.Further financial market reforms are crucial to expanding the sources of credit to maintain the high rates of economic growth, notwithstanding concer

With a heady economic growth of 9 per cent plus in the first half of the current fiscal, expectations about sustaining the trend have mounted; the Government has reassured investors, both domestic and foreign, about its commitment to economic reforms.

Only recently, the Finance Minister, Mr P. Chidambaram, spoke about the United Progressive Alliance Government's intentions on the pending pieces of legislation pertaining to the Pension Fund Regulatory Development Authority (PFRDA) and the amendment to the Banking Regulations Act in the Budget session scheduled next month. The Minister in the Prime Minister's Office (PMO), Mr Prithviraj Chavan, emphasised the same in Mumbai last week.

The Prime Minister, Dr Manmohan Singh, has hinted at more reforms, particularly in the financial sector. Indeed this is imperative, if the flagship schemes of the UPA's National Common Minimum Programme, seeking inclusive growth, are to be implemented and funds found to overhaul the rickety infrastructure and build new ones.

Moody's report

In its annual report on India, released in New York on January 16, Moody's Investors Service cryptically notes: "India's robust economic momentum seems to defy the constraints posed by its inadequate social and physical infrastructure and an extremely inefficient government sector. Coalition politics have recently hindered the implementation of needed reforms on the labour and capital market and the public sector, which could make it hard to sustain progress on fiscal consolidation."

Moody's Vice-President and one of the report's authors, Ms Kristin Lindow, in response to whether the fiscal consolidation targets of the Fiscal Responsibility and Budget Management Act should be relaxed to meet the infrastructure shortfall, said, "Any such easing would signal undue complacency about the government's large debt and debt service burden, potentially exacerbating the overheating economy and spurring higher inflation and interest rates."

The report has drawn attention to the fact that India's domestic credit growth has outpaced nominal GDP growth by a factor of two for the last three years, reflecting demand that, coupled with crude oil import costs, had driven the trade and current account deficits to high levels.

It is also interesting to note that in a special comment on the need for more varied debt markets in India, brought out by Moody's Investors Service and ICRA Limited, economists have made out a forceful case for further financial market reforms to expand the sources and availability of credit for the maintenance of high rates of economic growth, notwithstanding current concerns about excessive credit growth, a overheating economy and inflationary pressures.

Development fallout

They point out that the fallout of India's accelerating economic development is its escalating demand for credit. Indian companies are expanding at home and abroad, and a large and growing middle-class is ready to utilise credit for purchases.

Domestic credit has been growing at about 30 per cent per annum ? more than double the rate of growth of nominal GDP ? while the bank deposit growth has been about 20 per cent. The high rate of credit growth has resulted in banks finding some of the funds by liquidating assets.

Besides, the current favourable conditions for global liquidity, including a high appetite for emerging market risk, will not persist indefinitely. Setbacks in the equity market ? for example, the corrections seen in mid-2006 ? could negatively impact the foreign currency convertible bonds (FCCB) markets.

Hence, an alternative would be to prioritise the deepening and broadening of the private sector's access to capital, including debt funding.

However, a constraining factor on the development of the domestic corporate debt market is the government's own financing need, which it implements primarily through local financial institutions. Stating that such an approach potentially prunes the capacity of these institutions for more productive lending, the report says the gross general government debt is equivalent to over 90 per cent of GDP at today's exchange rates.

The government's need to finance its deficit and massive debt-service obligations coupled with its social policy agenda mean restrictions in the local debt market. These include:

Ø Mandating banks to buy government-related securities to fulfil statutory liquidity and cash reserve ratio requirements;

Ø Directed lending, wherein all locally incorporated banks must lend 40 per cent of their total advances to `priority sectors' ? agriculture, exporters, and small businesses;

Ø Restrictions on investment guidelines for insurance companies and pension funds.

Pointing out that the domestic corporate bond market is essentially undeveloped, the report contends that the immature status of debt capital bond market largely reflects the historical crowding-out triggered by the government's gargantuan borrowing needs.

Other factors include robust competition among banks ? in the absence of notable banking sector consolidation or a broad-based risk/return ethos ? to lend to better-rated companies; this has curbed primary market development.

Here, according to the report, the undeveloped status of debt capital market is at odds with the conservatism of Indian retail investors. Notwithstanding publicity on gains in the equity market, much of the household saving is in gold, bank deposits and government savings scheme.

Given the consistent uptrend in the savings rate ? it is now almost 30 per cent of GDP ? the key challenge is to deploy these funds to greater effect within the domestic formal financial system.

Strengthen banking

Hence, the report makes a case for strengthening the banking sector. But neither the government nor the regulators has promoted consolidation. But given the very large amounts required for physical infrastructure projects, the government has little option but to go the whole hog in financial sector reforms.

On the demand front, such reforms, the report says, would include easing investment guidelines for pension funds and insurance companies; current rules hobble them from investing in non-governmental paper and this prevents the emergence of a deeper and broader credit culture through the financial system. On the supply side, reforms could facilitate the domestic corporate bond market as a viable alternative to bank lending.

Additional reforms could encourage development of the structured finance market, which would enhance the capacity of banks to lend; a further easing of restrictions on foreign currency borrowings may be necessary, especially to meet the infrastructure sector's long-term funding needs.

The report rightly highlights the dangers of complacency in not going ahead with the financial sector reforms.