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New Brookings report calls for financial sector reform in India

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Authors Eswar Prasad and Isha Agarwal recommends broad-ranging reform in the banking sector.

With more than 6 percent annual GDP growth, India is expected to continue its momentum and hold its rank as one of the fastest growing economies in the world, but the country’s financial sector has to play a crucial role in sustaining high growth rate and spread its benefits more evenly, according to a new report released by Brookings India January 15.

The report, titled “A Vision and Action Plan for Financial Sector Development and Reforms in India,” was authored by Prominent Indian American economist Eswar Prasad and Isha Agarwal, a PhD student at Cornell University. Prasad is a Senior Fellow at the Brookings Institution in Washington, DC, and a professor at Cornell.

The report recommends broad-ranging reform in the banking sector which is facing a crisis of mounting non-performing assets. Public Sector Banks must be recapitalized to make them more accountable and “change their incentive structures to promote efficient allocation of credit to the most productive uses,” it states.

“More competition through entry of new banks and greater private ownership of PSBs would increase the overall dynamism of the banking sector,” notes the report.

Though India has a well-developed equity market, corporate bond markets and secondary markets for managing risk remain underdeveloped. At the moment, there are quantitative restrictions on investment in corporate bonds by institutional investors, such as insurance companies and pension funds. The institutional investors should be permitted to invest more in corporate bonds by relaxing the restrictions, the report says, adding that this will widen the investor base.

Simultaneously, other measures such as “development of secondary markets to hedge investor risk, facilitation of trading in the corporate repo market, rationalization of stamp duty, and easing of investment limits for foreign institutional investors,” are also necessary to bring more players into the market, it states.

READ: Loss of momentum in reforms could hamper investment in India: Moody’s (November 25, 2015)

According to the report, apart from issuing conventional bonds, the government should capitalize the benefits of new instruments like inflation-indexed and floating-rate bonds and foreign investors should be allowed a higher investment limit to increase their participation.

Lowering the Statutory Liquidity Ratio, would increase depth and liquidity in both corporate and government bond markets, and reduce financial system distortions resulting from bank financing of fiscal deficits, it says.

Development of the secondary market for hedging risk is another area that requires special attention, say Prasad and Agarwal.

Technical, institutional, and regulatory constraints have hindered the development of hedging in India. Introduction of more hedging instruments for a variety of commodities, followed by steps to attract more investors to commodity futures markets to improve liquidity, and development of the interest rate futures market would improve the scope of hedging.

For strengthening institutional framework in the financial sector, the report recommends effective implementation of the Insolvency and Bankruptcy Code (IBC) that came into effect in 2016.

Along with this, the creation of a resolution mechanism for failing financial institutions, consolidation of regulation across closely-connected financial markets will pave the way for the development of the financial sector.

“In addition to sustaining momentum on increasing financial inclusion, greater financial literacy and consumer protection are needed,” to achieve long-term objectives of economic development, the report says.