R Gandhi: Finance, credit and markets
Speech by Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at "Credit Summit
India 2014", organised by Association of International Wealth Management of India and
National Institute of Securities Market (NISM), Mumbai, 26 August 2014.
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1. The role of the financial system is to intermediate between lenders and borrowers
and provide avenues for saving and help investors find their financing needs. The financial
markets impact growth by channeling saving to firms and improving the allocation of capital.
Moreover, efficient financial markets and institutions tend to lower search and transactions
costs in the economy.
2. As the industrialized nations' economies grew in the eighteenth, nineteenth and
twentieth centuries, their financial systems also grew in depth and breadth. In the
19th century, London achieved its status as the world's leading financial centre, because the
financial sector had developed rapidly in order to serve the needs of British industry and
British exporters. Similar is the case with 20th century New York which played a similar role
in relation to the American economy.
3. The relationship between financial development and economic growth is a subject of
debate. Some economists just do not believe that the finance-growth relationship is
important. For instance, Robert Lucas asserted in 1988 that economists badly over-stress
the role of financial factors in economic growth. Moreover, Nobel laureate Joan Robertson
declared in 1952 that "where enterprise leads, finance follows". According to this view,
economic development creates demands for particular types of financial arrangements, and
the financial system responds automatically to these demands.
4. The well-known former editor of "The Economist" Walter Bagehot expressed this in
1873 as follows "In England, however, ... capital runs as surely and instantly where it is most
wanted, and where there is most to be made of it, as water runs to find its level".
5. However, it is now increasingly accepted that financial development has a positive
effect on growth. Financial intermediation can affect economic growth by acting on the saving
rate, on the fraction of saving channeled to investment, or on the social marginal productivity
of investment.
6. The studies of McKinnon and Shaw in early seventies propounded that financial
repression depresses growth; conversely, financial development should raise growth. A
positive correlation between growth and indicators of financial development is well
documented. A growing body of evidence suggests that financial institutions (such as banks
and insurance companies) and financial markets (including stock markets, bond markets,
and derivative markets) exert a powerful influence on economic development, poverty
alleviation, and economic stability. This position holds good for India too.
7. It is imperative that our nation must achieve high economic growth to cater to
growing aspirations of its people. To attain such growth large capital and efficient distribution
of capital is needed which can only be possible through efficient and developed financial
markets.
8. World Economic Forum has constructed an Index that measures financial
development. Measures of financial development are captured across the seven pillars of the
Index viz. Institutional environment; Business environment; financial stability; Banking
financial services; Non-banking financial services; financial market; and financial access.
9. India is ranked 40th out of 62 countries in the World Financial Development Index in
2012. India's rank in the parameters assessed in the Index is as under:
10. While there may be debate on the methodology of rankings and the relative
importance one may give to these rankings, it is pertinent to recognize the fact that there is
tremendous scope for improvement. There is a need for working together in building more
efficient financial markets.
11. Characteristics of financial markets development inter alia include:
a) Size of financial institutions and markets (financial depth)
b) Degree to which individuals can and do use financial institutions and markets
(access)
c) Efficiency of financial institutions and markets in providing financial services
(efficiency), and
d) Stability of financial institutions and markets (stability)
12. Market development is also dependent on the structure of the market and
preference of savers for intermediation. In Asian economies there is a marked preference for
bank intermediation. Bank-based finance has a special role to play for many economies in
need of capital, and thus helps to ensure a well-balanced growth process. Benefit of
bankbased finance relates to the intrinsic nature of the banking business: some projects cannot
be financed directly by the market on account of significant information asymmetries between
the borrowers and potential lenders. Banks can bridge this gap thanks to their comparative
advantages in the assessment and monitoring of investment projects, which contributes to
overcoming information asymmetries. Further, the economic literature on "relationship
banking" has demonstrated that banks can contribute to alleviating the impact of sudden
economic shocks on their clients. Banks are, however, financial intermediaries that by nature
add cost to the allocation of capital.
13. In Asian economies banking is a marvelous mechanism for channeling into
productive investments the huge flow of household savings generated, since those countries
including Mainland China, have savings-to-income ratios that are three, four, or even more
times than the countries in the West. For all its potential contributions to economic growth,
banking remains fragile. The high leverage combined with their "extreme mismatch" of
maturities (funding long-term assets with short-term and, in some cases, foreign
currencydenominated liabilities) and reliance on demand deposits, makes them inherently vulnerable
- and their economies to severe and recurring credit crunches.
14. Although banks play an important role in these economies by channeling funds from
depositors to companies without access to capital markets, banking itself, says Nobel
laureate Merton Miller from University of Chicago, is " basically a 19th century technology".
Today's emerging Asian economies do not have well-developed capital markets and so
remain heavily dependent on their banking systems to finance growth. However, as Miller
argues, countries should develop a well fleshed out set of financial markets and associated
institutions.
15. According to an Asian Development Bank's study the initiatives to develop bond
markets should focus on: (i) sustaining a stable macroeconomic environment with low
inflation and stable interest rates (ii) developing a healthy government bond market that
would serve as a benchmark for the corporate bond market (iii) completing the post-crisis
agenda of banking sector restructuring (iv) improving corporate governance (v) strengthening
the regulatory framework for bond market (vi) rationalizing tax treatment of bonds
(vii) broadening the investor base, and (viii) promoting the growth of regional bond market
centers.
Indian debt market
Bank credit
16. India has the distinction of long history of both banks and capital market. Economic
history of India narrates how both have been vibrant in many important cities, though
Mumbai has been dominating all others. Slowly and steadily, especially after nationalisation,
the banking sector has emerged as THE source for investment funding.
17. In India, bank credit has been the significant contributor to the investment. Bank
credit increased from ₹ 5 billion as at end March 1951 to ₹ 13 billion by March 1961,
₹ 47 billion by March 1971, ₹ 254 billion by March 1981, ₹ 1164 billion by March 1991,
₹ 5114 billion by March 2001, ₹ 39420 billion by March 2011 and ₹ 67352 billion by March
2014. What has been the contribution of capital market? During the 1970s, while capital
market helped raising ₹ 10 billion worth of equity, bonds and debentures, banks extended
credit worth ₹ 207 billion in that period. During the 1980s, the corresponding figures were
₹ 233 billion and ₹ 910 billion. In the 1990s, they were ₹ 1172 billion and ₹ 3950 billion
respectively and in 2000s they were ₹ 2115 billion and ₹ 34206 billion respectively. In
2013-14, it was ₹ 556 billion and ₹ 9,556 billion respectively.
18. While the capital market has been disappointing, the private placement market in
the past twenty years has been good. Though the issues thereat had been predominantly in
the form of bonds and debentures, the growth in size has been very reassuring. It gained
popularity from mid 1990s; from 1995-96 to 2000-01, this market raised ₹ 752 billion, in the
next ten years, it helped raise ₹ 7614 billion and in 2013-14, this market raised
₹ 3899 billion.
19. Thus, the primary engine for Indian investments is the credit market. Despite all our
efforts to develop corporate debt market, and calibrated increase in foreign capital, credit
market remains the bulwark of Indian investment scenario.
OTC market
20. In India, the small size of the OTC derivatives market, low level of complexity in
products and regulatory structure that mandates that validity of any OTC derivative contract
is contingent on one of the parties to the transaction being a regulated entity, resulted in
orderly derivatives market development and lessened the concerns with regard to systemic
risk. The OTC derivative products were introduced in a phased manner keeping in view the
hedging needs of the real sector. Reserve Bank has focused on improving transparency and
reducing counterparty risk in the OTC derivatives markets and fostered development of
robust market infrastructure for trading, settlement and reporting of transactions. As India is
committed to implementation of the G-20 / FSB reforms, reasonable progress has been
made in implementing the OTC derivative reform measures in India. The status of reforms is
as under:
• Standardization: The process of standardization is planned to be undertaken
gradually. CDS transactions are standardized in terms of documentation, coupon,
coupon payment date, etc. IRS on Overnight Index Swap have been standardized
from April 1, 2013. Other benchmarks in IRS would be standardized in a phased
manner.
• Central clearing: Calibrated steps towards central clearing of OTC derivative
transactions are being taken. More than 70% of IRS trades currently being centrally
cleared without regulatory mandate. CDS market is still developing and it may take
more time to achieve the necessary market activity to support central clearing of
CDS transactions. Timeframe for guaranteed settlement of CDS will be mandated
after a critical level of volume is attained.
• Exchange or electronic platform trading: Electronic platforms are available for
transactions involving repos in Government securities, IRS, forward rate agreements
and foreign exchange forwards. Report of the Working Group on Government
Securities and Interest Rate Derivatives Markets (Chairman: Shri R. Gandhi) has
also recommended introduction of an electronic swap execution facility (electronic
trading platform) for the IRS market, and consider introduction of a CCP which may
provide guaranteed settlement of trades executed through the electronic platform.
• Reporting to trade repositories: As per existing regulatory guidelines, banks and
primary dealers report IRS/FRA and foreign exchange derivatives transactions on
CCIL reporting platform. With regard to CDS, all market makers must report all
trades (including client trades) on the CCIL's reporting platform. Presently, client
trades in IRS are also being reported by banks.
Conclusion
21. I am sure in this Summit, you will all be discussing the credit investment market
infrastructure, the various opportunities and challenges that the credit investment market
offers and how to benefit out of this important segment of the financial market. I wish you all
useful deliberations.
22. Thank you all for your attention.