Journal of Financial Economics

REF 107 The Indian financial system

The integration of the Indian economy with the world economy from the 1990s onwards led to the rapid growth of the Indian GDP (7% to 9% per annum). This was necessary to empower the large numbers of the Indian population still floundering in abject poverty to improve their lot. The gradual nature of the reforms, including in the financial sector, enabled India to confront the 2008 financial crisis and the current euro crisis under relatively stable conditions. This, however, should not mask the existence of important structural imbalances – public deficit, poverty, marginal financial inclusion, low agricultural productivity and problematic infrastructure financing – which can hinder rapid growth in the absence of further financial reforms.

The last twenty years have witnessed major changes in India with the introduction of development boosting reforms, which assigned a central role to the private corporate sector. This string of reforms has enabled the country to post high growth rates but has also left it open to risks because of its inclusion in the global economy. A definition of development policy must necessarily take these two aspects into account in order to find a just balance between economic stability and efficiency. Although it is important to systematically introduce measures aimed at developing the productive sector, its diversification between the different sectors of activity is a key element of stability, as is also the existence of a powerful financial sector. Lastly, to protect the economy from financial shocks, the recourse to a combination of capital controls and currency flotation is desirable.

The developing countries’ share of GDP in the world GDP is increasing and could become 42% by 2017. If the growth achieved by these countries partly depends on dynamics which is unique to them, it needs to be reiterated that they are evolving in a global context, characterized by the existing difficulties of the United States and the European Union. This global context, of which the Indian economy is now increasingly a part, is analysed through the prism of short term, medium term and long term perspectives. In the second part, the paper undertakes an analysis of the characteristics of the Indian economy from the angle of investment and saving, before proposing a series of measures enabling it to face the challenges before it, especially in the field of infrastructure and agro-foods production.

The GDP growth acceleration has constituted an essential feature of Indian economic history of the last four decades. However, the slowdown of the Indian economy from early 2010 onwards raises questions on the country’s capacity to sustain levels of growth closed to those recorded before the international economic crisis. We here propose a quick review of macroeconomic challenges that Indian economy has to face.

The analysis of macroeconomic vulnerabilities of growth appears satisfactory on the whole. Low level of external debt, high level of official foreign exchange reserves, and the stability of the banking system are especially reassuring. However, the country’s ability to keep the investment rate growing will probably be an important determinant of country’s future economic growth. In this respect, the low level of government resources and limited access to long-term resources could be real constraints. Moreover, the demographic window of opportunity from which India could benefit in the next 20 years, requires that the country create sufficient jobs. One must hence keep in mind that maintaining high levels of growth in the future could turn out to be more challenging than in the past.

Recent literature on monetary policy issues sometimes criticizes the Reserve Bank of India’s tolerance regarding inflation, sometimes praises its “gradualism” when having to deal with macroeconomic objectives. Scholars tend likewise to take a stand on the issue of the desired hierarchy of objectives assigned to central banks and the “optimal” monetary regime, though remaining surprisingly silent on major structural questions. By tracking changes in the RBI’s balance sheet, this paper shows that following the 1991-liberalization reforms, the central bank has ceased to finance the expansion of the domestic economy involving itself instead in the task of integrating India’s financial system to a larger globalized financial market. Systematic accumulation of FX reserves, which is the policy response adopted to cope with large international capital inflows and the condition to succeed that integration, raises the question of the costs and risks the Indian financial system incurs in, at a time when major international currencies suffer from persistent macro imbalances.

Rising current account deficits in India imply external financing needs that now raise important challenges. In this paper we study the causes of this deterioration and observe that external shocks have played a significant role, especially the rise in commodity prices. Domestically, the counterpart of external imbalances has been a fall in savings, related to negative real interest rates and the lack of structural reforms to address inflation and budget deficits. Meanwhile, external deficits have been increasingly funded by debt capital inflows, in particular short-term flows, which imply that India’s external vulnerability is increasing. Foreign investors are now more and more reluctant to invest in emerging markets and European banks are decreasing their exposure in regions like Asia where their activity involves US dollar funding needs. The link between growth and savings suggests the current deceleration in economic activity is related to the fall of domestic savings and the tighter external financial constraint. Fostering savings is thus fundamental for India to achieve its growth potential and we suggest policy options to achieve this objective.

The resurgence of inflation in India since 2009 leads us to examine the steps taken by the Reserve Bank of India, its priorities and objectives. These are multiple: monetary stability and economic growth, but also exchange rate management. The paper assesses the recent activity of the central bank as well as the results from the point of view of its objectives. A restrictive monetary policy has no doubt curtailed activity but, in so doing, has enabled it to check an inflationary spiral from building. Nonetheless, structural economic reforms are necessary so that monetary policy can effectively meet the given objectives.

Although the Indian financial sector has undergone fundamental changes since the 1990s, it continues to be influenced by the pre-existing institutional framework and is charaterized by an important duality. Both with regard to financial markets and the banking sector, the private sector today comprises effective and forceful actors evolving in a competitive international environment. On the other hand, the public banking sector, still significant even though its share has decreased rapidly, is confronted by a series of structural problems that it is striving hard to overcome, namely the significant number of bad debts and a large unproductive workforce. This makes it necessary for it to resort to repeated recapitalization. Financial inclusion is moreover still very inadequate. The above spells out the need for further deep-seated reforms.

From a post-financial crisis perspective, Indian banks are rethinking their strategic models and their competitiveness. Four essential components have to be integrated in their competitive strategy: scale, scope, prudence and knowledge. Each organization must find a proper balance between these various parameters. These factors will impact economic policy in order to secure financial stability. Monetary authorities therefore must develop a framework which will take into account systemic risks, the necessary arbitrage between size and competition, and the means to achieve financial inclusion in a viable manner.

In this paper, we analyze the relation between stock prices and the macro economy in the Indian context. We try and answer whether the recent stock market boom can be explained in terms of macroeconomic fundamentals. We find that there is a strong connection between the recent macroeconomic indicators’ performance and the stock market in India.

Since the mid-1990s, mergers and acquisitions have become frequent in India because of economic liberalisation and structural reforms. In 2011, India was the second emerging country after China where such operations became a regular phenomena. This article examines the legal and fiscal environment and highlights the constraints to which Indian and foreign companies are subjected when undertaking such operations. In the second section, it analyses a certain number of typical examples to demonstrate the need for a better understanding of such constraints.

The 2008 financial crisis has highlighted the dangers of certain financial innovations that took place in the context of generalized deregulation. In India, as in other emerging countries, where financial markets are not very mature, the authorities could be tempted, by way of response, to take measures to prevent the appearance of innovative financial products with real utility. This is illustrated by the real estate market in India, which experienced a slowdown in 2008 because of the difficulties encountered by the principal financiers, commercial banks and the Housing Finance Corporation. In view of the great need for infrastructure and housing in India, the author recommends upgrading the securitization of real estate credits, which for him is an alternative to bank financing if it is accompanied by appropriate regulations and monitoring.

Indian microfinance has undergone extraordinary development in the post-2000 period before becoming a victim of the severe crisis that began in 2010. The reasons for the emergence of microfinance in India are linked to the inability of banks to finance poor households, despite the development of banking networks in rural areas. Thus in 2004, only 5% of the small borrowers were financed through their intermediary. In response to this situation, microfinance made its appearance in the beginning of the 1980s due to the initiatives of self-help groups (SHG) and microfinance institutions (MFI). This article brings out the advantages and defects of these two types of organizations and analyses the 2010 crisis by focusing on the central role played by the political authorities in its development. The transgressions and difficulties of the Indian microfinance model having been brought up to date, the sector should now be able to continue its activities on a healthier basis.

The poorest sections of the Indian population, particularly in rural areas, do not have access to banking or insurance services. Financial inclusion is therefore an important aspect of economic policy. On the basis of international comparaisons, the author maintains that the situation is not as bad as it is made out to be and that it has to be analysed in detail. To help the poorest of the poor, their needs have to be determined ; at least some of them such as health should be covered by the State without obliging these people to turn to costly and futile funding options. In addition, the authorities and financial players must propose products which respond to the real needs of these people.

This paper draws a picture of the Indian vision of globalization, along with the advantages and risks for Indian economy and society. From a long term perspective, current globalization does not appear as either unique or irreversible. Political considerations could call it into question if the advantages obtained in some countries do not compensate for the harmful social consequences, such as the abolition of jobs in developed countries. Over and above the exchange of non-financial goods and services, the question of the risks engendered by financial liberalization is also posed. The latter can contribute a lot to an economy such as India’s, but this implies the implementation of a complex monetary policy by the Reserve Bank of India if rapid growth, beneficial for society as a whole, is to be achieved.

The US dollar is not like any other national or regional currency; it is also an international one. More precisely, it becomes an international currency each time it is transferred by a US resident to a non-resident.

This paper analyses all the transactions that are summarized in the US balance of payments, which is presented as the balance sheet of a bank that creates money. It also contrasts these money-creation mechanisms with the conventional intermediation mechanisms. The analysis is then carried to the level of stocks that appear in the International Investment Position of the United States. Finally, this paper presents the evolution of the flows and stocks of the creation of the US international currency, notably in the context of the effects of the 2008-2009 financial crisis.

Taking into account the huge potential and the increasing role played by the Islamic finance, this paper analyses the methodological process linked to the introduction of a shariah compliant index on the Paris Stock market along with a study of its short and long term performance. A screening process is applied to different stocks composing the SBF 250 index in order to make it shariah compliant. This process leads to the exclusion of almost 90% of the stocks, thus the final Islamic index is composed by 25 companies. The weighting procedure is based on the free float of each stock composing the index with a capping factor of 15%. From August 31, 2007 to August 31, 2010 the Sharpe Ratio, the Jensen’s alpha and the «  Buy and Hold  » returns lead to the same conclusion : the French 25 shariah outperforms both its conventional and shariah compliant counterparts, on the short run and on the long run. Over the same period, the low average beta of the French 25 shariah index (0.30) can be explained by the dominance of stocks belonging to the health industry (40%).

This article shows that the polymorphic nature of liquidity and consequently liquidity risk by analyzing three types of liquidity and their associated risks, namely the Central Bank liquidity, the Market liquidity and the Funding liquidity. It emphasizes the interactions between Market liquidity risk and Funding liquidity risk and shows how these two types of risk reinforce each other. This analytical framework enables us to evaluate the Basel III proposals for the control of bank illiquidity risk by focusing on two new liquidity ratios, the “short term” liquidity ratio or LCR and the “long term” liquidity ratio or NSFR. We show the virtues and also the limitations of these proposals and suggest some avenues neglected by the regulator.