Banking reforms can free up $48 bn: McKinsey

Current Indian laws do not permit foreign banks to open full-fledged business in the country. Foreign banks are also not allowed to buy local banks.

Early this week, GE chairman and CEO, Jeff Immelt said his company will be interested in the Indian market — provided the government opens up this sector for foreign investment. The government of India is negotiating the opening up of the financial services sector in the World Trade Organisation forum but no decision has been taken as yet.

There is a demand from foreign banks on the government to allow it to expand arms or acquire local banks so that they can participate in the India growth story.

Though Indian financial system has a number of positives, particularly soaring equities market, the fast-growing sector falls short on several dimensions. ‘‘The system intermediates only half of country’s total savings and investment, and it channels majority of funding to least productive parts of the economy,’’ McKinsey says.

India’s private sector receives just 43 per cent of total credit, while the remaining 57 per cent of credit goes to state-owned enterprises, agriculture, and tiny businesses in the unorganized sector.

‘‘This pattern of capital allocation impedes growth because state-owned enterprises are only half as productive as the private corporate sector, and so require twice as much investment to get the same additional output, while productivity in agriculture and the unorganized sector is one-tenth as high,’’ it added.

The report says Indian banks lend just 6 per cent of their deposits, a much smaller fraction than banks in other countries, suggesting that they could play a far greater role in driving growth. Given the low level of bank lending and tiny corporate bond market, Indian companies rely heavily on retained earnings as a source of funding-much more than companies elsewhere, the McKinsey report said.

Moreover, Indian companies pay significantly higher interest rates in every sector of the economy than Chinese or US companies. These shortcomings of the financial system, along with others documented in the report, impose a heavy cost on India’s economy.

To capture this opportunity, India needs to reduce the role of government in its financial system. ‘‘Reforms to lessen government influence would result in more efficient use of savings. That would raise tax revenues, allowing the government to spend directly on welfare programs, rather than diverting resources from the financial system and so holding back growth,’’ it added.