Bank Nationalization, Financial Savings, and Economic Development: A Case Study of

India
Author(s): Kusum W. Ketkar and Suhas L. Ketkar
Source: The Journal of Developing Areas , Oct., 1992, Vol. 27, No. 1 (Oct., 1992), pp. 69-
84
Published by: College of Business, Tennessee State University

Stable URL: http://www.jstor.com/stable/4192167

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 The Journal of Developing Areas 27 (October 1992) 69-84

Bank Nationalization, Financial

Savings, and Economic
Development-a Case
Study of India

KUSUM W. KETKAR and

SUHAS L. KETKAR

The Indian government nationalized the commercial banking system in Ju

in the belief that it would give the Reserve Bank of India (RBI) more effective
over the activities of commercial banks. Initially, 14 major banks were broug
direct state control. The government took control of 6 additional banks in 1
Nationalization was premised on the argument that privately owned commerc
had failed to set up banking facilities across the sparsely populated, rural, an
sections of the country, thereby failing to gamer deposits from a significant pr
of the population. Furthermore, it was also thought that they had failed to
adequate financial support to the less-privileged sectors of the economy, part
agriculture and small-scale industries. It was believed that these shortcomin
be overcome under a nationalized banking system. Given that banks are an im
part of financial intermediation, they were expected to help the developmen
by influencing saving and investment. In defense of the bank nationalization
Prime Minister Indira Gandhi stated, "Our sole consideration has been to a
development and thus make a significant impact on the problems of pover
unemployment and to bring about progressive reduction in regional dispar
Thus, banking was thought to be a catalytic agent for economic grow
development having as its ultimate objective the reduction of income and emp
disparities among various regions of the country.

Kusum W. Ketkar is Associate Professor of Economics, Seton Hall University; and Suhas L. Ketkar
is Vice President, The First Boston Corporation, and was Vice President, Marine Midland Bank, when
the paper was written.
An initial version of the paper was presented at the Annual Allied Social Sciences Meetings in Atlanta,
Georgia, 28-30 December 1989. The authors are grateful for financial support from the Seton Hall
University Research Council for initial work on this project. All responsibility for error and opinion
rests with the authors.

? 1992 by Western Illinois University.

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70 Kusum W. Ketkar and Suhas L. Ketkar

Indeed, bank nationalization did produce some of the favorable effects that were
expected. The establishment of bank branches in rural and semiurban areas picked
up following bank nationalization. From a prenationalization pace of about 12 percent
per year in rural areas, bank branch expansion surged to 20 percent in the
postnationalization years. In the semiurban areas, too, the rate of bank branch
expansion rose from roughly 3 percent to 7 percent. In contrast, the number of bank
offices in the urban areas continued to increase at about the same average annual
rate of 8.6 percent both before and after bank nationalization. On the eve of
nationalization of banks, rural branches accounted for 22.4 percent of the 8,262 total
bank branches. The share of rural branches increased to 36.3 percent in 1975. By
1984, their share climbed to 56 percent of the 45,332 total bank branches. The share
of branches in semiurban, urban, and metropolitan areas suffered a decline during
this period, however, because 47.5 percent of new branches during 1969 to 1975
and 69.8 percent of new branches during 1975 to 1984 were opened in rural areas.2
The sectoral deployment of gross bank credit has also changed in recent years.
On the eve of bank nationalization in July 1969, some 14 percent of gross bank credit
went to the priority sectors-5.2 percent to agriculture, 7.9 percent to small-scale
industry, and 0.9 percent to others. By July 1979, the share of the priority sectors
had gone up to 30.3 percent-13.2 percent to agriculture, 11.9 percent to small-
scale industry, and 5.2 percent to other priority sectors. In 1980, the RBI introduced
another scheme, known as the Twenty-Point Program, to encourage nationalized
banks to increase their gross credit allocations for priority sectors. As a consequence,
all priority sectors together received 35.7 percent of gross bank credit in March 1983,
with agriculture, small-scale industry, and other priority businesses receiving,
respectively, 15.3 percent, 13 percent, and 7.4 percent of total bank credit.3 By 1984,
the RBI expected banks to direct 40 percent of their gross credit to priority sectors.
Under the Twenty-Point Program, nationalized banks are free to lend at their
discretion only 20 percent of their total credit at market-related interest rates; the
remaining 80 percent of credit is disbursed at predetermined interest rates.4
The principal objective of this paper is to evaluate the impact of stepped-up bank
branch expansion and enhanced priority sector credit allocations following bank
nationalization on the saving, investment, and growth performance of the Indian
economy. The presumption has been that bank nationalization should have contributed
to the growth in bank deposits. For example, the Committee to Review the Working
of the Monetary System in India blamed the observed constancy of the proportion
of saving in the form of financial assets to total household savings since nationalization
on the upsurge of inflation. The committee's final report concluded, "The financial
system should probably be given credit for not allowing the share of financial saving
to go much below its level in the mid 1960s in spite of the impact of inflation since
then. "5
The rest of the paper is organized as follows. The first section briefly reviews
the relevant literature on the determinants of saving and investment, and also considers
the likely effects on them of bank nationalization. Stochastic saving, investment,
government expenditures, and growth equations are then specified in the second
section. The third section discusses data sources while the fourth reports the empirical
results. Illustrative simulation results are presented in the fifth section, and a summary
and conclusions in the sixth.

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 Bank Nationalization and Economic Development: India 71

Review of Literature

The literature on the behavior of saving and investment has focused on their
relationship with income and the rate of interest. The presumption until the early
1970s was that saving is promoted by increases in income, and although low interest
rates are needed to encourage investment spending, their effect on savings is
indeterminate. The relationship between interest rates and savings is based on the
Fisherian theory that provides the basis for much of the analysis on saving behavior.6
In general, an increase in interest rate produces a positive substitution effect but
a negative income effect, leaving the net impact in doubt.
McKinnon and Shaw challenged this view in the early 1970s by analyzing a
financially repressed developing economy. Investors faced with a very limited access
to outside sources of finance, McKinnon argued, may be encouraged to accumulate
funds in monetary assets (i. e., bank deposits) as a precursor to investment in lumpy
physical assets.7 Under these conditions, a rise in deposit rates may increase both
saving and investment. Focusing on the role of deposits as a source of funds for
financial intermediaries, Shaw also argued that high deposit rates would encourage
both saving and investment.8
Recent studies look at financial intermediation in a dynamic setting. Spellman,
Gonzalez-Vega, Galbis, and Lopez consider financial intermediation as a techno-
logical innovation that can cause an increase in financial saving even if saving is
insensitive to changes in real rates of interest.9 They point out that improved financial
intermediation will lead to a reduction in social costs (or rise in output). Using a
neoclassical two-sector growth model, Galbis, for instance, shows that financial
intermediation will lead to capital augmentation that in turn will lead to higher levels
of output.'0 It is also believed by many that financial intermediation has not been
successfully used by less-developed nations to foster economic development. This
happens mainly because private marginal benefits of expanding banking and other
financial services outside the traditional urban areas are typically lower than marginal
costs of doing so. Often, financial intermediation fails to take hold in a country as
a result of excessive government regulation, "I shortage of entrepreneurial skills, lack
of sufficiently large markets to sustain the needed economies of scale, and/or outright
corruption. 12
In elaborating the McKinnon-Shaw hypothesis, Molho has demonstrated that saving
and investment behavior is determined by a complex set of forces in a dynamic
setup.'3 He begins by decomposing intertemporally the saving and investment
decisions of households. Given the lumpiness of investment in physical assets and
the lack of financial intermediation generally prevalent in a repressed economy, a
typical investor has to save first in terms of financial assets. The proceeds from
financial saving in a given time period are subsequently invested in physical assets,
provided that the risk-adjusted rate of return on capital exceeds the deposit rate.
Consequently, it would seem that an increase in the current deposit rate would reduce
investment in the short run. It may positively affect investment in the long run,
however, provided that the higher deposit rates encourage financial savings and raise
the supply of loanable funds. Thus, financial savings and capital investment are
substitutes in the short run, though they could be complementary in the long run.

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72 Kusum W. Ketkar and Suhas L. Ketkar

Molho further points out that financial saving itself would be determined by the
rate of return on deposits, the current and expected future rates of return on other
competing assets, and the future supply of loanable funds. While the effect of the
current deposit rate -on financial saving is expected to be indeterminate, a rise in
the current return on competing assets should depress financial saving. The expected
future rates of return on investment, however, should positively influence financial
savings. Finally, an increase in the availability of loanable funds in the future should
depress current financial savings since a rise in this supply lowers the need for current
accumulation of internal funds.
Much theoretical and empirical research has questioned, clarified, and tested the
McKinnon-Shaw hypothesis and its implications in recent years. Chandavarkar, Wai,
Christian and Pagoulatous, Bhatia and Khatkhate, Vogel and Buser, and others have
attempted to measure the effects of financial intermediation on economic
development. 14 The underlying hypothesis of these studies is that progress in financial
intermediation is a precondition for economic expansion. These studies have not
been able to establish unequivocally, however, that financial intermediation is a
significantly important precondition for economic growth. Calderon-Rossell, Buffie,
Cho, and others have attempted to modify the basic McKinnon-Shaw model to
determine the effect of fmancial repression or government regulation of interest rates
and credit allocation on a country's economic growth. 15 Cho shows that substantial
development of an equity market is a necessary condition for complete financial
liberalization. Bhatt also recommends that in order to improve the financial structure
and to encourage more fluid credit markets, a central agency, like the central bank
of a country, must bear responsibility for promoting a sound financial structure. 16
Buffie and Calderon-Rossell, however, note that government regulation of the
financial sector will be detrimental to the growth of an efficient financial system
and hence to overall economic development. Lanyi and Saracoglu as well as Vogel
and Burkett have demonstrated with the help of data from various developing countries
that high and positive interest rates do attract deposits to banks. 17 Vogel and Burkett
also point out that small savers prefer banks over post-office savings banks when
the former offer higher rates of return than the latter.
None of the preceding studies has, however, explicitly considered the impact of
bank nationalization on the saving and investment behavior in developing countries.
In the Indian context, bank nationalization resulted in a stepped-up expansion of bank
branches, particularly in the rural areas of the country. The population per bank
branch declined from 132,700 in 1950 to 53,200 in 1970-an average drop of 4.5
percent per year. Following bank nationalization in 1969, however, population per
bank branch fell to 14,600 by 1985-a much improved 8.3 percent average annual
reduction.18 This rise in the number of bank branches made banking facilities
increasingly more accessible to the population, thereby reducing the costs of banking
transactions and implicitly improving the rate of return on bank deposits.
A related effect of the bank nationalization program has been to make credit
accessible to many more potential investors, particularly those in the rural areas of
the country as well as those engaged in small-scale businesses. While gross credit
of commercial banks rose 7-fold between June 1972 and March 1984, credit to
agriculture and small-scale industries increased 14- and 9-fold, respectively, over

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 Bank Nationalization and Economic Development: India 73

the same time period. Furthermore, the share of rural savings or deposits has not
kept pace with either the rural branch expansion program or the expansion of credit
to agriculture. Between 1969 and 1984, the share of rural deposits in total deposits
rose from 3.1 percent to only 14.6 percent, even though over 60 percent of the bank
branches are in rural areas and agriculture still contributes over 40 percent of the
GNP. It is quite likely that the enhanced access to credit reduced the need to generate
internal sources of finance, thereby depressing financial savings.
In short, like the current deposit rates, the bank branch expansion program also
has two opposing effects on the growth of financial savings. A rise in the (transaction
cost adjusted) rate of return on deposits as a result of nationalization could encourage
or discourage financial saving depending upon the strength of the substitution and
income effects. Furthermore, a wider availability and accessibility of bank credit
following bank nationalization would diminish the desire to generate financial savings.
The net effect of bank nationalization on financial savings, therefore, cannot be
determined on the basis of economic theory. It is, in the ultimate analysis, an empirical
question.

The Empirical Model

A simultaneous equations model consisting of four structural relationships is

specified to determine the effect of bank nationalization and aggressive bank branch
expansion on financial savings, investment, government expenditures, and gross
domestic product. The model specification attempts to test the McKinnon-Shaw
hypothesis that financial savings are a precursor to investment and economic growth.
It also uses the mechanism suggested by Molho to determine the effect of an increase
in financial savings on capital accumulation. It is the capital accumulation that in
turn influences economic growth. The model further includes an equation for
government expenditure to test the general belief that the direct public ownership
and control of commercial banks made it easier for the government to raise funds
needed to carry out its development programs, including investment in infrastructure.
The model equations are specified as follows:

Dt = ao + al GDPt + a2 INFt + a3 IRTt + a4 IRTt-I + a5 RAAt + a6 NOFt +a7 BNtt (1)

INVt= bo + bl RRCt + b2 IRTt + b3 Dt + b4 FCt + b5 EDDt +b6 BN (2)

GEt + co + cl FCt + C2 Dt +C3 TXt + C4 BNt (3)

GDPt = do +dl Kt + d2Lt, (4)

where

D = real bank deposits

GDP = real gross domestic product

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74 Kusum W. Ketkar and Suhas L. Ketkar

INF = expected inflation rate

IRT = real interest rate
RAA = expected real return on competing assets
NOF = number of bank offices
INV = real investment expenditure
RRC = real rate of return on capital
FC = real foreign capital inflows
EDD = expected domestic demand
GE = real government expenditure
TX = real total tax collection

K = real capital stock, such that Kt = (l-d) Kt_1 + INV,, w

d is the annual depreciation rate of the existing capital stock
L = labor force
BN = dummy for bank nationalization that takes the value of 0
before and 1 after nationalization

The current financial savings or deposits Dt in the banking system are expected
to rise with GDPt (a, > 0). The expected inflation rate (INFt) is the yield on real
assets or alternatively the opportunity cost of holding cash. As a result, increases
in INFt should lead individuals to substitute real for money assets (a2 < 0). Several
methods to measure inflationary expectation are available. But following Darrat,
Crockett and Evans, as well as Driscoll and Lahiri, we use the actual inflation in
any given year as a proxy for the inflation rate expected to prevail in the next year. '9
Such a static inflationary expectation model is considered appropriate for developing
countries, especially when annual inflation data are used. The effect of current interest
rate (IRTt) on deposits, as pointed out before, depends on the relative strengths of
the income and substitution effects, so that the overall effect is indeterminate
(a3 > or < 0). Increases in interest rates (IRTJ_>) should, however, reduce current
financial savings. As stated by Molho, any changes in the past rates can produce
only income effects in the current time period and, as a result, only the negative
effects on current saving should prevail (a4 < 0). Increases in the real rates of return
on competing assets such as gold, land, and stocks should lead households to switch
out of deposits and into these other assets (a5 < 0). Finally, the effects of bank
nationalization on deposits are introduced in two ways-the direct impact of expansion
in the number of bank branches (NOF) and the indirect impact of greater access
to bank credit since nationalization for especially the underprivileged sectors. To
the extent the effective return on bank deposits rose in response to a greater number
of branches across various regions of the country, the increase would generate a
positive substitution effect but a negative income effect on deposits yielding an
indeterminate sign on NOF (a6 > or < 0). In the absence of comparable time-series
data on sectoral credit availability, a dummy variable (BN) is used to derive the
indirect impact of enhanced credit availability on deposits, with BN taking a value
of 0 prior to nationalization in 1961 and I thereafter. In keeping with Molho, it
is postulated that the enhanced access to bank credit following bank nationalization
should have reduced the need for internal financial savings, thereby yielding a negative
effect of BN on deposits in banks (a7 < 0).

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 Bank Nationalization and Economic Development: India 75

The structural equation for investment (INVt) is specified to incorporate the positive
impact of return on capital (b1 > 0); the negative impact of funding costs
(b2 < 0); and the positive effects of bank deposits (b3 > 0), foreign capital inflows
(b4 > 0), and expected domestic demand (b5 > 0). Foreign capital's positive impact
on investment derives from two factors. First, it supplements domestic savings.
Second, by allowing importation of technology, foreign capital enhances the rate
of return on investment. The expected state of domestic demand is also postulated
to influence the level of real investment positively. Given the importance of agriculture
and its enormous variability from one year to the next, the strength of domestic
demand in a given year is measured by the level of agricultural output in the previous
year. Finally, bank nationalization is introduced in the structural equation for
investment to determine the extent to which public ownership of banks promoted
aggregate investment.
The structural equation 3 is for real government expenditures. In this specification,
GEt is expected to be positively related to the availability of foreign capital, domestic
financial capital, and tax collection (cl, c2, C3 > 0). The bank nationalization dummy
variable BN is intended to determine if the government's ability to finance its
expenditures has been helped by public ownership of major banking institutions in
India following nationalization (c5 > or < 0).
Finally, the gross domestic product (GDPd) is treated as a function of available
capital stock (Kt) and labor pool (Lt) with coefficients on both expected to be positive
(d1 > 0, d2 > 0).

The Data Sources

Equations 1 through 4 are estimated using annual data covering the period f
1952 to 1985. While information on the number of bank branches is taken fr
Banking Statistics of India, published annually by the RBI,20 all other data are obta
from various issues of Internwtional Financial Statistics published by the Internati
Monetary Fund (IMF) .2 For lack of reliable information on the real rates of re
on capital, the RRC variable is excluded from estimation. Furthermore, since re
time-series data on total labor force is not available, total population is used as
proxy in its variable.
Total deposits in banks are defined to include demand as well as time (saving)
deposits. From the variety of interest rates prevalent in the economy, the money
market interest rate is used as a measure of return on bank deposits. Foreign capital
availability is derived from net capital inflows in the balance of payments. Finally,
capital stock at time t (Kt) is defined as INVt + (1 - d) Kt-1, where d is the rate
of depreciation of the existing capital stock. An estimate of the 1970 capital stock
as well as its depreciation rate is obtained from the RBI's Report on Capital Formation
and Savings in India.22 The aggregate estimate is based on separate estimates on
the stock of fixed capital at industry level for 13 sectors including agriculture, mining,
manufacturing, construction, banking, real estate, and public administration. Using
1970 capital stock as the benchmark, the capital stock series for the entire time period
is derived. All nominal rupee values are converted to constant 1980 rupees by using
the GDP deflator.

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76 Kusum W. Ketkar and Suhas L. Ketkar

Empirical Results

The structural model consisting of equations 1 through 4 is estimated using the

two-stage least squares method with the instrumental variable procedure. Since
preliminary runs indicated the presence of serial correlation in error terms, we made
appropriate adjustments as suggested by Fair.23 The results thus obtained are reported
in table 1. All equations are found to have high R2 and large F values, indicating
that the overall estimated regressions are statistically significant. Furthermore, all
TABLE 1
ESTIMATED STRUCTURAL EQUATIONS, 1952-1985
(TWO-STAGE LEAST SQUARES METHOD WITH INSTRUMENTAL VARIABLES PROCEDURE)
(t-values in Parentheses below the Coefficients)
Dependent
Variable Constant R2/F/DW
GDPt INFt IRTt IRTt-I NOFt BNt
Dt -50.600 0.144 -1.873 0.512 0.119 0.009 -24.852 0.994/758.127/1.972
(2.014) (3.325) (2.073) (2.073) (0.437) (9.962) (2.806)

IRTt FCt Dt EDDt BNt

INVt -126.754 -0.195 0.0001 0.189 0.007 -9.902 0.965/144.285/1.950
(1.646) (0.343) (0.332) (1.553) (2.480) (0.637)

TXt FCt Dt BNt

GEt 1,242.097 0.902 0.025 3.098 -44.395 0.987/477.460/1.893
(3.352) (7.370) (1.936) (0.673) (0.099)

Kt Lt
GDPt 358.627 0.325 -0.147 0.994/1686.737/1.957
(2.673) (7.634) (0.351)

NOTE: The t-values outside the range of -2 to +2 indicate that the estimated coefficient is different from
a 95 percent level of significance.

the statistically significant coefficients have signs that are in conformity with
expectations. Thus, real bank deposits are positively influenced by real GD
being negatively affected by a rise in the expected rate of inflation. The latt
confirms the suspicion of the Committee to Review the Working of the M
System in India that the acceleration in inflation in the 1970s and 1980s has
discouraged financial savings.24 The sign on the current interest rate variable IRTt
is also found to be positive as well as statistically significant, implying that the
(positive) substitution effect is stronger than the (negative) income effect. Against
a priori expectations is the positive sign on IRTt71, though it is not found to be
statistically significant. Real rate of return on competing assets, RAA, is not included
in the statistical estimation either because there is a lack of data (on land prices,
for instance) or a failure to obtain statistically significant results (for gold prices
and stocks).25 It should be noted that buying stocks as a vehicle for channeling savings
is an option available to a very small minority of the Indian population. Finally,
the estimated equation 1 results also reveal that while the aggressive bank branch
expansion program has had a significant favorable impact on the level of real bank
deposits, bank nationalization per se, which enhanced the flow of credit to the
disadvantaged sectors, has had a negative effect on the accumulation of real deposits.
From equation 2 in table 1, it appears that real deposits and lagged agricultural
production have the expected positive influence on real investment expenditures in

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 Bank Nationalization and Economic Development: India 77

India. While the coefficient on IRT7 has the expected negative sign, it is not found
to be significantly different from zero. Finally, foreign capital inflows as well as
the bank nationalization dummy variable BN do not seem to exert statistically
significant impacts on real investment. Thus, it would seem that while bank
nationalization has increased credit flows to farmers and small businesses, it has
not directly helped the overall level of investment in India. Note that for lack of
information the real rate of return on capital, RRC, could not be included in the
estimated equation 2.
Improvements in tax collection (7Xt) and increases in foreign capital inflows (FCt)
are found to be important catalysts in raising government expenditures in equation
3. Neither the bank deposit variable (D) nor the bank nationalization variable (BN)
is found to have a statistically significant impact on real government expenditures.
Thus, credit allocations in favor of nontraditional sectors did not crowd out
government from the financial markets.
Finally, equation 4 in table 1 confirms the McKinnon-Shaw hypothesis that financial
savings lead to capital accumulation and capital accumulation in turn leads to higher
GDP. The coefficient on capital is found to be positive and statistically significantly
different from zero. The coefficient on labor input L is not found to be statistically
significant. This may owe more to the problems involved in deriving labor force
data from the population. Changes in labor force participation rates and fluctuations
in unemployment and underemployment levels clearly make the latter a poor proxy
for the former.
Overall, the government ownership of India's banking system has produced positive
effects on financial savings and investment. By making credit available to rural
borrowers and small-scale businesses, bank nationalization appears to have somewhat
diluted the incentive to undertake financial savings as a precursor to real investment.
But bank nationalization has also contributed to a marked acceleration in the pace
of bank branch expansion that has helped real deposit growth. Furthermore, real
deposit growth has had a favorable impact on investment. Consequently, the net
impact of bank nationalization on the level of saving, investment, and GDP is an
empirical question to which we provide an answer in the following section.

Illustrative Simulation Results

Since the two effects associated with the nationalization of the Indian banking
system-the acceleration in the bank branch expansion program and the public
ownership of major banking institutions in the country-have produced opposing
impacts on real deposits, investment, and growth, we present in this section a few
simulations that show the behavior of the model's endogenous variables under
alternative scenarios. First, however, we present a historical simulation to determine
how well the model replicates the actual behavior of its endogenous variables.26
Comparing the actual versus the simulated historical values of the model's
endogenous variables in table 2 and figures 1.1 through 1.4, one can conclude that
the model is fairly successful in reproducing history.27 This provides a basis for
simulations 1, 2, and 3, which may be described as follows:

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78 Kusum W. Ketkar and Suhas L. Ketkar

TABLE 2
ILLUSTRATIVE SIMULATION RESULTS, 1980-1985
(In Billions of Rupees)
Dependent Historical Alternative Simulations
Variable Year Actual Simulation 1 2 3
Real deposits 1980 378.4 383.9 416.3 209.8 242.2
1981 411.6 416.1 449.0 216.9 249.8
1982 452.0 453.7 487.2 228.0 261.5
1983 491.2 498.4 532.4 250.9 285.0
1984 539.4 531.8 566.4 259.7 294.3
1985 598.6 602.5 637.6 281.5 316.7

Real investment 1980 262.8 237.3 253.4 204.4 220.4

1981 283.9 279.8 295.9 242.1 258.2
1982 300.6 306.7 322.9 264.0 280.2
1983 310.5 308.8 325.1 262.0 278.3
1984 329.4 352.8 369.2 301.3 317.8
1985 373.2 364.6 381.2 303.9 320.5

Real government 1980 167.0 172.8 174.3 167.4 168.9

expenditure 1981 179.3 193.2 194.7 187.0 188.5
1982 199.9 205.8 207.3 198.8 200.3
1983 218.2 209.9 211.4 202.2 203.7
1984 251.8 227.5 229.1 219.1 220.6
1985 265.1 263.5 265.0 253.5 255.1

Real GDP 1980 1,358.1 1,389.1 1,441.7 1,334.7 1,387.3

1981 1,438.8 1,449.9 1,506.5 1,384.6 1,441.2
1982 1,492.3 1,513.8 1,574.2 1,436.3 1,496.7
1983 1,604.7 1,580.6 1,644.8 1,489.7 1,553.9
1984 1,678.2 1,659.9 1,727.8 1,554.8 1,622.5
1985 1,780.9 1,742.2 1,813.8 1,619.8 1,691.4

Simulation 1-bank branch expansion follows the 12.2 percent annual pace
set since 1970 but as a result of incentives rather than the
transfer of bank ownership to the public sector
Simulation 2-despite the transference of bank ownership to public hands,
bank branches expand at the prenationalization pace of 4.2
percent per year
Simulation 3- neither public ownership of banks nor acceleration in the bank
branch expansion program occurs

Simulation I is based on the absence of public ownership of banks and the credit
allocation rules that it implied (so that BN = 0 throughout) while preserving the
accelerated pace of bank branch expansion. With the negative impact of BN on
deposits eliminated, real bank deposits are found to be substantially in excess of
their actual level in every year from 1970 to 1985. This is clear from figure 2.1.
Higher deposits yield higher investment expenditures, which in their turn contribute
to higher levels of real GDP, as is evident from figures 2.2 through 2.4. From the
numerical results reported in table 2, it is observed that real deposits, real investment,
and real GDP from 1980 to 1985 would have been on average 7.6 percent, 4.7
percent, and 3.8 percent higher than their respective actual performance.

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 Bank Nationalization and Economic Development: India 79

Figure 1.1I Figure 1.2

700 - 400 -

600- 350-

500- 300-

c: 400- cc 250-

200-20-
=200j - i 5 -Sl_

100 100 -

0)- I,I,II, ,I,II, II,i , 50- 4 9l|lW^ ,l ,lI

56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84
Actual Real Deposits Actual Real Investment
. Simulated Real Deposits ...... Simulated Real Investment

Figure 1. 3 Figure 1.4

30000 - 2000-

25000- 1750-

.20000- ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~ 212500

_215000- | .2 1250 - s
10000 -- 1000 -

5000- /~ 750-

__ _ _ _ _ _ _ __ _ _ _ _ _ _ __ _ _ _ _ _ _ _ 5 0 0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 56 58 60 62 64 66 68 70'
Actual Real Government Expenditures - Actual Real GDP
.--- Simulated Real Government Expenditures *-.--.Simulated Real GDP

Fig. 1. Results of Historical Simulation.

Figure 2.1 Figure 2.2

700 400-

600/ 350

500 300.

0- 400 c 20

300- 200

200 _ 150 <

100 10

0 -I I I 501
56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84
Actual Real Deposits Actual Real Investment
.Simulated Real Deposits ...... Simulated Real Investment

Figure 2.3 Figure 2.4

30000 2000-

25000- 1750*

.20000- 1500;

_l 15000 - 2g 1250 .i

10000- 1000v

5000- 750-

56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84
- Actual Real Government Expenditures - Actual Real GDP
...... Simulated Real Government Expenditures ...... Simulated Real GOP

Fig. 2. Results of Simulation Alternative 1.

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80 Kusum W. Ketkar and Suhas L. Ketkar

Simulation 2 derives the behavior of the model's endogenous variables assuming

public ownership of banks from 1969 onward, but continuation of the pre-
nationalization pace of bank branch expansion (4.2 percent per year on the average)
in the postnationalization years as well. With substantially fewer bank branches,
real deposit mobilization is found to suffer a massive setback, leading to lower
investment as well as smaller real GDP (figs. 3.1 through 3.4). Specifically, the
1980-85 real deposits, real investment, and real GDP would have been 49.6 percent,
15.2 percent, and 5.7 percent lower, respectively, if bank nationalization had occurred
(BN = 1 from 1969) but the acceleration in the bank branch expansion program
had not materialized.

Figure 3.1 Figure 3.2

700 - 400

600 -350

500 300

X 400 - c 250-

300 co 200-

200 - 150 -

200 - 1 fOS/
0 50
56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84
- Actual Real Deposits Actual Real Investment
* . Simulated Real Deposits * Simulated Real Investment

Figure 3.3 Figure 3.4

30000 - 2000-

25000 1750

20000- / 1500 //

2 15000 - Jz1250 v

10000- - 1000

5000- 750

0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 500 _ _ _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ _ _

56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 56 58 60 62 64 66 6
- Actual Real Government Expenditures - Actual Real GDP
. Simulated Real Government Expenditures * Simulated Real GDP

Fig. 3. Results of Simulation Alternative 2.

Finally, simulation 3 is performed to determine the behavior of real deposits, real

investment, and real GDP in India if bank nationalization had not taken place at
all; that is, BN is always 0 and the number of bank branches expand at the
prenationalization pace of 4.2 percent per year. Comparison of these simulation results
against the actual outcome shows that overall bank nationalization has raised deposit
mobilization, real investment, and real GDP in India (figs. 4.1 through 4.4). The
numerical results in table 2 indicate that real deposits, real investment, and real GDP
would have been lower by an average of 42.5 percent, 9.9 percent, and 1.6 percent,
respectively, in the total absence of bank nationalization. Overall, therefore, the
positive impact of acceleration in the bank branch expansion program has outweighed
the negative effect of public ownership.

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 Bank Nationalization and Economic Development: India 81

Figure 4. 1 Figure 4.2

700 - 400-

6000 350

500 / 300 -

200 -,, ,, 150 , -IT

56586062 646688 70 72 74 76 78E80 82 84 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84

- Actual Real Geposits e- Actual Real Investment
.*-- Simulated Real Deposits ..e e * Simulated Real Investment

Figure 4.3 Figure 4.4

StO
30000- 250
2000-

25000 r 1750 y

.20000 . 1500 .;

=0l500000 - 1250olX
5000 X||.r,r,W,X,|, , ,E, 750- ,

56 58 60 62 64 66 6870 72 74 76 78 so 82 84 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84
Actual Real Government Expenditures - Actual Real GDP
- --. Simulated Real Government Expenditures ...... Simulated Real GDP

Fig. 4. Results of Simulation Alternative 3.

Summary and Conclusions

The statistical analysis of financial savings, investment, government expenditures,

and growth performance of the Indian economy in the past 35 years shows that bank
nationalization has been a mixed blessing. The aggressive bank branch expansion
program under the auspices of bank nationalization has increased financial savings,
but the credit allocation program associated with it has had a negative effect on deposit
mobilization and capital accumulation.
More generally, this study confirms the findings of Lanyi and Saracoglu that
financial savings are likely to increase with interest rates, especially if they become
positive in real terms.28 Furthermore, the rise in deposits should lead to a higher
level of investment, thereby promoting growth. Lanyi and Saracoglu also point out
that the policy of selective credit arrangements may fail owing to a number of factors
including the inability of policymakers to identify priority sectors and as a result
of social and political pressures. The empirical findings of this paper show in addition
that administered credit allocation since bank nationalization may have discouraged
the accumulation of financial savings.
The impact of interest rates on saving, investment, and growth is found to be in
conformity with the McKinnon-Shaw and Molho hypotheses. Their work begins by
postulating that financial saving is a prerequisite for investment in financially repressed
economies. High interest rates in such economies could raise saving as well as
investment and therefore affect growth positively. This overall conclusion is
confirmed by the empirical findings reported in this paper.

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82 Kusum W. Ketkar and Suhas L. Ketkar

The confirmation of this positive link between interest rates on the one hand, and
savings, investment, and growth on the other, in the Indian context provides support
for the typical IMF recommendation that developing countries maintain positive and
high real interest rates. Such a policy will not discourage investment. Instead, by
promoting financial savings, it would encourage both investment and growth.
Yet another important conclusion relates to the link between expected inflation
and financial savings. Since a rise in the expected rate of inflation depresses financial
savings and real investment, it is important that developing countries like India
maintain a firm grip on inflation. This is quite evident from the experience of many
Latin American countries that have allowed inflation to accelerate and financial
savings to slip. As a result, these economies have suffered from lack of real investment
and absence of robust economic growth.
Finally, to the Indian government's credit is the statistical finding that neither the
public ownership of banks nor the enhanced mobilization of real bank deposits was
used to finance real government expenditures. The government apparently depended
only on tax collections and foreign capital inflows to fund its spending program.

NOTES

1. Prime Minister of India, "Indira Gandhi's Statement," The Banker (July 1969).
2. R. Kannan, "Banking Development and Regional Disparities," Indian Economic Journal 35
(October-December 1978): 58-76.
3. Felipe Morris, India 's Financial System: An Overview of Its Principal Structural Features, World
Bank Staff Working Papers, no. 73 (Washington, DC: World Bank, 1985).
4. Government of India, Reserve Bank of India (RBI), Annual Report and Trend in and Program
of Banking in India (Bombay, India: RBI, 1985 and 1987).
5. Government of India, RBI, Report of the Committee to Review the Working of the Monetary System
(Bombay, India: RBI, 1985), p. 43.
6. Irving Fisher, The Theory of Interest (New York: MacMillan, 1930).
7. Ronald I. McKinnon, Money and Capital in Economic Development (Washington, DC: Brookings
Institute, 1973).
8. Edward S. Shaw, Financial Deepening in Economic Development (New York: Oxford University
Press, 1973).
9. Lewis Spellman, "Economic Growth and Financial Intermediation," in Money and Finance in
Economic Growth and Development, Essays in Honor of Edward S. Shaw, ed. Ronald McKinnon (New
York: Marcel Dekker, 1976); Claudio Gonzalez-Vega, "Comment," in Money and Finance in Economic
Growth and Development, ed. McKinnon; Vincente Galbis, "Financial Intermediation and Economic
Growth in Less-Developed Countries: A Theoretical Approach," Journal of Development Studies 13
(January 1977): 58-91; Franklin Lopez, "Financial Intermediation and Economic Development: A
Conceptual Framework," Journal of Economic Development 7 (December 1982): 129-40.
10. Galbis, "Financial Intermediation and Economic Growth."
11. McKinnon, Money and Capital; Shaw, Financial Deepening.
12. Rattan J. Bhatia and Deena R. Khatkhate, "Financial Intermediation, Savings Mobilization, and
Entrepreneurial Development: The African Experience," International Monetary Fund Staff Papers 22
(March 1975): 20-22.
13. Lazaros E. Molho, "Interest Rates, Saving, and Investment in Developing Countries," International
Monetary Fund Staff Papers 33 (March 1986): 90-116.
14. A. G. Chandavarkar, "Some Aspects of Interest Rate Policies in Less Developed Economies: The
Experience of Selected Asian Countries," International Monetary Fund Staff Papers 18 (March 1971):
48-112; U Ten Wai, Financial Intermediaries and National Savings in Developing Countries (New York:
Praeger, 1972); James W. Christian and Emilio Pagoulatous, "Domestic Financial Markets in Developing

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 Bank Nationalization and Economic Development: India 83

Economies," Kyklos 26 (March 1973): 75-90; Bhatia and Khatkhate, "Financial Intermediation, Savings
Mobilization"; Robert C. Vogel and Stephen A. Buser, "Inflation, Financial Repression, and Capital
Formation in Latin America," in Money and Finance in Economic Growth and Development, ed.
McKinnon.
15. Jorge R. Calderon-Rossell, "Optimal Financial Structure of Finance Companies in a Regulated
Environment of a Developing Country," Journal of Bankng and Finance 18 (September 1984): 443-57;
Edward F. Buffie, "Financial Repression, The New Structuralists, and Stabilization Policy in Semi-
Industrialized Economies," Journal of Development Economics 14 (April 1984): 305-322; Yoon J E
Cho, "Inefficiencies from Financial Liberalization in the Absence of Well-Functioning Equity Markets,"
Journal of Money, Credit, and Banking 18 (May 1986): 192-99.
16. V. V. Bhatt, "Improving the Financial Structure," Finance and Development 26 (June 1986): 20-22.
17. Anthony Lanyi and Rusdu Saracoglu, "The Importance of Interest Rates in Developing Economies,"
Finance and Development 23 (June 1983): 20-23; Robert C. Vogel and Paul Burkett, "Deposit Mobilization
in Developing Countries: The Importance of Reciprocity in Lending," Journal of Developing Areas 20
(July 1986): 425-38.
18. These and other banking statistics are obtained from Banking Statistics of India, published annually
by the Government of India, RBI (Bombay, India: 1968 to 1985).
19. Ali F. Darrat, "The Stability of the Indian Money Demand Function: Some Further Results,"
Savings and Development 12, no. 1 (1988): 89-97; Andrew D. Crockett and Owens J. Evans, "Demand
for Money in Middle Eastern Countries," International Monetary Fund Staff Papers 27 (September 1980):
543-77; Michael J. Driscoll and Ashok K. Lahiri, "Income Velocity of Money in Agricultural Developing
Economies," Review of Economics and Statistics 65 (August 1983): 393-401.
20. Government of India, RBI, Banking Statistics of India (1968 to 1986); and Government of India,
RBI, Supplement to the Reserve Bank of India Bulletin (Bombay, India: RBI, July 1980).
21. International Monetary Fund (IMF), International Financial Statistics (Washington, DC: IMF,
1951 to 1987).
22. Government of India, Ministry of Planning, Report of the Working Group on Saving: Capital
Formation and Savings in India 1950-51 to 1979-80 (Bombay, India: RBI, 1982).
23. Ray C. Fair, "The Estimation of Simultaneous Equation Models with Lagged Endogenous Variables
and First Order Serially Correlated Errors," Econometrica 38 (May 1970): 507-16.
24. Government of India, RBI, Report of Committee to Review Working of Monetary System.
25. When changes in gold prices, lagged one year, are included in the equation for bank deposits (Dt),
the sign on the coefficient is negative as expected, but it is not statistically significant. Furthermore,
inclusion of this variable reduces the Durbin-Watson statistic to 1.83, indicating the presence of serial
correlation in this specification.
26. Since the endogenous variable Dt is not found to exert a statistically significant impact on real
government expenditures, equation 3 plays no significant role in the simulation exercise.
27. The root mean square percent errors are found to be relatively low. They are as follows: 9.85
percent for real deposits; 8.63 percent for real investment; 7.53 percent for real government expenditures;
and, finally, 0.89 percent for real GDP.
28. Lanyi and Saracoglu, "Importance of Interest Rates in Developing Economies," pp. 20-23.

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84 Kusum W. Ketkar and Suhas L. Ketkar

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