The Indian economy registered a GDP growth of over 7% p.a. during 1994-95 to 1996-97. However, this growth rate has not been sustained. The trend path is moving down to register a growth of only 5.1% in 1997-98. The industrial sector has grown at only 3.6% during the first six months of 1998-99. Exports have registered a negative growth of 3.3% during the same period. Agricultural growth for 1998-99 is also likely to be lower than the government projections of 4%.

4.2 DEBT TRAP

India is in the midst of a debt trap. Burgeoning fiscal deficit and rising government borrowings to fund unproductive expenditure is pushing India deeper into a debt trap. Fiscal deficit, on a consolidated basis, has reached an alarming 9% of GDP. (Annex. 4.1)

The gross fiscal deficit does not take into account:

1. borrowing by the Oil Coordination Committee to finance the oil pool deficit. If this were treated as revenue expenditure, the fiscal deficit would be greater.

2. contingent liabilities on account of government guarantees for borrowings by public sector entities, financially weak local bodies, municipal corporations, water boards, state electricity boards etc.

3. hidden foreign currency linked liabilities in power purchase agreements, fuel supply agreements and other contracts entered into by the government.

4. non-performing assets of government owned banks and financial institutions.

Sustained increase in borrowings have led to a situation where interest payments are 64% of tax revenues, 79% of fiscal deficits and 94% of market borrowings. In other words, two thirds of taxes collected go to meet obligations of past borrowings, a large part of the difference between revenue and expenditure goes to meet interest payments and repayments are far greater than market borrowings. (Annex. 4.2)

The future portends to be even grimmer. Skewed maturity structure of public debt towards the shorter maturity side implies ballooning repayment obligations. (Annex. 4.3). With little room for manoeuvre, Government of India will be forced to go repeatedly to the market regardless of borrowing cost and market conditions and at the cost of crowding out private investment. Higher investment in infrastructure will only aggravate the process.

4.3 FUTURE GROWTH

The unsustainable fiscal deficit, currently at 9% of GDP on a consolidated basis, is throttling economic growth. Most of the incremental deposits currently flow into government securities. The government, in turn, is deploying a significant portion of its borrowings in non-productive uses such as interest payments. This limits the growth potential of the economy to a large extent.

4.4 ASSET QUALITY

Asset quality is an area of concern arising out of quality of past loans, inadequate credit appraisals and high degree of directed lending. The gross non-performing assets (NPAs) in the financial system is estimated at Rs 45,000 crore and the net NPAs are estimated at Rs 21,000 crore as of end-March, 1998.

The financial system, till date, has been providing funds mainly to the government and the industry. In the protected environment of the past, Indian industry was less prone to shocks. This enabled the industrial sector to cross-subsidise funds being provided to the government without any adverse pressures on the financial system. In the post reform period, with substantial removal of protection, the ability of the industrial sector to continue the above role has been seriously impaired. This coupled with the enhanced government fund requirements has raised issues about the stability of the Indian financial system. Recent distress in the real sector is also leading to expectations of higher defaults in the system.

4.5 FINANCIAL SYSTEM - LESSONS FROM EAST ASIA

T he case for reforms in the financial sector needs to be understood in the context of the crisis in the East Asian economies and the lessons that India learns from this crisis.

Even though the East Asian economies had better growth performance, the weakness of the financial system in these countries was the root cause of the crisis. Local financial intermediaries were often undercapitalized and rapidly expanded lending, in expectation of a continued boom, with little credit appraisal. Heavy government involvement ensured that players in the system would not suffer a loss in their assets. This led to poor incentives for prudent behavior in the financial system.

It is imperative that India learns from the experience of the regional economies and develops and restructures its banking, financial sector and the capital markets at the earliest. Weakness in the financial sector, as is evident from the East Asian crisis, can have broader ramifications resulting in a macroeconomic crisis. This has implications in terms of economic disruption, a sharp reversal in the growth process, defaulting on external obligations and consequent social unrest.

4.6 FINANCIAL SECTOR REFORMS

A strong financial system is essential to support and sustain the growth of an economy. In India, the financial system is responsible for collecting funds from millions of individual households, which provide bulk of the financial savings in the economy.

Financial savings of households as a proportion of total financial savings in the economy have averaged around 78%-80% during the last three years. The financial system in India transfers these funds to the major users of these funds, which are the government and the industry. Consequently, the health of financial system impacts both the providers and the users of funds – economically and socially.

A strong financial system would enable the economy to absorb adverse shocks. It would create an efficient mechanism to cater to funding needs of the agricultural, industry and the infrastructure sectors by channeling domestic savings to productive use. It would, by ensuring flow of adequate and low cost funds to the key sectors, enable the economy achieve a vision of a double digit GDP growth of 12%.

4.7 REAL SECTOR REFORMS

A strong financial sector is a necessary condition for a sustained economic growth. However, it is not a sufficient condition. Reforms in the real sector have to go alongside reforms in the financial sector to enable the economy to grow at a sustained high rate.

An important area that needs to be addressed is the fiscal conditions of both the centre and the state governments. Bottlenecks in the agricultural sector, the industrial sector and the infrastructure sector also need to be tackled.

4.8 SUMMARY

To sum up, India is in a debt trap, high fiscal deficit is throttling growth in an investment driven economy, asset quality is poor and is placing pressures on the financial system, reforms are critical to strengthening the financial system in the interest of a double digit economic growth and reforms in the real sector are complementary to financial sector reforms.

ANNEXURES

Annex. 4.1

India – Government Fiscal deficits

% of GDP

India – Government Finances

Annex. 4.3

India – Government Borrowings – Maturity Profile