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Wednesday, January 17, 2007

Growth Through Better Allocation

In the latest McKinsey Quarterly, comparing Indian and Chinese finance sector impediments to accelerating growth, two key distortions of Indian finance sector are identified: huge spending binge of government and non-existent corporate bond market. (There is other interesting information about savings, return on savings, and public ownership of GDP comparisons between the two countries in the report.)

India's problem seems to be less to do with financial markets efficiency and more to do with distorted allocation of capital. Although one widely noted study shows that India produces more growth per invested capital when compared to China - i.e. India uses capital more efficiently - allocation of capital is worst than China. And it is mainly because of government's visible hand in bank loans - with 10% deficit spending (central and states) on all kinds welfare schemes, including the latest and expensive employment guarantee scheme, government is crowding out bank lending market. Beyond deficit spending government has mandated loans to agriculture, small businesses, public sector companies, and now communal lending (yes, 6% of all loans should apparently now go to religious minorities). Although private sector is lot more productive than public sector companies, it receives only 43% of total credit. And it also increases borrowing costs to everyone resulting in higher interest rates.

Another distortion relates to large companies borrowing from banks instead of from markets. Vast majority of bank loans go to large companies because there is no active bond market. So small businesses, which do not have government mandate - usual clients for bank loans in more developed economies - are starved for capital.

While India's equity market is developed, with private companies making up vast majority of listed companies (Chinese market is dominated by public sector companies and have all sorts restrictions on trading of listed shares), and bank non-performance loans have been reduced from 10.4 to 3.5% in the last five years (Chinese reduced their official NPA from 31 to 10% but it's mostly accounting gimmicks), removing the distortions in Indian financial sector would, McKinsey projects, increase the annual GDP by $48billion, that's 6.7% of GDP.

Ila Patnaik wrote a column in Financial Express, few weeks ago, about the how the Chinese are reforming their equity markets and banks, mostly by allowing foreign investors, when compared to India's tighter rules on foreign investing. In contrast, McKinsey's report deals mainly with internal, policy-based, reforms dealing with capital allocation.

With the introduction of state VAT, in 2006, and possible introduction of central Goods and Services Tax (GST), by 2010, India is dealing with tax distortions of all sorts amongst states thus enabling India to become one large common market with huge consumer base and improved business efficiency to generate higher employment and economic growth (a high-level article on what GST is). It’s time to address financial sector distortions also.

While China has lot more to gain from correcting its financial sector distortions ($321bil or 16.6% of GDP), because its financial sector and GDP are lot bigger than India's, correcting India's capital allocation distortions will accelerate India's overall GDP growth going forward.