India must guard against ‘excessive financialisation’ warns economic survey

India must guard against ‘excessive financialisation’ warns economic survey

The Economic Survey 2024-25 has warned that excessive financialization can harm the economy, with potentially severe consequences for a low-middle-income country like India.

While acknowledging the increasing reliance on financial markets for funding, the Survey emphasized that financial markets must complement the banking sector to bridge the capital requirement gap. “Financial markets must grow in tandem with the economy’s capital needs and overall economic growth, rather than outpacing them,” it cautioned.

The Survey warned that “over-finance” can lead to the financial sector competing with the real sector for resources, including skilled labour. This can result in the real economy being deprived of essential resources.

Furthermore, the Survey expressed concerns that excessive financial engineering can create complex products with hidden risks, which can be detrimental to consumers. The proliferation of such products can increase the likelihood of a financial crisis, similar to the one experienced in 2008.

The Survey also noted that financial sector innovation may not always add value to the real economy. Research has shown that rapid financial sector growth often favours projects with high collateral but low productivity, such as construction. This can lead to financial booms that are not sustainable in the long term.

It may be recalled that India was not immune to the far-reaching impact of the 2008 global financial crisis, which sent shockwaves through the world economy. As the crisis deepened, the Reserve Bank of India (RBI) sprang into action, intervening multiple times to stabilize the Indian economy and mitigate the damage.

On the other hand, a well-functioning financial system can reduce transaction costs, facilitate price discovery, and channel capital into innovative and high-risk economic activities, the Survey said. “Research has shown that finance is a key driver of economic growth, rather than simply a by-product of development.”

The Survey also emphasized the importance of finance in reducing poverty and inequality, as well as in aiding consumption smoothing and shock absorption for firms and households.

However, the Survey warned that there is a tipping point beyond which financial development can actually hinder economic growth.

Citing examples from Ireland and Thailand, the Survey noted that excessive private credit growth can lead to reduced productivity growth, while prudent management of credit can contribute to increased productivity.