# **Appendix II: Evolution of India’s Domestic Financial Sector**

This appendix provides additional details on the developments in the domestic financial sector in India, and the links to its international financial integration.

# **AII.b.i. Capital Account Liberalization and Exchange Rate Policies**

The Indian economy, from independence in 1947 until the early 1990s, was characterized by a system of licensing and protection that inhibited the growth of the corporate sector and contributed to corruption and inefficiency. Many industries and strategic sectors were beyond the reach of the private sector, and 90 percent of the banks were nationalized after independence, starting in 1969. Many sectors were restricted to “small scale” firms, to promote employment. During this period, current account deficits were financed mostly with debt and official flows.

India experienced widening current account deficits during the 1980s, driven by a deteriorating fiscal position. The slow growth of India’s trading partners, political problems inside India, and a rise in world oil prices in 1990 precipitated a severe financial crisis in the early 1990s (Cerra and Chaman Saxena 2002). Following that crisis, a series of reforms were instituted. As mentioned above, the goal was to spur Indian growth by fostering trade, FDI, and portfolio equity flows and also avoid debt flows, particularly short-term, that were perceived as being potentially destabilizing. Then an extensive but selective liberalization followed. Table 5 provides a summary chronology of the liberalization measures that have taken place in recent years.<sup>47</sup> However, substantial controls remain.

The discouragement of external debt has restricted the ability of domestic entities to issue bonds on international markets and the entry of foreign investors to the domestic bond market.<sup>48</sup> Hence, the market for private bonds remains underdeveloped, as shown in Figure 10. The restrictions on external debt are heavily influenced by memories of India’s debt crisis in the early 1990s, with the composition of capital inflows subsequently shifting towards a much higher ratio of equity to debt flows.

As argued by Kletzer (2005), the state of the Indian public finances might be a major constraint on the relaxation of restrictions on capital outflows.<sup>49</sup> Indian banks have been encouraged to hold government bonds, lowering the cost of financing public deficits, and have not been permitted to invest abroad. In fact, private credit over GDP has remained stagnant at low levels (Figure 8), while the level of government debt over GDP has

> 47 Also see Government of India (2005) for a comprehensive description of the restrictions on inward investment and the papers listed as sources of the table.

> 48 Patnaik and Shah (2006a) also highlight that the composition of external debt has shifted in recent years, with private debt and official government external debt in decline but the quasi-sovereign debt of parastatals increasing. A part of the quasi-sovereign debt is the State Bank of India debt, which is guaranteed by the government. The other part is non-resident Indian deposits in banks, which are not guaranteed, but the state has no track record of allowing non-trivial banks to fail.

> 49 According to the Reserve Bank of India Statistical Handbook, Indian public debt was 82 percent of GDP by the 2004-2005 fiscal year, with the public deficit at eight percent of GDP.

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