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Unit 2: Financial Market Reforms

17 to six. In addition, private sector participation was allowed even in many industries Notes
reserved for small firms and public sector, and access to foreign technology was make
much easier [Gol 1993]. The foreign investment restrictions were largely abolished with
majority ownership for foreign investors in most industries, including industries hitherto
reserved for public sector and now open to the Indian private sector. The new industrial
policy was combined with reduction in tariff barriers and elimination of quotas in the
import policy.
That the old industrial licensing regime was flawed and unable to achieve its stated
objectives is now widely accepted. That the system of licensing was used arbitrarily and to
strengthen the stranglehold of a small group of business houses and foreign firms was
demonstrated by the enquiry into the system by Dutt Committee in the early 1970s [ILPIC
1969]. That the system resulted in rent-seeking behaviour from the private entrepreneurs
and political elite has been the accepted paradigm amongst a number of economists
[Ahluwalia 1985].
This paper is an exploratory attempt at tracing the crucial link between the financial sector
and the industrial sector in India, both of which have been in the throes of restructuring
due to far reaching and sometimes ill-conceived attempts at deregulation during the last
seven years. It is grounded in the firm belief that the financial sector has no role other than
to channelise domestic (and where applicable, foreign) savings to the entrepreneurs and
managers in the real sectors of the form level response to these changes in the policy and
regulatory regime. It seeks to explain the turmoil and the crisis in the Indian corporate
sector to among other things, the changes in the financial sector and the macro-economic
policies of the central bank to shocks provided to the economy from large cross border
financial flows. Section I discusses the financial sector before and Section II after the
reforms. Section III discusses industrial sector reforms and Section IV and V examine firm
level response to internal and external deregulation of the industrial sector. Section VI
seeks to draw some conclusions based on the interaction between the financial and the
industrial sectors.
Reforms in Theory
Financial Sector
That the financial markets are markedly different from other markets and that market
failures are likely to be pervasive in these markets has been the received wisdom for some
time [Stiglitz: 1993]. The specific characteristics of the financial markets require government
intervention, including the kind that was practised in India during the last four decades.
This intervention helped raised investment and savings rate in Indian economy and
supported the strategy of industrial growth.
Indian financial sector experienced rapid growth and deepening during the first four
decades of economic development in India. India pioneered the concept of development
banking to provide long-term finance to long gestation industrial projects, often at
marginally subsidised rates of interest. Given the fact that capital markets in India were
small and underdeveloped, these development financial institutions (along with state-
owned insurance firms) helped to develop and deepen the capital market through their
underwriting activity. The nationalisation of the banks in 1969 and the subsequent impetus
given to branch expansion, especially in small towns and semi-urban and rural areas,
fostered the banking habit and accelerated the monetisation of the economy [Ghosh 1979].
The critics of state intervention of financial markets characterize Indian financial sector as
'repressed' [following MCKinnon 1973; Shaw 1973] with high reserved requirements, interest
rate controls, and direction of credit to priority sectors, the repression, it is argued is harmful
to resource mobilisation and (efficient) resource allocation' (Joshi and Little 1996.

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