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Contents

Contents ............................................................................................................................... 1

INDIAS STRATEGY OF ECONOMIC DEVELOPMENT POST-INDEPENDENCE .. .2Development Strategies .................................................................................................. 3

Foreign Trade and Investment ......................................................................................... 5THE CONSEQUENCES OF INDIAS REGULATED ECONOMIC DEVELOPMENT

............................................................................................................................................ 10

Reasons India adopted the New Economic Policy ........................................................12The 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 ..................................................... 16Expected benefits from the NEP were: ..........................................................................17

Banking Industry of India: .................................................................................................20History of the Indian Banking Industry: ............................................................................ 21Pre-reform period of banking sector in India .....................................................................23

Reforms undertaken in the banking sector in the 1990s: ..................................................25

Statutory pre-emptions ...................................................................................................26Priority sector lending ....................................................................................................27

Interest rate liberalization ..............................................................................................27

Entry barriers ................................................................................................................. 28

Prudential norms ............................................................................................................28Public Sector Banks ....................................................................................................... 29

Credit Market .................................................................................................................31

INSTITUTIONAL STRUCTURE OF THE CREDIT MARKET IN INDIA ................... 34POLICY DEVELOPMENTS IN THE CREDIT MARKET IN INDIA ...........................35

TRENDS IN CREDIT THE 1990s AND ONWARDS ..................................................37

STATUS AND EFFECTS OF LIBERALIZATION .........................................................38Impact 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) .................................. 45Deployment of credit .....................................................................................................46

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INDIAS STRATEGY OF ECONOMIC DEVELOPMENTPOST-INDEPENDENCE

British colonial rule in India ended in 1947 with the establishment ofthe two independent countries of India and Pakistan. The governmentsof India turned to planning for national development soon thereafter:Indias s First Five-Year Plan (FYP) covered the period covered 1951-56though India's FYPs were occasionally interrupted with annual plans.Although Indias been and still is, a mixed economy with a large privatesector, state regulation of economic activity was very extensive untilthe reforms of 1991.Indias economic development strategy immediately afterIndependence was based primarily on the Mahalanobis model, whichgave preference to the investment goods industries sector, withsecondary importance accorded to the services and household goodssector .For example, the Mahalanobis model placed strong emphasison mining and manufacturing (for the production of capital goods) andinfrastructural development (including electricity generation andtransportation). The model downplayed the role of the factory goodssector because it was more capital intensive and therefore would notaddress the problem of high unemployment in India. Any increase inplanned investments in India required a higher level of savings thanexisted in the country. Because of the low average incomes in India,the needed higher levels of savings had to be generated mainly byrestrictions on the growth of consumption expenditures. Therefore, theIndian government implemented a progressive tax system not only togenerate the higher levels of savings but also to restrict increases inincome and wealth inequalities.

Among other things, this strategy involved canalization of resourcesinto their most productive uses. Investments were carried out both bythe government and the private sector, with the government investingin strategic sectors (such as national defense) and also those sectors inwhich private capital would not be forthcoming because of lags or thesize of investment required (such as infrastructure). The private sectorwas required to contribute to Indias economic growth in waysenvisaged by the government planners. Not only did the government

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determine where businesses could invest in terms of location, but italso 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 thethen perceived success of the Soviet Union in rapidly industrializing alargely rural economy in a relatively short span of four decades withoutsignificant external assistance. The future Indian Prime MinisterJawaharlal Nehru had visited the Soviet Union in the late 1920s andcame away very impressed with their planning.

Professor P. C. Mahalanobis, whose model had provided the analyticalfoundation for Indias development strategy in general, and its SecondFive Year Plan (1956-1961) in particular, had visited the Soviet Unionand were familiar with the Soviet planning system.

Although apparently Mahalanobis independently arrived at it, themodel had been formulated in the Soviet Union by Feldman in the1920s. In the model the share of investment devoted to augmentingthe stock of capital in the equipment producing (heavy industry) sectordetermined the long-run rate of growth of the economy, and the largerthis share the greater was the growth rate. This finding rationalizedSoviet Unions development strategy that emphasized heavy industryand its later adoptionIndia.India shifted relatively rapidly away from agriculture. The share ofagriculture 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 roseonly very slowly, from about 11 percent in 1950-51 to about 15percent in 1999-2000. The capital-intensive nature of investment inindustry meant that the share of agriculture in total employmentremained high, at least in their pre-reforms comparable data are not

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available on the share significantly, but in India it is still high, nearlytwo-thirds, in 2000.India implemented its industrialization programs through State controlson investment and on foreign trade and Indias economy followedvirtually autarkic policies which imposed a heavy cost on both in terms

of efficiency of resource allocation and foregone growth. Further in theearly 1950s India had virtually no capital goods producing industry.This meant that most of the equipment needed for investment had tobe imported, at least until enough capacity for producing equipmenthad been built. Heavy industry was capital-intensive as well. Thus theemphasis on heavy industry made substantial demands on foreignexchange and investment resources. In order to generate theseresources it had to rely on administrative controls on investment andimport quotas, rather than on the markets and the price mechanism.In India's mixed economy, the control mechanism had to ensure thatindustrial development in the private sector conformed to the national

plans by preventing diversion of investible resources and foreignexchange to privately profitable but socially undesirable activities.

Industrialization

Industrialization, through import substitution and public sectorproduction with emphasis on heavy industry, was viewed as the only

means for eradicating Indias poverty by India's political and economicleaders even before independence. They advocated planning and putforward their own plans for development. These included the plans ofVisveswaraya (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 of1948 (amended and elaborated in 1956) had set the broad outlines ofIndia's industrial development strategy by distinguishing industriesaccording 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, heavymachinery including electric generators, was assigned to the publicsector.

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Foreign Trade and Investment

Indias insulation from world markets until the reforms of 1991stemmed from a long standing distrust of markets and internationaltrade in general, and the fear that greater involvement in foreign trade

would inevitably retard Indias industrialization.

Visveswaraya, the authors of the plans of industrialists and laborunions as well asNehrus National Planning Committee, which went in the furthest, wasunanimous in expressing such distrust. The insulation was enforcedthrough import tariffs, export taxes and quantitative restrictions onboth. The import weighted average of tariffs on all imports, on the eveof reforms was 87 %, with the average for consumer goods being 164% .There was an enormous variance in tariffs across commodities withrates on some imports exceeding 300 percent and also tariff escalation

based on the stage of processing. Such escalation led to extremelyhigh rates of effective protection on some of the manufactured goods. Taking the explicit subsidies on some purchased inputs such asfertilizers, the implicit taxes through export restrictions and othermeans, and presumed exchange rate over-valuation; there wasdisprotection of agriculture as a whole. Foreign trade in a number ofagricultural commodities was reserved for state monopolies. Around90-95% of all trade prior to reform was covered by quantitativerestrictions (QRs) and other non-tariff barriers. The net result was adrastic fall in Indias hare in World trade from 2.5% in the early 1950sto around 0.6% in 1991.

Until the reforms, India's policy with respect to private foreign capitalof all typesForeign Direct Investment, (FDI), Portfolio Investment and Debt hadbeen as restrictive as the policy regarding trade in goods and services.Restrictions included limits on entry into specified priority areas, andupper limit of 40 percent on equity participation, and requirements ontechnology transfer, phased manufacturing, and export obligations.Chopra et al. (1995) estimate that government approvals were neededfor 60 percent of new FDI in the industrial sector and that FDI averagedonly around $200 million annually between 1985 and 1991. Most ofcapital flows consisted of foreign aid, commercial borrowing anddeposits of non-resident Indians.

Controls on Economic Activities

The First Five-Year Plan (1951-56) set the overall interventionistframework of policy. The Second Plan (1956-61) articulated an inward

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oriented development strategy that emphasized investment in heavyindustry such as steel and machinery. The massive investment(relative to resources available for its financing) envisaged in the Planprecipitated a macroeconomic and balance of payments crisis. In thewake of the crisis, an elaborate system of controls (that was expanded

in subsequent decades) was put in place to enforce the plans and theirunderlying 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 thansmall ones) and controlled the expansion, relocation and change in theoutput or input mixes of operating plants; the exchange control systemwhich required exporters to surrender their foreign exchange earningsto the Reserve Bank of India and importers were allocated foreignexchange through import licensing; capital issues control on access todomestic equity and debt finance; price controls on some vitalconsumption goods (e.g. food grains) and critical inputs (e.g. fertilizer);

made-to-measure protection from import competition, granted todomestic producers in many 'priority' industries, including in particularthe equipment producers. The agricultural sector was insulated fromworld markets, subject to land ceiling and tenancy legislation, andforced to sell part of the output at fixed prices, but it was also providedsubsidies on irrigation, fertilizer and electricity. Large commercialbanks, were nationalized in 1969, and subjected to controls on theirdeposit and lending rates and directed to extend credit to prioritysectors. The crucial aspect of all the regulations is that they wereessentially discretionary rather than rule-based and automatic. Thiscreated uncertainty about their fair implementation. Devising a set of

principles to govern the operation of the control system and translatingthem into operational decisions were impossible tasks given themultiplicity, and often mutually inconsistent, policy goals. Further thecontrols were largely in the form of quantitative restrictions unrelatedto market realities. A chaotic incentive structure, and the unleashing ofrapacious rent seeking and political corruption, was the inevitableoutcome of the control system. Indeed the system, instituted in thename of planning for national development, instead became a cancerin the body politic.

Performance of State Owned Enterprises

The actual performance of the state owned enterprises (SOEs) did notconform to the role envisaged by policy makers, namely, to promoteprivate sector development and channel it in socially desirabledirections through appropriate pricing and supply of key inputs

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produced by them. The outputs of SOEs were often of poor quality,costly, and inadequate to meet the demand for key industrial inputsand infrastructure services.Commercial SOEs were run less as commercial enterprises but more aspromoters of the welfare of their employees and managers who were

bureaucrats and politicians. Finally, there was no accountability for themanagement since, first of all, its reward was not based onperformance and, second, performance itself was influenced by someof the activities forced on the enterprise in the name of public interestand not related to its core function. Thus, by and large, the publicsector acted as a brake on, rather than a promoter of, private sectordevelopment. Choice of location, technology, employment and pricingpolicies of the public sector became politicized so that efficientdevelopment was precluded. Far from generating resources, the publicsector 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 capabilityfor designing and fabricating industrial plants and machinery. But thestrategy virtually ignored considerations of scale economies, vastlyrestricted domestic and import-competition, encouraged capital-intensive production by subsidizing the use of capital and making laborcostly through restrictive labor laws. The consequence was a high costand globally uncompetitive industrial sector, which was also out oftune with India's capital scarcity and labor abundance.

Macroeconomic Policies

Until the early eighties Indias macroeconomic policies wereconservative. Current revenues of the central government exceededcurrent expenditures so that there was a surplus available to finance inpart the deficit in capital account. In the early eighties, because of laxfiscal policies current revenue surpluses turned into deficits, so thatthe government had to borrow at home and abroad, not only to financeits investment, but also its current consumption.Fiscal deficits, as published in government budget documents, havetended to understate the real imbalances. The reason was that the

rates of interest at which the government appropriated a large share ofthe loan able resources of the banking system, through statutoryliquidity ratio (38.5% maximum), and cash reserve ratio (15%maximum), were administratively set below what would have beenmarket clearing levels. Also, at least in the early years, externalborrowing was largely on concessional terms from multilateral lendinginstitutions and from bilateral, government to government external aid.As the eighties wore on, the government also resorted to borrowing

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from abroad on commercial terms both from the capital market andnon-resident Indians (NRIs). In 1983-84, out of $22.8 billion of publicand publicly guaranteed external debt, roughly 17% was owed toprivate 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-foldin seven years. Since the gross fiscal deficit was too large to befinanced entirely by drawing on savings, part of it was domestic andexternal monetized.Although fiscal expansionism was unsustainable, with someliberalization in the form of delicensing of some industries andpermitting flexible use of capacity in others through changes inproduct-mix within the licensed capacity under so-called broadbanding, and relaxation of some import restrictions, it did generategrowth. The average annual rate of growth of real GDP in the sixth andseventh plans, which covered the eighties, was 5.5 and 5.8 percent

respectively, much higher than the so-called Hindu rate of growth of3.5 percent of the earlier three decades (Government of India, 1999:Appendix Table 1.2). By 1990-91, the gross fiscal deficit had grown toabout 10% of GDP. If one includes the losses of non-financial publicsector enterprises, the consolidated public sector deficit stood ataround 10.9% of GDP in 1990-91, of which nearly 4.3 percent ofGDP was for interest payments on domestic and external debt. Therising 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 theexchange rate, fueling expectations about imminent devaluation of thecurrency. 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 theeconomy. The expectation of a devaluation of the rupee and the fall inconfidence, led to the withdrawal of their deposits in Indian banks byNRIs and withdrawal of capital by other external investors. Foreignexchange reserves dwindled to a level that was less than the cost oftwo weeks worth of imports. The spectre of default on short-termexternal loans loomed and led to a downgrading of Indias creditrating.

Thus the strategy of economic development in India meant (1) directparticipation of the government in economic activities such asproduction and selling and (2) regulation of private sector economicactivities through a complex system of controls. In addition, the Indianeconomy was sheltered from foreign competition through use of boththe infant industry argument and a binding foreign exchangeconstraint. Imports were limited to goods considered essential either to

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the development of the economy (such as raw materials andmachines) or to the maintenance of minimal living standards (such ascrude oil and food items). It was further decided that exports shouldplay a limited role in economic development, thereby minimizing theneed to compete in the global market place. As a result, India became

a relatively closed economy, permitting only limited economictransactions with other countries. Domestic producers were shelteredfrom foreign competition not only from abroad but also from withinIndia itself.

Over time, India created a large number of government institutions tomeet the objective of growth with equity. The size of the governmentgrew substantially as it played an increasingly larger role in theeconomy in such areas as investment, production, retailing, andregulation of the private sector. For example, in the late 1950s and

1960s, the government established public sector enterprises in suchareas as production and distribution of electricity, petroleum products,steel, coal, and engineering goods. In the late 1960s, it nationalizedthe banking and insurance sectors. To alleviate the shortages of foodand other agricultural outputs, it provided modern agricultural inputs(for example farm machinery, irrigation, high yielding varieties ofseeds, chemical fertilizers) to farmers at highly subsidized prices(World Economic Indicators, 2001). In 1970, to increase foreignexchange earnings, it designated exports as a priority sector for activegovernment help and established, among other things, a dutydrawback 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 themid-1980s, India liberalized imports such that those not subject tolicensing as a proportion to total imports grew from five per cent in1980-1981 to about 30 per cent in 1987-1988. However, this partialremoval of quantitative restrictions was accompanied by a steep rise intariff rates.This active and dominant participation by the government in economicactivities resulted in the creation of a protected, highly-regulated,public sector-dominated economic environment. Along with thisgovernment 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 increasein 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.

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THE CONSEQUENCES OF INDIAS REGULATEDECONOMIC DEVELOPMENT

Indias environment of regulated economic development led to theformulation of policies that were concerned with both macroeconomicand microeconomic aspects.

Indias environment of regulated economic development led to theformulation of policies that were concerned with both macroeconomicand microeconomic aspects.

Domestic demand was stimulated by protecting the homemarket through high import duties and competition wasprevented between domestic producers and their foreigncounterparts. Due to this India became a high cost economyunable to compete in the world.

Extensive licensing led to bureaucratization of the economybreeding inefficiency and corruption.

Mismanagement and inefficiency was at its worst in case of PSUs(Public sector undertakings). Political interference, lack ofmanagerial responsibility, over-manning, indiscipline among

workers was rampant. The PSUs as a group never reported asatisfactory rate of return out of the massive capital invested inthem.

Low rate of return on PSUs and leniency in tax collection led toresource crunch and a subsequent decline in public investment.

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Whereas much attention in the literature has been devoted to themacroeconomic issues, we focus primarily on the microeconomicaspects of Indian economic policies. In particular, we examine how

individuals guided by their self-interests of survival and wealthaccumulation will act in a regulated environment, which in factdiscourages the pursuit of those self-interests. To do so, we describethe consequences of Indias use of price ceilings, in which prices areset below their equilibrium level to make products and servicesaffordable to relatively poorer sections of the society.

Figure 1 illustrates how price ceilings can influence a nationseconomy. Specifically, when prices are kept artificially low, demandoutstrips supply. To alleviate the resulting shortage of products and

services, the government can either help to increase the supply or helpto decrease demand for those products and services. Considering thesupply side options first, the government had the following choices: (1)increase the price of the product; (2) subsidize production of existingsuppliers so they will produce and sell more; (3) encourage newbusinesses to enter the line of production and selling; or (4) permitimports to reduce or eliminate the shortage. In India, none of theseoptions was seen as satisfactory. First, the government certainly did

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not wish to increase prices, because price ceilings appealed to amajority of the vote bank. Second, although the government didsubsidize production in several sectors considered essential, theresulting increased production was not sufficient to eliminate the largeshortages. Third, the government decided to restrict rather than

increase the entry of new producers under the pretext of directingscarce resources into their efficient uses. Finally, it allowed only limitedrecourse to imports, in order to protect Indian producers, unless theshortage reached a stage of crisis. The overall result was thatinadequate amounts of products and services were supplied to themarket.

Reasons India adopted the New Economic Policy

Indian economic reforms of 1991 represent a radical shift from thedysfunctional development strategy of the previous four decades,which pursued import-substituting industrialization, with the stateplaying the dominant role in the economy. Its foundations were laidprior to independence and attracted wide support across the politicalspectrum. As such, there was no significant political support forreforms 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-mealfashion in the 1980s but its significant opening to the world economyand deeper domestic reforms did not begin until after the severemacroeconomic crisis of 1991.

The severe macroeconomic and balance of payment crisis certainlycalled for immediate policy action. In earlier crises such as the one in1966, the government approached the IMF and World Bank forassistance and had to make such changes in policies as weremandated by the conditionality attached to their assistance. But oncethe crisis eased the government reverted to its pre-crisis policies.

In contrast, even though the government sought assistance from theIMF and the World Bank in the 1991 crisis, this time policy makersrealized that a return to status-quo-ante with respect to policies was nolonger tenable. There were two main reasons for this:

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The collapse of Soviet Union and East European economiesundermined central planning as a means for achieving rapidgrowth and economic development.

The second was the phenomenal growth performance ofChina since its opening and reforms in 1978. Although, the

rapid growth of other outward-oriented East Asian economiessuch as Korea and Taiwan had been evident much earlier,Indian policy makers dismissed their experiences as irrelevantwith the argument that, India was a much larger economy asthe East Asian economies, even though Korea's industrialsector was rapidly approaching the size of India's. However,Chinese success was a different matter all together: Not onlyChina was a large economy which succeeded with economicreforms and opening to world markets, but its successexacerbated India's feeling of insecurity vis--vis China, sinceIndia's defeat by China in the border clash of the early sixties.

Indian policy makers realized that systematic and deepreforms were needed, and in particular, India had to abandonits insulation from the world economy, if India were ever togrow rapidly enough to catch up with China. Thus the reformsof 1991 were born.

The New Economic Policy of 1991

From 1950 to 1980, while the Indian economy was growing at arelatively slow rate of 3.6 percent, domestic investment exceededdomestic savings by only a small margin. The gap could be bridged

through foreign borrowing on a small scale. However, during the period1979 to 1990, when the growth rate of GDP accelerated to 5.4 percent,the gap between savings and investment widened substantially. Theneed to finance large capital expenditures, imports of machinery andraw materials, including oil, necessitated heavy borrowing fromabroad. The result was a cumulative increase in foreign debt and inrepayment liability. Foreign debt increased from US$23.5 billion in1980 to $63.40 billion in 1991. In 1991, nearly 28 percent of totalexport revenues went to service the debt. The most important reasonfor the internal savings rate falling increasingly short of investmentrequirements was the expanding fiscal deficit of the government which

had risen from an average of 6.3 percent of GDP during the SeventhFive-Year Plan to 8.2 percent by 1990-91.

Large fiscal deficits arose for a number of reasons: exorbitantexpenditures were incurred by the central government's subsidies offertilizers, food and exports and by the state governments' of power,transport and irrigation. The inefficient functioning of many of the

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central and state public sector enterprises further burdened thegovernment budget.

Finally, in addition to the current account deficit, mounting capitalaccount expenditures by the government and public enterprises had to

be financed through public borrowing. By 1990, internal debt liabilitieshad increased to 53 percent of GDP compared with 35 percent in 1980,and interest payments accounted for as much as 24 percent of totalgovernment expenditure. In addition, the sources of foreign borrowingunderwent some important changes, as soft International DevelopmentAssociation (IDA) and government-to-government loans dried up andhigh-cost commercial loans from the banks and non-resident Indianshad to fill the gap.

As long as the international credibility of India was high, loans wereforthcoming and the country could go on living on foreign borrowing.

However, the combination of a number of factors, including the sharprise 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-termcredit along with a net outflow of non-resident Indian deposits. Thus, inspite of borrowing from the International Monetary Fund (IMF), theforeign exchange reserves declined.

It was against this background that an urgent need was felt to diversifyand open up the economy and formulate a new economic policy to kickstart the growth. The multilateral agencies such as IMF and the WorldBank insisted that the policymakers undertake structural reforms

before they agreed to salvage the country from the foreign exchangecrisis.

New Economic Policy of 1991 included globalization,liberalization and privatization (Disinvestment)

Globalization means flow capital finance in the formofforeign direct investment (FDI) and foreign portfolioinvestment (FPI), technology, human resource, goods and service

among countries. FDI is investment in real assets likeautomobile, consumer goods production, service sectors likeinsurance, telecommunication, air transport etc. The NewEconomic Policy aimed at strengthening the private sector in abig way. The thrust of the new economic policy was a marketdriven economy; so in line with that objective, the new policyprovided for the privatization of the public sector units (PSUs).The New economic policy provided for an enlargement in the

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field of operation of the private sector (and a contraction in thefields of operation of the public sector). A number of activities(17 in number) which so far had been the exclusively in therealm 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 newpolicy. The Government also, to a certain extent, privatized theownership of the PSUs. This was done by the sale of a part of thecapital of some enterprises. Thus by disinvestment of a part ofthe capital, the Government made the public sector accountableto the private sector criterion, namely market - related profits.

Liberalization: Liberalization means freeing the economicactivities and business from unnecessary bureaucratic and othercontrols imposed by the governments. Liberalization has done

away with the License Raj (investment, industrial and importlicensing) and ended many public monopolies, allowingautomatic approval of foreign direct investment in manysectors. Rao's government's goals were reducing the fiscaldeficit, privatization of the public sector, and increasinginvestment in infrastructure. Trade reforms and changes in theregulation of foreign direct investment were introduced to openIndia to foreign trade while stabilizing external loans. The Neweconomic policy laid a lot of stress on the market forces and amarket driven economy. It intended to dismantle the restrictiveand regulatory system and allow private entrepreneurs to

venture into any industrial sector based on their own commercialdecisions with no government judgment. In the absence ofGovernment controls these decisions were in terms of marketprices and profits. In other words, allocation of resources amongindustries with respect to the scale, size of product ion and thenature of the product would be determined by market prices. Therole of the state was confined to selected non-market areas- toensure a smooth functioning of the market economy.

Privatization or Disinvestment: Selling the governmentowned public sector enterprises to private industrialists andopening the government operating sectors for privateinvestment. The NIP took great steps towards the integration orthe unification of the Indian economy with the world economy. I tmade the economy outwardly oriented so that its activities werenow governed both by the domestic as well as the foreignmarket.

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The following steps were taken:

The rupee was also made fully convertible on current account ofthe 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 tohave 51% equity holdings.

All this adds up to an open economy with respect to themovements of exchange rate, foreign exchange, imports,exports and foreign direct investment (FDI )

The New Economic Policy includes reduction in governmentexpenditure, 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 theremoval 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 inimport tariffs on most goods other than consumer goods, removal ofquantitative restrictions and liberal terms of entry for foreign investorsIndias simple average tariff rate was reduced from 128% in 1991 to

about 32.3% in 2001-02. Quotas and non-tariff barriers were alsoreduced. To restore Macro economic stability, the reforms package ofstructural adjustment policies are aimed at freeing markets bydismantling controls on production, prices and trade and reducingintervention in the economy. The need to control the fiscal deficit ledto policies to curb public expenditure and these cuts were mainly onsocial sector expenditure and on production and consumptionsubsidies, which directly affected the living standards of the

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economically vulnerable sections of the population. Privatization,Liberalization and export-promotion were the main features of theeconomic reforms recommended by the international institutions forthe 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 promoteindividual entrepreneurs and this increased competition would help inpromoting industry in India. The privatization of the PSUs and the entryof FDI would also bring about an improvement in efficiency.

2. Increase in the economic growth rate: The growth rate of theeconomy was also expected to go up sizably as a result of the

implementation of the NIP through an increase in the efficiency of theindustries.

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 tofall due to competition.

5. Improved Foreign Exchange position: The NEP was alsoexpected 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

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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 MNCS 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

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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

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

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

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cosmopolitans in India. In fact, Indian banking system has reachedeven to the remote corners of the country. This is one of the mainreasons of India's growth process.

Prime Minister Indira Gandhi nationalized 14 banks in 1969, followedby six others in 1980, and made it mandatory for banks to provide 40%of their net credit to priority sectors like agriculture, small-scaleindustry, retail trade, small businesses, etc. to ensure that the banksfulfill their social and developmental goals.

Since then, the number of bank branches has increased from 10,120 in1969 to 98,910 in 2003 and the population covered by a branchdecreased from 63,800 to 15,000 during the same period. The totaldeposits increased 32.6 times between 1971 and 1991, compared to 7times between 1951 and 1971. Despite an increase of rural branches,

from 1,860 or 22% of the total number of branches in 1969 to 32,270or 48%, only 32,270 out of 5 lakh (500,000) villages are covered by ascheduled bank.

The public sector banks hold over 75% of total assets of the bankingindustry, with the private and foreign banks holding 18.2% and 6.5%respectively. Since liberalization, the government has approvedsignificant banking reforms. While some of these relate to nationalizedbanks (like encouraging mergers, reducing government interferenceand increasing profitability and competitiveness), other reforms haveopened 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 besegregated 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 alsoexperienced periodic failures between 1913 and 1948. There wereapproximately 1100 banks, mostly small. To streamline the functioningand activities of commercial banks, the Government of India came upwith The Banking Companies Act, 1949 which was later changed toBanking Regulation Act 1949 as per amending Act of 1965 (Act No. 23

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of 1965). Reserve Bank of India was vested with extensive powers forthe supervision of banking in India as the Central Banking Authority.During those days, public had less confidence in the banks. As anaftermath deposit mobilization was slow. Abreast of it the savings bankfacility provided by the Postal department was comparatively safer.

Moreover, funds were largely given to traders.

Nationalization of Indian Banks and up to 1991 prior toIndian banking sector Reforms:

Seven banks forming subsidiary of State Bank of India was nationalizedin 1960 on 19th July, 1969, major process of nationalization wascarried out. It was the effort of the then Prime Minister of India, Mrs.Indira Gandhi. 14 major commercial banks in the country werenationalized.Second phase of nationalization Indian Banking Sector Reform was

carried out in 1980 with seven more banks. This step brought 80% ofthe banking segment in India under Government ownership. After thenationalization of banks, the branches of the public sector bank Indiarose to approximately 800% in deposits and advances took a hugejump by 11,000%.Banking in the sunshine of Government ownership gave the publicimplicit faith and immense confidence about the sustainability of theseinstitutions.

New phase of Indian Banking System with the advent ofIndian Financial Banking Sector Reforms after 1991:

This phase introduced many more products and facilities in thebanking sector in its reforms measure. In 1991, under the

chairmanship of M Narasimham, a committee was set up by his namewhich worked for the liberalization of banking practices. The country isflooded with foreign banks and their ATM stations. Efforts are being putto give a satisfactory service to customers. Phone banking and netbanking is introduced. The entire system became more convenient andswift as time is given more importance than money.

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Pre-reform period of banking sector in India

The primary role of the banking sector in a free market economy is tochannel savings to investment. Banks are an intermediary that borrow

money from account-holders and lends money to others. The ability toborrow money in an economy is crucial for making long-terminvestments. Without a robust, efficient banking system, investmentwill be inadequate and inefficient. This, in turn, will tend to lead to lowproductivity and low economic growth.

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But the banking sector in India was highly regulated with policiesregarding 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 multifoldgains of bank nationalization, it may be noted that the importantfinancial institutions were all state owned and were subject to centraldirection and control.

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

By 1991, the countrys financial system was saddled with an inefficientand financially unsound banking sector. Some of the reasons for thiswere:

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 effectivecompetition in the Indian banking system for at least two reasons.First, the detailed prescriptions of the RBI concerning for example thesetting of interest rates left the banks with limited degrees of freedomto differentiate themselves in the marketplace. Second, India had strictentry restrictions for new banks, which effectively shielded theincumbents from competition. Therefore, the structure was that of aregulated monopoly because the government set policies such assetting interest rates to ensure fair returns.

The Government of India has a history of restricting the ability of banksto accurately judge risk and return on loans and make decisions onloans based on profitability. As in many other areas, the Governmentof India justified its intervention in the banking arena by claiming thatas a developing economy, a free-market system would not provideadequate funds for investment and so government was required todevelop a strong industrial sector. According to C Rangarajan, the free-market was seen by the government as unable to optimally allocate

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resources over time, that is, for investment because of the myopicnature of markets. Therefore, the government forced all public banksto allocate a certain percentage of their total credit for certainimportant sectors of the economy that the government felt weredisadvantaged by the banking system.

.

Reforms undertaken in the banking sector in the 1990s:

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As recommended by the Narasimham Committee Report (1991)several reform measures were introduced which included reductionof reserve requirements, de-regulation of interest rates, introductionof prudential norms, strengthening of bank supervision andimproving the competitiveness of the system, particularly by

allowing entry of private sector banks.With a view to adopting the Basel Committee (1988) framework oncapital adequacy norms, the Reserve Bank introduced a risk-weighted asset ratio system for banks in India as a capital adequacymeasure in 1992. Banks were asked to maintain risk-weightedcapital adequacy ratio initially at the lower level of 4 per cent, whichwas gradually increased to 9 per cent.Banks were also directed to identify problem loans on their balancesheets and make provisions for bad loans and bring down theburgeoning problem of non-performing assets. The period 1992-97laid for reform in the banking system (Rangarajan, 1998). The

second Narasimham Committee Report (1998) focused on issueslike strengthening of the banking system, upgrading of technologyand human resource development. The report laid emphasis on twoaspects of banking regulation, viz., capital adequacy and assetclassification and resolution of NPA-related problems

The 1991 report of the Narasimham Committee served as the basis forthe initial banking sector reforms. In the following years, reformscovered 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 withthe overall goals of the 1991 economic reforms of opening theeconomy, giving a greater role to markets in setting prices andallocating 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 wassignificantly reduced with the lowering of the CRR and SLR, which wereregarded as one of the main causes of the low profitability and highinterest rate spreads in the banking system. During the 1960s and1970s the CRR was around 5%, but until 1991 it increased to itsmaximum legal limit of 15%. From its peak in 1991, it has declinedgradually to a low of 4.5% in June 2003. In October 2004 it was slightlyincreased to 5% to counter inflationary pressures, but the RBI remains

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committed to decrease the CRR to its statutory minimum of 3%. TheSLR has seen a similar development. The peak rate of the SLR stood at38.5% in February 1992, just short of the upper legal limit of 40%.Since then, it has been gradually lowered to the statutory minimum of25% in October 1997.

The reduction of the CRR and SLR resulted in increased flexibility forbanks in determining both the volume and terms of lending.

Priority sector lending

Besides the high level of statutory pre-emptions, the priority sectoradvances were identified as one of the major reasons for the belowaverage profitability of Indian banks. The Narasimham Committeetherefore recommended a reduction from 40% to 10%. However, thisrecommendation has not been implemented and the targets of 40% of

net bank credit for domestic banks and 32% for foreign banks haveremained the same. While the nominal targets have remainedunchanged, the effective burden of priority sector advances has beenreduced by expanding the definition of priority sector lending toinclude for example information technology companies, export activity,education, housing, software industry, venture capital, leasing and hirepurchase.

Interest rate liberalization

Prior to the reforms, interest rates were a tool of cross-subsidizationbetween different sectors of the economy. To achieve this objective,the interest rate structure had grown increasingly complex with bothlending and deposit rates set by the RBI. The deregulation of interestrates was a major component of the banking sector reforms that aimedat promoting financial savings and growth of the organized financialsystem.The lending rate for loans in excess of Rs200, 000 that account for

over 90% of total advances was abolished in October 1994. Bankswere at the same time required to announce a prime lending rate (PLR)which according to RBI guidelines had to take the cost of funds andtransaction costs into account. For the remaining advances up toRs200,000 interest rates can be set freely as long as they do notexceed the PLR.On the deposit side, there has been a complete liberalization for therates of all term deposits, which account for 70% of total deposits. The

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deposit rate liberalization started in 1992 by first setting an overallmaximum rate for term deposits. From October 1995, interest rates forterm deposits with a maturity of two years were liberalized. Theminimum maturity was subsequently lowered from two years to 15days 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 Indiandeposit rate. For all other deposits above 15 days, banks are free to settheir own interest rates.

Entry barriers

Before the start of the 1991 reforms, there was little effectivecompetition in the Indian banking system for at least two reasons.First, the detailed prescriptions of the RBI concerning for example thesetting of interest rates left the banks with limited degrees of freedomto differentiate themselves in the marketplace. Second, India had strictentry restrictions for new banks, which effectively shielded theincumbents from competition.Through the lowering of entry barriers, competition has significantlyincreased since the beginning of the 1990s. Seven new private banksentered the market between 1994 and 2000. In addition, over 20foreign banks started operations in India since 1994. By March 2004,the new private sector banks and the foreign banks had a combinedshare of almost 20% of total assets. Deregulating entry requirementsand setting up new bank operations has benefited the Indian bankingsystem from improved technology, specialized skills, better riskmanagement practices and greater portfolio diversification.

Prudential norms

The report of the Narasimham Committee was the basis for thestrengthening 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

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have been continuous efforts to enhance the transparency andaccountability of the banking sector.

The improvements of the prudential and supervisory framework wereaccompanied by a paradigm shift from micro-regulation of the banking

sector to a strategy of macro-management. The Basle Accord capitalstandards were adopted in April 1992. The 8% capital adequacy ratiohad to be met by foreign banks operating in India by the end of March1993; Indian banks with a foreign presence had to reach the 8% by theend of March 1994 while purely domestically operating banks had untilthe end of March 1996 to implement the requirement.

Significant changes where also made concerning non-performingassets (NPA) since banks can no longer treat the putative 'income'from them as income. Additionally, the rules guiding their recognitionwere tightened. Even though these changes mark a significant

improvement, the accounting norms for recognizing NPAs are lessstringent than in developed countries where a loan is considerednonperforming after one quarter of outstanding interest paymentscompared 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 ofPublic Sector Banks' profitability. Enhancing the profitability of PSBsbecame necessary to ensure the stability of the financial system. Therestructuring measures for PSBs were threefold and includedrecapitalization, debt recovery and partial privatization.

Despite the suggestion of the Narasimham Committee to rationalizePSBs, the Government of India decided against liquidation, whichwould have involved significant losses accruing to either thegovernment or depositors. It opted instead to maintain and improveoperations to allow banks to create a good starting basis before a

possible privatization. Due to directed lending practices and poor riskmanagement skills, India's banks had accrued a significant level ofNPAs. Prior to any privatization, the balance sheets of PSBs had to becleaned up through capital injections. In the fiscal years 1991/92 and1992/93 alone, the GOI provided almost Rs40 billion to clean up thebalance sheets of PSBs. Between 1993 and 1999 another Rs120 billionwere injected in the nationalized banks. In total, the recapitalizationamounted to 2% of GDP.

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Credit Market

Credit markets have, historically, played a crucial role in sustaininggrowth in almost all countries, including advanced countries, whichnow have fully developed capital markets. Credit markets perform thecritical function of intermediation of funds between savers andinvestors and improve the allocative efficiency of resources. Banks,which are major players in the credit market, play an important role inproviding various financial services and products, including hedging ofrisks. Credit markets also play a key role in the monetary transmissionmechanism.

The credit market in India has traditionally played a predominant rolein meeting the financing needs of various segments of the economy.

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Credit institutions range from well developed and large sizedcommercial banks to development finance institutions (DFIs) tolocalized tiny co-operatives. They provide a variety of credit facilitiessuch as short-term working loans to corporates, medium and long-termloans for financing large infrastructure projects and retail loans for

various purposes. Unlike other segments of the financial market, thecredit market is well spread throughout the country and it touches thelives of all segments of the population.

Prior to initiation of financial sector reforms in the early 1990s, thecredit market in India was tightly regulated. Bank credit was theprincipal focus of monetary policy under the credit planning approachadopted in 1967-68. In the absence of a formal intermediate target,bank credit aggregate as well as sectoral came to serve as aproximate 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 monetarybudgeting .The credit market was characterized by credit controls anddirected lending. Various credit controls existed in the form of sectorallimits on lending, limits on borrowings by individuals, stipulation ofmargin requirements, need for prior approval from the Reserve Bank, ifborrowing exceeded a specified limit (under the Credit AuthorizationScheme), and selective credit controls in the case of sensitivecommodities. Lending interest rates by all types of credit institutionswere administered. Credit markets were also strictly segmented. Whilecommercial banks catered largely to the short-term working capitalrequirements of industry, development finance institutions focused

mainly on long-term finance. Competition in the credit market was alsolimited. This led to several inefficiencies in the credit market.

A wide range of regulatory reforms, therefore, were introduced as partof financial sector reforms in the early 1990s to improve the efficiencyof the credit market. As a result, the credit market in India hasundergone structural transformation. The credit market has becomehighly competitive even though the number of credit institutions hasreduced due to merger/conversion of two DFIs into banks, weeding outof unsound NBFCs and restructuring of urban co-operative banks andRRBs. 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 debtfinance, including bank credit. The emphasis on credit rather thanequity arises due to various reasons. The cost of equity in developingeconomies is often much higher than the cost of debt due to the

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existence of higher perceived risk premia than in developed countries.The existence of artificially repressed interest rates contributes furtherto the problem. The other reasons for the heavy reliance on debt indeveloping countries include the fragility of their equity markets, lackof suitable accounting practices and the absence of adequate

corporate governance practices. Given the high dependence on bankcredit and lack of substitutes for external finance, firms in developingeconomies are generally highly sensitive to changes in the cost andflow of credit.

Credit markets in developing countries, in particular, play an importantrole, where apart from industry agriculture is also an importantsegment of the economy. Besides, there are also a large number ofsmall and medium enterprises in the industrial and service sectors,which are not able to access the capital market and have to depend onthe credit market for their funding requirements. Thus, the importance

of banks and other lending institutions in developing countries canhardly be overemphasized.

Commercial banks, given their preeminent position in the regulatedfinancial sector, dominate the credit market. The quantity of loanscreated by the banking system is generally a function of both thewillingness and ability of banks to lend. In an economy with ceilings onlending rates, banks face a higher credit demand than they caneffectively supply, thus, necessitating reliance on a credit rationingmechanism. 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 ratesto account for default probabilities. This, however, may create theproblem of adverse selection. Though riskier projects bring higherreturns, banks, out of sustainability consideration, need to optimize therisk of their portfolio.

Another important factor influencing the supply of credit is the amountof reserves available from the central bank to the banking system. Alarge pre-emption of central bank money by the Government mayconstrain reserve supply to the banking system, thus, affecting theircapacity for credit creation. Moreover, credit expansion could also be

an endogenous process, i.e., it is the demand for credit that may drivethe banking systems ability to create credit in the economy.

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INSTITUTIONAL STRUCTURE OF THE CREDIT MARKETIN INDIA

The credit market structure in India has evolved over the years. A widerange 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).

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POLICY DEVELOPMENTS IN THE CREDIT MARKET ININDIA

The credit market, with commercial banks as its predominant segment,has been the major source for meeting the finance requirements in theeconomy, both for the private sector and the Central and StateGovernment enterprises. In addition to sharing of resources betweenthe private and the public sectors, a significant proportion of credit bycommercial banks is earmarked for the priority sector. For a fewdecades preceding the onset of banking and financial sector reforms inIndia, credit institutions operated in an environment that was heavilyregulated and characterized by barriers to entry, which protected them

against competition. The issue of allocation of bank resources amongvarious sectors was addressed through mechanisms such as SLR,credit authorization scheme (CAS), fixation of maximum permissiblebank finance (MPBF) and selective credit controls. This regulatedenvironment set in complacency in the manner in which creditinstitutions operated and responded to the customer needs. Theinterest rate played a very limited role as the equilibrating mechanismbetween demand and supply of resources. The resource allocationprocess 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), smallscale industries, small roads and water transport operators, smallbusiness, retail trade, professional and self-employed persons, statesponsored 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 rangingreforms were introduced in the credit market with a view to making thecredit institutions more efficient and healthy. The reform processinitially focused on commercial banks. After significant progress was

made to transform commercial banks into sound institutions, thereform process was extended to encompass other segments of thecredit market. As part of the reform process, the strategy shifted frommicro-management to macro level management of the credit market.These measures created a conducive environment for banks and othercredit institutions to provide adequate and timely finance to differentsectors of the economy by appropriately pricing their loan products onthe basis of the risk profile of the borrowers.

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Lending interest rates were deregulated with a view to achievingbetter price discovery and efficient resource allocation. This resulted ingrowing sensitivity of credit to interest rates and enabled the ReserveBank to employ market based instruments of monetary control. TheStatutory Liquidity Ratio (SLR2) has been gradually reduced to 25 per

cent. The Cash Reserve Ratio (CRR) was reduced from its peak level of15.0 per cent maintained during 1989 to 1992 to 4.5 per cent of NetDemand and Time Liabilities (NDTL) in June 2003. The reduction instatutory preemptions has significantly augmented the lendableresources of banks. Although the Reserve Bank continues to pursue itsmedium-term objective of reducing the CRR, in recent years, on areview of macroeconomic and monetary conditions, the CRR has beenrevised upwards in phases to 6.5 per cent.

While the stipulation for lending to the priority sector has beenretained, its scope and definition have been fine-tuned by including

new items. Further, restrictions on banks lending for project financeactivity and for personal loans were gradually removed in order toenable banks to operate in a flexible manner in the credit market

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TRENDS IN CREDIT THE 1990s AND ONWARDS

Total loans outstanding by all credit institutions (commercial banks,DFIs and cooperatives) combined together increased at a compoundannual rate of 15.7 per cent during the 1990s and by 17.7 per cent perannum during the current decade so far (up to 2005-06). Aspercentage of GDP, loans outstanding increased from 34.2 per cent atend-March 1991 to 54.1 per cent at end-March 2006, suggestingincreased credit penetration in the country.

During the 1990s, the credit growth of commercial banks was lowerthan that of credit institutions in the co-operative sector. However, thetrend has reversed during the current decade (up to 2005-06) withcredit growth of commercial banks being significantly higher than thecredit growth of the co-operative institutions. Credit growth of NBFCsduring the first five years of the current decade was significantly lowerthan the growth of total credit by all institutions. Loans and advancesby 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 bankscredit in total outstanding credit by all institutions increasedsignificantly from 59.7 per cent at end-March 1991 to 78.2 per cent atend-March 2006. During the same period, the share of RRBs andSCARDBs also increased marginally. The share of all other creditinstitutions declined. Apart from aggressive retail lending strategiesadopted by commercial banks, which captured some of the businessesof NBFCs, increased and persified lending intorural areas contributedto the rise in the share of commercial banks. Conversion of two DFIsinto commercial banks also contributed to the increase in the share ofcommercial banks in the current decade and a sharp decline in theshare of FIs. In the case of co-operative institutions, which arefinancially weak and inadequately capitalized, reforms have beeninitiated very recently, which may help in reversing the declining shareof co-operative institutions.

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STATUS AND EFFECTS OF LIBERALIZATION

India has over the last decades experienced different degrees ofrepressive policies in the banking sector. In the following section welook at the degree of financial repression with respect to the changingintensity of three policies that are commonly associated with financialrepression, namely interest rate controls statutory pre-emptions anddirected credit after the reforms taken in the banking sector.

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

Status of removal of repressionist policies

As described above, India used several policies to gain influence overthe banking sector. Besides the outright nationalization of banks, thekey policies were the directed credit program, the statutorypreemptions 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 ofdummy variables. The advantage of this method is that the differentvariables can be aggregated to a composite index of financialrepression.

Interest rate restrictions

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

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The existence of controls is measured with dummies that take thevalue of 1 if a control is present and 0 in the absence of a control. Thesix controls are then aggregated to an equally-weighted index that isscaled between 0 and 1.

The aggregated results show that the degree of interest rate regulationalmost steadily increased until reaching a peak in the early 1980s.After the first liberalization efforts in the mid-1980, the degree ofinterest rate controls was somewhat lowered, but then increased againat the end of the 1980s. Since the beginning of the 1990s, the degreeof 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 canbecome instruments of financial repression however, if their amountexceeds the level that is necessary to pursue an orderly monetarypolicy. Since it is difficult to gauge the CRR and SLR levels that arenecessary for the pursuit of monetary policy, the degree of repressioncan only be approximated.

In India, a legal minimum and maximum rate are set for both the CRRand SLR. For estimating the amount of repression, the assumption ismade that CRR and SLR levels above the minimum rate are repressive.Even though this is a simplification, it should approximate the policystance fairly well since the SLR has been at its statutory minimum of25% since October 1997 and the RBI has a medium-term objective tolower the CRR to its statutory minimum of 3%.

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The historical development of the two ratios shows that they havealmost steadily increased from 1960 until 1991, when the combinedamount 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 of2004. In line with this policy shifts, the degree of financial repressionthrough statutory pre-emptions has been significantly reduced since1991.

Directed credit program

As with the other two policies, the intensity of the directed creditprogram is scaled between 0 and 1, where 0 indicates that norestraints from a directed credit program exist and 1 indicates a highdegree of directed credit. The intensity of the program is measured bythe amount of credit that is included in the program. Somewhat

arbitrarily, for a level of directed credit between 0 and 10%, the degreeof repression is set as 0, 10 to 20% at 0.25, for 20 to 30% at 0.5, for 30to 40% at 0.75 and above 40% at 1.8.This is certainly a simplification since the degree of repression of adirected credit program is influenced by additional variables such assub-targets for certain sectors, the types of sectors that are defined aspriority sectors and interest rate restrictions on the advances. Thebasis for the classification is the share of priority sector advances in

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

Like the other repressionist policies, the intensity of the directed creditprogram increased steadily between 1960 and the beginning of the1980s when over 40% of bank credit went to priority sectors.Throughout the 1980s, the level of directed credit was almostcontinuously well above 40% of total advances. During the 1990s, thelevel decreased by about 10 percentage points to around 35% ofadvances where it has since then remained. This reflects the currentnominal targets of 40% for domestic banks and 32% for foreign banks.

Impact of the banking sector reforms on the bankingindustry of Indias

After the major economic reforms since the beginning of the 1990scompetition I the bank industry significantly increased because of thelowering of entry barriers, seven new private banks entered the marketbetween 1994 and 2000. In addition, over 20 foreign banks startedoperations in India since 1994. By March 2004, the new private sectorbanks and the foreign banks had a combined share of almost 20% of

total assets.

The banking sector reforms undertaken in India from 1992 onwardswere aimed at ensuring the safety and soundness of financialinstitutions and at the same time making them efficient, functionallydiverse and competitive. Financial sector reforms provided banks withoperational flexibility and functional autonomy. Reforms also broughtabout structural changes in the financial sector by recapitalizing them,

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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 netprofit or loss to average advances and investments.

For all scheduled commercial banks, the ROA increased from 0.1per cent in 1980 to 1.1 per cent in 2005. Amongst the bankgroups, the ROA of foreign banks group is the highest at 1.8 percent in 2005.

All other bank groups recorded a return on assets of 1.1 per centshowing that all banks are making profits and their performancesare good.

Foreign banks group is on a higher plane with respect to itsperformance in comparison with other bank groups.

Compared to the pre-reform period, the ROA of public sectorbanks improved significantly after the initiation of reforms. In thecase of foreign banks and domestic private sector banks, dataare available only from 1995.

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The distribution of scheduled commercial banks by ROA reveals that in1995, with respect to State Bank group, all 8 banks were in the ROArange 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 toenhance their performance. Similarly, majority of the banks in thenationalized group were in the ROA range of less than 1 per cent in1995, which exhibited some improvement since 2000.

Nominal Weighted Average Lending Rates of Banks(1990-2009)

The movements in nominal weighted average lending rate for thebanking industry as a whole has shown a gradual decline. It has comedown from a range of 16-17 per cent in most part of the 1990s toabout 11.5 per cent by 2008-09. The declining trend is clearly visible inthe 2000s.

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At a fundamental level the decline in the inflation ratebetween the 1990s and 2000s contributed to lower nominallending rates.

Also the observed decline in weighted average lending ratesin the banking system can be attributed to the improvementsin pricing of risk due to the increased space provided byprogressive deregulation of lending rates.

Deployment of credit

Agriculture

As a result of the sharp deceleration in the growth of credit toagriculture, the share of agriculture in total bank credit declined

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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 inGDP also declined significantly. As a result, credit intensity of theagriculture sector (credit to agriculture sector as percentage ofsectoral GDP) remained broadly at the same level. In the early part of

the current decade, the Government and the Reserve Bank took aseries of measures to facilitate the flow of credit to the agriculturesector.

Credit growth to agriculture picked up significantly from 2003-04onwards. The share of agricultural credit in total bank credit alsoincreased to 10.8 per cent by end-March 2005. The gap between theshare of agriculture credit in total bank credit and its share in GDPnarrowed down to less than 8 percentage points at end-March 2006from 17.4 per cent at end-March 1995. Furthermore, credit intensity ofthe 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 theagriculture sector also increased to 26.66 millions in 2004-05 from19.84 millions in 2000-01.

Industries

The credit extended to the industrial sector decelerated marginally inthe 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 intotal bank credit declined sharply from 48.0 per cent at end-June 1990to 38.8 per cent at end-March 2005.

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Banks support to the industrial sector in the form of non-traditionalinstruments such as commercial paper, shares/bonds/ debenturesissued by corporate, which increased sharply in the second half of the1990s, also declined/decelerated beginning with 2001-02.

Deceleration in the financial support by banks to industry, despite therobust performance of the industrial sector during last few years, wasmainly due to their increased reliance on retained earnings andincreased access to the domestic and international capital markets.Creditworthy corporates also resorted to large external commercialborrowings.

As a result of reduced reliance of industry on bank credit, the gapbetween the share of the industrial sector in total non-food credit andits share in GDP narrowed down significantly. The industrial sectoraccounted 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 theindustrial 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 wasreflected in increased credit intensity of industry, which was alreadysignificantly higher than the other sectors.

Small Scale Industries (SSI)

The small scale industries (SSI) sector is an important segment ofthe Indian economy. However, credit flow to the small scaleindustries sector decelerated in recent years as is evident fromvarious indicators.

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First, the average annual growth of SSI advances deceleratedto 9.5 per cent during 2001-2006 from 13.6 per cent duringthe 1990s.

Second, the share of the SSI sector in total priority sectoradvances 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 8.1per cent of net bank credit at end-March 2006 as comparedwith 9.5 per cent at end-March 2005. In the case of privatesector banks, SSI advances accounted for 4.2 per cent of NBCat 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 industrialsector continued to decline. Fifth, the number of loanaccounts of the SSI sector in commercial banks declined from219 million in 1992 to 93 million in 2005.

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

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

In recent years (i.e., from 2003-04 to 2005-06), the performance of theSSI sector has improved. Accordingly, NPAs in the SSI sector have alsodeclined significantly. This was reflected in the improved flow of creditto the SSI sector in 2004-05 and 2005-06. As a result, the creditintensity of the SSI sector, after declining almost consistently between1997-98 and 2004-05, increased somewhat in 2005-06

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Services

While credit extended by commercial banks to all the sub-sectors inthe services sector accelerated in the current decade (up to 2005-06)

as compared with the 1990s, the acceleration was more pronounced inthe case of personal loans and professional services.

The share of the services sector in total bank credit increased sharplyfrom 30.9 per cent in 1990-91 to 48.7 per cent in 2005-06, essentiallyreflecting its growing share in total GDP; the services sectorcontributed 60.7 per cent of GDP in 2005-06 as against 46.7 per centin 1990-91.

Credit intensity of the services sector increased from 14.9 per cent in1990 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 asharp rise in credit demand from the household sector, a trend whichstarted in the 1990s and gathered further momentum in the current

decade.

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Household Credit

Until the early 1990s, there were several restrictions for granting ofpersonal 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 thebanks 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 theearly 1990s and banks were given freedom to decide the

quantum, rate of interest, margi

Nep Report Fin

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