1

Contents

Contents...............................................................................................................................1
INDIA’S STRATEGY OF ECONOMIC DEVELOPMENT POST-INDEPENDENCE...2
Development Strategies ..................................................................................................3
Foreign Trade and Investment.........................................................................................5
THE CONSEQUENCES OF INDIA’S REGULATED ECONOMIC DEVELOPMENT
............................................................................................................................................10
Reasons India adopted the New Economic Policy........................................................12
The New Economic Policy of 1991...............................................................................13
New Economic Policy of 1991 included globalization, liberalization and privatization
(Disinvestment)..................................................................................................................14
The Major areas of New Economic Policy 1991 are.....................................................16
Expected benefits from the NEP were:..........................................................................17
Banking Industry of India:.................................................................................................20
History of the Indian Banking Industry:............................................................................21
Pre-reform period of banking sector in India.....................................................................23
Reforms undertaken in the banking sector in the 1990’s:..................................................25
Statutory pre-emptions...................................................................................................26
Priority sector lending....................................................................................................27
Interest rate liberalization..............................................................................................27
Entry barriers.................................................................................................................28
Prudential norms............................................................................................................28
Public Sector Banks.......................................................................................................29
Credit Market.................................................................................................................31
INSTITUTIONAL STRUCTURE OF THE CREDIT MARKET IN INDIA...................34
POLICY DEVELOPMENTS IN THE CREDIT MARKET IN INDIA...........................35
TRENDS IN CREDIT – THE 1990s AND ONWARDS..................................................37
STATUS AND EFFECTS OF LIBERALIZATION.........................................................38
Impact of the banking sector reforms on the banking industry of Indias..........................42
Return on Assets............................................................................................................44
Nominal Weighted Average Lending Rates of Banks (1990-2009)..................................45
Deployment of credit.....................................................................................................46
 2

INDIA’S STRATEGY OF ECONOMIC DEVELOPMENT

POST-INDEPENDENCE
British colonial rule in India ended in 1947 with the establishment of
the two independent countries of India and Pakistan. The governments
of India turned to planning for national development soon thereafter:
India’s s First Five-Year Plan (FYP) covered the period covered 1951-56
though India's FYP’s were occasionally interrupted with annual plans.
Although India’s been and still is, a mixed economy with a large private
sector, state regulation of economic activity was very extensive until
the reforms of 1991.
India’s economic development strategy immediately after
Independence was based primarily on the Mahalanobis model, which
gave preference to the investment goods industries sector, with
secondary importance accorded to the services and household goods
sector .For example, the Mahalanobis model placed strong emphasis
on mining and manufacturing (for the production of capital goods) and
infrastructural development (including electricity generation and
transportation). The model downplayed the role of the factory goods
sector because it was more capital intensive and therefore would not
address the problem of high unemployment in India. Any increase in
planned investments in India required a higher level of savings than
existed in the country. Because of the low average incomes in India,
the needed higher levels of savings had to be generated mainly by
restrictions on the growth of consumption expenditures. Therefore, the
Indian government implemented a progressive tax system not only to
generate the higher levels of savings but also to restrict increases in
income and wealth inequalities.
Among other things, this strategy involved canalization of resources
into their most productive uses. Investments were carried out both by
the government and the private sector, with the government investing
in strategic sectors (such as national defense) and also those sectors in
which private capital would not be forthcoming because of lags or the
size of investment required (such as infrastructure). The private sector
was required to contribute to India’s economic growth in ways
envisaged by the government planners. Not only did the government
 3

determine where businesses could invest in terms of location, but it

also identified what businesses could produce, what they could sell,
and what prices they could charge.

Development Strategies

Political leaders of India in the fifties were heavily influenced by the

then perceived success of the Soviet Union in rapidly industrializing a
largely rural economy in a relatively short span of four decades without
significant external assistance. The future Indian Prime Minister
Jawaharlal Nehru had visited the Soviet Union in the late 1920s and
came away very impressed with their planning.

Professor P. C. Mahalanobis, whose model had provided the analytical

foundation for India’s development strategy in general, and its Second
Five Year Plan (1956-1961) in particular, had visited the Soviet Union
and were familiar with the Soviet planning system.
Although apparently Mahalanobis independently arrived at it, the
model had been formulated in the Soviet Union by Feldman in the
1920s. In the model the share of investment devoted to augmenting
the stock of capital in the equipment producing (heavy industry) sector
determined the long-run rate of growth of the economy, and the larger
this share the greater was the growth rate. This finding rationalized
Soviet Union’s development strategy that emphasized heavy industry
and its later adoption
India.
India shifted relatively rapidly away from agriculture. The share of
agriculture in
GDP in India fell from 52 percent in 1950-1951 to 25 percent in 1999-
2000 (Central Statistical Organization, 1989, Press Information Bureau,
2001a, b). However, the share of manufacturing industry in GDP rose
only very slowly, from about 11 percent in 1950-51 to about 15
percent in 1999-2000. The capital-intensive nature of investment in
industry meant that the share of agriculture in total employment
remained high, at least in their pre-reforms comparable data are not
 4

available on the share significantly, but in India it is still high, nearly

two-thirds, in 2000.
India implemented its industrialization programs through State controls
on investment and on foreign trade and India’s economy followed
virtually autarkic policies which imposed a heavy cost on both in terms
of efficiency of resource allocation and foregone growth. Further in the
early 1950s India had virtually no capital goods producing industry.
This meant that most of the equipment needed for investment had to
be imported, at least until enough capacity for producing equipment
had been built. Heavy industry was capital-intensive as well. Thus the
emphasis on heavy industry made substantial demands on foreign
exchange and investment resources. In order to generate these
resources it had to rely on administrative controls on investment and
import quotas, rather than on the markets and the price mechanism.
In India's mixed economy, the control mechanism had to ensure that
industrial development in the private sector conformed to the national
plans by preventing diversion of investible resources and foreign
exchange to privately profitable but socially undesirable activities.

Industrialization

Industrialization, through import substitution and public sector

production with emphasis on heavy industry, was viewed as the only
means for eradicating India’s poverty by India's political and economic
leaders even before independence. They advocated planning and put
forward their own plans for development. These included the plans of
Visveswaraya (1934), National Planning Committee (Nehru, 1946),
industrialists (Thakurdas at al, 1944) and labor unions (Banerjee et al,
1944).

In the post-independence period, the Industrial Policy Resolution of

1948 (amended and elaborated in 1956) had set the broad outlines of
India's industrial development strategy by distinguishing industries
according to the end use of their outputs (e.g. capital, intermediate
and consumer goods), their ownership (public, cooperative, private,
and joint) and their size or technology (cottage, village, small-scale,
and organized). Development of key industries, such as railways,
telecommunications and electricity generation, steel, petroleum, heavy
machinery including electric generators, was assigned to the public
sector.
 5

Foreign Trade and Investment

India’s insulation from world markets until the reforms of 1991

stemmed from a long standing distrust of markets and international
trade in general, and the fear that greater involvement in foreign trade
would inevitably retard India’s industrialization.

Visveswaraya, the authors of the plans of industrialists and labor

unions as well as
Nehru’s National Planning Committee, which went in the furthest, was
unanimous in expressing such distrust. The insulation was enforced
through import tariffs, export taxes and quantitative restrictions on
both. The import weighted average of tariffs on all imports, on the eve
of reforms was 87 %, with the average for consumer goods being 164
% .There was an enormous variance in tariffs across commodities with
rates on some imports exceeding 300 percent and also tariff escalation
based on the stage of processing. Such escalation led to extremely
high rates of effective protection on some of the manufactured goods.
Taking the explicit subsidies on some purchased inputs such as
fertilizers, the implicit taxes through export restrictions and other
means, and presumed exchange rate over-valuation; there was
disprotection of agriculture as a whole. Foreign trade in a number of
agricultural commodities was reserved for state monopolies. Around
90-95% of all trade prior to reform was covered by quantitative
restrictions (QRs) and other non-tariff barriers. The net result was a
drastic fall in India’s hare in World trade from 2.5% in the early 1950s
to around 0.6% in 1991.

Until the reforms, India's policy with respect to private foreign capital
of all types
Foreign Direct Investment, (FDI), Portfolio Investment and Debt had
been as restrictive as the policy regarding trade in goods and services.
Restrictions included limits on entry into specified priority areas, and
upper limit of 40 percent on equity participation, and requirements on
technology transfer, phased manufacturing, and export obligations.
Chopra et al. (1995) estimate that government approvals were needed
for 60 percent of new FDI in the industrial sector and that FDI averaged
only around $200 million annually between 1985 and 1991. Most of
capital flows consisted of foreign aid, commercial borrowing and
deposits of non-resident Indians.

Controls on Economic Activities

The First Five-Year Plan (1951-56) set the overall interventionist

framework of policy. The Second Plan (1956-61) articulated an inward
 6

oriented development strategy that emphasized investment in heavy

industry such as steel and machinery. The massive investment
(relative to resources available for its financing) envisaged in the Plan
precipitated a macroeconomic and balance of payments crisis. In the
wake of the crisis, an elaborate system of controls (that was expanded
in subsequent decades) was put in place to enforce the plans and their
underlying development strategy. At its most expansive and inclusive,
the system involved industrial licensing which determined the scale,
technology, and location of any new investment project (other than
small ones) and controlled the expansion, relocation and change in the
output or input mixes of operating plants; the exchange control system
which required exporters to surrender their foreign exchange earnings
to the Reserve Bank of India and importers were allocated foreign
exchange through import licensing; capital issues control on access to
domestic equity and debt finance; price controls on some vital
consumption goods (e.g. food grains) and critical inputs (e.g. fertilizer);
made-to-measure protection from import competition, granted to
domestic producers in many 'priority' industries, including in particular
the equipment producers. The agricultural sector was insulated from
world markets, subject to land ceiling and tenancy legislation, and
forced to sell part of the output at fixed prices, but it was also provided
subsidies on irrigation, fertilizer and electricity. Large commercial
banks, were nationalized in 1969, and subjected to controls on their
deposit and lending rates and directed to extend credit to priority
sectors. The crucial aspect of all the regulations is that they were
essentially discretionary rather than rule-based and automatic. This
created uncertainty about their fair implementation. Devising a set of
principles to govern the operation of the control system and translating
them into operational decisions were impossible tasks given the
multiplicity, and often mutually inconsistent, policy goals. Further the
controls were largely in the form of quantitative restrictions unrelated
to market realities. A chaotic incentive structure, and the unleashing of
rapacious rent seeking and political corruption, was the inevitable
outcome of the control system. Indeed the system, instituted in the
name of planning for national development, instead became a cancer
in the body politic.

Performance of State Owned Enterprises

The actual performance of the state owned enterprises (SOEs) did not
conform to the role envisaged by policy makers, namely, to promote
private sector development and channel it in socially desirable
directions through appropriate pricing and supply of key inputs
 7

produced by them. The outputs of SOEs were often of poor quality,

costly, and inadequate to meet the demand for key industrial inputs
and infrastructure services.
Commercial SOEs were run less as commercial enterprises but more as
promoters of the welfare of their employees and managers who were
bureaucrats and politicians. Finally, there was no accountability for the
management since, first of all, its reward was not based on
performance and, second, performance itself was influenced by some
of the activities forced on the enterprise in the name of public interest
and not related to its core function. Thus, by and large, the public
sector acted as a brake on, rather than a promoter of, private sector
development. Choice of location, technology, employment and pricing
policies of the public sector became politicized so that efficient
development was precluded. Far from generating resources, the public
sector became a monumental waste and liability for taxpayers.
The industrialization strategy based on public investment in industry
and public control over private investment, though grossly inefficient,
did, however, generate a diversified industrial base, and a capability
for designing and fabricating industrial plants and machinery. But the
strategy virtually ignored considerations of scale economies, vastly
restricted domestic and import-competition, encouraged capital-
intensive production by subsidizing the use of capital and making labor
costly through restrictive labor laws. The consequence was a high cost
and globally uncompetitive industrial sector, which was also out of
tune with India's capital scarcity and labor abundance.

Macroeconomic Policies

Until the early eighties India’s macroeconomic policies were

conservative. Current revenues of the central government exceeded
current expenditures so that there was a surplus available to finance in
part the deficit in capital account. In the early eighties, because of lax
fiscal policies current revenue surpluses turned into deficits, so that
the government had to borrow at home and abroad, not only to finance
its investment, but also its current consumption.
Fiscal deficits, as published in government budget documents, have
tended to understate the real imbalances. The reason was that the
rates of interest at which the government appropriated a large share of
the loan able resources of the banking system, through statutory
liquidity ratio (38.5% maximum), and cash reserve ratio (15%
maximum), were administratively set below what would have been
market clearing levels. Also, at least in the early years, external
borrowing was largely on concessional terms from multilateral lending
institutions and from bilateral, government to government external aid.
As the eighties wore on, the government also resorted to borrowing
 8

from abroad on commercial terms both from the capital market and
non-resident Indians (NRIs). In 1983-84, out of $22.8 billion of public
and publicly guaranteed external debt, roughly 17% was owed to
private creditors. On the eve of the macroeconomic crisis in 1990-91,
external debt had tripled to $69.3 billion, of which around 30% were
owed to private creditors. Thus debt to private creditors grew five-fold
in seven years. Since the gross fiscal deficit was too large to be
financed entirely by drawing on savings, part of it was domestic and
external monetized.
Although fiscal expansionism was unsustainable, with some
liberalization in the form of delicensing of some industries and
permitting flexible use of capacity in others through changes in
product-mix within the licensed capacity under so-called “broad
banding”, and relaxation of some import restrictions, it did generate
growth. The average annual rate of growth of real GDP in the sixth and
seventh plans, which covered the eighties, was 5.5 and 5.8 percent
respectively, much higher than the so-called Hindu rate of growth of
3.5 percent of the earlier three decades (Government of India, 1999:
Appendix Table 1.2). By 1990-91, the gross fiscal deficit had grown to
about 10% of GDP. If one includes the losses of non-financial public
sector enterprises, the consolidated public sector deficit stood at
around 10.9% of GDP in 1990-91, of which nearly 4.3 percent of
GDP was for interest payments on domestic and external debt. The
rising fiscal deficits and the steep rise in oil prices during the Gulf war
(Iraq & Kuwait) of 1990s, a lot of pressure was put on prices and on the
exchange rate, fueling expectations about imminent devaluation of the
currency. Political instability in 1990, as reflected in two changes of
prime ministers within a year, led to a lack of confidence of non-
resident Indians (NRIs) in the government's ability to manage the
economy. The expectation of a devaluation of the rupee and the fall in
confidence, led to the withdrawal of their deposits in Indian banks by
NRIs and withdrawal of capital by other external investors. Foreign
exchange reserves dwindled to a level that was less than the cost of
two weeks worth of imports. The spectre of default on short-term
external loans loomed and led to a downgrading of India’s credit
rating.

Thus the strategy of economic development in India meant (1) direct

participation of the government in economic activities such as
production and selling and (2) regulation of private sector economic
activities through a complex system of controls. In addition, the Indian
economy was sheltered from foreign competition through use of both
the “infant industry argument” and a binding foreign exchange
constraint. Imports were limited to goods considered essential either to
 9

the development of the economy (such as raw materials and

machines) or to the maintenance of minimal living standards (such as
crude oil and food items). It was further decided that exports should
play a limited role in economic development, thereby minimizing the
need to compete in the global market place. As a result, India became
a relatively closed economy, permitting only limited economic
transactions with other countries. Domestic producers were sheltered
from foreign competition not only from abroad but also from within
India itself.

Over time, India created a large number of government institutions to

meet the objective of growth with equity. The size of the government
grew substantially as it played an increasingly larger role in the
economy in such areas as investment, production, retailing, and
regulation of the private sector. For example, in the late 1950s and
1960s, the government established public sector enterprises in such
areas as production and distribution of electricity, petroleum products,
steel, coal, and engineering goods. In the late 1960s, it nationalized
the banking and insurance sectors. To alleviate the shortages of food
and other agricultural outputs, it provided modern agricultural inputs
(for example farm machinery, irrigation, high yielding varieties of
seeds, chemical fertilizers) to farmers at highly subsidized prices
(World Economic Indicators, 2001). In 1970, to increase foreign
exchange earnings, it designated exports as a priority sector for active
government help and established, among other things, a duty
drawback system, programmes of assistance for market development,
and 100 per cent export-oriented entities to help producers export
(Government of India, 1984). Finally, from the late 1970s through the
mid-1980s, India liberalized imports such that those not subject to
licensing as a proportion to total imports grew from five per cent in
1980-1981 to about 30 per cent in 1987-1988. However, this partial
removal of quantitative restrictions was accompanied by a steep rise in
tariff rates.
This active and dominant participation by the government in economic
activities resulted in the creation of a protected, highly-regulated,
public sector-dominated economic environment. Along with this
government domination of the economy, India soon faced not only
some major problems in its overall approach to development,
particularly in the area of industrialization but also a dramatic increase
in corruption in its economy. Finally, like any other growing economy,
the Indian economy faced a number of serious sectoral imbalances,
with shortages in some sectors and surpluses in others.
 10

THE CONSEQUENCES OF INDIA’S REGULATED

ECONOMIC DEVELOPMENT
India’s environment of regulated economic development led to the
formulation of policies that were concerned with both macroeconomic
and microeconomic aspects.

India’s environment of regulated economic development led to the

formulation of policies that were concerned with both macroeconomic
and microeconomic aspects.

 Domestic demand was stimulated by protecting the home

market through high import duties and competition was
prevented between domestic producers and their foreign
counterparts. Due to this India became a high cost economy
unable to compete in the world.
 Extensive licensing led to bureaucratization of the economy
breeding inefficiency and corruption.
 Mismanagement and inefficiency was at its worst in case of PSUs
(Public sector undertakings). Political interference, lack of
managerial responsibility, over-manning, indiscipline among
workers was rampant. The PSU’s as a group never reported a
satisfactory rate of return out of the massive capital invested in
them.
 Low rate of return on PSU’s and leniency in tax collection led to
resource crunch and a subsequent decline in public investment.
 11

Whereas much attention in the literature has been devoted to the

macroeconomic issues, we focus primarily on the microeconomic
aspects of Indian economic policies. In particular, we examine how
individuals guided by their self-interests of survival and wealth
accumulation will act in a regulated environment, which in fact
discourages the pursuit of those self-interests. To do so, we describe
the consequences of India’s use of price ceilings, in which prices are
set below their equilibrium level to make products and services
affordable to relatively poorer sections of the society.

Figure 1 illustrates how price ceilings can influence a nation’s

economy. Specifically, when prices are kept artificially low, demand
outstrips supply. To alleviate the resulting shortage of products and
services, the government can either help to increase the supply or help
to decrease demand for those products and services. Considering the
supply side options first, the government had the following choices: (1)
increase the price of the product; (2) subsidize production of existing
suppliers so they will produce and sell more; (3) encourage new
businesses to enter the line of production and selling; or (4) permit
imports to reduce or eliminate the shortage. In India, none of these
options was seen as satisfactory. First, the government certainly did
 12

not wish to increase prices, because price ceilings appealed to a

majority of the vote bank. Second, although the government did
subsidize production in several sectors considered essential, the
resulting increased production was not sufficient to eliminate the large
shortages. Third, the government decided to restrict rather than
increase the entry of new producers under the pretext of directing
scarce resources into their efficient uses. Finally, it allowed only limited
recourse to imports, in order to protect Indian producers, unless the
shortage reached a stage of crisis. The overall result was that
inadequate amounts of products and services were supplied to the
market.

Reasons India adopted the New Economic Policy

Indian economic reforms of 1991 represent a radical shift from the

dysfunctional development strategy of the previous four decades,
which pursued import-substituting industrialization, with the state
playing the dominant role in the economy. Its foundations were laid
prior to independence and attracted wide support across the political
spectrum. As such, there was no significant political support for
reforms until internal and external events forced them in 1991

The Economic Crisis of 1990-91

India began relaxing its rigidly controlled economy in a piece-meal

fashion in the 1980s but its significant opening to the world economy
and deeper domestic reforms did not begin until after the severe
macroeconomic crisis of 1991.

The severe macroeconomic and balance of payment crisis certainly

called for immediate policy action. In earlier crises such as the one in
1966, the government approached the IMF and World Bank for
assistance and had to make such changes in policies as were
mandated by the conditionality attached to their assistance. But once
the crisis eased the government reverted to its pre-crisis policies.

In contrast, even though the government sought assistance from the

IMF and the World Bank in the 1991 crisis, this time policy makers
realized that a return to status-quo-ante with respect to policies was no
longer tenable. There were two main reasons for this:
 13

• The collapse of Soviet Union and East European economies

undermined central planning as a means for achieving rapid
growth and economic development.
• The second was the phenomenal growth performance of
China since its opening and reforms in 1978. Although, the
rapid growth of other outward-oriented East Asian economies
such as Korea and Taiwan had been evident much earlier,
Indian policy makers dismissed their experiences as irrelevant
with the argument that, India was a much larger economy as
the East Asian economies, even though Korea's industrial
sector was rapidly approaching the size of India's. However,
Chinese success was a different matter all together: Not only
China was a large economy which succeeded with economic
reforms and opening to world markets, but its success
exacerbated India's feeling of insecurity vis-à-vis China, since
India's defeat by China in the border clash of the early sixties.
Indian policy makers realized that systematic and deep
reforms were needed, and in particular, India had to abandon
its insulation from the world economy, if India were ever to
grow rapidly enough to catch up with China. Thus the reforms
of 1991 were born.

The New Economic Policy of 1991

From 1950 to 1980, while the Indian economy was growing at a

relatively slow rate of 3.6 percent, domestic investment exceeded
domestic savings by only a small margin. The gap could be bridged
through foreign borrowing on a small scale. However, during the period
1979 to 1990, when the growth rate of GDP accelerated to 5.4 percent,
the gap between savings and investment widened substantially. The
need to finance large capital expenditures, imports of machinery and
raw materials, including oil, necessitated heavy borrowing from
abroad. The result was a cumulative increase in foreign debt and in
repayment liability. Foreign debt increased from US$23.5 billion in
1980 to $63.40 billion in 1991. In 1991, nearly 28 percent of total
export revenues went to service the debt. The most important reason
for the internal savings rate falling increasingly short of investment
requirements was the expanding fiscal deficit of the government which
had risen from an average of 6.3 percent of GDP during the Seventh
Five-Year Plan to 8.2 percent by 1990-91.

Large fiscal deficits arose for a number of reasons: exorbitant

expenditures were incurred by the central government's subsidies of
fertilizers, food and exports and by the state governments' of power,
transport and irrigation. The inefficient functioning of many of the
 14

central and state public sector enterprises further burdened the

government budget.

Finally, in addition to the current account deficit, mounting capital

account expenditures by the government and public enterprises had to
be financed through public borrowing. By 1990, internal debt liabilities
had increased to 53 percent of GDP compared with 35 percent in 1980,
and interest payments accounted for as much as 24 percent of total
government expenditure. In addition, the sources of foreign borrowing
underwent some important changes, as soft International Development
Association (IDA) and government-to-government loans dried up and
high-cost commercial loans from the banks and non-resident Indians
had to fill the gap.

As long as the international credibility of India was high, loans were

forthcoming and the country could go on living on foreign borrowing.
However, the combination of a number of factors, including the sharp
rise in import prices of oil and the downgrading of India's credit rating,
led to a loss of confidence that resulted in the drying up of short-term
credit along with a net outflow of non-resident Indian deposits. Thus, in
spite of borrowing from the International Monetary Fund (IMF), the
foreign exchange reserves declined.

It was against this background that an urgent need was felt to diversify
and open up the economy and formulate a new economic policy to kick
start the growth. The multilateral agencies such as IMF and the World
Bank insisted that the policymakers undertake structural reforms
before they agreed to salvage the country from the foreign exchange
crisis.

New Economic Policy of 1991 included globalization,

liberalization and privatization (Disinvestment)
• Globalization means flow capital finance in the form
of foreign direct investment (FDI) and foreign portfolio
investment (FPI), technology, human resource, goods and service
among countries. FDI is investment in real assets like
automobile, consumer goods production, service sectors like
insurance, telecommunication, air transport etc. The New
Economic Policy aimed at strengthening the private sector in a
big way. The thrust of the new economic policy was a market
driven economy; so in line with that objective, the new policy
provided for the privatization of the public sector units (PSUs).
The New economic policy provided for an enlargement in the
 15

field of operation of the private sector (and a contraction in the

fields of operation of the public sector). A number of activities
(17 in number) which so far had been the exclusively in the
realm of the public sector were thrown open to private sector.
Only 8 industries where security and strategic concerns
predominated were reserved for the public sector under the new
policy. The Government also, to a certain extent, privatized the
ownership of the PSUs. This was done by the sale of a part of the
capital of some enterprises. Thus by disinvestment of a part of
the capital, the Government made the public sector accountable
to the private sector criterion, namely market - related profits.

• Liberalization: Liberalization means freeing the economic

activities and business from unnecessary bureaucratic and other
controls imposed by the governments. Liberalization has done
away with the License Raj (investment, industrial and import
licensing) and ended many public monopolies, allowing
automatic approval of foreign direct investment in many
sectors. Rao's government's goals were reducing the fiscal
deficit, privatization of the public sector, and increasing
investment in infrastructure. Trade reforms and changes in the
regulation of foreign direct investment were introduced to open
India to foreign trade while stabilizing external loans. The New
economic policy laid a lot of stress on the market forces and a
market driven economy. It intended to dismantle the restrictive
and regulatory system and allow private entrepreneurs to
venture into any industrial sector based on their own commercial
decisions with no government judgment. In the absence of
Government controls these decisions were in terms of market
prices and profits. In other words, allocation of resources among
industries with respect to the scale, size of product ion and the
nature of the product would be determined by market prices. The
role of the state was confined to selected non-market areas- to
ensure a smooth functioning of the market economy.

• Privatization or Disinvestment: Selling the government

owned public sector enterprises to private industrialists and
opening the government operating sectors for private
investment. The NIP took great steps towards the integration or
the unification of the Indian economy with the world economy. I t
made the economy outwardly oriented so that its activities were
now governed both by the domestic as well as the foreign
market.
 16

The following steps were taken:

• The rupee was also made fully convertible on current account of

the balance of payments.
• The custom duties on imports were also reduced with a view to
bring them in line with custom duties of other countries.
• The NEP of 1991 the doors of the Indian economy were thrown
open to foreign investment. Foreign investors were allowed to
have 51% equity holdings.
• All this adds up to an ‘open’ economy with respect to the
movements of exchange rate, foreign exchange, imports,
exports and foreign direct investment (FDI )

The New Economic Policy includes reduction in government

expenditure, opening of the economy to trade and foreign investment,
adjustment of the exchange rate from fixed exchange rate system to
flexible exchange rate system, deregulation in most markets and the
removal of restrictions on entry, on exit, on capacity and on pricing.

The Major areas of New Economic Policy 1991 are

• Fiscal policy reforms

• Monetary policy reform
• Pricing policy reform
• External policy reform
• Industrial policy reform
• Foreign investment policy reform
• Trade policy reform
• Public sector policy reform

The principal reforms initiated in the year 1991 included; reduction in

import tariffs on most goods other than consumer goods, removal of
quantitative restrictions and liberal terms of entry for foreign investors
India’s simple average tariff rate was reduced from 128% in 1991 to
about 32.3% in 2001-02. Quotas and non-tariff barriers were also
reduced. To restore Macro economic stability, the reforms package of
structural adjustment policies are aimed at freeing markets by
dismantling controls on production, prices and trade and reducing
intervention in the economy. The need to control the fiscal deficit led
to policies to curb public expenditure and these cuts were mainly on
social sector expenditure and on production and consumption
subsidies, which directly affected the living standards of the
 17

economically vulnerable sections of the population. Privatization,

Liberalization and export-promotion were the main features of the
economic reforms recommended by the international institutions for
the problems facing by the developing countries.

Expected benefits from the NEP were:

1. Improved efficiency in the use and allocation of resources:

With the removal of controls and restrictions the NEP would promote
individual entrepreneurs and this increased competition would help in
promoting industry in India. The privatization of the PSUs and the entry
of FDI would also bring about an improvement in efficiency.

2. Increase in the economic growth rate: The growth rate of the

economy was also expected to go up sizably as a result of the
implementation of the NIP through an increase in the efficiency of the
industries.

3. Increase in employment levels: With higher rate of growth;

expansion of employment was also expected.

4. Fall in rate of inflation: The rate of inflation was also predicted to

fall due to competition.

5. Improved Foreign Exchange position: The NEP was also

expected to improve the Foreign exchange reserves of the country by
improving the Balance of Payments.

The new economic policy has lead to globalization, privatization and

liberalization there its effects are mostly related to these elements.

Positive effects of NEP

 18

• Privatizations lead to selling of government equity partially or

wholly to the private sector. Therefore, since the new economic

policy had been made most of the industries taken care off by

government were than executed by private companies. For e.g.:

the service sector was majorly affected as the

telecommunication service, banking etc. which was all running

by the government had now been taken care off by many private

firms.

• Mergers: privatization had lead to mergers that is the public

companies could merge with the private ones.

• The benefit of globalization was mainly that MNC’S could enter

India which gave the Indian economy a new shape altogether

• Free flow of technology, this did help the Indian companies to

advance there technologies and produce goods with better

quality and less costing generating more revenue.

• Free movement of labor and capital among countries was

permitted under this

policy. This turned out to be very beneficial especially in

generating the capital.

• Reduction in trade barriers: Trading became easier leading to

increase in exports and imports. With a large number of exports

 19

taking place lead to an increase in the foreign exchange and

helped develop good relations with other countries.

• Outsourcing: The new concept of outsourcing had begun as

foreign companies had started to get there work done in Indian

companies placed in India itself therefore getting there work

outsourced which lead to more of employment and revenue

generation in India.

• Except six industries all other industrial license had been

abolished

• Economic activities had picked up and growth of GDP has shown

an impressive increase.

• It stimulated industrial production.

• It leads to significant increase in government revenue and

decrease in fiscal deficit.

• Greater flow of goods and services checked the inflation rate that

is with availability of more goods with the help of trading the

inflation rate had

• Flow of private foreign investment increased

• India had been recognized as emerging super power

 20

• Monopoly markets had been converted into competitive markets.

Negative effects of NEP

• The major concentration was on the growth of the urban sector

• It lead to increase in consumerism

• Multinational products had dominated the local production

• Shortage of raw materials, electricity, water etc had an negative

impact on the goods that is production of low quality products

Banking Industry of India:

A banking sector performs three primary functions in an economy:

1) The operation of the payment system.

2) The mobilization of savings and the allocation of savings to

investment projects.

3) By allocating capital to the highest value use while limiting the risks

& costs involved.

The banking sector can exert a positive influence on the overall

economy, and is thus of broad macro-economic importance.

For the past three decades India's banking system has several
outstanding achievements to its credit. The most striking is its
extensive reach. It is no longer confined to only metropolitans or
 21

cosmopolitans in India. In fact, Indian banking system has reached

even to the remote corners of the country. This is one of the main
reasons of India's growth process.

Prime Minister Indira Gandhi nationalized 14 banks in 1969, followed

by six others in 1980, and made it mandatory for banks to provide 40%
of their net credit to priority sectors like agriculture, small-scale
industry, retail trade, small businesses, etc. to ensure that the banks
fulfill their social and developmental goals.

Since then, the number of bank branches has increased from 10,120 in
1969 to 98,910 in 2003 and the population covered by a branch
decreased from 63,800 to 15,000 during the same period. The total
deposits increased 32.6 times between 1971 and 1991, compared to 7
times between 1951 and 1971. Despite an increase of rural branches,
from 1,860 or 22% of the total number of branches in 1969 to 32,270
or 48%, only 32,270 out of 5 lakh (500,000) villages are covered by a
scheduled bank.

The public sector banks hold over 75% of total assets of the banking
industry, with the private and foreign banks holding 18.2% and 6.5%
respectively. Since liberalization, the government has approved
significant banking reforms. While some of these relate to nationalized
banks (like encouraging mergers, reducing government interference
and increasing profitability and competitiveness), other reforms have
opened up the banking and insurance sectors to private and foreign
players.

History of the Indian Banking Industry:

The first bank in India, though conservative, was established in 1786.
From 1786 till today, the journey of Indian Banking System can be
segregated into three distinct phases. They are as mentioned below:

• Early phase from 1786 to 1969 of Indian Banks:

During the first phase the growth was very slow and banks also
experienced periodic failures between 1913 and 1948. There were
approximately 1100 banks, mostly small. To streamline the functioning
and activities of commercial banks, the Government of India came up
with The Banking Companies Act, 1949 which was later changed to
Banking Regulation Act 1949 as per amending Act of 1965 (Act No. 23
 22

of 1965). Reserve Bank of India was vested with extensive powers for
the supervision of banking in India as the Central Banking Authority.
During those days, public had less confidence in the banks. As an
aftermath deposit mobilization was slow. Abreast of it the savings bank
facility provided by the Postal department was comparatively safer.
Moreover, funds were largely given to traders.

• Nationalization of Indian Banks and up to 1991 prior to

Indian banking sector Reforms:

Seven banks forming subsidiary of State Bank of India was nationalized

in 1960 on 19th July, 1969, major process of nationalization was
carried out. It was the effort of the then Prime Minister of India, Mrs.
Indira Gandhi. 14 major commercial banks in the country were
nationalized.
Second phase of nationalization Indian Banking Sector Reform was
carried out in 1980 with seven more banks. This step brought 80% of
the banking segment in India under Government ownership. After the
nationalization of banks, the branches of the public sector bank India
rose to approximately 800% in deposits and advances took a huge
jump by 11,000%.
Banking in the sunshine of Government ownership gave the public
implicit faith and immense confidence about the sustainability of these
institutions.

• New phase of Indian Banking System with the advent of

Indian Financial Banking Sector Reforms after 1991:

This phase introduced many more products and facilities in the

banking sector in its reforms measure. In 1991, under the
chairmanship of M Narasimham, a committee was set up by his name
which worked for the liberalization of banking practices. The country is
flooded with foreign banks and their ATM stations. Efforts are being put
to give a satisfactory service to customers. Phone banking and net
banking is introduced. The entire system became more convenient and
swift as time is given more importance than money.
 23

Pre-reform period of banking sector in India

The primary role of the banking sector in a free market economy is to

channel savings to investment. Banks are an intermediary that borrow
money from account-holders and lends money to others. The ability to
borrow money in an economy is crucial for making long-term
investments. Without a robust, efficient banking system, investment
will be inadequate and inefficient. This, in turn, will tend to lead to low
productivity and low economic growth.
 24

But the banking sector in India was highly regulated with policies
regarding as directed credit, interest rate regulation and stuatory-
preemptions

Although post nationalization, the Indian banking system registered

tremendous growth in volume but despite the undeniable and multifold
gains of bank nationalization, it may be noted that the important
financial institutions were all state owned and were subject to central
direction and control.

Banks enjoyed little autonomy as both lending and deposit rates were
controlled until the end of the 1980s. However, the nationalization of
banks helped in the expansion of banks to the rural and hitherto
uncovered areas, the monopoly granted to the public sector and lack
of competition led to overall inefficiency and low productivity.

By 1991, the country’s financial system was saddled with an inefficient

and financially unsound banking sector. Some of the reasons for this
were:

• High reserve requirements

• Administered interest rates
• Directed credit
• Lack of competition
• Political interference and corruption.

Before the start of the 1991 reforms, there was little effective
competition in the Indian banking system for at least two reasons.
First, the detailed prescriptions of the RBI concerning for example the
setting of interest rates left the banks with limited degrees of freedom
to differentiate themselves in the marketplace. Second, India had strict
entry restrictions for new banks, which effectively shielded the
incumbents from competition. Therefore, the structure was that of a
regulated monopoly because the government set policies such as
setting interest rates to ensure fair returns.

The Government of India has a history of restricting the ability of banks

to accurately judge risk and return on loans and make decisions on
loans based on profitability. As in many other areas, the Government
of India justified its intervention in the banking arena by claiming that
as a developing economy, a free-market system would not provide
adequate funds for investment and so government was required to
develop a strong industrial sector. According to C Rangarajan, the free-
market was seen by the government as unable “to optimally allocate
 25

resources over time, that is, for investment because of the ‘myopic’
nature of markets.” Therefore, the government forced all public banks
to allocate a certain percentage of their total credit for certain
important sectors of the economy that the government felt were
disadvantaged by the banking system.

Reforms undertaken in the banking sector in the 1990’s:

 26

As recommended by the Narasimham Committee Report (1991)

several reform measures were introduced which included reduction
of reserve requirements, de-regulation of interest rates, introduction
of prudential norms, strengthening of bank supervision and
improving the competitiveness of the system, particularly by
allowing entry of private sector banks.
With a view to adopting the Basel Committee (1988) framework on
capital adequacy norms, the Reserve Bank introduced a risk-
weighted asset ratio system for banks in India as a capital adequacy
measure in 1992. Banks were asked to maintain risk-weighted
capital adequacy ratio initially at the lower level of 4 per cent, which
was gradually increased to 9 per cent.
Banks were also directed to identify problem loans on their balance
sheets and make provisions for bad loans and bring down the
burgeoning problem of non-performing assets. The period 1992-97
laid for reform in the banking system (Rangarajan, 1998). The
second Narasimham Committee Report (1998) focused on issues
like strengthening of the banking system, upgrading of technology
and human resource development. The report laid emphasis on two
aspects of banking regulation, viz., capital adequacy and asset
classification and resolution of NPA-related problems

The 1991 report of the Narasimham Committee served as the basis for
the initial banking sector reforms. In the following years, reforms
covered the areas of interest rate deregulation, directed credit rules,
statutory pre-emptions and entry deregulation for both domestic and
foreign banks. The objective of banking sector reforms was in line with
the overall goals of the 1991 economic reforms of opening the
economy, giving a greater role to markets in setting prices and
allocating resources, and increasing the role of the private sector.

A brief overview of the most important reforms follows:

Statutory pre-emptions

The degree of financial repression in the Indian banking sector was

significantly reduced with the lowering of the CRR and SLR, which were
regarded as one of the main causes of the low profitability and high
interest rate spreads in the banking system. During the 1960s and
1970s the CRR was around 5%, but until 1991 it increased to its
maximum legal limit of 15%. From its peak in 1991, it has declined
gradually to a low of 4.5% in June 2003. In October 2004 it was slightly
increased to 5% to counter inflationary pressures, but the RBI remains
 27

committed to decrease the CRR to its statutory minimum of 3%. The

SLR has seen a similar development. The peak rate of the SLR stood at
38.5% in February 1992, just short of the upper legal limit of 40%.
Since then, it has been gradually lowered to the statutory minimum of
25% in October 1997.
The reduction of the CRR and SLR resulted in increased flexibility for
banks in determining both the volume and terms of lending.

Priority sector lending

Besides the high level of statutory pre-emptions, the priority sector

advances were identified as one of the major reasons for the below
average profitability of Indian banks. The Narasimham Committee
therefore recommended a reduction from 40% to 10%. However, this
recommendation has not been implemented and the targets of 40% of
net bank credit for domestic banks and 32% for foreign banks have
remained the same. While the nominal targets have remained
unchanged, the effective burden of priority sector advances has been
reduced by expanding the definition of priority sector lending to
include for example information technology companies, export activity,
education, housing, software industry, venture capital, leasing and hire
purchase.

Interest rate liberalization

Prior to the reforms, interest rates were a tool of cross-subsidization

between different sectors of the economy. To achieve this objective,
the interest rate structure had grown increasingly complex with both
lending and deposit rates set by the RBI. The deregulation of interest
rates was a major component of the banking sector reforms that aimed
at promoting financial savings and growth of the organized financial
system.
The lending rate for loans in excess of Rs200, 000 that account for
over 90% of total advances was abolished in October 1994. Banks
were at the same time required to announce a prime lending rate (PLR)
which according to RBI guidelines had to take the cost of funds and
transaction costs into account. For the remaining advances up to
Rs200,000 interest rates can be set freely as long as they do not
exceed the PLR.
On the deposit side, there has been a complete liberalization for the
rates of all term deposits, which account for 70% of total deposits. The
 28

deposit rate liberalization started in 1992 by first setting an overall

maximum rate for term deposits. From October 1995, interest rates for
term deposits with a maturity of two years were liberalized. The
minimum maturity was subsequently lowered from two years to 15
days in 1998. The term deposit rates were fully liberalized in 1997. As
of 2004, the RBI is only setting the savings and the non-resident Indian
deposit rate. For all other deposits above 15 days, banks are free to set
their own interest rates.

Entry barriers

Before the start of the 1991 reforms, there was little effective
competition in the Indian banking system for at least two reasons.
First, the detailed prescriptions of the RBI concerning for example the
setting of interest rates left the banks with limited degrees of freedom
to differentiate themselves in the marketplace. Second, India had strict
entry restrictions for new banks, which effectively shielded the
incumbents from competition.
Through the lowering of entry barriers, competition has significantly
increased since the beginning of the 1990s. Seven new private banks
entered the market between 1994 and 2000. In addition, over 20
foreign banks started operations in India since 1994. By March 2004,
the new private sector banks and the foreign banks had a combined
share of almost 20% of total assets. Deregulating entry requirements
and setting up new bank operations has benefited the Indian banking
system from improved technology, specialized skills, better risk
management practices and greater portfolio diversification.

Prudential norms

The report of the Narasimham Committee was the basis for the
strengthening of prudential norms and the supervisory framework.
Starting with the guidelines on income recognition, asset classification,
provisioning and capital adequacy the RBI issued in 1992/93, there
 29

have been continuous efforts to enhance the transparency and

accountability of the banking sector.

The improvements of the prudential and supervisory framework were

accompanied by a paradigm shift from micro-regulation of the banking
sector to a strategy of macro-management. The Basle Accord capital
standards were adopted in April 1992. The 8% capital adequacy ratio
had to be met by foreign banks operating in India by the end of March
1993; Indian banks with a foreign presence had to reach the 8% by the
end of March 1994 while purely domestically operating banks had until
the end of March 1996 to implement the requirement.

Significant changes where also made concerning non-performing

assets (NPA) since banks can no longer treat the putative 'income'
from them as income. Additionally, the rules guiding their recognition
were tightened. Even though these changes mark a significant
improvement, the accounting norms for recognizing NPAs are less
stringent than in developed countries where a loan is considered
nonperforming after one quarter of outstanding interest payments
compared to two quarters in India.

Public Sector Banks

At the end of the 1980s, operational and allocative inefficiencies

caused by the distorted market mechanism led to a deterioration of
Public Sector Banks' profitability. Enhancing the profitability of PSBs
became necessary to ensure the stability of the financial system. The
restructuring measures for PSBs were threefold and included
recapitalization, debt recovery and partial privatization.

Despite the suggestion of the Narasimham Committee to rationalize

PSBs, the Government of India decided against liquidation, which
would have involved significant losses accruing to either the
government or depositors. It opted instead to maintain and improve
operations to allow banks to create a good starting basis before a
possible privatization. Due to directed lending practices and poor risk
management skills, India's banks had accrued a significant level of
NPAs. Prior to any privatization, the balance sheets of PSBs had to be
cleaned up through capital injections. In the fiscal years 1991/92 and
1992/93 alone, the GOI provided almost Rs40 billion to clean up the
balance sheets of PSBs. Between 1993 and 1999 another Rs120 billion
were injected in the nationalized banks. In total, the recapitalization
amounted to 2% of GDP.
 30

In 1993, the SBI Act of 1955 was amended to promote partial private
shareholding. The SBI became the first PSB to raise equity in the
capital markets. After the 1994 amendment of the Banking Regulation
Act, PSBs were allowed to offer up to 49% of their equity to the public.
This lead to further partial-privatization of eleven PSBs. Despite those
partial privatizations, the government is committed to keep their public
character by maintaining strong administrative control such as the
ability to appoint key personnel and influence corporate strategy.

In 1993, the Reserve Bank of India permitted private entry into the
banking sector, provided that new banks were well capitalized and
technologically advanced, and at the same time prohibited cross-
holding practices with industrial groups. The Reserve Bank of India also
imposed some restrictions on new banks with respect to opening
branches, with a view to maintaining the franchise value of existing
banks.

As a result of the reforms, the number of banks increased rapidly. In

1991, there were 27 public-sector banks and 26 domestic private
banks with 60,000 branches, 24 foreign banks with 140 branches, and
20 foreign banks with a representative office. Between January 1993
and March 1998, 24 new private banks (nine domestic and 15 foreign)
entered the market; the total number of scheduled commercial banks,
excluding specialized banks such as the Regional Rural Banks to 99 in
1997/98. Entry deregulation was accompanied by progressive
deregulation of interest rates on deposits and advances. From October
1994, interest rates were deregulated in a phased manner and by
October 1997, banks were allowed to set interest rates on all term
deposits of maturity of more than 30 days and on all advances
exceeding Rs.200,000. While the CRR and SLR, interest rate policy, and
prudential norms have always been applied uniformly to all
commercial banks, the Reserve Bank of India treated foreign banks
differently with respect to the regulation that requires a portion of
credit to be allocated to priority sectors. In 1993, foreign banks – which
used to be exempt from this requirement while all other commercial
banks were required to earmark 40 per cent of credit – were required
to allocate 32 per cent of credit to priority sectors.
 31

Credit Market

Credit markets have, historically, played a crucial role in sustaining

growth in almost all countries, including advanced countries, which
now have fully developed capital markets. Credit markets perform the
critical function of intermediation of funds between savers and
investors and improve the allocative efficiency of resources. Banks,
which are major players in the credit market, play an important role in
providing various financial services and products, including hedging of
risks. Credit markets also play a key role in the monetary transmission
mechanism.

The credit market in India has traditionally played a predominant role

in meeting the financing needs of various segments of the economy.
 32

Credit institutions range from well developed and large sized

commercial banks to development finance institutions (DFIs) to
localized tiny co-operatives. They provide a variety of credit facilities
such as short-term working loans to corporates, medium and long-term
loans for financing large infrastructure projects and retail loans for
various purposes. Unlike other segments of the financial market, the
credit market is well spread throughout the country and it touches the
lives of all segments of the population.

Prior to initiation of financial sector reforms in the early 1990s, the

credit market in India was tightly regulated. Bank credit was the
principal focus of monetary policy under the credit planning approach
adopted in 1967-68. In the absence of a formal intermediate target,
bank credit – aggregate as well as sectoral – came to serve as a
proximate target of monetary policy. Monetary policy up to the mid-
1980s was predominantly conducted through direct instruments with
credit budgets for banks being framed in sync with monetary
budgeting .The credit market was characterized by credit controls and
directed lending. Various credit controls existed in the form of sectoral
limits on lending, limits on borrowings by individuals, stipulation of
margin requirements, need for prior approval from the Reserve Bank, if
borrowing exceeded a specified limit (under the Credit Authorization
Scheme), and selective credit controls in the case of sensitive
commodities. Lending interest rates by all types of credit institutions
were administered. Credit markets were also strictly segmented. While
commercial banks catered largely to the short-term working capital
requirements of industry, development finance institutions focused
mainly on long-term finance. Competition in the credit market was also
limited. This led to several inefficiencies in the credit market.

A wide range of regulatory reforms, therefore, were introduced as part

of financial sector reforms in the early 1990s to improve the efficiency
of the credit market. As a result, the credit market in India has
undergone structural transformation. The credit market has become
highly competitive even though the number of credit institutions has
reduced due to merger/conversion of two DFIs into banks, weeding out
of unsound NBFCs and restructuring of urban co-operative banks and
RRBs. Credit institutions now offer a wide range of products. They are
also free to price them depending on their risk perception.

Firms in developing countries generally tend to rely more on debt

finance, including bank credit. The emphasis on credit rather than
equity arises due to various reasons. The cost of equity in developing
economies is often much higher than the cost of debt due to the
 33

existence of higher perceived risk premia than in developed countries.

The existence of artificially repressed interest rates contributes further
to the problem. The other reasons for the heavy reliance on debt in
developing countries include the fragility of their equity markets, lack
of suitable accounting practices and the absence of adequate
corporate governance practices. Given the high dependence on bank
credit and lack of substitutes for external finance, firms in developing
economies are generally highly sensitive to changes in the cost and
flow of credit.

Credit markets in developing countries, in particular, play an important

role, where apart from industry agriculture is also an important
segment of the economy. Besides, there are also a large number of
small and medium enterprises in the industrial and service sectors,
which are not able to access the capital market and have to depend on
the credit market for their funding requirements. Thus, the importance
of banks and other lending institutions in developing countries can
hardly be overemphasized.

Commercial banks, given their preeminent position in the regulated

financial sector, dominate the credit market. The quantity of loans
created by the banking system is generally a function of both the
willingness and ability of banks to lend. In an economy with ceilings on
lending rates, banks face a higher credit demand than they can
effectively supply, thus, necessitating reliance on a credit rationing
mechanism. In a non-repressed financial system, on the other hand,
the borrowers are, in principle, differentiated along the lines of risk
characteristics and riskier borrowers are charged higher interest rates
to account for default probabilities. This, however, may create the
problem of adverse selection. Though riskier projects bring higher
returns, banks, out of sustainability consideration, need to optimize the
risk of their portfolio.

Another important factor influencing the supply of credit is the amount

of reserves available from the central bank to the banking system. A
large pre-emption of central bank money by the Government may
constrain reserve supply to the banking system, thus, affecting their
capacity for credit creation. Moreover, credit expansion could also be
an endogenous process, i.e., it is the demand for credit that may drive
the banking system’s ability to create credit in the economy.
 34

INSTITUTIONAL STRUCTURE OF THE CREDIT MARKET

IN INDIA

The credit market structure in India has evolved over the years. A wide
range of financial institutions exist in the country to provide credit to
various sectors of the economy. These include:

• Commercial banks
• Regional rural banks (RRBs)
• Cooperatives [comprising urban cooperative banks (UCBs)
• State co-operative banks (STCBs)
• District central co-operative banks (DCCBs)
• Primary agricultural credit societies (PACS)
• State co-operative and agricultural rural development banks
(SCARDBs) and primary co-operative and agricultural rural
development banks (PCARDBs)]
• Financial institutions (FI) (term-lending institutions, both at the
Centre and State level, and refinance institutions) and
• Non-banking financial companies (NBFCs).
 35

POLICY DEVELOPMENTS IN THE CREDIT MARKET IN

INDIA

The credit market, with commercial banks as its predominant segment,

has been the major source for meeting the finance requirements in the
economy, both for the private sector and the Central and State
Government enterprises. In addition to sharing of resources between
the private and the public sectors, a significant proportion of credit by
commercial banks is earmarked for the priority sector. For a few
decades preceding the onset of banking and financial sector reforms in
India, credit institutions operated in an environment that was heavily
regulated and characterized by barriers to entry, which protected them
against competition. The issue of allocation of bank resources among
various sectors was addressed through mechanisms such as SLR,
credit authorization scheme (CAS), fixation of maximum permissible
bank finance (MPBF) and selective credit controls. This regulated
environment set in complacency in the manner in which credit
institutions operated and responded to the customer needs. The
interest rate played a very limited role as the equilibrating mechanism
between demand and supply of resources. The resource allocation
process was deficient, which manifested itself in poor asset quality.
They also lacked operational flexibility and functional autonomy.

Priority sector comprises agriculture (both direct and indirect), small

scale industries, small roads and water transport operators, small
business, retail trade, professional and self-employed persons, state
sponsored organizations for Scheduled Castes/Scheduled Tribes,
education, housing (both direct and indirect), consumption loans,
micro-credit, loans to software, and food and agro-processing sector.

As part of financial sector reforms in the early 1990s, wide ranging

reforms were introduced in the credit market with a view to making the
credit institutions more efficient and healthy. The reform process
initially focused on commercial banks. After significant progress was
made to transform commercial banks into sound institutions, the
reform process was extended to encompass other segments of the
credit market. As part of the reform process, the strategy shifted from
micro-management to macro level management of the credit market.
These measures created a conducive environment for banks and other
credit institutions to provide adequate and timely finance to different
sectors of the economy by appropriately pricing their loan products on
the basis of the risk profile of the borrowers.
 36

Lending interest rates were deregulated with a view to achieving

better price discovery and efficient resource allocation. This resulted in
growing sensitivity of credit to interest rates and enabled the Reserve
Bank to employ market based instruments of monetary control. The
Statutory Liquidity Ratio (SLR2) has been gradually reduced to 25 per
cent. The Cash Reserve Ratio (CRR) was reduced from its peak level of
15.0 per cent maintained during 1989 to 1992 to 4.5 per cent of Net
Demand and Time Liabilities (NDTL) in June 2003. The reduction in
statutory preemptions has significantly augmented the lendable
resources of banks. Although the Reserve Bank continues to pursue its
medium-term objective of reducing the CRR, in recent years, on a
review of macroeconomic and monetary conditions, the CRR has been
revised upwards in phases to 6.5 per cent.

While the stipulation for lending to the priority sector has been
retained, its scope and definition have been fine-tuned by including
new items. Further, restrictions on banks’ lending for project finance
activity and for personal loans were gradually removed in order to
enable banks to operate in a flexible manner in the credit market
 37

TRENDS IN CREDIT – THE 1990s AND ONWARDS

Total loans outstanding by all credit institutions (commercial banks,

DFIs and cooperatives) combined together increased at a compound
annual rate of 15.7 per cent during the 1990s and by 17.7 per cent per
annum during the current decade so far (up to 2005-06). As
percentage of GDP, loans outstanding increased from 34.2 per cent at
end-March 1991 to 54.1 per cent at end-March 2006, suggesting
increased credit penetration in the country.

During the 1990s, the credit growth of commercial banks was lower
than that of credit institutions in the co-operative sector. However, the
trend has reversed during the current decade (up to 2005-06) with
credit growth of commercial banks being significantly higher than the
credit growth of the co-operative institutions. Credit growth of NBFCs
during the first five years of the current decade was significantly lower
than the growth of total credit by all institutions. Loans and advances
by DFIs declined during the period from 2000-01 to 2005-06,
essentially due to the conversions of two large DFIs into banks.

Reflecting movements in growth rates, the share of commercial banks’

credit in total outstanding credit by all institutions increased
significantly from 59.7 per cent at end-March 1991 to 78.2 per cent at
end-March 2006. During the same period, the share of RRBs and
SCARDBs also increased marginally. The share of all other credit
institutions declined. Apart from aggressive retail lending strategies
adopted by commercial banks, which captured some of the businesses
of NBFCs, increased and persified lending into rural areas contributed
to the rise in the share of commercial banks. Conversion of two DFIs
into commercial banks also contributed to the increase in the share of
commercial banks in the current decade and a sharp decline in the
share of FIs. In the case of co-operative institutions, which are
financially weak and inadequately capitalized, reforms have been
initiated very recently, which may help in reversing the declining share
of co-operative institutions.
 38

STATUS AND EFFECTS OF LIBERALIZATION

India has over the last decades experienced different degrees of

repressive policies in the banking sector. In the following section we
look at the degree of financial repression with respect to the changing
intensity of three policies that are commonly associated with financial
repression, namely interest rate controls statutory pre-emptions and
directed credit after the reforms taken in the banking sector.

The main findings are that the degree of financial repression has
steadily increased between 1960 and 1980, and then declined
somewhat before rising to a new peak at the end of the 1980s. Since
the start of the overall economic reforms in 1991, the level of financial
repression has steadily declined.

Status of removal of repressionist policies

As described above, India used several policies to gain influence over

the banking sector. Besides the outright nationalization of banks, the
key policies were the directed credit program, the statutory
preemptions and the interest rate controls.
To evaluate the changes in these policies in India over the last years,
the intensity of the policies over time is captured with the help of
dummy variables. The advantage of this method is that the different
variables can be aggregated to a composite index of financial
repression.

Interest rate restrictions

Interest rate restrictions can take different forms. The focus is on the
following interest rate controls: a fixed deposit rate, a ceiling on the
deposit rate, a floor on the deposit rate, a fixed lending rate, a ceiling
on the lending rate and a floor on the lending rate.
 39

The existence of controls is measured with dummies that take the

value of 1 if a control is present and 0 in the absence of a control. The
six controls are then aggregated to an equally-weighted index that is
scaled between 0 and 1.

The aggregated results show that the degree of interest rate regulation
almost steadily increased until reaching a peak in the early 1980s.
After the first liberalization efforts in the mid-1980, the degree of
interest rate controls was somewhat lowered, but then increased again
at the end of the 1980s. Since the beginning of the 1990s, the degree
of interest rate controls has steadily declined which reflects that today
most interest rates are determined by the market.

Statutory pre-emptions

Statutory pre-emptions can serve as tools of monetary policy. They can

become instruments of financial repression however, if their amount
exceeds the level that is necessary to pursue an orderly monetary
policy. Since it is difficult to gauge the CRR and SLR levels that are
necessary for the pursuit of monetary policy, the degree of repression
can only be approximated.

In India, a legal minimum and maximum rate are set for both the CRR
and SLR. For estimating the amount of repression, the assumption is
made that CRR and SLR levels above the minimum rate are repressive.
Even though this is a simplification, it should approximate the policy
stance fairly well since the SLR has been at its statutory minimum of
25% since October 1997 and the RBI has a medium-term objective to
lower the CRR to its statutory minimum of 3%.
 40

Consequently, to approximate the degree of repression through the

CRR and SLR, the difference between the actual rate and the minimum
rate is divided by the difference between the maximum and minimum
rate. Thus, as with the interest rate regulations, 1 denotes high
repression and 0 denotes no repression.
 41

The historical development of the two ratios shows that they have
almost steadily increased from 1960 until 1991, when the combined
amount reached a peak of 53.5%. Starting in 1991, the statutory pre-
emptions have been gradually lowered to a level of 30% at the end of
2004. In line with this policy shifts, the degree of financial repression
through statutory pre-emptions has been significantly reduced since
1991.

Directed credit program

As with the other two policies, the intensity of the directed credit
program is scaled between 0 and 1, where 0 indicates that no
restraints from a directed credit program exist and 1 indicates a high
degree of directed credit. The intensity of the program is measured by
the amount of credit that is included in the program. Somewhat
arbitrarily, for a level of directed credit between 0 and 10%, the degree
of repression is set as 0, 10 to 20% at 0.25, for 20 to 30% at 0.5, for 30
to 40% at 0.75 and above 40% at 1.8.
This is certainly a simplification since the degree of repression of a
directed credit program is influenced by additional variables such as
sub-targets for certain sectors, the types of sectors that are defined as
priority sectors and interest rate restrictions on the advances. The
basis for the classification is the share of priority sector advances in
 42

total credit of scheduled commercial banks. While this does not reflect
the nominal level of directed credit, it gives a better indication of the
effective burden on banks.

Like the other repressionist policies, the intensity of the directed credit
program increased steadily between 1960 and the beginning of the
1980s when over 40% of bank credit went to priority sectors.
Throughout the 1980s, the level of directed credit was almost
continuously well above 40% of total advances. During the 1990s, the
level decreased by about 10 percentage points to around 35% of
advances where it has since then remained. This reflects the current
nominal targets of 40% for domestic banks and 32% for foreign banks.

Impact of the banking sector reforms on the banking

industry of Indias

After the major economic reforms since the beginning of the 1990’s
competition I the bank industry significantly increased because of the
lowering of entry barriers, seven new private banks entered the market
between 1994 and 2000. In addition, over 20 foreign banks started
operations in India since 1994. By March 2004, the new private sector
banks and the foreign banks had a combined share of almost 20% of
total assets.

The banking sector reforms undertaken in India from 1992 onwards

were aimed at ensuring the safety and soundness of financial
institutions and at the same time making them efficient, functionally
diverse and competitive. Financial sector reforms provided banks with
operational flexibility and functional autonomy. Reforms also brought
about structural changes in the financial sector by recapitalizing them,
 43

allowing profit making banks to access the capital market and

enhancing the competitive element in the market through the entry of
new banks. Apart from achieving greater efficiency by introducing
competition through the new private sector banks and increased
operational autonomy to public sector banks, reforms in the banking
system were also aimed at enhancing financial inclusion, funding of
economic growth and better customer service to the public.

The Government and the Reserve Bank provided the enabling

environment through an appropriate fiscal, regulatory and supervisory
framework for the consolidation of financial institutions and at the
same time ensured that a few large institutions did not create an
oligopolistic structure in the market. And therefore, competitive
conditions in the Indian banking sector were strengthened by relaxing
entry and exit norms and the increased presence of foreign banks.

Deregulating entry requirements and setting up new bank operations

has benefited the Indian banking system from improved technology,
specialized skills, better risk management practices and greater
portfolio diversification.

The banking and insurance sector is growing to be a big part of the

Indian economy.
The banking and insurance sector contributed less than 11% 1990. In
2007 it amounted to about 15%.
 44

Return on Assets

Return on assets (ROA) is an important performance indicator of

banks. Return on assets has been worked out by taking the ratio of net
profit or loss to average advances and investments.
• For all scheduled commercial banks, the ROA increased from 0.1
per cent in 1980 to 1.1 per cent in 2005. Amongst the bank
groups, the ROA of foreign banks group is the highest at 1.8 per
cent in 2005.
• All other bank groups recorded a return on assets of 1.1 per cent
showing that all banks are making profits and their performances
are good.
• Foreign banks group is on a higher plane with respect to its
performance in comparison with other bank groups.
• Compared to the pre-reform period, the ROA of public sector
banks improved significantly after the initiation of reforms. In the
case of foreign banks and domestic private sector banks, data
are available only from 1995.
 45

The distribution of scheduled commercial banks by ROA reveals that in

1995, with respect to State Bank group, all 8 banks were in the ROA
range of up to 1 per cent. This position improved slightly as one bank
was in the ROA category of more than 1.5 per cent in 2000 and 2005.
This goes to indicate that State Bank group has much potential to
enhance their performance. Similarly, majority of the banks in the
nationalized group were in the ROA range of less than 1 per cent in
1995, which exhibited some improvement since 2000.

Nominal Weighted Average Lending Rates of Banks

(1990-2009)
The movements in nominal weighted average lending rate for the
banking industry as a whole has shown a gradual decline. It has come
down from a range of 16-17 per cent in most part of the 1990s to
about 11.5 per cent by 2008-09. The declining trend is clearly visible in
the 2000s.
 46

• At a fundamental level the decline in the inflation rate

between the 1990s and 2000s contributed to lower nominal
lending rates.

• Also the observed decline in weighted average lending rates

in the banking system can be attributed to the improvements
in pricing of risk due to the increased space provided by
progressive deregulation of lending rates.

Deployment of credit

Agriculture

As a result of the sharp deceleration in the growth of credit to

agriculture, the share of agriculture in total bank credit declined
 47

sharply from 15.9 per cent at end-March 1990 to 9.6 per cent by end-
March 2001. During this period, however, the share of agriculture in
GDP also declined significantly. As a result, credit intensity of the
agriculture sector (credit to agriculture sector as percentage of
sectoral GDP) remained broadly at the same level. In the early part of
the current decade, the Government and the Reserve Bank took a
series of measures to facilitate the flow of credit to the agriculture
sector.

Credit growth to agriculture picked up significantly from 2003-04

onwards. The share of agricultural credit in total bank credit also
increased to 10.8 per cent by end-March 2005. The gap between the
share of agriculture credit in total bank credit and its share in GDP
narrowed down to less than 8 percentage points at end-March 2006
from 17.4 per cent at end-March 1995. Furthermore, credit intensity of
the agriculture sector increased sharply from 11.1 per cent in 2001-02
to 27.0 per cent by 2005-06. The number of borrowal accounts in the
agriculture sector also increased to 26.66 millions in 2004-05 from
19.84 millions in 2000-01.

Industries
The credit extended to the industrial sector decelerated marginally in
the 1990s (16.4 per cent) and the current decade so far (15.8 per cent)
in comparison with the 1980s (16.7 per cent). The share of industry in
total bank credit declined sharply from 48.0 per cent at end-June 1990
to 38.8 per cent at end-March 2005.
 48

Banks’ support to the industrial sector in the form of non-traditional

instruments such as commercial paper, shares/bonds/ debentures
issued by corporate, which increased sharply in the second half of the
1990s, also declined/decelerated beginning with 2001-02.

Deceleration in the financial support by banks to industry, despite the

robust performance of the industrial sector during last few years, was
mainly due to their increased reliance on retained earnings and
increased access to the domestic and international capital markets.
Creditworthy corporates also resorted to large external commercial
borrowings.

As a result of reduced reliance of industry on bank credit, the gap

between the share of the industrial sector in total non-food credit and
its share in GDP narrowed down significantly. The industrial sector
accounted for 54.3 per cent of bank credit as against its share of 22.0
per cent in GDP in 1990-91. By 2005-06, however, the share of the
industrial sector in non-food credit declined sharply to 39.1 per cent,
even as its share in GDP declined marginally to 20.8 per cent. This was
reflected in increased credit intensity of industry, which was already
significantly higher than the other sectors.

Small Scale Industries (SSI)

The small scale industries (SSI) sector is an important segment of

the Indian economy. However, credit flow to the small scale
industries sector decelerated in recent years as is evident from
various indicators.
 49

• First, the average annual growth of SSI advances decelerated

to 9.5 per cent during 2001-2006 from 13.6 per cent during
the 1990s.
• Second, the share of the SSI sector in total priority sector
advances declined steadily from 44 per cent at end-March
1998 to 18 per cent at end-March 2006.
• Third, the share of credit to the SSI sector in NBC declined
from 15.7 per cent at end-March 1990 to 8.6 per cent at end-
March 2004. SSI advances by public sector banks were 8.1
per cent of net bank credit at end-March 2006 as compared
with 9.5 per cent at end-March 2005. In the case of private
sector banks, SSI advances accounted for 4.2 per cent of NBC
at end-March 2006 as compared with 5.4 per cent at end-
March 2005.

• Fourth, although credit growth to the SSI sector accelerated

in 2004-05 and 2005-06, the share of SSI credit in total non-
food gross bank credit and in total credit to the industrial
sector continued to decline. Fifth, the number of loan
accounts of the SSI sector in commercial banks declined from
219 million in 1992 to 93 million in 2005.
 50

The main reason for slowdown of credit to the SSI sector was its poor
performance and consequent risk aversion by banks. The activity of
the SSI sector slowed down significantly between 1997-98 and 2002-03
with the value of production growing at an average annual rate of 7.7
per cent as compared with 11.1 per cent in the 1980s.

The poor performance of the SSI sector was also reflected in the
significantly higher level of NPAs in this sector. Banks, therefore,
became somewhat risk-averse and they reduced their exposure to the
SSI sector.

In recent years (i.e., from 2003-04 to 2005-06), the performance of the

SSI sector has improved. Accordingly, NPAs in the SSI sector have also
declined significantly. This was reflected in the improved flow of credit
to the SSI sector in 2004-05 and 2005-06. As a result, the credit
intensity of the SSI sector, after declining almost consistently between
1997-98 and 2004-05, increased somewhat in 2005-06
 51

Services

While credit extended by commercial banks to all the sub-sectors in

the services sector accelerated in the current decade (up to 2005-06)
as compared with the 1990s, the acceleration was more pronounced in
the case of personal loans and professional services.

The share of the services sector in total bank credit increased sharply
from 30.9 per cent in 1990-91 to 48.7 per cent in 2005-06, essentially
reflecting its growing share in total GDP; the services sector
contributed 60.7 per cent of GDP in 2005-06 as against 46.7 per cent
in 1990-91.

Credit intensity of the services sector increased from 14.9 per cent in
1990 to 15.2 per cent in 2001 and further to 36.5 per cent in 2006.
Faster credit growth to the services sector was mainly on account of a
sharp rise in credit demand from the household sector, a trend which
started in the 1990s and gathered further momentum in the current
decade.
 52

Household Credit

Until the early 1990s, there were several restrictions for granting of
personal loans. For instance, in the case of housing loans, the
restrictions were in the form of:

• Limits on total amount of housing loan to be given by all the

banks in a given year;
• Limits on maximum loan amount to individuals.
• Prescription of rate of interest according to loan size.
• Prescription of margin requirement and
• Prescription of maximum period of repayment.

All these conditions/restrictions were gradually removed in the

early 1990s and banks were given freedom to decide the
quantum, rate of interest, margin requirement, repayment period
and other related conditions. These relaxations had a positive
impact on the growth of personal loans.

Household or personal loans, on an average, registered a rise of

38.2 per cent during the five-year period ended March 2005 as
compared with 25.2 per cent in the 1990s; overall bank credit
during this period increased by 20.3 per cent. Consequently, the
share of personal loans in total bank credit increased from 9.4
per cent at end-March 1990 to 14.4 per cent in 2000 and further
to 22.2 per cent at end-March 2005. Latest available data reveal
that the share of personal loans increased further to 25.2 per
cent of non-food gross bank credit at end-March 2006.

The number of personal loan accounts also increased sharply

from 1995.

Within personal loans, housing loans accounted for a little over

one half of total loans, distantly followed by advances made
against fixed deposits with a share of around 10.0 per cent.

Housing loans grew at an average annual rate of 47.7 per cent

during the five year period from 2000-01 to 2004-05. The
average housing loan amount increased almost four times
between end-March 2000 and end-March 2005. At end-March
2005, the average housing loan outstanding per account at
Rs.3.45 lakhs, which was more than two times the average
amount in respect of all types of accounts of commercial banks.
 53

The share of housing loans increased steadily from 2.7 per cent
of total loans of commercial banks at end-March 1991 to 11.0 per
cent at end-March 2005.

The share of personal loans in total credit extended by respective bank

group at end-March 2000 was highest in respect of foreign banks and
lowest in respect of private banks. In recent years, however, private
sector banks became very aggressive in the retail loan segment. As a
result, by end-March 2005, the share of personal loans in total credit
extended by private banks and foreign banks reached almost at the
same level.
 54

The sharp increase in bank credit to the household sector has been
contributed by several factors.

• The demand for credit by the industrial sector slowed down,

especially between 1996-97 and 2001-02, due to their focus on
restructuring and consolidation, as alluded to earlier. This
encouraged banks to focus on retail loans.

• With high economic growth, job opportunities have expanded

and income levels have risen. Tax rates have also moderated
over the years. As a result, disposable incomes have risen
sharply in recent years. This has increased the capacity of the
borrowers to repay the loans.
• With the decline in inflation and stable inflationary expectations,
the inflation risk premium fell resulting in decline in both
nominal and real interest rates. This encouraged the households
to avail credit for various purposes such as purchase of houses,
automobiles and consumer durable items.
• Increase in real estate prices as also the stock market might
have also boosted the household demand for bank credit due to
wealth effect, although exposure of Indian households to the
equity market, at present, is limited.
• The rapid growth in the housing market, in particular, has been
supported, inter alia, by the emergence of a number of second
 55

tier cities as upcoming business centers and increase in IT and

IT-related activities, which have had a positive impact on
household’s demand for housing. Further, tax incentives offered
to salary earners made housing loans more attractive by
bringing down the effective rate of interest. Also, comfortable
liquidity position with banks, which created easy credit
conditions, encouraged them to look to new clients and emerged
as another significant factor that drove the growth of the
housing market in India in recent years.

REFERENCES:

 Journal of Economic Development (Volume 18), India’s

new economic policy (JS Uppal)
 ECONOMIC DEVELOPMENT IN INDIA: THE ROLE OF
INDIVIDUAL ENTERPRISE (Anil K. Lal & Ronald W. Clement)
 Banking Sector Developments in India,1980-2005
(Ramasastri A.S. and Achamma Samuel)
 Banking sector liberalization in India (Christian Roland)
 Political economy of directed credit (Mark Miller)
 Economic Reforms and Global Integration T.N. Srinivasan
 Recent banking developments in India (Vittaldas Leeladhar)
 http://www.rbi.org.in/home.aspx
 Credit Market
(http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?
UrlPage=ID=487&ID=502)