Why is India’s financial system less solvent than China’s?

First, I have to make it clear that, I am NOT saying that (1) India’s financial system is insolvent, or (2) China’s financial system is solvent. I am only arguing that India’s financial system is less solvent than China’s, i.e., you should worry about India too if you think China’s financial system is in big trouble.

There is this popular view that India is blessed by a sound and efficient financial system, while China will be troubled by the huge amount of non-performing loans sooner or later.

It is however not clear whether India’s or China’s financial system has greater amount of “non-performing assets”, because financial system is consisted of both the banking sector and the government public finance system.  Chinese banks have to assume some public finance roles and fiscal functions, while India parks all bad assets in the government’s public finance balance sheet. We thus need to take into account India’s bankrupt public finance system when we compare China and India’s financial systems.

In the early stage of China’s economic reform, in order to increase the efficiency of distributing resources, part of the government’s fiscal function was transferred to commerical banks that were spinned out from the planning-era mono-bank. Before the reform, there were no commercial banks, and planning commission of the central government was in charge of disbursing all investment funds.

Certainly state-owned banks are less efficient than private-sector banks, I don’t deny. But this move was an improvement of efficiency for public finance, which is also part of the financial system.  Later empirical studies show that state-owned banks distribute resources more efficiently than government agencies, partly because there are four state-owned bank of equal size operating nationally that are competing with each other.  Most of the non-performing loans were accumulated in this transition period. Argubaly, the other option at that time was to park these liabilities direclty in the government’s public finance balance sheet. This option is choosen by India.

In India, banks are not asked to assume these fiscal functions (burdens) as Chinese banks are, and thus the banks are much healthier. But we have to understand that bad "white elephant" projects are still there. They have to be financed by someone. They are financed by the government, directly. These "non-performing" liabilities don’ disappear, they are simply moved from the balance sheet of the banking sector to the balance sheet of the government’s public finance.  When an Indian PSU wants funding, the government borrows money and the liability is in the government’s balance sheet.  I don’t think PSU sector in any time soon will return large amount of money to the government, and I thus can assume that all the investment in PSUs by Indian government can be defined as “non-performing” if we think of the government as a “bank” that pursues profits

When we evaluate the health of India’s financial system, we have to evaluate the system as a whole, not only the banking system, but also the public finance system.  India’s public debt is more than 80% of its GDP. If Chinese government leverages its public debt to this level, she will have more than sufficient funds to write off all non-performing loans in state-owned banks. And it is legitimate for the government to do for she is the lender of last resort.  This is why depositors are still pouring more money into the system.  For India, the risk is in the balance sheet of the government, and IMF is her lender of last resort.

The reasons why India’s financial system is less solvent than China’s are that (1) when public finance and bank finance is combined, India’s balance sheet is more leveraged; (2) Chinese banks, although much less efficient than Indian banks, allocate resources better than Indian government; (3) India has a bigger public sector, more aggressive and less responsible fiscal policy;  (4) It is not clear whether IMF will bail out Indian government in a prompt fashion when she declares bankruptcy, while Chinese government will certainly bail out her banks as their is concensus that the banks have suffered for the government and it is time for paying back now that the government is flooded with tax revenues that are rising +20% yearly.

Note:   I don’t deny that China’s banking system also is in big trouble. How to improve efficiency of Chinese banks is an extremely difficult task.

Comments

[K.V.A. Iyer]

The author is concerned of huge public debt in India and wonders whether IMF would bail India out of bankruptcy.

Most of the public debt is domestic debt. Foreign debts are mostly from IMF, World Bank, ADB etc. Foreign debts are no longer posing as problem in view of burgeoning inflow of funds from Indians who work abroad and from foreign portfolio and direct investment in India.

As the annual rate of inflation has been restrained at single digit to around 5% and the annual growth in recent years ranges between 6% and 8 %, the concern regarding India's ability to service debts has no basis.

In the worst scenario, if it ever happens, India can simply print currency to pay back domestic debt.

There is no scope for bankruptcy.

[jvz]

Just come to this two years old article.

The latest inflation rate for India already hitting 11.9% and the fiscal deficit is growing with increasing fuel subsidy.

India cannot simply print currency to pay back domestic debt because this will only make the rupee purges and inflation worsens .

Worse , growth is expected to slow down amidst of global slowdown.

But between saving the economic growth and tackling the inflation rate , the populist Indian goverment will have no choice but to raise interest rate which will further giving more pressure the banking sector.

For China case, with inflation rate is still much lower at 7% while still maintaining double digit growth and accumalated massive foreign reserves.

The challege is more daunting for India now .