Financial Sector Reforms in India

FINANCIAL SECTOR REFORMS IN INDIA

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The period immediately after independence posed a major challenge to the country. Due to centuries of exploitation at the hands of foreign powers, there were very high levels of deprivation in the economy—both social as well as economic. To take up the Herculean task of rapid growth with socio-economic justice, the country adopted the system of planned economic development after independence. Due to paucity of economic resources and limitations of availability of capital for investment, the government also came up with the policy of setting up public enterprises in almost every field.

The fiscal activism adopted by the government resulted in large doses of public expenditures for which not only the revenues of the government were utilized but the government also resorted to borrowing at concessional rates, which kept the financial markets underdeveloped. The growth of fiscal deficit also continued unabated year after year. Complex structure of interest rates was a resultant outcome of this system.

Nationalisation of major commercial banks in the late sixties and early seventies provided the government with virtually the complete control over the direction of the bank credit. The emphasis was mainly on control and regulation and the market forces had very limited role to play.

The economic system was working to the satisfaction of the government. The social indicators were gradually improving and the number of people below poverty line also declined steadily. The only problem area had been that the growth rate of the economy had been very low, and till late seventies, the growth rate of the GDP was hovering around 3.5 per cent per annum. It was only during mid-eighties that the growth rate touched 5 percentage points.

The situation became difficult by the eighties. Financial system was considerably stretched and artificially directed and concessional availability of credit with respect to certain sectors resulted in distorting the interest rate mechanism. Lack of professionalism and transparency in the functioning of the public sector banks led to increasing burden of non-performance of their assets.

Late eighties and early nineties were characterised by fluid economic situation in the country. War in the Middle East had put tremendous pressure on the dwindling foreign exchange reserves of the country. The country witnessed the worst shortages of the petroleum products. High rate of inflation was another area of serious concern. Most of the economic ailments had resulted due to over regulation of the economy. The international lending and assisting agencies were ready to extend assistance but with the condition that the country went in for structural reforms, decontrols and deregulation, allowing increased role for the market forces of demand and supply.

The precarious economic conditions left the country with no alternative other than acceptance of the conditions for introducing the reforms.

Post Reforms

Rationalisation of the taxes has already taken place on the basis of the recommendations of Raja Challiah Committee Report during mid-nineties. The government has been able to tighten its fiscal management through the FRBMA and the continuing increase in the fiscal deficit has been contained significantly. Reforms in the external sector management have yielded results in the form of increased foreign capital inflows in terms of Foreign Direct Investment (FDI), Foreign Institutional Investment (FII) and the exchange rate has also represent true international value of Indian rupee vis-à-vis hard global currencies.

The primitive foreign exchange regulation regime controlled by FERA has been replaced by a liberalized foreign exchange rate management system introduced by FEMA. Introduction of such a modern management law was perhaps a pre-condition for allowing FDI and FII. In 1993, the RBI issued guidelines to allow the private sector banks to enter the banking sector in the country, a virtual reversal of the policy of bank nationalisation. Foreign banks were also given more liberal entry.

The thrust of the monetary policy after the introduction of the process of reforms has been able to develop several instruments of efficient financial management. A Liquidity Adjustment Facility (LAF) was introduced in June 2000 to precisely modulate short-term liquidity and signal short-term interest rates. A lot of reliance is being placed on indirect instruments of monetary policy. Strengthening and upgradation of the institutional, technological and physical infrastructure in the financial markets has also improved the financial framework in the country.

Economy and Reforms

The introduction of financial sector reforms has provided the economy with a lot of resilience and stability. The average annual growth rate of the economy during the post-reform period has been more than 6 per cent, which was unimaginable a decade before that. The economy withstood boldly the Asian economic crisis of 1997-98. Even the economic sanctions by the US and other developed countries after the nuclear testing did not affect the economy to the extent apprehended. The current global slowdown and sub-prime crisis affecting the banking system all over the world has not impacted the Indian economy to that extent.

Banking and insurance sectors are booming. While the private and foreign banks are giving stiff but healthy competition to the public sector banks, resulting in overall improvements in the banking services in the country, the insurance sector has also witnessed transformation. The consumer is a gainer with the availability of much better and diversified insurance products.

The stock exchanges in the country are in the process of adopting the best practices all over the world. The RBI has also been able to control and regulate effectively the operations and growth of the Non-Banking Financial Companies (NBFCs) in the country.

A few changes which are on the anvil pertain to the legal provisions relating to fiscal and budget management, public debt, deposits, insurance etc. As per the Finance Minister, future reforms by making legal changes also pertain to banking regulations, Companies Act, Income Tax, Bankruptcy, negotiable instruments etc.

But there are certain issues that call for more cautious approach towards the financial sector reforms in the future. The social sector indicators—like availability of doctor per 1000 population, availability of health institutions, quality of elementary education, literacy rate, particularly among the females—are some of the areas of serious concern. Countries like China, Indonesia and even Sri Lanka are much better than India in most of the social sector indicators.

Despite being among the most rapidly developing economies of the world, the literacy rate and poverty percentage are two biggest embarrassments and the country still languishes at 128th position in the Human Development Index of the UNDP, where it is virtually stagnating for the last about five years. Further, the systems should also be able to check any unusual rise in prices to protect the common man from inflation.

One of the major criticisms of the government policy has been that the reforms have lacked the human face, as the government has been over-obsessed with the idea of achieving higher growth rate and fiscal and monetary management, rather than addressing the needs for equitable and inclusive growth. The reforms process has ignored the common man and the trickle down theory has actually failed to deliver.

The Planning Commission, while finalising the Eleventh Five-Year Plan has now sought to achieve the overall objective of achieving the ‘inclusive growth’, i.e., to include all those in the process of economic growth, who has remained excluded from the process of economic growth experienced by the country during the past decades.