McKinsey seeks diluted govt role in financial sector

Consultancy firm McKinsey & Company has called upon the government to reduce its role in the financial system.

An integrated programme of financial system reforms could free up to $48 billion of capital per year, equivalent to 7 per cent of gross domestic product (GDP), according to the latest McKinsey report Accelerating India's Growth through Financial System Reform, released today.

These reforms would raise real GDP growth to 9.4 per cent a year and increase household incomes 30 per cent above the current projections by 2014, lifting millions more households out of poverty.

"To capture this opportunity, India has to reduce the role of government in its financial system," the report said.

Today, the government maintains many restrictions on banks and other financial intermediaries that limit competition, lower their performance, and serve to channel majority of the funding to the government and its priority investments.

According to the report, India's private corporations receive only 43 per cent of the total credit - a level that has not changed much since 1999 - and the remaining 57 per cent of credit goes to state-owned enterprises, agriculture and tiny businesses in the unorganised sector.

This pattern of capital allocation impedes growth because state-owned enterprises have only half the private corporate sector's level of labour productivity and require twice as much investment to get the same additional output, while productivity in agriculture and the unorganised sector is one-tenth as high.

Admitting that the equity market does a better job of funding the private sector with private firms accounting for 70 per cent of market capitalisation, the report pointed out that new equity issues amount to just two per cent of all corporate funding in India.

McKinsey attributed poor allocation of capital to the government's tight control of financial system. Apart from investing at least 25 per cent of their assets in government bonds, banks are required to direct 36 per cent of their loans to agriculture, household businesses, and other "priority" sectors.

But such directed loans have higher default rates than other loans and are costlier to administer due to their small size. Similar policies have resulted in 90 per cent of the assets of provident funds (essentially pension funds) and 50 per cent of life insurance assets being held in government bonds and related securities.

Without these rules, pension funds, mutual funds and insurance companies would be an important source of demand for corporate bonds and equities in India.