India’s Goldilocks problem
The recent financial crisis and its continuing repercussions have forced us to carefully re-evaluate the size, role, and optimal rate of growth of the financial sector. There is a sense that finance may have grown out of all proportion with its importance to the real economy. Internationally, much of the public commentary has focused on the (in)appropriateness of regulations prior to the crisis, on the continuing stories of (mis)conduct by financial sector professionals involved in setting benchmarks such as the London interbank offer rate (Libor), and on whether the level of compensation for finance-related jobs is too high relative to other occupations. Many of these issues highlight lax regulation and malfeasance that must be fixed for the financial sector to perform its proper functions. The mood is one of great anger—banker-bashing has become the obligatory prologue to most public pronouncements on the subject of finance.
There is, however, another side to this debate which is not being heard much at present. In countries such as India, the size of the financial sector relative to real economic activity is small compared with the magnitudes seen in the West. Limiting the growth of the financial sector could have adverse consequences for the growth and development of the real economy, which, in turn, is essential for pulling millions out of poverty.
The prospective users of financial innovations in India do not currently have access to instruments which satisfy their needs. Financial innovation is desirable in a number of areas: to help farmers seeking to hedge grain price or weather risk, prospective students to finance their education, and to alleviate friction in corporations raising capital for productive enterprises.
A specific example: financing education in India is very difficult if fees are above certain bank-determined numerical thresholds. Many prestigious Indian MBA programmes have fees well above these thresholds, as do medical degrees from several well-regarded Indian private education providers. Banks require co-borrowing by parents, third-party guarantees, and even tangible collateral before loans above these thresholds can be issued.
One government-led financial innovation that might be helpful here is a system, utilized, for example, in the UK, of income-contingent loan repayment, in which repayment is collected via an additional cess on income tax once income exceeds a certain threshold. Private sector provision of similar products has begun—upstart.com is an example of such innovation. However, in the current environment, proposing such innovations is likely to be fraught with peril—an attitude of conservatism might well prevent a serious discussion in which benefits, costs, and an appropriate regulatory framework are carefully evaluated.
The key to these discussions is the Goldilocks problem. How large should the financial system be? If it is too small, real activity will suffer. If it is too large, we may be at risk of another crisis. How do we figure out whether the porridge is too hot or too cold?
The answer lies in finding ways to estimate the demand from the real economy for financial services. If demand for financial services is driven by growth in the real economy, or by the need to remove bottlenecks in growth, then financial innovation should be encouraged. However, if the growth of finance is supply-driven—a result of the capture of regulators, as a product of regulatory arbitrage, or as a consequence of the exploitation of poorly-informed clients, then it would be appropriate to pause financial innovation to fix these problems.
One measure of demand for financial services has been suggested by the economist Thomas Philippon of the New York University. He recommends analysing the types of firms making the largest capital expenditures at each point in time. When firms are faced with increased investment opportunities, but have low levels of cash reserves, they are constrained in their ability to finance new ideas. This represents high demand for financial services, which can enable these idea-rich, but finance-poor firms to generate real economic growth. If, however, firms with high levels of cash are increasingly the main source of capital expenditures, demand for financial services is lower, since ideas and cash reside in the same entities, thus eliminating the need for outside financing.
The accompanying chart plots the extent to which aggregate capital expenditures by manufacturing firms in India (data on all firms from Compustat Global) come from low-cash firms. In the year 2001, such low-cash but high-expenditure firms (shown for income/capital expenditure fractions of 15, 25, and 33%) generated only around 5% of the total capital expenditures of the Indian corporate sector. By 2010, such firms constituted between 50% and 55% of total capital expenditures.
These patterns indicate that in India, there is increasing demand for financial services arising from the real economy. This suggests that we need to think hard about our current attitude towards financial innovation, and take steps to implement the necessary reforms.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance. A part of this work was completed when the author was visiting scholar at the Prime Minister’s Economic Advisory Council.