evaluate the impact of Financial Sector Reforms on Indian Financial System.

Financial sector reforms are at the centre stage of the economic liberalization that was initiated in India in mid 1991. This is partly because the economic reform process itself took place amidst two serious crises involving the financial sector: the balance of payments crisis that threatened the international credibility of the country and pushed it to the brink of default; and the grave threat of insolvency confronting the banking system which had for years concealed its problems with the help of defective accounting policies.

Moreover, many of the deeper rooted problems of the Indian economy in the early nineties were also strongly related to the financial sector: the problem of financial repression in the sense of McKinnon-Shaw (McKinnon, 1973; Shaw, 1973) induced by administered interest rates pegged at unrealistically low levels; large scale pre-emption of resources from the banking system by the government to finance its fiscal deficit; excessive structural and micro regulation that inhibited financial innovation and increased

 transaction costs; relatively inadequate level of prudential regulation in the financial sector; poorly developed debt and money markets; and outdated (often primitive) technological and institutional structures that made the capital markets and the rest of the financial system highly inefficient

Exchange Control and Convertibility

One of the early successes of the reforms was the speed with which exceptional financing was mobilized from multilateral and bilateral sources to avert what at one stage looked like a imminent default on the country's external obligations. Subsequently, devaluation, trade reforms and the opening up of the economy to capital inflows helped to strengthen the balance of payments position.

The significant reforms in this area were:

  • Exchange controls on current account transactions were progressively relaxed culminating in current account convertibility.
  • Foreign Institutional Investors were allowed to invest in Indian equities subject to restrictions on maximum holdings in individual companies. Restrictions remain on investment in debt, but these too have been progressively relaxed.
  • Indian companies were allowed to raise equity in international markets subject to various restrictions.
  • Indian companies were allowed to borrow in international markets subject to a minimum maturity, a ceiling on the maximum interest rate, and annual caps on aggregate external commercial borrowings by all entities put together.
  • Indian mutual funds were allowed to invest a small portion of their assets abroad.
  • Indian companies were given access to long dated forward contracts and to cross currency options.

Banking and credit policy

At the beginning of the reform process, the banking system probably had a negative net worth when all financial assets and liabilities were restated at fair market values (Varma 1992). This unhappy state of affairs had been brought about partly by imprudent lending and partly by adverse interest rate movements. At the peak of this crisis, the balance sheets of the banks, however, painted a very different rosy picture. Accounting policies not only allowed the banks to avoid making provisions for bad loans, but also permitted them to recognize as income the overdue interest on these loans. The severity of the problem was thus hidden from the general public.

The threat of insolvency that loomed large in the early 1990s was, by and large, corrected by the government extending financial support of over Rs 100 billion to the public sector banks. The banks have also used a large part of their operating profits in recent years to make

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