Arguably, compelling arguments have been made for this involvement in theinitial stages of a country’s development. It is in the financial sector that market failures

2are particularly likely to occur.1 In addition, the significant asymmetries of informationcharacterising the sector, as well as the commercial unviability of lending to mostpioneering or small scale projects, generate a bias in bank loan portfolios away fromareas deemed vulnerable but are identified as thrust areas for development. As a result,governments had often established “development” oriented intermediaries to nurtureinfant industries and have also occasionally resorted to bank expropriations andnationalisations if the need was felt to advance social goals like expanding the reach ofbanking; in other words, addressing “market failures”. Even in countries that did nothave a high level of direct government ownership of financial intermediaries, theinvolvement of governments in intermediation has been significant.Reflecting the erstwhile predominance of the public sector in most areas ofeconomic activity, the government involvement in the financial sector had been devisedto implicitly assume counter-party risks. This cover had been adequate in the past giventhe relative simplicity of transactions then prevalent. As economic activity becameincreasingly commercially oriented, however, the government dominated financialsystems of most developing countries became ill-equipped to tackle the changed profileof risks arising from the increased complexity of transactions. Nor did there exist therobust clearing systems needed to support new financial products, or the accountingand hedging mechanisms to deal with the significant counter-party risks that nowpermeated the system. The consequence was a large increase in both institution-specificas well as systemic moral hazard, manifest in repeated bailouts and recapitalisations.1 Events over the past half a decade have provided numerous examples of these failures spanninggeographical areas as well as various types of economic systems.3Worldwide experience suggests that in the case of public sector institutions, theowner – the government – typically lacks both the incentive and the means to ensure anadequate return on its investment (La Porta, et al. [2000]). Political decisions, asopposed to rate of return calculations, are often important in determining resourceallocation. In many instances, as well as across a wide spectrum of countries, thisinvolvement has led to fragility of the financial sector, occasionally resulting inmacroeconomic turbulence as well. One thread of explanations for this stems from the“political” theories advanced, for instance, by Kornai [1979], Shleifer and Vishny[1994] and others. Directed lending to projects that might be socially desirable but notprivately profitable is not likely to be sustainable in the long run. These weaknesses gobeyond the normal crises that have characterised the financial sector and have beenexplored in detail in Patel [1997b]. A “conflict of interest” arises between developmentgoals of the government directed credit flows and the absence of commercial disciplinethat gradually percolates the lending process.The issue of incentives is especially relevant in India’s financial reforms,particularly given the current importance of government owned financial entities thatcover almost all segments. India is one of a number of countries whose intermediarieshave been used by the government to allocate and direct financial resources to both thepublic and the private sector. Government ownership of banks in India is, barringChina, the highest among large economies.2 Beside the standard problems of thefinancial sector that result from information asymmetry and “agency” issues, moral2 Hawkins and Mihaljek [2001] outline the characteristics of financial systems that are dominated bygovernment ownership of intermediaries.4hazard might be aggravated3 in countries like India with high government involvement

because both depositors and lenders count on explicit and implicit guarantees.4 Thehigh degree of government involvement gives rise to a belief of depositors andinvestors that the system is insulated from systemic risk and crises by engendering asense of confidence, making deposit runs somehow unlikely, even when the systembecomes insolvent. While selective regulatory forbearance might be justified as ameasure designed to balance the likely panic following news of runs on troubledinstitutions, a blanket guarantee by government makes forbearance difficult to calibrateand has the effect of sharply increasing system-wide moral hazard. Depositors,borrowers and lenders all know that the government is guarantor. Since, for all intentsand purposes, all deposits are covered by an umbrella of implicit governmentguarantees, there is little incentive for “due diligence” by depositors, which furthererodes any semblance of market discipline for lenders in deploying funds, as witnessedmost recently in the case of cooperative banks in India. The regularity of “sectorrestructuring packages” (for steel and textiles and proposed most recently for telecom),on the other hand, diminishes incentives for borrowers for mitigating the credit riskassociated with their projects.Just as importantly, India now has a banking sector whose indicators (in termsof standard norms like profitability, spreads, etc.) are prima facie more or less3 We distinguish the term “aggravated” from “enhanced”, considering the former as a parametric shift ofthe underlying variables as opposed to a functional dependence in the case of the latter. More explicitly,increasing moral hazard enhances the incentives of banks to accumulate riskier portfolios, whereas anaggravated moral hazard results in a failure to initiate corrective steps to mitigate the enhanced hazard,for example, increasing requirements of capital, proper risk weighting, project monitoring, etc.4 In this regard, India’s decision not to provide deposit insurance, ex post, to non-bank financialintermediaries was commendable.5comparable to international peer group standards. This sector is also complemented byrelatively well developed capital markets which are playing an increasingly importantrole in the resource requirements of commercial entities.The paper draws heavily on recent papers (Bhattacharya and Patel [2002],Bhattacharya and Patel [2003b] and Patel and Bhattacharya [2003]). It argues that theuseful role of public sector financial institutions in resource intermediation in India isnow very limited. After a brief sketch of the status of the sector, Section 2 highlightsthe infirmities and weaknesses of the system engendered by the high degree ofinvolvement of the government in the sector. Section 3 is a critical look at the areaswhich are often claimed to be the residual (but legitimate) domain of intervention bythe government, and examines the merits of the arguments advanced. Section 4concludes.2. THE FINANCIAL SECTOR IN INDIA AND CURRENT INFIRMITIESFrom independence to the end of the 1960s, India’s banking system consisted ofa mix of banks, some of which were government owned (the State Bank of India and itsassociate banks), some private and a few foreign. The political class felt that privatebanks, which concentrated mainly on high-income groups and whose lending wassecurity rather than purpose oriented, were not sufficiently encouraging widening of theentrepreneurial base, thereby stifling economic growth. Hence, it was decided tonationalise 20 large private banks in two phases, once in 1969 and again in 1980, withthe objectives of promoting broader economic goals, better regional balance ofeconomic activity, extending the geographic reach of banking services and the diffusionof economic power. Significant financial deepening has taken place over the three6

decades since the seventies (see Table 1 below). The M3/GDP ratio has increased from24% in 1970-71 to 70% at present, and the number of bank branches have increasedeight fold over the same period, with much of the expansion in rural and semi-urbanareas, which now account for 71% of total branches.Table 1: Decadal indicators of financial deepening1970-71 1980-81 1990-91 2000-01 2002-03M3 / GDP 24% 39% 47% 63% 70%Bank branches / ‘000 population 0.02 0.05 0.07 0.07 0.07Source: RBI Report on Trend and Progress of Banking in India, various issues.

After a hiatus of two decades, private banks were allowed to be established in1993, but their share in intermediation, albeit increasing, continues to be low. Thelargest growth in savings since 1997-98 has been in bank deposits, which now accountfor half of financial savings.2.1 Public sector involvement in the Indian financial systemBanking intermediaries continue to dominate financial intermediation (seeAppendix 1 Table A1.1 and Patel [2000] for a detailed exposition). Much of thissegment is publicly owned and accounts for an overwhelming share of financialtransactions (see Table 2 below for a thumbnail view). Appendix 1 Figure A1.1 alsoshows that the extent of government ownership of banks in India is quite highcompared to international levels. The Reserve Bank of India (RBI), moreover, has amajority ownership in the State Bank of India (SBI), the largest Public Sector Bank(PSB).7Table 2: Share of public sector institutions in specific segments of the financial sectorPublic sector (%) Private (%) Total (Rs. bn)Scheduled Commercial Banks (SCBs) 75.6 24.4 16,989Mutual Funds (MFs) 48.2 51.8 1,093Life Insurance 99.9 -- 2,296Source: RBI Report on Trend and Progress in Banking 2002-03; Annual Reports of SEBI(2002-03) and IRDA (2001-02).Banking and mutual fund data are at end-March 2003. Insurance data is end-March 2002.Definition of shares:SCBs: Total assets. Private banks include foreign banks.MFs: Total Net Assets of domestic schemes of MFs (public sector includes UTI).Insurance: Life insurance Policy Liabilities. Public sector insurance includes LIC and SBI Life.

The shortcomings of the banking system in India are now relatively wellknown. There have also been efforts, predominantly through a regulation-centricapproach, to tackle these issues. There is also a move to transform the major DFIs5 intoentities approximating commercial banks. But there remains another large section ofintermediaries that has not attracted requisite attention: specifically, the largegovernment-sponsored Systemically Important Financial Institutions (SIFIs).6 A veryserious lacuna in the oversight framework is the inadequate attention that has beendevoted to the role of market discipline for SIFIs like Life Insurance Corporation ofIndia (LIC) and Employees’ Provident Fund Organisation (EPFO). A particular causeof concern is the opacity of the asset portfolios of LIC and EPFO, a shortcoming whichis especially serious in the case of the latter.LIC, as of March 2003, had investible funds of Rs. 2,899 bn (which, to provideperspective, was 11.9% of GDP in 2002-03)7. The book value of LIC’s “sociallyoriented investments” – mainly comprising of government securities holdings andsocial sector investments – at end-March 2003 amounted to Rs. 1,882 bn, i.e., 71% of a5 In India, DFIs are a sub-group of intermediaries termed All India Financial Institutions (AIFIs).6 Our classification of SIFIs is somewhat different from the government’s view, enunciated in the RBI’sMonetary and Credit Policy, April, 2003, which referred to “large” intermediaries, including banks likeSBI and ICICI Bank.

8total portfolio value of Rs. 2,650 bn (10.9% of GDP)8. A staggering 87% of thisportfolio comprises of exposure to the public sector.Compared to the LIC, the EPFO’s accounts are, simply, opaque. Cumulativecontributions to the three schemes of the EPFO, i.e., Employees’ Provident Fund(EPF), Employee Pension Scheme (EPS) and Employees’ Deposit Linked Insurance(EDLI), up to the end-March 2002, amounted to Rs. 1,271 bn (5.1% of GDP). Totalcumulative investments of these three schemes were Rs. 1,390 bn (5.6% of GDP), withthe EPF being the largest scheme. The EPFO does not come under the purview of anindependent regulator, with oversight resting on three sources: Income Tax Act (1961),EPF Act (1952) and Indian Trusts Act (1882).More importantly, the involvement of the government in intermediation is muchwider than mere ownership numbers indicate; its ambit stretches across mobilisation ofresources, direction of credit, appointments of management, regulation ofintermediaries, providing “comfort and support” to depositors and investors, as well asinfluencing lending practices of all intermediaries and the investment stimuli of privatecorporations. These practices include treating banks as quasi-fiscal instruments, theconsequent pre-emption of resources through statutory requirements, directed lending,administered interest rates applicable for selected savings instruments, encouragingimprudent practices like cross-holding of capital between intermediaries, continual bailoutsof troubled intermediaries, control and manipulation of smaller intermediaries like7 The Industrial Development Bank of India (IDBI) Report on Development Banking in India, 2002-03,Appendix Tables 117-119.8 Social sector investments include loans to State Electricity Boards, housing, municipalities, water andsewerage boards, state Road Transport Corporations, roadways and railways. These, however, account9cooperative banks, weak regulatory and enforcement institutions, unwarranted levels ofgovernment controlled deposit insurance, etc (Buiter and Patel [1997]). A set of indicesto quantify the extent of this involvement was developed in Bhattacharya and Patel[2002]9. Figure 1 below (here updated from the paper) shows that after having declinedalmost secularly till 1995-96, the degree of involvement has risen – fairly sharply after1997-98.Figure 1: Index of Density of Government Involvement in the Financial Sector (IDGI-F) in India

One of the arguments previously advanced to justify government ownership ofmany intermediaries was related to concerns about systemic stability. The argumentwent that an implicit government net of “comfort and support” to both depositors andlenders deterred the prospect of financial runs. Till 2001-02, the explicit component ofthis support had translated into a cumulative infusion into banks of Rs. 225 bn.The government has also engineered many other indirect forms of bailouts.Financial interventions in the Unit Trust of India’s10 (UTI) US-64 scheme arefor about a fifth of the socially oriented investments portfolio, with the balance accounted by governmentand government guaranteed securities.9 Appendix 2 provides a description of the Index construction methodology.10 India’s largest mutual fund.80901001101201301401990-911991-

921992-931993-941994-951995-961996-971997-981998-991999-002000-012001-0210examples. Following the recommendations of an Expert Committee constituted after anearlier payments crisis in 1998, the government decided to exempt for three years theUS-64 from a 10% dividend tax (deducted at source) that other equity mutual fundswere required to pay. Data on dividend income distribution and the dividend tax forUS-64 for 1999-2000 indicate foregone tax revenue of around Rs. 2 bn. Under theSpecial Unit Scheme of 1999, the Government of India (GoI) did a buyback of PSUshares at book value, higher than the then prevailing market value, effectivelytransferring Rs. 15 bn to investors. After the second US-64 payments crisis in 2001,under a Repurchase Facility covering 40% of the assets of US-64, investors wereallowed to redeem up to 3000 units at an administratively determined price, with theGoI making up the gap between this price and the NAV of a unit. Eight Public SectorBanks “offered” liquidity support to UTI in the event of large-scale redemptions.Recognising the unviability of this support and a high probability of an ultimate defaulton these loans, however, these banks have sought comfort through governmentguarantees to help in easy provisioning against the loans and avoiding violation ofnorms of lending without collateral. Even more than the actual losses to the exchequer,these implicit safety nets create an insidious expectation of government support toinvestors, weakening their commercial judgment.2.2 Weaknesses characterising the Indian financial systemCertain structural characteristics and institutional rigidities evident in Indiafurther weaken mechanisms for prudent de-risking of portfolios. The absence ofeffective bankruptcy procedures leading to a lack of exit opportunities for bothintermediaries and the firms that they lend to, force intermediaries to roll-over existing11sub-standard debt or convert them into equity, thereby continually building up theriskiness of their asset portfolio. The use of intermediaries by the government in“diverting” funds, for purposes that are not entirely commercially motivated, reinforcesthe decline in the quality of assets. A prominent reason is an attempt by government toboost investment, both by direct spending and indirectly via credit enhancements, likeguarantees, partially to counter low private investment. In combination with thefrequently observed “tunnelled” structure of many corporations (Johnson, et al.[2000]), which facilitates connected lending and diversion of funds between groupcompanies, institutional rigidities (especially weak foreclosure laws) and regulatoryforbearance (including inadequate disclosure requirements of investments and other

lending practices), the outcome is a disproportionate build up of the riskiness ofintermediaries’ asset portfolios.2.2.1 Incentive distortions arising from public ownership of intermediariesIn the process, the incentive structures that underlie the functioning ofintermediaries are blunted and distorted to the extent that they over-ride the safetysystems that have nominally been put in place. The large fiscally-fundedrecapitalisations of banks in the early and mid-nineties may be rationalised as beingdesigned to prevent a system-wide collapse at a time when the sector had been buffetedby the onset of reforms and it had not had time to develop risk mitigation systems.Moreover, the overall reforms were designed to enhance domestic and externalcompetition, as a result of which past loans to industry were bound to get adverselyaffected, impacting these banks’ balance sheets. The nascent state of capital markets atthat time might also have been seen as a hindrance in accessing capital, especially12capital without large attached risk premia. The impact of this support, though, has beenconsiderably reduced, if not eliminated, by the series of ongoing bailouts, withseemingly little by way of (binding) reciprocating requirements imposed onintermediaries to prevent repeats of these episodes. It needs to be recognised that theonly sustainable method of ensuring capital adequacy in the long run is throughimprovement in earnings profile, not government recapitalisation or even mobilisationof private capital from the market.A singular aspect of financial sector reforms in India has been that, while the“look and feel” of organisations associated with intermediation has altered, the focus ofthe changes has revolved around the introduction of stricter sector regulatory standards.Caprio [1996] argues that regulation-oriented reforms cannot deliver the desiredoutcome unless banks are restructured simultaneously; this includes introduction ofmeasures that empower banks to work the new incentives into a viable and efficientbusiness model and encourage prudent risk-taking. These mechanisms are also meant tointer alia mitigate the “legacy costs” that continue to burden intermediaries even afterrestructuring. Some of these costs, in the Indian context, apart from the consequencesof public ownership discussed above, are well known: weak foreclosure systems andlegal recourse for recovering bad debts, ineffective exit procedures for both banks andcorporations, etc. In addition, during difficult times, fiscal stress is sought to be relievedthrough regulatory forbearance; there are demands for (and occasionally actualinstances of) lax enforcement (or dilution) of income recognition and assetclassification norms. A multiplicity of “economic” regulators, most of them not wholly13independent, deters enforcement of directives (see Bhattacharya and Patel [2001] for ananalysis of the way regulators have looked at financial market failures).11

Other than structural changes in corporate resource raising patterns, commerciallending is inhibited inter alia due to distortions in banks’ cost of borrowing and lendingstructures arising from interest rate restrictions. Continuing floors on short-termdeposits and high administered rates on bank deposit-like small savings instruments(National Savings Certificates, post office deposits, etc.) artificially raise the cost offunds for intermediaries. Lending constraints relate to various PLR related guidelinesfor Small Scale Industries (SSIs) and other priority sector lending. This constellation offactors has made treasury operations an important activity in improving banks’profitability.12 Over and above the regulatory oversight of the RBI, the role ofgovernment audit and enforcement agencies – like the Comptroller and Auditor

General (CAG), Central Vigilance Commission (CVC), Central Bureau of Investigation(CBI), etc. – in audits of decisions taken by loan officers at banks undermines “normal”risk taking associated with lending (see Banerjee et al. [2004]).13

The outcome of this environment is “lazy banking”14; banks in India seem tohave curtailed their credit creation role. Outstanding assets of commercial banks ingovernment securities are, as of March 5, 2004, much higher (just over 46%) than the11 For instance, cooperative banks have been lax in implementing RBI notifications on lending tobrokers.12 Declining interest rates increased trading profits (in securities) of PSBs in 2001-02 more than two anda half times that of the previous year and accounted for 28% of operating profits (RBI Report on Trendand Progress of Banking in India, 2001-02, Table II.14).13 Loan officers have complained about being harassed, if not penalised, for having taken on “good”credit risks, whereas risks not warranted by sound commercial practices have often been foisted on bythe political owners of these institutions.14 A term coined by one of the current Deputy Governors of the RBI.14mandated SLR (25%).15 As Figure 2 below shows, a large fraction of bank deposits arebeing deployed for holding government securities. This ratio, as is evident, has beenincreasing steadily over the last seven quarters and, more pertinently, has persisted overthe last two quarters despite a strong economic rebound and, presumably, a consequentincrease in demand for credit.Figure 2: Cumulative (quarter-wise) SLR securities investment - deposit ratio of SCBs (in %)Sources: RBI Handbook of Statistics, 2002-03 and Weekly Statistical SupplementsNote: Q4 2003-04 figures are as of March 5, 2004.

Note that this phenomenon is actually rational behaviour by banks given theincentive structure described above. In deciding on a trade-off between increasingcredit flows and investing in government securities, the economic, regulatory and fiscalenvironment is stacked against the former. An unintended consequence of theincreasingly tighter prudential norms that banks will be forced to adhere has been a15 It is also noteworthy that 51% of the outstanding stock of central government securities at end-March2002 was held by just two public sector institutions: the State Bank of India and the Life InsuranceCorporation of India (sourced from Government of India Receipts Budget, RBI Report on Trend andProgress and investment information on LIC’s website).40%50%60%70%80%Q1 Q2 Q3 Q42001-02 2002-03 2003-0415further shift in the deployment of deposits to government securities and otherinvestments that carry a comparatively lower risk weight16.3. RESIDUAL ROLES OF GOVERNMENT IN INTERMEDIATION IN AMARKET ECONOMY: A CRITICAL LOOKGiven the scenario described in the previous section, primarily driven throughdistorted incentives, of public sector involvement described above, there is a robustcase for the government to exit from actual intermediation. This section is a criticallook at the functions which are often claimed to be the residual (but legitimate) domainof intervention by the government, and examines the merits of the arguments advanced.We need to emphasise that even though the paper analyses the specific activities thatare claimed to be the residual arenas of government involvement in a commercialenvironment, it in no way provides a blanket endorsement of these actions in India.The paper adapts an institution-specific framework explored in Rodrik [2002] –

formulated in the context of general economic development – as a touchstone for thisanalysis. Rodrik groups the shortcomings and required actions related to market drivenreforms into four components, viz., (i) market stabilisation; (ii) market regulation; (iii)market creation; and (iv) market legitimisation. This paper relates to the last twoaspects, but primarily through the lens of a fifth component that we add and explore inthis paper, namely, “market completion”. Table 3 below provides a schematic layout asan organising scaffold for drawing together the threads of various aspects of the role of16 Banks were advised in April 2002 to build up an investment fluctuation reserve (IFR) of a minimum5% of their investments in the categories “Held for Trading” and “Available for Sale” within 5 years. Asat end-June 2003, total IFR amounted to only about Rs. 100 bn (i.e., 1.7% of investments under relevantcategories). While 12 banks are yet to make any provisions for IFR, 20 have built IFR up to 1% but only65 have IFR exceeding 1% (RBI Mid-term Credit and Monetary Policy, 2003). 17 PSBs have IFRs of2% or more (RBI Report on Trend and Progress, 2002-03).16the government in creating new markets that are necessary for facilitating transactionsas well as deal with issues that are a corollary of a move towards commercialorientation of economic activity.17Table 3: Matrix of institutional processes in the reform of the financial sectorInstitutions’roleObjective Mapping to the Indian(financial) contextAddressing specific shortcomingsMarketstabilisationStable monetary and fiscal management. Profligate fiscalenvironment.Pre-emption of resources by government.Efficacy of central bank functions.MarketregulationMitigating the impact of scale economiesand informational incompleteness.Regulatory forbearance.Public ownership ofinstitutions.Appropriate prudential regulation.Imposition of market discipline.Transparency and information disclosure.Market creation Enabling property rights and contractenforcement.Public ownership ofinstitutions.Enforcing creditor rights.Effective dispute resolution mechanisms.MarketlegitimisationSocial protection; conflict management;market access.Profligate fiscalenvironment.Regulatory forbearance.Public ownership ofinstitutions.Mixing social and commercial objectives(e.g., rural branch requirements for banks).

Appropriate insurance for depositors.Capital markets enforcement.Effective redressal of investor grievances.Marketcompletion“Spanning states of nature”. Shallow or non-existentmarkets.Lack of institutions and products to mitigatespecific (market-making) risks that hamperformation of markets.Inadequate old-age income safety nets.183.1 Facilitating transactions and deepening marketsGiven the significant information asymmetries that normally characterise capitalmarkets and, consequently, the specific risks that individual intermediaries (or evengroups) might not be able to bear, there are often inefficiencies in market transactions orthe inability of institutions to catalyse certain specialised economic activities. Marketinstitutions that minimise transactions cost, often in the nature of a quasi-public good, maynot necessarily emerge as a rational collective outcome of the individual players involved.These activities usually share characteristics of public merit goods. The government has animportant role in developing institutions that serve as platforms for correcting marketdeficiencies and failures as well as facilitating transactions and increasing marketliquidity, as well as improving clearing and settlement systems.Dealing with the commercial consequence of the new set of risks, however,demands the presence of specialised institutions. Debt markets in developed countries nowserve both as a complement to intermediaries’ loans to corporations as well as forinnovating structured financial instruments. In India, on the other hand, the fragmentednature of debt markets had entailed significant counter-party risk, thereby becoming abarrier to market integration and further hindering the formation of benchmark yieldcurves. This resulted in large and distorted spreads on rates of interest on debt instruments.As a consequence, the market disciplining effect of capital markets on intermediaries’loans, especially to corporations, has tended to be mitigated.The RBI, recognising the need for a financial infrastructure for clearing andsettlement of government securities, forex, money and debt markets (thereby bringing inefficiency in the transaction settlement process and insulate the financial system fromshocks emanating from operations related issues), initiated a move to establish the19Clearing Corporation of India (CCIL), with the SBI playing a lead role. CCIL wasincorporated in October 2001. CCIL takes over and mitigates counterparty risks by“novation”17 and “multilateral netting”. The risk management system at CCIL includes aSettlement Guarantee Fund (SGF) composed of collaterals contributed by the members,liquidity support in the form of pre-arranged lines of credit from banks, and a procedurefor collecting initial and mark-to-market margins from the members to ensure that the riskon account of members’ outstanding trade obligations remains covered by their respectivecontributions to SGF.The core activities of the Securities Trading Corporation of India (STCI) compriseparticipation, underwriting, market making and trading in government securities. It wassponsored by the RBI (jointly with PSBs and AIFIs18) with the main objective of fosteringthe development of an active secondary market for Government securities and bondsissued by public sector undertakings.In the equity markets, an important component of the government’s reform

programme in the 1990s consisted of creating three new institutions – the National StockExchange (NSE), National Securities Clearing Corporation (NSCC) and NationalSecurities Depository Limited (NSDL) – to facilitate the three legs of trading, clearing andsettlement. The first of these has been the most successful, and was in fact the progenitorof the other two. Promoted in 1993 by some AIFIs (at the behest of the government), as analternative to the incumbent Stock Exchange, Mumbai (BSE), the NSE has since become abenchmark for operations characterised by innovation and transparency. The NSE has17 Novation is the original contract between the two counterparties being replaced by a set of two contracts –between CCIL and each of the two counterparties, respectively.18 These comprise the DFIs, Investment Institutions like LIC and UTI, other Specialised FinancialInstitutions and Refinance Institutions (NABARD and the National Housing Bank, NHB).20overtaken the BSE in terms of spot transactions and has spearheaded the introduction ofderivative instruments, where it now accounts for 95% of trades.The NSCCL, a wholly owned subsidiary of NSE, was incorporated in August1995. It was constituted with the objectives of providing counter-party risk guarantees andto promote and maintain, short and consistent settlement cycles. NSCC has had a troublefreerecord of reliable settlement schedules since early 1996, having evolved asophisticated “risk containment” framework.To promote dematerialisation of securities, the NSE, IDBI and UTI set up NSDL,which commenced operations in November 1996, to gradually eradicate physical papertrading and settlement of securities. This got rid of risks associated with fake and badpaper and made transfer of securities automatic and instantaneous. Demat delivery todayconstitutes 99.99% of total delivery-based settlements.A point worth noting has been the inherent profitability of many of theseinstitutions. Volumes at the NSE, both in the spot and derivatives segments, haveincreased significantly in recent times. The annual compound growth in turnover at NSEover 1995-96 to 2002-03 was 73.1%19, and is likely to have significantly increased in thecurrent fiscal year. The government (indirectly, through the sponsoring financialinstitutions) stands to increase its returns from the volumes evident in these markets (notto mention the service taxes that directly accrue to it).3.2 Catalysing niche economic activitiesAs the government begins to open up areas of economic activity that had hithertobeen the exclusive domain of government to the private sector, many processes andinstitutions have to develop that can mitigate and allocate the attendant risks through21appropriate financial structures, innovative products, resource syndication and projectfacilitation. Without these institutions, the probability of private sector operations notsucceeding increases, leading to the political risk of re-nationalisation of at least some ofthese activities. In addition, individual initiatives depend upon a critical mass beingattained in certain “supporting” areas, which we analyse in the sub-sections below.3.2.1 Exim financingAlthough commercial banks in developed markets have the capability of financing(and re-financing) most trade related transactions, there remains – even in developedcountries – a residual role for a state-sponsored Exim bank for underwriting sovereignrelatedrisks, as well as advancing matters that are strategic in nature, apart from thetraditional role in building export competitiveness. In developing countries, in addition,there might not be commercial banks with sufficiently diversified portfolios of assets thatcan adequately cover the forex risks that are necessarily an adjunct of trade financing.

The Export-Import Bank of India (Exim Bank) was established in 1982, for thepurpose of financing, facilitating, and promoting foreign trade of India. It is the principalintermediary for coordinating institutions engaged in financing foreign trade transactions,accepting credit and country risks that private intermediaries are unable or unwilling toaccept. The Exim Bank provides export financing products that fulfill gaps in tradefinancing, especially for small businesses, in the areas of export product development,financing export marketing, besides information and advisory services20. As Indiancorporations increasingly invest in foreign countries, there is also a need for political riskinsurance, the mantle of which might also be assumed by this institution.19 NSE Factbook 2002-03.20 The Exim Bank’s role in export promotion, besides extending lines of credit, consists of educatingexporters about market potential, banking facilities, payment formalities, etc., which has a bearing on thecountry risk they might face.22Exim Bank’s loan assets have risen from Rs. 20.3 bn in 1993-94 to Rs. 87.7 bn in2002-03 (an increase of 340%), and its guarantee portfolio from Rs. 7.5 bn to Rs. 16.1 bn(113%) over this period. India’s manufacturing exports, over this period, has increasedfrom Rs. 685 bn to about Rs. 2,290 bn (234%).3.2.2 Infrastructure and project financingUniversally considered a pivot for economic growth, infrastructure has been one ofthe two large segments that has traditionally been under the rubric of the state in India (theother, as we have discussed, being the financial sector). The gradual recognition of theinefficiencies inherent in public provision of utility services, as well as the inability of theexchequer to cope with the large investments needed to upgrade, refurbish and buildassets, made the Indian government amenable to introducing private participation in thesector (in the early 1990s). Bhattacharya and Patel [2003a] had previously detailed thenecessity of developing sound regulatory structures in emerging economies forencouraging private investment in infrastructure. The unique requirements of projectfinance necessary for financial closure of private infrastructure projects had beenrecognised early on, but, of itself, this was soon found to be insufficient. After years ofeffort, and initial failure in most sectors in India, the importance of sound policy andregulatory frameworks to complement specialised financial products and markets wasunderstood.As an outcome of this understanding, the Infrastructure Development FinanceCompany (IDFC) was established to “lead private capital into commercially viableinfrastructure projects”. Apart from its responsibility in structuring finances forinfrastructure to lower the cost of capital, IDFC was tasked with rationalising the existingpolicy regimes in sectors as diverse as electricity, telecom, roads, ports, water &23sanitation, etc. Its policy advocacy initiatives in the telecom and civil aviation sectors aregood examples of the success in “developing sectors”, in contrast (and addition) to merelyfinancing individual projects. IDFC has also made an impact in bringing in funds intoprojects through innovative financial products like “take-out” financing and the use ofvarious risk-guarantee instruments, as well as financing structures such as the “annuity”method for road projects. These initiatives have had the effect of orchestrating asignificant quantum of private investment into infrastructure projects.3.3 Channels and instruments for social objectivesThe original rationale for nationalisation of banks in India, as well as theestablishment of DFIs, was the failure of existing private sector intermediaries to extend

the reach of banking to rural and remote areas, as well as perceived inadequacies inchannelling credit to what were then deemed as critical areas of industrialisation. Althoughunderstandable, and even recommended, in a specific context, the justification for acontinuation of these policies has been largely eroded. For some of these objectives, Indiaalready has specialised intermediaries – the National Bank for Rural Development(NABARD), Small Industries Development Bank of India (SIDBI), State FinanceCorporations (SFCs), etc. These institutions have quite obviously failed to live up to theirmandates, given the periodic exhortations by the government and supplementarymechanisms that are proposed to be instituted to advance their stated objectives.21 We lookat individual components of these objectives and argue that using bank intermediaries toachieve them is sub-optimal.21 There is a proposal in the Interim Budget 2004-05 for a “Fund” for small scale enterprises, but theobjective and disbursement mechanisms of this fund are not clear.243.3.1 Intermediating rural financial resourcesRural banking is rife with inefficiencies. Commercial banks, especially PSBs, havean inordinately large presence in rural and semi-urban areas. While only 33% of theirdeposits are sourced from (and 21% of credit is disbursed in) these areas, a full 71% oftheir branches are located there (see Appendix 1 Table A1.2). RBI licensing conditions fornew private sector banks stipulate that, after a moratorium period of three years, one out offour new branches has to be in rural areas, thereby adding significantly to operating costsin an intensely competitive environment.This is despite the prevalence of a large network of post offices that is thepredominant channel for small savings, as well as specialised Regional Rural Banks(RRBs), cooperatives and other intermediaries working through NABARD. India hadaround 155,000 post offices at end-March 2002, including about 139,000 in rural areas.22

The Post Office Savings Bank, operated as an agency for the Ministry of Finance, besidesbeing a conduit for National Small Savings (NSS) schemes, also offer money order andlimited life insurance schemes. The ambit of these outlets, many already operating inpartnership with commercial banks and insurance companies, can be further expanded inrural areas to address credit delivery shortcomings (the problematic aspect of ruralintermediation). Although, to the best of our knowledge, an exploration of the potential ofa re-organised post office network in India as the main channel of delivery of rural credithas not been done, an instructive report is that of the Performance and Innovation Unit ofthe British government, whose post office organisational structure is similar to India’s(PIU [2000]).Rural banking needs might be “narrower” in nature and alternative credit deliverymechanisms – which might be better suited and more cost effective – may be considered.25The other side of the coin is the reported shortcomings of credit delivery throughinstitutions like NABARD, which is validated through the casual empiricism of a periodicrefrain of the government to disburse funds to the agricultural sector at administrativelymandated rates of interest.23 Not only are lending decisions of individual banks distorted(through the implicit cross-subsidies), financial sector reforms are systemicallyundermined through these administrative directives. The success of operations of certainSelf Help Groups (SHGs) and micro credit institutions (SEWA being a prime example)has also demonstrated the viability and higher sustainability of these alternative channels.The use of minimum subsidy bidding to achieve some of the government’s socialobjectives might be more cost-effective.

3.3.2 Lending to “priority sectors”As seen above, the dilution of the credit creation role of banks have raisedconcerns about under-lending. This worry is especially high for agriculture and small scaleindustries. According to RBI guidelines, banks have to provide 40% of net bank credit topriority sectors, which include agriculture, small industries, retail trade and the selfemployed.Within this overall target, 18% of the net bank credit has to be to theagriculture sector and another 10% to the weaker sections. Commercial banks have beenconsistently unable to attain these targets, and the expedient of channeling the shortfalls tothe Rural Infrastructure Development Fund (under NABARD’s administrative ambit) hasled to concerns about its relatively non-transparent procedures of disbursement and thepotential of future Non Performing Assets (NPAs).One of the arguments for mandating lending to the priority sectors at interest rateslower than market rates is an administrative mitigation of the higher risk premiums for the22 India Post Annual Report 2002-03.26(supposedly) inherently risky nature of this lending. An outcome of this risk is the level ofNPAs. While credit appraisals for small firms are definitely more difficult, the argumentof potentially high NPAs in priority sector advances may need to be nuanced (even if justa little) in light of the numbers on the sector-wise origins of NPAs of PSBs, as of end-March 2003. While the share of priority sector NPAs in the total is about 47%24 for PSBs,their total loans outstanding to the priority sector (as a percentage of total loans) at end-March 2003 was about 43%25. At the same time, the high NPAs of DFIs remain a pointerto the perils of administrative mandates in advancing social goals as well as reliance onstate government-guaranteed lending.26

3.3.3 Social security netsThe provident fund system is the most important component of the social securitynet, but covers a meager 11 million persons, all of them in the organised sector. Animportant component of the Employee Provident Fund (EPF) Scheme of the EPFO(discussed earlier) is the administratively determined markup for the returns provided ondeposits into the EPF, justified on the basis of providing an adequate livelihood forpensioners and others on limited fixed incomes. It is estimated that the average real annualcompound rate of return over the period 1986-2000 was 2.7% (Asher [2003]).One of the worries, apart from concerns about investment efficiency, is thesustainability of this method. The average markup between the returns provided by theEPF and 10-year Government of India securities since 1995-96 has been 120 basis23 For instance, the recent directive to banks in December 2003 to disburse farm credit at 2% below theirrespective Prime Lending Rates (PLRs).24 RBI Statistical Tables Relating to Banks in India, 2002-03, Table 7.2.25 RBI Report on Trend and Progress in Banking, 2002-03, para. 3.93. This includes transfers to RIDF,SIDBI, etc.26 Net NPAs of DFIs were 18.8% of advances in 2002-03 (RBI Report op. cit).27points27. The various tax exemptions that are granted to these deposits – throughout thelife of these deposits – make the effective rate of return even higher. A back-of-theenvelopecalculation in Patel [1997a] indicated that the EPS was actuarially insolvent andthe EPFO’s reluctance to make public its actuarial calculations does little to assuage thisconclusion. Other than issues of sustainability, there remain concerns of these and otherNational Small Savings (NSS) schemes regarding the distortive effects on the yield curve(term structure of interest rates). As Table A1.1 shows, small savings outstandingaccounted for over 15% of GDP in 2002-03, dwarfing all other intermediaries but banks.

3.4 Deposit insurance to enhance systemic stabilityOther than instituting a sound regulatory mechanism and facilitating efficient andseamless transactions, a major aspect of the government’s role in imparting stability to thefinancial system is the constitution of an appropriate safety net for depositors. The currentsystem has a built-in bias which leans towards using taxpayer funds to finance bank losses,thus undermining even limited market discipline and encouraging regulatory forbearance.India has a relatively liberal deposit insurance structure, compared to internationalnorms (Demirguc-Kunt and Kane [2001]). Depositors in India do not have to bear coinsuranceon the insured deposit amount and the ceiling insured amount (Rs. 100,000) isfive times the per capita GDP, high by international standards. This encourages somedepositors to become less concerned about the financial health of their banks and forbanks to take on additional (and commercially non-viable) risks.The Deposit Insurance and Credit Guarantee Corporation (DICGC) came intoexistence in 1978 as a statutory body through an amalgamation of the erstwhile separateDeposit Insurance Corporation (DIC) and Credit Guarantee Corporation (CGC). DICGC27 The rate of return on the EPF scheme has been set at 12% per annum from 1989-90 onwards, till July 200028extended its guarantee support to credit granted to small scale industries from 1981, andfrom 1989, the guarantee cover was extended to priority sector advances. However, from1995, housing loans have been excluded from the purview of guarantee cover. As of 2001-02, about 74% of the total (accessible, i.e., excluding inter-bank and government) depositsof commercial banks was insured28. Banks are required to bear the insurance premium ofRe 0.05 per Rs. 100 per annum (depositors are not charged for insurance protection).The issues raised by an overly generous deposit insurance structure have beenrecognised by the government. Some of the major recommendations of the 1999 WorkingGroup constituted by the RBI to examine the issue of deposit insurance are withdrawingthe function of credit guarantee on loans from DICGC and instituting a risk-based pricingof the deposit insurance premium instead of the present flat rate system. A new law,superceding the existing one, is supposedly required to be passed in order to implementthe recommendations.4. CONCLUSIONDespite the institution of market reforms in India since the early nineties,government “interests” in the financial sector have not diminished commensurate to itswithdrawal from most other aspects of economic activity. The continuing presence is toolarge to be justified solely on considerations of containing systemic risk.There might have been justifiable reasons for government ownership ofintermediaries in the early years of India’s development, but these have now beenrendered redundant, and possibly even damaging. India now has a relatively welldeveloped intermediation network, with intermediaries that are becoming increasinglycommercially oriented. The raison d’etre of the Development Finance Institutions (DFIs)from when they have been progressively reduced to the current 9%.29is also now obsolete, with the continuing development of project finance skills of banksand the maturing of capital markets.A combination of directing resources of intermediaries in fulfilling a quasi-fiscalrole for government, extra-commercial accountability structures and regulatoryforbearance (arising out of an implicit overarching guarantee umbrella) has mitigated theessential corrective effect of market discipline in both lending and deposit decisions.

Coupled with persisting government involvement in intermediation and an implicitsupport scaffold, this has resulted in an aggravation of the problems of moral hazard thatis a normal feature of financial systems.A cycling analogy is the most apt to describe the outcome of these deficiencies.The set of actions that increasingly aggravate moral hazard, through visible and invisibleprops to keep the edifice from falling, is like riding a bicycle without brakes down a hill –attempting to stop or intensifying pedalling will lead inexorably to a wreck. The prudentescape is to look for a soft spot to crash to minimise damage and then get the brakesrepaired.India is unlikely to suffer a full-blown systemic crisis, witnessed in differentcontexts in various countries. Its financial sector inefficiencies are likely to simplysimmer, with occasional payments crises, like the one at the dominant mutual fund overthe last five years. However, the cumulative inefficiencies and grim fiscal outlook, withthe concomitant regulatory forbearance that public involvement inevitably entails, arecertain to retard India’s transition to a high growth trajectory. The persistent unease withthe state of the system, it can be speculated, arises from the recognition that the perceived28 DICGC Annual Report 2001-02.30safety of intermediaries is due more to the “social contract” between the government anddepositors than underlying robustness in the health of the sector.The system of intermediation will not improve appreciably in the absence of anyserious steps towards changing incentives blunted by public sector involvement (of whichownership is an important aspect). To sharpen these incentives, outright privatisation maynot be sufficient, but it is necessary. It is the first step to a true relinquishing ofmanagement control, which remains far beyond the scope envisaged in the BankingCompanies (Acquisition and Transfer of Undertakings) Bill tabled in Parliament in 2002(and still languishing), designed to reduce government holding in nationalised banks to33%, but allowing them to retain their “public sector character” by maintaining effectivecontrol over their boards and restricting the voting right of non-government nominees.Attempts to shed commercial risks of investors, borrowers and depositors (throughimplicit bailout and other means of accommodating fragility) will almost certainly lead toeconomic ones during slowdowns, creating a new kind of instability.Old habits, unfortunately, die hard. There has re-emerged in official thinking anambiguity about the perceived role of financial institutions as a tool of financial policy. Onthe one hand, there is an extensive restructuring of the DFIs underway, through mergersand redefinitions of their statutory status. Yet, on the other, various aspects of financialsector reforms are either being rolled back (directives for lending to target groups) or arenot being addressed (artificially high rates of interest for small savings schemes). Variousdecisions that strengthen the “DFI model” – including directed disbursements at lowerthan market interest rates, use of public sector intermediaries for interventions in capitalmarkets, etc. – have recently been taken. More than anything else, the cardinal mistake is31to confuse outcomes with mechanisms and processes. Both, after a brief period ofincreasing emphasis on commercial viability, are again becoming target driven.Given the increasing integration of financial markets, there is also a need to shiftreform focus from individual intermediaries to a system level. An important component inthis shift is enhancing intermediaries’ ability to de-risk their asset portfolios. Undoubtedly,the Securitisation and Reconstruction of Financial Assets and Enforcement of SecurityInterest (SARFAESI) Act of 2002 is a crucial step forward in addressing bad loans, but, on

its own, it is limited in scope and even this is beset by various legal challenges.Establishing asset reconstruction companies, even under private management, will serveonly to tackle the overhang of existing bad assets – they per se do little to correct thedistortions in incentives that are intrinsic to large parts of the system.There, however, remain some aspects of intermediation that are in the nature ofpublic goods. One is the establishment of specific “platforms” for facilitating transactions.Another is to catalyse certain economic activities that are in the nature of testing waters orelse are pioneering financial services. The government has constituted diverse bodies tofulfill these roles; it is worth noting that the most successful among these have beeninstitutions that have had no direct intermediation functions. The state might have otherlegitimate social objectives like extending the reach of intermediation in rural and remoteareas and providing social security nets; these, though, would be better achieved throughthe use of existing networks like post offices rather than commercial banks.32ReferencesAllen, F. and D. Gale, 2001, “Comparative financial systems: A survey”, Mimeo., NewYork University.Asher, M. G., 2003, “Reforming India’s social security system”, Mimeo., NationalUniversity of Singapore, May.Banerjee, A. V., S. Cole and E. Duflo, 2004, “Banking Reform in India”, paper presentedat the Inaugural Conference of the India Policy Forum, New Delhi, March.Bhattacharya, S. and U. R. Patel, 2001, “New regulatory institutions in India: WhiteKnights or Trojan Horses?”, forthcoming in volume of Conference Proceedings on PublicInstitutions in India: Performance and Design, Harvard University (revised version: May2003).Bhattacharya, S. and U. R. Patel, 2002, “Financial intermediation in India: A case ofaggravated moral hazard?”, Working Paper No. 145, SCID, Stanford University, July;(revised version forthcoming in volume on Proceedings of Third Annual Conference onthe Reform of Indian Economic Policies, Stanford University, (ed) T. N. Srinivasan).Bhattacharya, S. and U. R. Patel, 2003a, “Markets, regulatory institutions, competitivenessand reforms”, Working Paper No. 184, SCID, Stanford University, September.Bhattacharya, S. and U. R. Patel, 2003b, “Reform strategies in the Indian financial sector”,forthcoming in the Proceedings volume of IMF-NCAER Conference on India’s andChina’s Experience with Reform and Growth, New Delhi, November.Buiter, W. H. and U. R. Patel, 1997, “Budgetary aspects of stabilisation and structuraladjustment in India”, in Macroeconomic Dimensions of Public Finance, Essays in Honourof Vito Tanzi, M. Blejer and T. Ter-Minassian (Eds.) (Routledge, London).Calomiris, C. W. and A. Powell, 2000, “Can emerging market bank regulators establishcredible discipline?”, National Bureau of Economic Research Working Paper No. 7715,May.Caprio, G., 1996, “Bank regulation: the case of the missing model”, Paper presented atBrookings - KPMG Conference on Sequencing of Financial Reform, Washington, D.C.Demirguc-Kunt, A. and E. J. Kane, 2001, “Deposit insurance around the world: Wheredoes it work?”, Paper prepared for World Bank Conference on Deposit Insurance, July.Gerschenkron, A., 1962, “Economic backwardness in historical perspective: A book ofessays”, Harvard University Press.Hawkins, J. and D. Mihaljek, 2001, “The banking industry in the emerging marketeconomies: Competition, consolidation and systemic stability,” Overview Paper, BISPapers No. 4, August.

Kornai, J., 1979, “Resource-constrained vs. demand-constrained systems,” Econometrica,vol. 47, pp. 801-819.33La Porta, R., F. L. de-Silanes and A. Shleifer, 2000, “Government ownership of banks”,Mimeo., Harvard University.Levine, R., 1997, “Financial development and economic growth: Views and agenda”,Journal of Economic Literature, vol. XXXV, pp. 688-726.Lewis, W. A., 1955, “The theory of economic growth”, London.Patel, U. R., 1997a, “Aspects of pension fund reform: Lessons for India”, Economic andPolitical Weekly, vol. XXXII (No. 38, September 20-26) pp. 2395-2402.Patel, U. R., 1997b, “Emerging reforms in Indian banking: International perspectives”,Economic and Political Weekly, vol. XXXII (No. 42, October 18-24) pp. 2655-2660.Patel, U. R., 2000, “Outlook for the Indian financial sector”, Economic and PoliticalWeekly, vol. XXXV (No. 45, November 4-10), pp. 3933-3938.Patel, U. R. and Bhattacharya, S., 2003, “The Financial Leverage Coefficient:Macroeconomic implications of government involvement in intermediaries”, WorkingPaper No. 157, SCID, Stanford University.Performance and Innovation Unit Report, 2000, “Counter revolution: Modernising thepost office network”, UK Government Cabinet Office, June.Rodrik, D., 2002, “After neo-liberalism, what?”, Mimeo. Harvard University, June.Shleifer, A. and R. Vishny, 1994, “Politicians and Firms,” Quarterly Journal ofEconomics, vol. 109, pp. 995-1025.34APPENDIX 1Table A1.1: Comparative profile of financial intermediaries and markets in India(Amounts in Rupees billion, and numbers in parentheses are percentage of GDP)1990-91 1998-99 2002-03Gross Domestic Savings 1,301 3,932 5,500(24.3) (22.3) (24.0)Bank deposits outstanding 2,078 7,140 13,043(38.2) (40.5) (50.1)Small Savings deposits, PPFs, outstanding etc 1,071 3,333 3,810(20.0) (19.1) (15.4)Mutual Funds (Assets under management) 253 858 1,093(4.7) (4.9) (4.2)Public / Regulated NBFC deposits 174* 204 178(2.4) (1.2) (0.7)Total borrowings by DFIs (outstanding) -- 2108 901(12.0) (3.5)Annual Stock market turnover (BSE & NSE) 360& 15,241 9,321(5.6) (79.0) (35.8)Stock market capitalisation (BSE & NSE) 845& 18,732 11,093(15.8) (97.1) (42.6)Turnover of Government securities (excluding repos)through SGL (monthly average)-- 310 2,287(1.8) (9.0)Annual turnover as % of stock market turnover -- 24% 276%Volume of corporate debt traded at NSE (excludingCommercial Paper)-- 9 58Legends: *: denotes figures at end-March 1993. &: Pertains only to BSE. --: Not comparable.

Table A1.2: Current trends in banking in urban and non-urban areas (as on March 31, 2003)No. ofbankbranchesDeposits(Rs. bn)

Credit(Rs. bn)C-D Ratio(%)Scheduled Commercial BanksUrban centres (including metros) 19,379 29% 8,619 67% 5,998 79% 70%Metro centres 8,664 13% 5,719 45% 4,745 62% 83%Top 100 centres 15,066 23% 7,603 61% 5,758 75% 74%Non Urban centres 38%Semi urban centres 14,813 22% 2,405 19% 847 11% 35%Rural centres 32,244 49% 1,763 14% 748 10% 42%All India 66,436 12,787 7,592 59%Regional Rural Banks (RRBs) 14,462(21%)498(4%)221(3%)44%Source: Culled from RBI Banking Statistics – Quarterly Handout, March 2003.Note: Percentages for RRBs in parentheses represent shares relative to those for all India ScheduledCommercial Banks.35Figure A1.1: Country comparison of government ownership of banks867968524431 30 2518 151 0 0 012132332 496221558278938395502 8 9 167 7492019 6175500%25%50%75%100%ChinaIndiaRuss iaBrazilIndonesiaThailandArgentinaMe xicoGe rm anySw itzerlandJapanAus traliaUSASingapor eGovernment banks Domestic private banks Foreign Banks

Source: BCG presentation, CII Banking Summit, 2003.36APPENDIX 2METHODOLOGY OF CONSTRUCTION OF THE INDEX OF DENSITY OFGOVERNMENT INVOLVEMENT IN THE FINANCIAL SECTOR (IDGI-F).This appendix is an enumeration of the constituent groupings of the Index ofDensity of Government Involvement in the Financial Sector (IDGI-F) and an associatedweighting system. The weights are uniform, being simply +1 or –1 depending on theappropriate definition of the respective series vis-à-vis the definition of impact oninvolvement.I. Constituents of IDGI-FA. Share of public sector banks (PSBs) and financial institutions (FIs) in total financialintermediation.1. Share in resource mobilisation (as a sum of the following):a. Net demand and time liabilities of public sector banks (as % offinancial savings).b. Resources mobilised by DFIs through bond issues (as % of financialsavings).c. Premia of LIC / Amounts mobilised by UTI (as % of financial savings).B. Lending practices and use of funds.2. Investments in government securities by banks and financial institutions (as %of their incremental lendable resources).3. Excess deposits deployed by PSBs in priority sectors (as % of Net Bank Credit,in excess of minimum prescribed norms).C. Trends in the government’s pre-emption of financial resources.4. Share of public investment in overall investment (e.g., 7.7 percent out of 26.8percent in 1995-96 and 6.9 percent out of 23.7 percent in 2001-02).375. Public sector saving - investment gap (as % of GDP).6. Public sector fiscal / resource gap (a proxy for Public Sector BorrowingRequirement (PSBR), as % of GDP).7. Outstanding explicit liabilities of the (central and state) governments (as % ofGDP).8. Outstanding contingent liabilities (guarantees and other off-balance sheetitems) of the (central and state) governments (as % of GDP).II. Methodology for construction of the IDGI-FThe IDGI-F is a simple weighted average of the rates of change of “synthetic”(sub-index) constituent series. These synthetic sub-index series are constructed using the(observed) rates of change of the constituent variables (detailed above), with the values ofvariables of the individual series each being normalised to 100 in 1990-91.

RURAL AGRI- MARKETING IN INDIA - WITH SPECIAL REFERENCE TO AGRICULTURAL PRODUCE IN INDIA

ABSTRACT

Around 700 million people, or 70% of India's population, live in 6,27,000 villages in rural areas. 90% of the rural population is concentrated in villages with a population of less than 2000. Rural marketing is as old as the civilization. Surplus of agro - products are exchanged in earlier days in the barter system. The introduction of currency, transport, and communication has increased the scope of rural market. This paper discusses the present scenario of rural marketing especially rural produce, and its importance, current trends, and highlights certain problems related to rural marketing. Further it highlights the improvements that make the rural marketing system most effective.------------------------------------------------------------------------------------------------------

RURAL AGRI - MARKETING IN INDIA - WITH SPECIAL REFERENCE TO AGRICULTURAL PRODUCE IN INDIA

RURAL MARKETING

Rural marketing facilitate flow of goods and service from rural producers to urban consumers at possible time with reasonable prices, and agriculture inputs/ consumer goods from urban to rural. Marketing as a function has started much earlier when civilization started but not recognized as marketing. All economy goods are marketed in terms of goods and services (Barter system). Now money is being practiced as a good exchanging medium. The market may be a street, or a small town/ metropolitan city, Developments in infrastructure, transport, and communication facilities has increased the scope of the rural market.

Environment

The difference between rural and urban markets on the basis of various socio – economic factors, most dominant among them being the source of income, the frequency of receipt of income, the seasonal nature of income and consumption. Rural markets are small, non- contiguous settlement units of village relatively low infrastructure facilitates, low density of population, their life styles also being different. Rural consumers are mostly farmers whose income receipts are dependent on the vagaries of nature.

Agri-Marketing

Rural population has been increased about 74% of the total population; the demand for products and services has increased a lot in rural areas. Green revolution in the North and white revolution in the West has brought about a new prosperity in the lives of rural people. Government emphasis on rural development has caused significant changes in the rural scenario. Moreover, the special attention given for infrastructure development through the successive Five-year plans has improved the buying and consumption pattern of rural people.

The Rural Agro – Products:

The rural agro-products are

* Fruits & Vegetables * Grains * Flowers

Rural sale products

* Milk & poultry products * Handicrafts and Hand loom products * Tribal village products like tamarind, Lac, soapnut etc

The peculiar characteristics of agricultural produce are:

* Bulkiness * Perishability * Wide varietal differences * Dispersed production * Processing needs for consumption * Seasonality

GROSS CROPPED AREA BY 1997 CROP WISE PERCENTAGE GIVEN BELOW

CROP PERCENTAGE AREA

SUGGER CANE 2

COTTON 4

RICE 22

WHEAT 13

OTHER CEREALS 19

PULCESS 13

OIL SEEDS 15

OTHERS 12

TOTAL 100

More than 40 % of the gross cropped area under non- food grains is under oilseeds. Principally groundnut and rapseed and mustered, cotton and sugar cane area the other major non- food grain crops.

VEGETABLES (share in production)

CROP % 0F TOTAL PRODUCTION

TOMATO 8

ONION 8

BRINJAL 9

CAULIFLOWER 6

OKAR 6

PEAS 3

POTATO 25

CABBAGE 6

OTHER 29

TOTAL 100

FRUITS

The major fruits share in total fruit production

Fruit name Percentage of fruit Production

BANANA 27

APPLE 2

CITRUA 8

MANGO 23

GUVA 3O

OTHERS 37

India is the largest producers of mangos and banana in the world, and top ten producers of apples and pineapples. Other fruits, guava, sapota, papaya etc. Area under fruits which was estimated to 1.45 millions hectares in 1970-71 grow slowly and gear up after 1991-92 to 2.8 million hectares.

DAIRY

India is the largest milk producer and processing of milk was largely in the cooperatives sector.

NATIONAL DAIRY DEVELOPMENT BOARD PLAN ESTIMATION FOR YEAR 2010

Year 1999 Year 2010

6 lack liters per day sale 34 lack litters per day

9.11 lack litters per day procurement 71 Lack lit per day

174 ml per consumption per day 230 ml per consumption per day

Rural marketing depends on agricultural produce, the production is seasonal and the consumption is spread out equalization of demand and supply has to be done. In addition, the raw agricultural produce as marketed by farmers has to be processed by many middlemen This include collection and assembling, financing, grading and standardization, storage, transportation, wholesaling and retailing these functions performed by village merchants, commission agents, wholesalers, processors etc. These people seek returns commensurating with their investments of capital, time and labour. As a result, the middlemen get more share of the price than the producers.

TYPES OF RURAL MARKETS

HAATS /SANDIES (mostly for weekly market for all commodities)

MANDIS (mostly for all types of grains)

COMMODITY SPECILISED MARKETS

Nasik for onions and Grapes market, Nagpur for Orange market, Delhi for Apples market, Salem{TN} for Mangoes, Farkka market for potato market and Calcutta / Assam for tea market.

REGULATED MARKETS

There are more than 5000 primary and Secondary Agricultural produce wholesale assembling markets functioning in the country. These markets are meant for the farmers to take their produce for sale. These markets facilitate formers, immediate cash payments. The directorate of state Agricultural Marketing Board or Registrar of cooperative marketing societies is controlling these markets. The market is run by an elected committee comprising of members from the farmers community, commission

agents/wholesalers and some government nominees from Directorate of state agriculture / cooperative societies.

COOPERATIVE MARKETING

Another major improvement for rural producers is the formation of cooperative societies. Farmer's common interest helped to increase the incomes of the farmers and avoid exploitation of the middlemen. There are about five lack cooperatives working but very few cooperative societies in selected areas like Dairy, sugar, oilseeds, Mahagrape in Maharastra, tomato growers in Punjab etc. succeeded in cooperative processing industry.

Problems in Rural Marketing

The rural market offers a vast untapped potential. It is not that easy to operate in rural market because of several problems and also it is a time consuming affair and it requires considerable investments in terms of evolving appropriate strategies with a view to tackle the problems.

The problems are.

* Underdeveloped people and underdeveloped markets * Lack of proper physical communication facilities* Inadequate Media coverage for rural communication* Multi language and Dialects* Market organization & staff

Underdeveloped people and underdeveloped markets

The agricultural technology has tried to develop the people and market in rural areas. Unfortunately, the impact of the technology is not felt uniformly through out the country. Some districts in Punjab, Haryana or Western Uttar Pradesh where rural consumer is somewhat comparable to his urban counterpart, there are large areas and groups of people who have remained beyond the technological breakthrough. In addition, the farmers with small agricultural land holdings have also been unable to take advantage of the new technology.

Lack of proper physical communication facilities

Nearly 50 percent of the villages in the country do not have all weather roads. Physical communication to these villages is highly expensive. Even today, most villages in eastern part of the country are inaccessible during monsoon season.

Inadequate Media coverage for rural communication

A large number of rural families own radios and television sets there are also community radio and T.V sets. These have been used to diffuse agricultural technology to rural areas. However the coverage relating to marketing is inadequate using this aid of Marketing.

Multi language and Dialects

The number of languages and dialects vary from state to state region to region This type of distribution of population warrants appropriate strategies to decide the extent of coverage of rural market.

OTHER FACTORS INFLUENCING MARKETING

Natural calamities and Market conditions (demand, supply and price). Pests and diseases, Drought or too much rains, Primitive methods of cultivation, lack of proper storage facilities which exposes grain to rain and rats, Grading, Transport, Market Intelligence (up to date market prices to villagers), Long chain of middlemen (Large no. of intermediaries between cultivator and consumer, wholesalers and retailers, Fundamental practices (Market Dealers and Commission Agents get good part of sale of receipts).

MAJOR LOSERS IN AGRICULTURAL MARKETING

Small and marginal farmers , 75% villagers are illiterates or semiliterate, they facing difficulties like proper paper procedures for getting loans and insurance. The farmers facing high interest rates for their credits (Local money lending system). Most of the credit needed for agricultural inputs like seeds, pesticides, and fertilizers.

THE MAJOR WEAKNESS AND CHALLENGES IN THIS SECTOR

* Traditional mind not to react new ideas. * Agricultural income mostly invested in gold ornaments and weddings. * Low rural literature. * Not persuading new thinking and improved products

EMERGING TRENDS IN MARKETS

ON LINE RURAL MARKET (INTERNET, NICNET):

Rural people can use the two-way communication through on – line service for crop information, purchases of Agri-inputs, consumer durable and sale of rural produce online at reasonable price. Farm information online marketing easily accessible in rural areas because of spread of telecommunication facilities all over India. Agricultural information can get through the Internet if each village have small information office

COST BENEFIT ANALYSIS IN THIS SECTOR

Cost benefit can be achieved through development of information technology at the doorsteps of villagers. Most of the rural farmers need price information of agri-produce and inputs. If the information is available farmers can take quick decision where to sell their produce, if the price matches with local market farmers no need to go near by the city and waste of money & time it means farmers can enrich their financial strength.

NEED BASED PRODUCTION

Supply plays major role in price of the rural produce, most of the farmers grow crops in particular seasons not through out the year, it causes oversupply in the market and drastic price cut in the agricultural produce. Now the information technology has

been improving if the rural people enable to access the rural communication, farmers' awareness can be created about crops and forecasting of future demand, market taste. Farmers can equates their produce to demand and supply, they can create farmers driven market rather than supply driven market. If the need based production system developed not only prices but also storage cost can be saved. It is possible now a days the concept of global village.

MARKET DRIVEN EXTENSION

Agricultural extension is continuously going through renewal process where the focus includes a whole range of dimensions varying from institutional arrangements, privatization, decentralization, partnership, efficiency and participation. The most important change that influences the extension system is market forces. There is a need for the present extension system to think of the market driven approach, which would cater the demands of farmers.

AGRO- PROCESSING INDUSTRY

India is the second largest producer of fruits and vegetables in the world with an annual production of more than 110 million tonnes of fruit and vegetable only 1.3 percent of the output is processed by the organised sector commercially, the reason higher consumption in fresh form. However, as the packaging, transportation and processing capacities increase, the market for processed fruits and vegetables is projected to grow at the rate of about 20 % per annum. 100 % export oriented units (EOU) and Joint venture units required improving the processing industry.

KISAN MANDI

There is a need to promote direct agricultural marketing model through retail outlets of farmer's co-operatives in urban areas. The direct link between producers and consumers would work in two ways: one, by enabling farmers to take advantage of the high price and secondly, by putting downward pressure on the retail prices.

RECENT DEVELOPMENTS IN TAMILNADU

Many remote villages now connected to main roads and link roads with the help of innovative technique of grass root development by the people for the people of the people. "Uzhavar sandhai" the another development of rural farmers reducing middle men and also cost to the benefit of urban society.

The Innovative –" Uzhavar sandhai"

The recent changes in agricultural produce sale by farmers in Uzhavar sandhai leads to direct selling vegetables and other commodities to urban needs. Government of Tamilnadu started Uzhavar sandhai all over the state for the purpose of direct selling their produce to urban needs, not only selling of rural produce but also exchange of their ideas each others.

Procurement Prices / Support Prices

These prices are more than minimum prices, which facilitates government bulky procurement for Public Distribution System and maintains buffer stock levels.

Farmer has little control over prices, which are determined by the broad factors of, supply and demand market at large.

SUGGESTIONS FOR SOUND AGRICULTURAL MARKETING IN INDIA

* Suitable structure of support prices for various farm commodities adjusted from time to time. * Adequate arrangement of agricultural produce on support price if the price falls below the level. * Regulated infrastructure of markets and warehouses, which ensure fair prices * Rural roads must be compliment and coordinate with railways, nearest waterways (port), airports if possible. * The efficient marketing is predominantly influenced by efficient distribution system it means products such ultimate consumer in the quickest time possible at minimum cost. * The development of communication systems appropriate to rural market may cost up to six times as much as reaching an urban market through established media, need rural communication facilities. * The state marketing board or federation or market committees also the producers, traders and sellers have necessarily to be consulted as they have the principle interest towards it s use. * The arrivals of various products such as    Food grains    Vegetables    Dairy products    Flowers etc. need speedy transport. * Public weighing machines one in each rural market to ensure correct weightment both for farm and non-farm arrivals. Storage godowns and an office also required. * For storage facilities the government should not depend on private agencies to store food grains (National commission on Agriculture recommended). * Rural markets need more number of godowns and ancillary platforms for packaging places, market office cum information cell, bank and post office. * Rural marketing is the nerve center of a rural economy, rural markets are the channels for the movements of goods and services as well as to promote cultural integration. * Agricultural technology must reach all over the country, irrespective of size of land holding. * Improve physical communication facility to nook and corner of the country. * Land reforms need effectively implemented, because the land is basic asset of rural people. * Rural communication must be in regional language and dialects. * The existing marketing staff must be increased and adequate training must be given. * Extending of financial support for modernization of the agro-processing units is also needed. * Processing units should utilise fully capacity. * There is need to find out markets for agro-processed products within and out side of the country. * The proper packaging technology must be improved.

CONCLUSION

Considering the emerging issues and challenges, government support is necessary for the development of marketing of agricultural produce. The government may

adjust suitable budget allocations to rural infrastructure plans, and proper supervision for effective plan implementation. The core areas like transport, communication, roads, credit institutions, crop insurance for better utilization of land and water at appropriate level. The rural people and markets will definitely develop rural income and reduce poverty, on the whole countries economy will boost at an expected level. MANAGE an extension management institution may provide extension services to rural people in crop information, price information, insurance and credit information by using various media. MANAGE may recommend / advice to central and state governments on suitable infrastructure development, current problems in rural markets and problem solving techniques.

REFERENCES

1. Marketing of Agricultural inputs by Manohar Lal Jalan., Published by Himalaya Publishing House (Delhi). 1988. 2. Agricultural Price Policy in India by Raj Kumar Singh., Published by Print well Publishers –(Jaipur). 1990.3. Communication and Rural Development by J.B. Ambekar Yadav. Published by Mittal Publications (New Delhi). 1992. 4. Development of Agricultural Marketing in India by Dr. Rajagopal Published by Print well (Jaipur). 5. Marketing Management by Philip kotlar. 1992. 8th edition. 6. Rural Marketing by T.P.Gopal Swamy published by Wheeler publishings (New Delhi) 1998. 7. CMIE report 97 8. Indian agrl. Journal of agril.economics vol. 54