Modern Banking
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Chinese bank reforms, 1993 – present
In 1993 the State Council32 announced a second stage of banking reforms which had three objectives:33
žTo further refine the central bank functions of the PBC.
žTo create a competitive commercial banking sector where state banks coexisted with other forms of banking institutions.
žTo ensure a sound financial market.
In 1995, the People’s Bank of China was reformed by the Central Bank Law. The PBC was to control the money supply, formulate and implement monetary policy, act as the government’s fiscal agent and supervise the financial system. From 1992, its role as financial supervisor was gradually reduced,34 culminating in 2004 when bank supervision was transferred to a new body, the China Banking Regulatory Commission.
There have also been major reforms to address the problem of the increasing amount of bad debt held by the ‘‘big four’’ state banks. These banks are, by any measure, effectively insolvent, but they continue to function because of the injection of funds by central and local governments. Their bad debt problem is largely due to the loss-making state owned firms they lend to, and the banking system is used to support them. According to official estimates, non-performing loans as a percentage of total loans is about 25%, but Whalley (2003) puts unofficial estimates as high as 50 – 60%. China is in the unique position of having a largely insolvent banking sector which is highly liquid, with liquidity ratios averaging about 57% for the big four, about 1% higher than the big four UK banks.35 Not only is the savings rate high (30% of GDP), but customers are content to keep their deposits at these banks because they are confident the state will always support the banks. Likewise, even though required to lend to loss-making SOEs, the state banks are not too concerned about it because the loans are considered ‘‘safe’’ – the state will bail them out. This situation has created serious moral hazard problems – bankers have virtually no incentive to practice good risk management techniques. Depositors think it is the job of the state to protect their deposits. Borrowers, in turn, have little motivation to make their firms profitable and repay the loans. The World Bank (2002) estimates that to restore the banking system to financial health, the stock of government debt will have to increase from 20% to 75% of GDP, and its servicing is likely to be a serious burden for the government.36
Part of the second stage of reform attempts to address the issue of the critical condition of these state owned banks. Since 1993, a number of reforms have been put in place.
32‘‘The Decision on Financial System Reform’’.
33Wu (1998).
34Supervision of insurance and securities firms was gradually transferred to, respectively, the China Insurance Regulatory Commission (established in 1998) and the China Securities Regulatory Commission (set up in 1992).
35Source: BankScope. The liquidity ratio is defined as net loans to total assets, and has been averaged over 2000 to 2002.
36Source: World Bank (2002), p. 36.
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žCreation of new policy banks (1994): to encourage the state banks to act like commercial banks, the government created three new state owned policy banks to assume the development goals of the state banks, freeing them to meet commercial banking objectives. The new policy banks are the Export – Import Bank of China, the Agricultural Development Bank of China and the China Development Bank. All three provide financial support for key projects designated by government to be of central importance to the nation. The first two banks grant policy loans to the agricultural and trade sectors, respectively, and the China Development Bank covers industries not included by the other two.
žThe Commercial Bank Law (1995): this law formalised a rule the PBC had imposed since 1993, terminating the practice of universal banking. Financial firms can only operate as banks or securities firms or insurance companies. Banks had to terminate all insurance and securities operations. The reasons given were that in an emerging market where bank finance accounts for 85% of finance, the system is not mature enough to cope with universal banking. It is blamed for many of the problems banks have, especially a real estate ‘‘bubble’’ created when some banks used their investment and trust affiliates to invest in property. When the bubble burst, they incurred a substantial amount of debt. However, the main source of the bad debt is from loans to state owned enterprises. The authorities are also worried about contagion effects, but in a country full of insolvent banks where there have been no bank runs,37 this concern seems unwarranted unless the authorities are planning to let one of the major state banks fail.
žThe 1995 Commercial Banking Law also made banks responsible for profits and losses, and set explicit prudential ratios, but at the same time required state banks to make loans according to the needs of the national economy and social development as outlined in the state’s industrial policy. The law sends out conflicting signals: be profitable, but at the same time, make what are effectively policy loans when called upon to do so, even though the three development banks were established for this purpose.
žAt the end of 1997, the credit quota system was terminated. Under this system, the central bank had set a limit on the amount of new loans, and specified how the loans
were to be allocated among the different sectors of the economy. In 1998, a new system was introduced by the PBC, which requires banks to satisfy various constraints on their balance sheet ratios. In China these are collectively referred to as asset liability ratios, consisting of a number of ratios including a liquidity ratio of at least 25%;38 the Basel 1 capital adequacy ratios (≥4%, ≥8% – see Chapter 4); and a reserve ratio of at least 5% for local and foreign currency deposits. There are also limits on loan exposure to an individual (≤4%) and a bank’s top ten clients (≤8%) which commercial banks are
37The Hainan Development Bank is the only bank that has been closed since 1949. Created as a joint stock bank in 1995, it had been profitable until the Hainan provincial government, which held 30% of its shares, asked it to take over 28 credit unions – about two-thirds of their debt was non-performing. This proved a disaster for the bank, and it was closed by the central bank in 1998. It was never declared bankrupt: all the creditors were paid off, and the government repaid depositors. This type of record explains why Chinese depositors have so much confidence that they will be protected by the state.
38The liquidity ratio is defined as liquid assets/liquid liabilities. Liquid assets must account for at least a quarter (25%) of liquid liabilities (e.g. demand deposits). The foreign currency liquidity ratio must be at least 60%.
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supposed to use.39 In addition banks are given a non-binding annual loan target to provide guidance on the total volume of loans they can make.
žWidening the ownership of the joint stock banks (1993 – 96): during the first stage of reform, the joint stock banks were largely regional, with a small number of owners. For example, the China Merchants Group Company Limited, a SOE, owned the China Merchants Bank. Between 1993 and 1996, these banks were allowed to operate nationwide and their ownership was widened, which increased their capital base. For example, a company with the same name had wholly owned China Everbright Bank, but by 1996, the China Everbright Group Limited had reduced its shareholding to 51%. Institutions such as the Asian Development Bank and other domestic firms (130) hold the other 49%, which more than doubled its capital base. Two new joint stock banks were created during this period. By the end of 2002, some shares of four joint stock banks were being traded on the stock exchange. However, these banks are still controlled by the state, despite the
joint stock label, because for all but one of them,40 the government remains a majority shareholder, usually via the shares held by state owned enterprises. According to Sun et al. (2002), the arrangement preserves the communist principle of public ownership. The Communist Party officially recognised private ownership in 2004,41 though within the banking sector the state will continue as a major player.
žRecapitalisation of state owned commercial banks (1998): a new Treasury bond was issued. The reserve ratio was permanently reduced from 13% to 8% (for all banks), freeing up funds to enable the state banks to purchase the bond. The yield from the bond would raise these banks’ income streams. The aim was to recapitalise them so their capital asset ratios would rise to the Basel requirement of 8%, though in 2002, only one of these banks, the Bank of China, met this target, with a Basel ratio of 8.15%.42 In 2003 another government injection worth $45 billion raised the capital adequacy ratios of the Bank of China and the China Construction Bank to 16.4% and 14.4%, respectively. In early 2004 the China Regulatory Commission stated that all commercial banks must meet a minimum capital ratio of 8% by 2007. There are reasons for pessimism about these plans. There have been no changes to curtail directed lending, and these banks are used to government rescues – since 1998, they have received about $200 billion to boost their capital. Furthermore, the injection of $45 billion is quite low when bad debt of the bigfour is estimated to be just under $300 billion and analysts think it could be as high as $420 billion.43
žAsset management corporations (AMCs)44 (1999): even by official estimates, the percentage of non-performing loans is high. The government created four asset management corporations, each affiliated with one of the four state owned banks. Bonin and Huang (2001) argue that having one AMC for each bank could create the expectation that the
39Other ratios place limits on international borrowing, the percentage of medium and long-term loans in the portfolio and limits on interbank borrowing.
40The China Mingsheng Banking Corporation created in 1996.
41In 2004, at a session of the Communist Party of China, the constitutional ban on the ownership of private property was removed.
42Source: The Banker, July 2003.
43The capitalist injection figures are from ‘Botox Shot’, The Economist, 10/01/04, p. 65.
44For more on AMCs, including their pros and cons, see Box 8.1 in Chapter 8.
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bank can dump bad loans with its AMC. However, the AMCs are supposed to close within 10 years. Also, they may only deal with debt incurred before 1996. This cut-off was chosen because under the Commercial Bank Law, these banks were supposed to be responsible for loans made from 1996 onwards. However, as was noted above, the Law has not freed the state banks from involvement in policy type loans. Another problem is that by 2001, the AMCs had reduced the state banks’ NPLs by 10%, quite a low percentage by the standards of other countries that have created AMCs (see Chapter 8). These AMCs have used a variety of means to manage/offload this debt, including restructuring, sales/auctions and collecting the principal and interest. By 2002, an average of 36% of the NPLs had been recovered. The AMCs also entered into debt equity swap agreements with just over 1100 state owned enterprises, to help alleviate the debt burden of the state banks. The central bank loaned the AMCs funds to purchase enterprise debt from the state bank, then swapped them for equity in the enterprises. The plan is for the equity to be sold by the AMC, and the funds used to repay the PRC loan. In 2004, Shi Jiliang, Vice Chairman of the China Banking Regulatory Commission, admitted bad loans for the four major state commercial banks averaged about 20%.45
žOrganisational changes (1998 – 2002): by merging or closing branches, these banks refocused their operations on city based construction and medium to large-sized SOEs. During the period the number of branches was reduced by 36%, from 154 051 to 55 324. Staff cuts were less successful – just 362 900 employees (18%) were reduced from a total of 2 001 300 workers in 1998.
žShareholder restructuring (2002): a three-stage plan to transform the state owned banks into first, joint stock banks and eventually for them to seek a public listing. The $45 billion capital injection for the Bank of China and the China Construction Banks is a pilot scheme to convert them into joint stock banks and encourage a more competitive environment. They have been told to implement an efficiency drive to ensure a return to profitability within three years. It is unclear what the sanction is if these banks fail to meet the target. In the past, managers have been let go only if they fail to be profitable over a number of years.
Many credit cooperatives, like their banking counterparts, found themselves burdened with a large amount of debt. The credit coops were never bound by the PBC’s credit quota system. Though the coops were supervised by the PBC, the power of local governments (majority shareholders in the coops) was such that the central bank cannot control their lending decisions. No attempt was made to apply the basic principles of asset liability management, and many of them are effectively insolvent. For example, 49% of the rural credit coops had liabilities exceeding assets by 1996. At the end of 2003, the official estimate of the ratio of non-performing loans to total loans was 12.9% for urban credit coops and 29.7% for their rural equivalents.46 It is unclear whether the new regulation will be able to make a difference. In 1992, there were more than 4000 urban credit coops. After 1995, 2000 were converted into 111 city commercial banks with local shareholders (e.g. urban firms, residents and local
45Source: channelnewsasia.com, 27 May 2004. He was referring to the Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China and the Agricultural Bank of China.
46Source: cbrc.gov.cn/chinese/module/viewinfo.jsp?
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government), serving small and medium enterprises in the cities where they operate. The remaining 2000 were reduced to just 758 by 2002 through mergers and some closures.
In 2001, China became a member of the World Trade Organisation. China is committed to allowing foreign banks completely open access to Chinese markets by the end of 2006. The government has a long way to go, though there has been some progress. By 2000, foreign financial institutions had 233 representative offices and 191 subsidiaries in 23 cities, with assets worth $34 billion.47 Foreign banks have been allowed to offer foreign exchange services to residents and non-residents since 2001. In Pudong and Shenzen, they have been allowed to convert offices into branches and engage in renminbi businesses. Some have also been allowed to acquire small shareholdings in the joint stock banks. Newbridge Financial now owns 15% of Shenzen Development Bank, and Citicorp has a 5% share in Pudong Development Bank. Geographical restrictions are due to be lifted in 20 cities/provinces by 2005.
Loan classification has also been reformed. Until 1995, the PBC placed a ceiling on the percentage of loans that could be classified as bad debt, independent of a bank’s asset quality. From 1995, the system was changed: loans were to be classified as past due, doubtful or bad debt, though banks could still classify a loan as past due even if the firm had closed down! To bring China up to international standards, it was announced (in 1998) that by 2002, banks had to place loans in one of five categories: normal/pass (the borrower is repaying on schedule), special mention (the loan is being repaid but there may be factors which interrupt the loan repayment), substandard (the income from the firm’s business is insufficient to service the loan), doubtful (debtor unable to repay the loan; even with the guarantees, the bank will incur losses) and lost (either the principal and interest cannot be recovered or, with legal action, a very small amount may be recovered).
External examination of the banks has been improved. Since 2000, state supervisory boards have been supervising state owned banks. External auditing has been introduced, and external agencies have the duty to sign off bank statements as reflecting true and fair value.
Until very recently, the government, through the PBC, maintained a tight control over interest rates: they were seen as a key instrument of political control. However, in 2002 two State Council announcements began a protracted, gradual process of interest rate reform, with liberalisation of:
žLong-term funds followed by short-term funds;
žForeign rates to precede domestic rates; and
žDomestic loan rates before domestic deposit rates.
Small interbank money markets have operated in different provinces since the 1980s. In 1996 the money market was centralised, with rates to be determined by market supply and demand. Since then, it has become quite active – a major source of liquidity for banks, depositing and lending funds at a CHIBOR rate. The inter-rate bond market was also opened in 1996. Bond and long-term deposit rates were liberalised between 1998 and 1999.
Deposit rates are fixed by the PBC and remain so, though longer term deposits are paid a slightly higher rate than short-term deposits. Banks have always had some discretion in
47 Source: Almanac of Chinese Finance and Banking (2002).
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setting loan rates. Until 1998 it was the central bank rate plus a rate added by the bank, up to a limit of 10%, with the exception of rural credit cooperatives, where it was 40%. In 1998, this limit was raised from 10% to 20% for small and medium-sized enterprises and from 40 to 50% for the RCCs. In 1999, the band for SMEs was widened again, from 20 to 30%. Since 2000, the bank and customer can negotiate the rate paid on foreign exchange deposits in excess of $3 million; the same privileges were extended to small foreign exchange deposits in 2003.
The decade between 1992 and 2002 saw many changes in China’s banking sector, leaving a system consisting of the following components.
žThe central bank, PBC: responsible for implementation of monetary policy, though the State Council sets interest rates (China’s equivalent of a cabinet). The Governor of the PBC is on the committee that advises the State Council. When its supervisory functions were reassigned to separate authority, a financial stability bureau was established at the PBC to take decisions about liquidity support in the event of bank runs.
žThe China Banking Regulatory Commission: established in 2003, it is the bank supervisory authority.
žThree policy banks were established and are funded through issues of state bonds and loans from the PBC.
žFour state owned commercial banks offer nation-wide wholesale (to large and mediumsized enterprises) and retail banking services. Overseas branches have been established to serve Chinese customers abroad.
žEleven48 joint stock banks, with shares owned by the state, private sector and some foreign concerns. A portion of shares of four of these banks is traded on the stock market. Retail and wholesale banking services are offered to firms and residents in large and medium-sized cities.
žCity commercial banks (111) owned by local government, local enterprises and households. Commercial banking services (intermediary, settlements, money transfers, etc.) are offered to city based small and medium-sized enterprises and residents, though they are also trying to attract larger firms headquartered in their city, which would normally do business with a state bank. There is some customer overlap with the Commercial Credit Cooperatives (758), though the coops offer basic banking services (taking deposits, making small loans) to residents and small local firms in urban areas.
žRural commercial banks (3): like their urban counterparts but offering commercial bank services in rural areas.
žRural credit cooperatives (35 544 in 2002): each coop offers basic banking services to residents and local enterprises based in a particular rural area.
žForeign banks (424 subsidiaries or representative offices) offer nation-wide foreign exchange services to foreigners and Chinese citizens, and renminbi bank services to all customers (Chinese nationals and others) in Pudong and Shenzen. By 2006, restrictions on offering renminbi services will be lifted.
Despite all these changes, two indicators suggest that their impact, to date, has been nominal. First, the banking system remains highly segmented, as indicated by the above
48 In 2003, the Yantai House Savings Bank became a new joint stock bank, the China Evergrowing Bank.
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Table 6.4 Market Shares of Chinese Banks: 1992 and 2002
Banks |
Deposits 1992 |
Deposits 2002 |
Loans 1992 |
Loans 2002 |
|
|
|
|
|
Policy banks |
na |
0 |
na |
13% |
State owned commercial |
78% |
66% |
84% |
59% |
Joint stock commercial |
6% |
13% |
4% |
11% |
City commercial |
na |
7% |
na |
6% |
Urban credit coops |
3% |
1% |
2% |
0.005% |
Rural credit coops |
13% |
12% |
9% |
10% |
Foreign banks |
0.004% |
1% |
1% |
1% |
Total |
RMB2742 bn |
RMB16 861 bn |
RMB2759 bn |
RMB13 528 bn |
Source: Fu (2004) and Almanac of China’s Finance and Banking.
list. Second, the distribution of shares of total loans and deposits has changed, but not significantly so. Table 6.4 illustrates how, since 1992, the market shares of the state owned banks and rural credit cooperatives have declined, partly due to a redistribution of loans to the policy banks, but also because of the growth of the joint stock banks. However, the market share of the big four state banks continues to be very high. The shares of the foreign banks remain low, though these figures were compiled just as some of the restrictions on foreign banks began to be lifted.
China and financial repression
In 1979, China’s banking system was financially repressed by any measure used. The banking system is undergoing reform as part of a bigger plan to move to a market based economy, while conforming to the political ideals of communism. To what degree have these reforms removed the characteristics of financial repression from the Chinese banking system?
One interesting figure is China’s ratio of M2 to annual GDP, reported in Table 6.3. In 2002, it stood at 165%, higher than any country listed, including the UK and USA, and it has exceeded 100% for a number of years. Part of the explanation relates to financial repression. Residents of China have a dearth of alternative assets to hold. The stock market is underdeveloped and thin, and access to real assets (e.g. property) has been very limited, though private ownership of assets should begin to rise, now that it is officially recognised in the Constitution. In this environment, the large savings (prompted by China’s very rapid rate of growth) will accumulate substantially in (interest bearing) financial assets, included in M2. The confidence in Chinese banks reassures savers that they are a safe place for their deposits. Other factors have contributed to this unusually high figure. Inflation (and nominal interest rates) are very low, and expected to remain so, which builds real M2. By contrast, other countries in the list have much slower growth, a worse inflation record and prospects and (in many cases) more access to alternative assets in which savings can be held.
The state used the central bank to administer the credit quota system, which involved control over all deposit and loan rates, domestic and foreign. This meant credit was directed
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where the state wanted it to go – the third feature of financial repression. Plans to ease control began with the interbank market in 1996, and since then controls have been relaxed (though not removed) on a variety of loan rates. Renminbi deposit rates remain fixed and determined by the PBC.
The degree of financial repression was reduced after China’s reserve ratio was lowered from 13% to 8%, as part of a programme to recapitalise the debt ridden state owned banks. Unlike other emerging economies, it had never been used as a major policy tool, and though it is on the high side by western standards, the PBC pays banks a small amount of interest on the reserves.49 Chinese banks are subject to a large number of ‘‘asset liability’’ ratios, but most of these are used by supervisors in the developed world, and the ratio requirements are not particularly restrictive.
The reorganisation of the banking system after 1992, with its emphasis on corporate governance and profitability, is indicative of a move away from government interference with the day to day management of bank activities. However, as can be seen from Table 6.4, the nationalised banks continue to control a large portion of deposits and loans, giving the state an option to interfere with how they are run. Also, the central, provincial and local governments hold sizeable stakes in the joint stock and city commercial banks. Traded shares make up just a small proportion of total shares, and until this arrangement is changed, the potential for state interference in running the majority of Chinese banks is high. The influence of powerful local governments on the lending policies of credit coops is unhealthy. Nor does there appear to be any mechanism that allows new private banks to enter the system.50
Finally, as the discussion and Table 6.4 shows, foreign banks have been largely barred from operating in Chinese banking markets. In anticipation of its obligation to the World Trade Organisation to allow full foreign bank participation by 2006, controls on foreign bank participation are gradually being lifted. However, given the state of the Chinese banks, as shown by their high rates of non-performing loans and other indicators, if foreign banks are accorded the equal treatment expected by the WTO, they could emerge as a dominant force in Chinese banking. Whalley (2003) notes that such a prospect will give China the incentive to keep the renminbi inconvertible,51 to deny access of foreign banks to renminbi deposits, which in turn will limit their participation in local currency lending. However, foreign banks could bypass this type of restriction (assuming the WTO conditions are satisfied) by accepting domestic currency deposits. The more efficient foreign banks, unencumbered by the debts of state owned firms, could offer higher deposit rates to attract Chinese depositors and fund renminbi loans from these deposits.52 This would aggravate the problems of most Chinese banks and the government – a major stakeholder in these
49The banks are paid 1.89% on their reserves (2002 figures).
50There is a plan to allow new private banks, but to date the government has shelved all new applications.
51The renminbi is currently fixed against the US dollar with convertibility restrictions. For over a decade, the rate has been $1 = 8.3 RMB.
52Under the principle of ‘‘equal treatment’’ (see Chapter 5), provided foreign and domestic banks are subject to the same regulations, the Chinese government is not violating WTO conditions. This means it could require foreign banks to adhere to the same deposit and loan rate controls as the local banks, which would considerably reduce the foreign banks’ competitive advantage.
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banks. They could either restrict foreign bank business (reneging on their WTO agreement) and/or reorganise the entire banking sector, a costly exercise, as was noted earlier. However, given the ongoing economic boom, tax revenues should rise which will help to finance the restoration of the banking sector. Also, the presence of foreign banks means they can pass on their expertise in risk management and other areas, a crucial consideration if the Chinese banks are to operate efficiently in a market based economy. Nonetheless, it appears the Chinese government must act to resolve a major policy dilemma: it either protects its bankrupt state banking sector, which currently dominates the entire banking system, or it adheres to the conditions of the WTO agreement.
Other features of financial repression remain. Although inflation (a key problem in many financially repressed regimes) is low, some restrictions on capital inflows and outflows remain. Limitations have been placed on inward FDI – all foreign investors must have a local partner. Also, Chinese nationals have limited access to foreign equity markets and foreign currency.
To summarise, the approaches taken to banking reform in Russia and China could not have been more different. China has adopted a very gradual approach while many of the changes in Russia can be described as haphazard and ad hoc. The reforms of the Russian banking system mean it is largely free of financial repression whereas in China, the opposite is true. Yet both countries have ended up with an inefficient banking system, where the main problems are high percentages of non-performing loans due to the debts of the state owned enterprises, little incentive on the part of bank managers to introduce risk management systems, and widespread moral hazard among depositors, borrowers and the banks themselves.
6.3.3. India
Since India’s independence in 1947 (it became a republic in 1950), this democratic nation has never operated a centralised economic system to the degree witnessed in the USSR and China (until 1979). Its private sector is well established in some areas of the economy and the financial system was quite unrestricted at the time of independence. However, by the 1960s, the economy was characterised by rigid state controls designed to meet the objectives of national 5-year economic plans. The state effectively assumed control of the financial sector to raise saving and investment rates and channel funds to priority sectors, agriculture and heavy industry. In 1969 the 14 largest commercial banks were nationalised to ensure that funds were allocated in line with the economic plan, and to create branches in rural and semi-urban areas which, at the time, had no direct access to bank services. To increase the amount of agricultural credit, the regional rural banks were established in 1975. In 1980, another six commercial banks were nationalised. Specialised development financial institutions (DFIs) were created in the 1980s, such as the National Bank for Agricultural and Rural Development, established in 1982 to coordinate and supervise the rural credit cooperatives. Other DFIs included the Export Import Bank of India and the National Housing Bank.
India, like China, did not experience any serious upheaval but in 1991 severe balance of payments problems emerged because of the effects of the first Gulf War in 1990 – 9153
53 Oil prices soared which was a serious problem for oil importing countries like India.
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and a large, rapidly growing fiscal deficit. The government responded with a systematic programme of economic reform. The objectives were to increase the role of the private sector in a more open economy (including easing controls on foreign direct investment), allow market forces (rather than the state) to play a greater role in resource allocation, and redefine the role of the government in economic development. Reforms included new measures to improve fiscal discipline and sweeping changes in industrial, trade, foreign direct investment and agricultural policies, together with a plan to overhaul the infrastructure. Not all the changes were implemented but the plan was most successful in the removal of controls in the industrial sector, abolishing import licensing, allowing foreign ownership (either 100% or majority) in most sectors, and dismantling the tariff structure. The reforms appeared to pay dividends. India became one of the fastest growing emerging markets in the 1990s, averaging about 6.7% per annum between 1992 and 1997. Gordon and Gupta (2003) produce econometric evidence (using data from the 1980s and 1990s) showing that in the 1990s, the growth of India’s service sector was due to rapid growth in communications, IT, financial services and community services (education and health). Though a high income elasticity of demand and the growth of service exports partly explains this growth, economic reforms were also found to be statistically significant. Nonetheless, between 1997 and 2002, the growth rate slowed to an average of 5.4%, which increased pressure for more reform.
This section concentrates on reforms to the financial sector,54 and in particular banking, the dominant form of financial intermediation. As Table 6.3 shows, India, like China (but unlike Russia) has functioning bond and equity markets. However, the bond market is largely made up of government bonds – corporate issues make up about 9% of the total market.
Reforms in the financial sector were based on ‘‘pancha sutra’’ or five principles:
žA gradual process of sequential changes;
žMeasures to reinforce each other;
žChanges in the banking sector to complement macroeconomic policy;
žFinancial markets to operate on market principles; and
žDevelopment of the financial infrastructure.55
Key reforms included the establishment of the National Stock Exchange (1992) – India’s first screen based exchange56 – the introduction of an auction system for government securities (1992), and improved regulatory powers for the Securities and Exchange Board of India. In banking, the objectives were to keep banks financially sound while encouraging more competition, and reducing government ownership of state banks.
žA commitment to adopt the Basel 1 supervisory standards (see Chapter 4).
žIncreased supervision of banks. In 1994, the Board for Financial Supervision was
established, and though part of the Reserve Bank of India (RBI), is supposed to be autonomous.
54For a general discussion of the economic reforms, see Ahluwalia (2002), Acharya (2002) and Dreze and Sen (1995). For a discussion of the Indian financial system preand post-reform, see Mohan (2004).
55Mohan (2004), p. 122.
56Stock exchanges in Mumbai, Calcutta, Dehli, Bangalore and others throughout the country were well established.