Financial Reforms in India: Restructuring the Nation’s Financial Machine for Double-Digit Growth

The Indian economy is at a critical inflection point in its modern history. India’s GDP growth has accelerated to become the fastest of all major economies in the world, with income levels today at China’s c.10 years ago, it is expected that India is now the next big story. Given its favourable demographics and other resources, India has the inherent drivers to sustain 7-8% growth over the medium to long term and the potential to achieve 10%. An India that can sustainably harness its core assets and create new ones has the potential to emerge as one of the key drivers of growth and stability in a world faced with increasing global economic and geopolitical uncertainty. In order to attain this position, however, India will need to do what China has historically excelled at, creating significant population-wide savings and channelling these into (reasonably) efficient assets to deliver competitive returns. Doing this requires a robust financial machine ready to finance the nation’s growth. Despite the significant growth and evolution of its financial services industry, India’s financial sector continues to be hamstrung by major structural inefficiencies, including an old fashioned state-dominated banking system and, despite increasingly aggressive changes, a lack of financial inclusion for large parts of the population. It is a sector in need of a new vision as the basis of a restructuring so it can play its part in India’s new growth story. Recent years have seen a concerted effort by both the Reserve Bank of India (RBI) and the Modi-led government to rapidly grow financial inclusion and bring more and more of India’s poor into the formal banking system. The country’s technology sector has also made a significant contribution by developing delivery systems that reduce transaction costs and spread access by leveraging growing smartphone penetration. However, as various factors including the large pile-up of stressed assets in the banking system, the sharp slowdown in industrial credit growth and other measures of inefficiency of the financial system indicate, India still faces significant challenges in creating an effective financial system if it is to stride more aggressively towards its potential. While addressing these challenges will undoubtedly be a painful process and require the expenditure of political capital, the prize is significant: potential incremental growth of 2-3% p.a. would set India’s growth on the path to achieve the double digit levels necessary to replicate China’s economic miracle.

The Role of the Financial System in Wealth Creation in our Turbulent Times

India stands as a stable and growing zone in a world that seems to be facing ever greater political risk and turbulence. The Modi government has been a beneficiary of the relative unattractiveness of other emerging markets, the collapse of China’s growth, currency stability and political issues and a growing series of political and security risks world over.

Stable growth but higher savings rate needed to grow faster

In 2015, India attracted an unprecedented US$55m of foreign direct investment (FDI), making it the number one foreign investment destination globally. The Modi government’s focus on FDI makes complete sense: India’s saving rate generates 82% of the US$820bn it needs to sustain a GDP growth rate of 8% but for a 10% GDP growth rate, India would need an additional US$950m to US$1,000bn. The current savings rate is inadequate for financing this growth and FDI alone cannot be adequate for filling this gap at this point in time. Indeed, the rise of global macro political risk has come unexpectedly to make FDI less reliable for India than it was ten years ago for China. With the world facing an array of destabilising factors including the recent ‘Brexit’ vote, the potential election of a nationalist-isolationist in Donald Trump, destabilisation in the South China Sea, the continuing battles with ISIS in civilian and military arenas and Russian adventurism, India cannot rely on foreign investments alone to propel its growth. India’s domestic financial savings are unquestionably an essential part of the answer and indeed these savings need to become the stable core underpinning its long-term financing if it wishes to control its own destiny. The question for India therefore is how it can restructure its financial sector and augment it with the agents that allocate capital well so that it can create a flow of domestic financial savings that can play a critical role in propelling the economy towards sustainable double-digit growth.

Investment rate increase of 5% would set it on the path to match China’s rise

China’s savings and investment rate demonstrate how this needs to work to be effective. China’s success in generating over 10% growth over three decades (from 1982 to 2011) offers some clues as to the level of savings and capital efficiency required to achieve sustained double-digit growth. Firstly, in terms of generating financial savings, during these 30 years, China saved on average 41% of GDP. Given that it was able to exert a very high level of government control over its economy and financial system, it is unsurprising that India has been unable to match this and achieve a savings rate of ‘only’ 33%. More relevant to GDP growth though is the rate at which capital (including savings) are reinvested into the economy: China during its boom invested 39% of GDP, effectively nearly all of its savings. India on the other hand has actually been able to invest more than it saves, (mainly by running a current account deficit financed by FDI) achieving an investment rate of 34% over the past three years. Therefore, despite saving significantly less, India’s investment rate is only c.5% lower than China’s was, a gap that could potentially be bridged by a combination of more FDI and an increase in domestic financial savings.

Inefficient use of capital costing nearly 3% to GDP growth rate

The efficient use of capital is even more important and here India’s performance under the final years of the Congress government, prior to the Modi government, was a major setback, when a decline in capital efficiency reduced India’s annual GDP growth in by 2.5-3.0%. Capital efficiency is best measured by the incremental-capital-output-ratio (ICOR) , which effectively captures not only real-economy productivity metrics, but also the relative sectoral balance that results in a particular growth profile (see charts). During its high-growth phase, China was able to deploy its savings relatively effectively generating an average capital efficiency of 27% over a thirty-year period. Importantly, India’s capital efficiency has declined significantly with economic expansion, dropping from an average of 26% in the 2003-2007 period to 19% over the last five years. The impact on growth has been significant: if India had allocated its investment as efficiently in the last five years as it did from 2003-2007, GDP could have grown at 9.4% instead of 6.7%, an annual growth penalty of 2.7%.

India does not need to copy China to succeed, but will need to drive savings and capital efficiency

China provides an example of one solution to the problem of generating savings and investments. In the absence of a guiding government hand, the financial sector is the key determinant of how efficiently a country’s investment is deployed given it holds the deposits, issues debt and manages equity portfolios. China changed this by having the government play the key role in the savings and investment process. The government exerted significant control over the financial sector through a combination of capital controls, state ownership of banks, and the control of domestic capital markets to force a high degree of savings on the one hand and channel them towards investment in state-owned infrastructure, construction and manufacturing enterprises– on the other hand. With this formula, some of the fastest growing provinces in China achieved investment rates of 60-80% (compared to the national average of 39%). Clearly, the Indian government today does not have the level of control over all the pieces of value creation that China did to achieve this.

However, India’s model may not need to become more like China to succeed. As the analysis below demonstrates, its past peak investment rates and capital efficiency levels imply an ability for its economy to grow at c.10% based on changes that are not in the revolutionary end of the spectrum, namely a 4-5% increase in the savings rate and a 3-5% improvement in capital efficiency (see our analysis below on what level of investment and capital efficiency is required for various levels of GDP growth). The implication for India’s government and regulators is clear, drive both of these metrics and India can hit the magic 10% GDP growth rate. China was able to centrally direct the transfer of massive wealth from households to industry, with the aim that this would pay off because the trickle down and back to households through wage employment would be adequate and there would be only a minor leakage through corruption (the former did work well but is now faltering but the latter did not and has become the number one agenda item for the Xi government). India as a democracy clearly has fewer levers to pull and will need to pull those it does have more softly than China did, and in hindsight this may create a better and more sustainable system.

Based on the analysis of two key drivers of a given rate of GDP growth, namely the level of investment and the accompanying capital efficiency, some of the key conclusions for driving growth in India are:

  1. India was able to accelerate GDP growth from under 6% to c.9% in the 2003-2007 period on the back of a combined increase in both investment and capital efficiency
  2. The last few years of the previous government saw capital efficiency drop significantly, therefore even though investment increased, growth slowed down to c.6%
  3. Under the new government, capital efficiency has rebounded allowing growth to increase to over 7%, which could have been faster were it not for a slight drop in the investment rate
  4. 4 To get back to the 10% growth it achieved in 2007, India needs to drive investment higher by 4-5% and capital efficiency higher by 3-5%

As an aside, China has been gradually increased its investment rate from the early 1980s from 36% to 43% of GDP which has been the primary driver of the acceleration in GDP growth. China was able to maintain high levels of capital efficiency from 1982-2011, however, this has declined significantly as the chart and table above show, helping to drive down GDP growth to its current level of c.7%.

The Key Elements of Transforming India’s Financing Machine

While macroeconomic variables such as inflation and productivity are clearly key drivers of both savings and capital efficiency, the quality of the country’s financial system is the major long-term determinant of these metrics. Creating a robust and productive financial system, which aggregates capital and allocates it effectively will require India’s leaders to focus on restructuring a few key critical areas. These include:

I. Creating a Productive and Competitive Banking Sector

What is Required? The creation of a productive and competitive banking sector to ensure innovation of financial products and the rapid expansion of credit

Where is India Today? India’s banking sector was nationalised in the 1960s and remains heavily government influenced to this day despite being partially liberalised in the early 1990s, with government banks continuing to control c.70% of the country’s assets. Government banks have generally not been able to compete effectively with the private sector due to their inability to attract and retain the best talent and also due to political interference in their decision-making, among other factors. This has led to a sharp build-up in stressed assets and a slowdown in credit growth in the public sector banks, even while private sector banks continue to grow rapidly and more profitably (see table comparing key performance metrics of India private and public sector banks).

Key Focus Areas for Change To be effective engines of the economy, India’s banks will need to be run independently and professionally, be adequately capitalised to ride out their current asset quality issues, and be put on a level footing with private banks in every respect. The option is either for the government to finance this and implement major restructuring in the government banks or to begin the process of privatisation of the banks.

II. Moving From Physical to Financial SavingsThe transfer of physical wealth to financial wealth so that it can be used for much more sophisticated investment and capital formation, in common with other modern economies

Where is India Today? A combination of cyclical and structural factors has resulted in the bulk of Indian household savings being in physical assets (like land and gold) which account for 60% of household savings and 35% of overall domestic savings despite a reduction in the last few years. While there are a number of drivers for this phenomenon, the heavy rural bias of physical savings is indicative of the lower access to financial services in these regions. Recently, the government and the RBI have worked on multiple fronts to increase financial savings, resulted in 250 million new bank accounts for previously un-banked people and withdrawing key reforms which incentivised savers to invest in gold and real estate. As a result, the proportion of savings in physical assets has declined from 50% to 35% of total savings and the proportion of financial savings has started to rise nominally (see charts below). India’s level of physical savings as a proportion of total household savings is in line with China’s, however, the key difference for India is the lower overall savings rate which results in financial savings amount to under 8% of GDP.

Key Focus Areas for Change.The government’s main focus need to be on continuing to expand access to financial services in rural areas and among the poor who traditionally have been holders of physical assets. Control over inflation will help build trust in financial assets too.

III. Significantly Deepening the Debt Market

What is Required? A deeper debt market which creates financial innovation and the expansion of credit to the most productive parts of the economy, within a culture of responsible lending

Where is India Today?The dominance of government-owned players in India’s financial services industry has limited competition and innovation limiting the breadth and depth of financing available. Further, a state dominated banking system has resulted in the majority of debt flows to the least productive parts of the economy, choking off credit to private corporations which receive only 40% of total credit . India’s overall financial depth, at 209% of GDP (which takes into account total financial assets including corporate and government debt, bank deposits and cash, and equities) is c.0.5-1.0x of GDP lower than the US and China (see exhibit below). And while low leverage is clearly a good thing in the context of overall financial stability of an economy in the face of a domestic, regional or global crisis, the significantly lower penetration of debt, in particular corporate bonds indicates further headroom for India to expand leverage moderately without creating excessive risk.

Key Focus Areas for Change. Further developing the corporate bond market is critical. Although the absolute size is large at US$287 billion, the instruments issued by large financial firms and public sector enterprises remain basic. Deepening this market requires fundamental reforms including putting in place easily-enforceable creditor rights and bankruptcy and insolvency laws, such as the one just introduced this month, while creating demand by reducing government borrowing (the ‘crowding out’ effect) and easing restriction on foreign debt investments.

IV. Shift Financing Focus from Short- to Long-term Capital

What is Required? The corporate sector’s access to long-term capital needs to be geared up in a manner that enables increasing asset formation and growth

Where is India Today? The use of financing by India’s corporates remains inefficient, for example Indian corporations have c.3x the working capital requirements of American companies and c.2x that of Chinese ones (see exhibit below). The disproportionately large portion of corporate balance sheet tied up in working capital, primarily in long receivables cycles, is capital which could otherwise have been deployed in new capital formation. This is a function of India’s weak payment systems and contract enforcement mechanisms which make it easy for debtors to delay payments, with the biggest perpetrators often being state-owned enterprises and large private conglomerates. As a result, many mid-sized corporates are often burdened with high-cost sources of short term financing that prevents many businesses from scaling, even if they have strong business models.

Key Focus Areas for Change. An efficient payment system along with the ability to enforce contracts to ensure timely payments is a critical focus area, while deepening the market for corporate debt and innovative forms of working capital financing, in particular to mid-sized companies.

V. Reducing the Size of the Cash Economy

What is Required? A smaller relative cash economy which in turn frees up additional financial savings which can be used for productive investments, improves tax compliance and yields other benefits

Where is India Today? Cash in circulation accounts for 12% of GDP in India, c.1.5x the level in China and c.3x the level of Brazil (see exhibit below), reflecting India’s large underground economy and historical prevalence of tax avoidance. A large portion of the cash is converted into real estate and jewellery which links to another major structural issue for the financial sector. The government is looking to address this in a variety of ways, including the promotion of credit and debit cards, encouraging the growth of electronic and mobile payments solutions and clamping down on tax non-compliance and “black money”.

Key Focus Areas for Change. Reducing the cash economy even in line with other emerging markets could free up an additional 4-5% of GDP in financial savings, which alone could add 1.0% to India’s GDP growth. The government needs to maintain its current focus on tackling the “black money” issue and the underground economy while leveraging financial innovation and technology to move quickly towards a cashless economy.

The government is making significant progress in several of the critical areas that would transform the financing machine of the nation, most notably in terms of mass financial inclusion. However, in many critical areas there is much to do. The dominance of the state-owned banking sector in particular has resulted in a sharp build-up in poor quality assets, with the non-performing asset ratio doubling in the past four years, and a slowdown in credit growth, in particular to private corporations, with loan growth currently at 8.7%, the lowest in a decade. India’s reform approach to date is somewhat of a combination of many half-measures. Unable to fully privatise the banks, which would require wider political approval and the ability to co-opt powerful employee unions, the government continues to infuse capital into the state banks to shore up their balance sheets while trying to professionalise and improve management, systems and processes. While the private sector banks as a group are gradually overtaking the government sector by virtue of higher growth, it remains too small in relative terms. At current growth levels of 20% p.a. for private sector vs. 5% p.a. for the government sector, respectively, the public sector will still account for c.40% of the banking system in 2025, inhibiting India’s growth by virtue of inefficient capital allocation. If India is unable to properly solve this challenge, its progress on other financial reforms may well be wasted and its potential unachieved.

On the other hand, the prize is clear, namely, implementing a comprehensive set of structural reforms can accelerate growth further by driving increased savings, investment and capital efficiency while in parallel restructuring the banking sector to support the governments overall growth ambitions. Prime Minister Modi, through his flagship financial inclusion scheme which resulted in 226 million new bank accounts being opened with deposits of US$6.3bn in the span of 18 months for the country’s unbanked population, has demonstrated the ability to cut through political gridlock and implement big ideas in some of these critical areas.

In parallel to the series of measures to change how banking works in the country, the government will need to take some radical and symbolic steps that send the clear message that change is unavoidable. The Modi government has launched a huge spate of these across economic and social areas (see the Sign leader from June 2016 on the Modi government’s initiatives in its first two years in power ). This attention is now required to hit at the structure of the financial services establishment. As India seeks to address the other financial reform challenges, it should seek to leverage additional ideas for big reforms that can create positive movement in some of the key focus areas outlined above, including:

1. From Physical Infrastructure to Financial Infrastructure Funds: Raise a US$50 Billion Banking Fund. This would entail a pseudo privatisation of the state-owned banks, where the government would transfer ownership to an independently managed fund or funds which would deploy capital in exchange for specific changes in management and operations to improve performance metrics to align interests with shareholders. The government can structure this as convertible debt with a government guarantee, low fixed servicing and structured equity upside. If the banks are able to perform, the government would be able to retire the financing at a relative attractive cost (8-10%) and in cases where they do not perform, the funds would be able to convert into equity and management influence in the banks. Such a fund could provide a much-needed boost to the public sector banks to clean up their balance sheets and bring in the best practices needed to prepare them from more effective competition with the private sector.

2. Clear the Way for Value Creating Transactions: Remove Unnecessary Restrictions on Change in Control. Currently, there are a wide range of regulatory and other restrictions which limit the market for corporate control and the ability for assets to change owners, or be taken over by banks. While Indian companies can raise debt financing from abroad for acquisitions, there are restrictions domestically for using debt to pay for the acquisition of shares. This makes cash flow based leveraged acquisitions extremely difficult and complex to execute in India. Similarly, there are a number of restrictions that make it difficult for banks and other creditors to enforce their security interests and take over companies and assets. Removing these restrictions collectively, while leaving in place the flexibility for the government to reject change of control proposals based on national security interests, could have a significant impact in terms of allowing for assets to be quickly restructured and sold to different owners, while simultaneously deepening debt markets. This will also encourage significant additional FDI (more so if coupled by action of basic ease-of-doing-business regulations) and help pave the way for increased competition in a range of sectors, thereby driving growth, and at the same time consolidation in industries which require meaningful scale.

3. Beyond the ID system: Create Credit Analytics Databases Covering Customers and Companies. The government has a wealth of data on all companies in India and through the Unique Identification initiative has now mapped almost every citizen of India. Relevant official credit histories, although generally available, are split into many data silos including the RBI, the Ministry of Corporate Affairs, which in turn are analysed by various credit rating agencies. This however does not include newer forms of data which are now available as a result of increasing mobile penetration and electronic payments. If these can be combined into a single unified database, and made available to all approved lenders subject to privacy laws on access and use, the information gap that results in many borrowers not being able to access financing can likely be reduced significantly, while banks can make much more informed credit decisions by layering on sophisticated analytics technologies and techniques on the data.

None of these ideas, on their own, can address the whole list of areas that need to be addressed for India to build a robust financial system, and therefore they are not a substitute for gradually implementing the long list of recommendations that have already have been laid out in various financial reforms roadmaps. These ideas however acknowledge that India is facing some major structural obstacles in implementing the most politically difficult ones and therefore offer a way to catalyse the financial sector in a meaningful manner.


India today at 7% GDP growth is an interesting story, with an economy and reach that remains largely domestic or regional. India at 10% however is a global opportunity, one that has closed the c.US$100bn gap between savings and additional investment required, one that attracts billions in equity and debt inflows, and creates a significant step up in trade, creating global opportunities for wealth creation and stability.

While there is a long list of reforms on India’s overall growth roadmap, only a few have the ability to significantly accelerate growth on a standalone basis. Financial sector reforms are at the top of the list, with a potential growth benefit of 2-3% of GDP. This benefit will be weighed against the potential political costs given the strong opposition expected from entrenched interests who are beneficiaries of the current system. Taking these on, in India’s democratic context, necessarily means building some element of political consensus, which the government has now demonstrated its ability to do this with the nationwide goods and services tax, which seems to be on track towards implementation (and in itself is estimated to have the potential to accelerate economic growth by 1-2%).

Major state elections are due next year, which are precursors to the general election in 2019 where Mr. Modi’s parliamentary majority will be tested. Whether or not the government is able to maintain its majority will likely hinge around how voters perceive the answer to the question of whether the government has delivered on its promise of rapid economic development and “acche din” . While growth has accelerated in recent years to 7-8% levels, that may not be sufficient to keep voters happy. Placing a bet on financial reform now, 2-3 years before the general election, would allow for enough time for the potentially material benefits to accrue and the political opposition to gradually dissipate.

The impact of India’s financial reforms and growth extends beyond national borders and questions of electoral strategy though. As discussed in last month’s Sign of the Times, the global economy is facing increasing levels of uncertainty due to a combination of destabilising forces and events including Brexit, the US presidential election underway and resulting change in US policies, the continuing battle with ISIS, China’s economic slowdown and territorial issues with its neighbours and Russia’s adventurism. In a world of uncertainty, India’s demographic drivers and overall potential remain one of the few stable long term value trends and its growth makes it a genuine potential global economic stimulator, much as China has been for a decade of this century. Achieving this goal, however, will require transforming what today remains a certainty of potential into the certainty of economic growth. An India that fails to make this transformation, risks continuing to the 'next big thing' for another decade, an opportunity that everybody expects to materialize eventually but will not act on today without the path and the timeline to growth being clear enough.


1.    See appendix for definitions and sources

2.    Assumes c.20% capital efficiency based on average from 2011-2015

3.    The difference between a country’s domestic savings and investment rates is equal to its current account deficit

4.    The ICOR is the real growth rate of the economy divided by the rate of investment (as a percentage of GDP)

5.    Which means US$0.27 of incremental GDP for every US$1.00 of incremental investment

6.    Source: LiveMint, balance credit flows to state-owned enterprises, agriculture and small-scale businesses in the unorganized sector

7.    Source: Pradhan Mantri Jan Dhan Yojana website,

8.    India’s Steady Pace of Change: The NDA Government at 2 Years

9.    Literally translated to “good days”, this refers to a widely used election promise of Mr. Modi to deliver better days for the country if he was elected