India's Emerging Financial Market

Tomoe Moore

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781134079209
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

In the early 1990s, financial liberalization started in India, and it was thought that such reforms would increase economic growth. This argument formed part of the finance led industrialization hypothesis and although higher growth resulted, higher industrialization did not immediately.

This book is the first study to comprehensively apply the flow of funds model for India.
Using detailed data of the Indian economy, the whole financial sector is presented with associated policy simulation for India. The demand function is theoretically grounded in the Almost Ideal Demand System and cointegration techniques are adapted into the econometric methodology. The policy simulation experiments are conducted with a view to analyzing the delivery of loanable funds to sectors which are the most in need of poverty-reducing economic growth. The system-wide simulation as a result of interactions with disaggregated economic sectors will allow the analysis of a wide spectrum of policy effects on issues such as the determinant of interest rates, financial capital formulation, and the role of financial institutions, government debt and allocation of credit.

India's Emerging Financial Market provides a thorough and rigorous analysis of policy responses in India and will be of interest to academics working on development economics in general and South Asia in particular.

1 Introduction

A flow of funds in the financial sector arises from financial transactions among economic agents. These financial activities of an economy are then registered in a flow of funds account, which shows the flows of borrowing (i.e. sources) and lending (i.e. uses) of funds among disaggregated sectors for disaggregated financial instruments. Modelling the disaggregated sectors’ portfolio behaviour is termed as a flow of funds model. Flow of funds modelling is not widely used in developing countries, mainly because of an almost complete absence of sufficiently detailed data to construct even simple flow of funds accounts. Nevertheless, it is generally recognised that flow of funds analysis is potentially of great importance to developing countries because the flow of funds accounts reveal the sources and uses of a particular fund that are needed for growth and development (Klein 2000: 9).

The World Bank has used a flow of funds framework as part of its country-based RMSM-X modelling,¹ but this framework has its limitations. In typical applications, the whole private sector has to be treated as a single entity because of a lack of suitably disaggregated sectoral data (Holsen 1991). Green and Murinde (2003) argued that an important priority in flow of funds modelling for developing countries is to investigate patterns of intersectoral financial flows, focusing on a more disaggregated treatment of the portfolio choices of individual sectors such as households and businesses. Disaggregation is essential in empirical work, since the balance sheet and flow of funds data of different sectors clearly show marked differences with respect to their net wealth positions and the pattern of assets and liabilities.

We take up the challenge in this study by constructing data for and then estimating a complete model of disaggregated sectors’ portfolio choice with associated policy simulation for India. The methodological steps are taken as follows. First, a flow of funds is modelled for individual sectors of banks, other financial institutions, private corporate businesses and households with six financial instruments by demand functions. Second, by consolidating all the estimated models of dis-aggregated sectors, a system-wide flow of funds model is constructed where each financial market is solved by the market-clearing conditions. Third, using the system-wide flow of funds model, policy simulation experiments are conducted in order to investigate the appropriate policy instruments for financial development in India.

This study makes several major contributions to the literature. First, this is, to our knowledge, the only comprehensive, sector-specific, flow of funds model for any developing country.² The choice of India is suggested partly by the fact that it is unique among developing countries in that detailed national flow of funds accounts have been compiled by the central bank (the Reserve Bank of India: RBI) for over 40 years (RBI, various issues). Without this base, sectoral econometric modelling would be impracticable. For modelling purposes, however, the published data are incomplete in certain key respects, and our second contribution is to build on these data to construct the necessary time series of stocks in India, covering the period 1951/52 through 1993/94. Note that Indian flow of funds data are compiled on a fiscal year basis from April through end-March of the following calendar year.

Third, the model is more firmly grounded in theory than is common in flow of funds analysis. We use the Almost Ideal Demand System (AIDS) of Deaton and Muellbauer (1980a) as the basis for the empirical model. This allows us to test the theoretical restrictions of homogeneity, symmetry and negativity implied by the axioms of rational choice. The AIDS model is sufficiently flexible to enable us also to model the impact on portfolio behaviour of changes in the policy regime in India. The AIDS approach circumvents the well-known atheoretical limitations of Brainard–Tobin type models, while also being relatively parsimonious in parameters (see Chapter 2 for more detail).

Fourth, we use co-inte gration techniques to estimate the model. We follow Barr and Cuthbertson (1991a,b,c, 1992a,b and 1994) who conducted a flow of funds model for a single sector study in the United Kingdom, in employing the Engle–Granger method to tie down the long-run relationships (Engle and Granger 1987). But we also innovate by using the Johansen procedure (Johansen 1995) to check the reliability of our estimates of the co-integrating relationships.

Fifth, it is associated with the policy analyses. The financial systems in developing economies tend to be characterised by a range of restrictions. The flow of funds framework is able to incorporate these developing country-specific features and contributes to identifying effective policies for economic growth. In this book, the policy simulation experiments are conducted with a view to analysing the delivery of loanable funds to sectors which are the most in need of poverty-reducing economic growth, and they are largely in line with the financial reforms that started in the early 1990s, such as removing the ceiling for interest rates, lowering reserve requirements and the disciplinary stance of fiscal deficit. Simulation quantifies the potency of policy instruments on the flows, hence it can give a clear picture of the channels through which policies may affect different sectors of the economy (Green et al. 2002). Clear understanding of the outcomes of policy instruments is necessary for the re-designing and restructuring of the financial reforms. In this respect, we contribute to the literature on financial liberalisation in developing countries.

Sixth, the system-wide simulation designed in this book will permit us to analyse a wide spectrum of policy effects on such issues as the determinant of interest rates, financing capital formulation, the role of financial institutions, government debt and allocation of credit, as a result of interactions in the disaggregated economic sectors.

A flow of funds in India was modelled and simulated by Sen et al. (1996). They have used the RBI data to estimate a general disequilibrium model of the Brainard–Tobin type( Brainard and Tobin 1968). The study was conducted in line with the stabilisation macroeconomic policy undertaken in the early 1990s in a simple general equilibrium framework. Their study has important limitations: the sample period covers just 20 years (1970/71 to 1989/90); there are only two sectors of banking and household sectors with four financial assets, assuming financial flows in other sectors to be policy-determined. The current study extends their empirical study in a more rigorous and consistent manner in scope: we use the flow of funds time series (1951/52 to 1993/94) and we study a more comprehensively defined list of assets for four sectors. Moreover, these data are based on the total net transactions of uses and sources of funds satisfying the market-clearing conditions in a consistent manner, and not just their transactions with any particular sector.

Finally, note that there is a considerable time lag in the flow data published in the Reserve Bank of India Bulletin. The latest detailed flow data are those for 1993/94 published in 1998. This data period means that the analysis cannot be brought fully up-to-date, although it does cover the pre-reform and immediate post-reform eras. However, this does not limit the overall value of the study because a crucial contribution of this book is the manner in which it employs simulations (both deterministic and stochastic) on a complete flow of funds model of the whole financial sector portfolio behaviour: all the AIDS model for a single sector is consolidated to embody the financial sector for the simulation policy experiments. The empirical performance of such a complete flow of funds model is rare even for industrial economies; in many cases the study tends to stop at individual sectors. Covering a wide range of assets and considerable sectoral disaggregation, such an undertaking is huge and therefore tends to discourage researchers (Green 1982). In this respect, the study conducted in this book enables a more rigorous analysis of policy responses during financial liberalisation in India, than has heretofore been carried out in other emerging financial markets. Moreover, it is distinguished from the conventional macroeconomic policy models, in which typically only money and one homogenous non-money asset are considered in an aggregated economy.

The book consists of 11 chapters, and is organised as follows. In Chapter 2 the empirical and theoretical literature on the demand functions for a flow of funds model is reviewed by addressing the main features of the different types of demand functions.

Chapter 3 is dedicated to the financial system and the compilation of the flow of funds matrix for India. After independence, financial markets had been functioning in a heavily regulated framework in India, and financial liberalisation started in the early 1990s, aimed at the de-regulation of the financial system. In Section 3.1, the course of financial reforms and their effects on the financial markets are examined, versus their condition in the pre-reform period. In Section 3.2, based on the India-specific financial system, a flow of funds matrix is compiled using the published flow data, which forms a basis for deriving stock data used for estimation.

In Section 4.1 of Chapter 4, a theoretical flow of funds model in a general equilibrium framework for India is presented, in which a number of behavioural equations and market-clearing identities are determined, and this forms a foundation for econometric estimation. Data are also described in this section. In Section 4.2, the theoretical model, AIDS is thoroughly examined followed by estimation methodology.

The building blocks of a single sector study for a system-wide flow of funds are set up in Chapters 5 to 8, in which econometric estimation and results are presented for the four sectors. Chapter 5 studies the flow of funds and portfolio behaviour of Indian banks. During the sample period 1951–94, financial controls such as variable reserve ratios were important constraints on bank behaviour, especially before liberalisation took place in the early 1990s. The number of regulations imposed on this sector is an obstacle to modelling a portfolio behaviour for this sector. Despite this, the estimated model provides coherent and plausible parameter estimates for prices and other variables. We find that a standard portfolio model can usefully be applied to the study of financial behaviour in a developing economy such as India, and some interesting policy implications can be drawn.

In Chapter 6, portfolio behaviour of other financial institutions (OFIs) in India is modelled. The OFIs sector consists of term lending institutions and investment institutions. Applied literature has largely neglected the asset decision of OFIs, though it may possess important policy implications. This is evidenced from the finding of a strong influence of interest rates on portfolio behaviour, thereby the role of interest rates on resource allocation. It is interesting to find that macroeconomic management through monetary policy actions may not be unnecessarily limited through the channel of OFIs in India.

Chapter 7 is for the private corporate business (PCB) sector. Modelling a flow of funds for the PCB sector is equivalent to modelling the determinants of capital structure, since this sector is a deficit sector: A system approach is implemented on firms’ financing decisions by analysing portfolio behaviour within a balance sheet framework for non-financial corporations. We find relatively weak effects of prices on firms’ capital structure decisions reflecting the presence of financial repression, while there is evidence of a relatively strong impact of policy variables. Financial liberalisation is found to be a contributory factor to widening financing opportunities for firms.

We estimate a flow of funds model for the household sector in Chapter 8. The novelty of the household sector study is that the demand for money and the substitution effects between money and other financial assets is examined as an integral part of portfolio behaviour in a system of equations rather than in an aggregate single equation framework. Empirical results allow us to examine the asset motive in the demand for money in a richer mode, since the opportunity cost includes all the interest rates that are associated with a flow of funds in the household sector. We find a strong influence of interest rates on portfolio behaviour and also a strong substitutability among risk-free assets.

In Chapter 9, we implement policy simulation experiments by consolidating the separate sectoral models (derived in Chapters 5–8). The financial constraints such as reserve ratios, interest rate ceilings are relaxed in turn, to examine the channel in which a higher proportion of loanable funds is transferred to the non-financial private sectors. Empirical evidence stresses the effectiveness of a direct policy of cash reserve ratios and deposit rates, while highlighting the adverse effect of the complete liberalisation of government securities’ yields in terms of loanable funds to the private sector.

We then apply stochastic simulation methods to a system-wide flow of funds model in Chapter 10. We address two issues; first, the impact of financial reforms on interest rates and loanable funds, and second, the robustness of policy where there is uncertainty about the true model. In order to quantify the uncertainty, the results in this chapter are compared with those in Chapter 9 (i.e. deterministic simulation). We find considerable variation in policy risk depending on the policy instrument and the policy regime. Outcomes also depend on controls on intermediaries: more heavily controlled banks respond differently from other less heavily controlled financial intermediaries.

Chapter 11 is for the conclusion. The summary and the key policy implications drawn from the empirical analysis are found in this chapter, together with limitations and the areas of promising research ideas.

Notes

1 The revised minimum standard model (RMSM) is based on the simple framework of Harrod–Domar growth model.

2 Previously, a study of a flow of funds model for the whole financial sector was conducted by Hendershott (1977) in the United States, which was probably the only published book presenting an empirical model in a self-contained manner before this book appeared. Hendershott’s model contains significant complexity in disaggregating financial assets, while explaining only three market-clearing interest rates for the developed economy. The current study endeavours to minimise an unnecessary complexity in the construction of a flow of funds matrix, while maintaining wider scope in policy analyses. Cohen (1987) focuses on the theoretical part of a flow of funds in his book. The detailed flow of funds account and different flow of funds models are extensively spelt out. More recently, Dawson (1996) published a sizeable book on a flow of funds analysis. His book is primarily targeted at practitioners of the study of a flow of funds. The collection of articles in the book brings together the seminal writing explaining the creation of the flow of funds accounts and a single sector study, in which economists have investigated financial behaviour. Although Dawson’s book provides an excellent insight into the construction of a flow of funds model, the sector study from various contributions is fragmentary, and is not comparable with a complete flow of a funds study for a single country, which this book offers.

2 Survey of asset demand functions for modelling a flow of funds

2.1 Introduction

A flow of funds account takes the form of a matrix: each column indicates disag-gregated sectors and each row implies financial instruments. Entries in each cell indicate purchases or sales of assets during a discrete period of time. They can be positive, negative or zero depending on the position of a sector; for example, if the sector accumulates obligations in the asset in question, then it is a negative entry. The flow of funds matrix contains the interlocking nature of the accounting system as a whole. In its column, though each sector is free to choose the composition of assets, total net acquisitions of financial assets (NAFA) in any time period are constrained by the sector’s overall surplus or deficit on income and capital accounts. When stock data, rather than flow data, enter in the matrix, each column implies a given sector’s balance sheet, since this is the presentatio...