Title: Monetary policy in a developing economy
Full Citation
Permanent Link: http://ufdc.ufl.edu/UF00097969/00001
 Material Information
Title: Monetary policy in a developing economy the Indian experiment
Physical Description: xii, 401, 1 leaves : illus. ; 28 cm.
Language: English
Creator: Mittra, Siddheshwar, 1930-
Publication Date: 1962
Copyright Date: 1962
Subjects / Keywords: Economic policy -- India   ( lcsh )
Economics thesis Ph. D
Dissertations, Academic -- Economics -- UF
Genre: bibliography   ( marcgt )
non-fiction   ( marcgt )
Thesis: Thesis - University of Florida.
Bibliography: Bibliography: leaves 379-400.
Additional Physical Form: Also Available on World Wide Web
General Note: Manuscript copy.
General Note: Vita.
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Bibliographic ID: UF00097969
Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: alephbibnum - 000565911
oclc - 13592063
notis - ACZ2335

Full Text





February, 1962


When I was first confronted with the problem of

selecting a topic for my dissertation, I was determined to

search for some theme other than planning in India, which

was my occupation in India. But after a search for a

reasonable length of time I came back again to the same

hard core; namely, developmental planning in an under-

developed country like India. Perhaps in my inability to

get away from planning and development I acted like a

typical citizen of India. This problem is one in which

everyone in India is deeply interested. Moreover, being

associated with the Reserve Bank of India in a research

capacity for six years during which the First Five Year

Plan was completed and the Second Plan was launched, I

felt better qualified to evaluate critically the role of

the Reserve Bank in the development of the country. Con-

sequently, I decided to make it the topic of my study. It

may not be out of place to point out that I have made no

attempts to provide a panacea for the plethora of problems

with which the development planning in India is concerned.

Rather, I have come to the conclusion that there is no

unique monetary policy which will suit the ever changing

needs of the society. Through a method of trial and error

only India has to shape her national economic policy. The

Reserve Bank, which is the sole authority for the monetary

policy of the country, has a very difficult role to play.

On the one hand, it is vested with the primary responsibility

of bringing about a sustainable economic development and,

on the other, the Bank is called upon to realign the mone-

tary policy with the national economic policy. In the end,

some attempts have been made in this study to show that

the Reserve Bank was largely successful in playing its

difficult role.

I would like to mention that throughout the study

I had ample opportunity to consult the officers of the

Reserve Bank and experts on Indian economics. However, at

no time did I avail myself of this opportunity so that my

evaluations and judgments would be based solely upon what

I had learned about Indian economics in general and the

Reserve Bank in particular during my association with the

Bank. I should also like to make it clear that the views

expressed in this study are my own, and not those of the

Reserve Bank or any other organization.


It is never easy for a research student to make a

full and honest declaration of his intellectual and other

debts. The list of persons to whom I am indebted is far

greater than I know. As a practical matter, I can only

attempt to acknowledge the more pressing debts.

I wish first to thank members of my Committee;

namely, Drse C. H. Donovan, C. A. Matthews, E. L. Jackson,

and J. W. Gaddum, who have given me their help and assist-

ance. To Messrs. K. C. Mittra and D. N. Sarkar, who assis-

ted me with unbelievable efficiency with a constant source

of valuable material from India, I owe deep gratitude. I

also gratefully acknowledge the financial assistance granted

me by my brother Dr. Raj Mittra, and by the College of Busi-

ness Administration, University of Florida, without which

this study could not have been completed. I am especially

thankful to Dr. William Hugh McEniry, Dean, Stetson Univer-

sity, who so generously granted me sabbatical leave for the

completion of this study. The contribution of my wife, who

constantly gave me the sort of sympathy and encouragement

every research student needs most in the turbulent course

of serious writing, has been invaluable. My final thanks are

to Dr. Allen Morris Sievers for his time, patience, guidance,

advice, criticism, perseverance, and encouragement.

Siddheshwar Mittra
Gainesville, Florida


PREFACE . . . . . . . . . . .

LIST OF TABLES. .... . . . . . .




I. INTRODUCTION. . . . . . . .


The Meaning of Economic Development. .
General Problems of Economic Development
of Underdeveloped Areas . . . .
India: An Underdeveloped Country? . .
The Stage of Economic Development
in India.. . . . . . .
Problem of Economic Development in India .


The Banking System in India. . .
Money and Capital Markets in India . .

The Money Market, . * *. .
The Capital Market. . . . .

TIROUGH 1959-60. . . . . .

Background Note to India's Economic
Planning in India . . . . ..

The First and Second Plans: A Summary.

Economic Development in India during
the Period 1950-51 to 1959-60 . . .

















TO 1959-60 . . . . . . . . 153

General Credit Control . ... . .. 155

Bank Rate ... ... . . . 155
Open Market Operations. . ..... 158
Variable Reserve Requirements . . 159
Selective and Direct Credit Controls. 160
Moral Suasion . .... .. 161

History of Monetary Policy in India. 162
Overall View .............. 176

A THEORETICAL MODEL. ........ . 179

The Role of Government in Economic
Development .. . . . * 190
The Role of the Central Bank in
Economic Development. ... # . . 209
Monetary Policy and Economic Development 219

The Case against Active Monetary
Policy in Economic Development .* 224
The Case for Active Monetary
Policy in Economic Development . 225

Conclusion . * * * .* * * 226

ROLE . . . . . . . # .. 229

The Cause of New Inflation .... . 229
The Reserve Bank and the New Inflation . 273
Monetary Policy Vis-a-Via New Inflation. 284
The Restrictive Role of Monetary Policy. 324

MENTAL ROLE. . . . . . . . 345



Epilogue . . . . . 362
Conclusion................ 370

BIBLIOGRAPHY . . . . . . . 379

BIOGRAPHICAL SKETCH.. ............ 401



Table Page

1. Agricultural Production in India,
1950-51 and 1959-60,. . . . 34

2. Industrial Production in India, 1951 and 1960 35

3. India's Balance of Payments, 1950-51
and 1959-60. . .. . . . . 36

4. Per Capita National Product in Selected
Countries, 1955. . .. .. 42

5. Non-Monetary Measures of Material Welfare
in Selected Countries, 1955. * . . 43

6. Selected Liabilities and Assets of the
Reserve Bank of India during Selected Years, 54

7. Liabilities and Assets of Scheduled Banks
and All Commercial Banks in India
during the Year 1959-60. . . .. . 57

8. Margin between Advances and Deposit Rates
in India during Selected Months. .. . . 62

9. Distribution of Deposits of Scheduled Banks
in India during the Period 1955 to 1959. . 64

10. Maturity Distribution of Investments of
Scheduled Banks in Government Securities
during the Period 1956 to March, 1960. . 65

11. Ratio of Money Supply to Deposit Money with
the Public During Selected Years . . . 71

12. Advances of the Reserve Bank of India to
Scheduled Banks and State Cooperative
Banks during Selected Years. . . . . 79


Table Page

13. Money Rates in India (Bombay) during
Selected Years . . . . . . . 83

14. Reserve Bank Advances to Scheduled Banks
under Bill Market Scheme during the
Period 1952 to 1959. . . . . . .. 88

15. Net Absorption of Government Securities by the
Public during the Period 1951-52 to 1959-60. 97

16. Pattern of Ownership of the Combined Central
and State Government Securities, March,
1959, and March, 1960. . ....... .. 99

17. The National Income of India, 1950-51 (at
1948-49 Prices). . . . . . . . 104

18. Distribution of Planned Outlay during the
First Plan, 1951-52 to 1955-56: Public
Sector . . . . . . . . 110

19. Planned Resources during the First Plan,
1951-52 to 1955-56: Public Sector . . 111

20. Anticipated Increase in Productive Equipment
during the First Plan, 1951-52 to 1955-56. 114

21. Distribution of Plan Outlay by Major Heads
of Development during First and Second
Plans: Public Sector. ..... .. . .. 117

22. Public and Private Investments in Industry
during First and Second Plans. . . . 118

23. Total Planned Outlays in Five Year Plans. . 120

24. Sources of Finance for Public Sector Programs
during First and Second Plans. . . . 122

25. Sources of Finance for Industrial Programs
during First and Second Plans: Private
Sector (Other than Mining, Electric Power,
Plantations, and Small-Scale Industries) . 126

Table Page

26. Main Targets of Production and Development
in India under First and Second Plans. 127

27. Estimates of Additional Resources during
the Second Plan. . . . . . . 129

28. Outlay and Investment in First and Second Plans 133

29. Net Capital Formation out of the Budgetary
Resources of the Central Government during
the First Plan and First Four Years of
the Second Plan. . . .. . . 134

30. Sources and Uses of Funds of 814 Selected
Public Limited Companies for the Year 1959 138

31. Net National Output by Industrial Origin in
India during the Period 1950-51 to
1959-60 (at 1948-49 Prices). . . . . 139

32. Trends in the Volume and Pattern of Savings
in India during the Period 1950-51 to
1958-59 (at 1948-49 Prices). .. . . . 141

33. Estimates of Investment in India during the
Period 1950-51 to 1957-58 (at 1948-49
Prices . . . . . . . . . 143

34. Index Number of Agricultural Production in
India during the Period 1950-51 to 1959-60 146

35. Index Number of Industrial Production in India
during the Period 1950 to 1960 . .. .. 149

36. National and Per Capita Incomes in India
during the Period 1949-50 to 1959-60 . . 232

37. Indices of Selected Economic Indicators during
the Period 1949-50 to 1959-60 . . . 235

38. Index Number of Wholesale Prices during the
Period 1949-50 to 1959-60. . . .. . 237

39. Index Number of Wholesale Prices during
Selected Years. . . . . . . . 239

Table Page

40. Indices of Wholesale Prices and Money Supply
during the Period 1949-50 to 1960-61 ,. 243

41. Indices of Money Supply, Foodgrains Production,
and Wholesale Prices during .the Period
1950-51 to 1959-60 .. . . . . 246

42. India's Balance of Payments during the Period
1950-51 to 1959-60 , . . . 258

43, Variations in the Net Foreign Exchange Assets
of the Banking Sector during the Period
1951-52 to 1959-60 A. . . . 260

44. Plan Outlays and Their Financing during the
Period 1951-52 to 1959-60,. . . 264

45, Income Velocity of Money in India during the
Period 1949-50 to 1959-60, . . . 267

46. Percentage Change in National Income and
Money Supply during the Period 1951-52
to 1959-60 . .. . . . # . 275

47. Analysis of Money Supply Variations during
the Period 1951-52 to 1959-60. . . . 277

48. Index of Wholesale Prices during the Period
1951-52 to 1959-60 .. . . . . . . 286

49. Variations in Bank Credit and Money Supply
with Public during Busy and Slack Seasons
for the Period 1950-51 to 1959-60. .. . 288

50. Scheduled Bank Credit during the Period
1951-52 to 1959-60 . . . . . 292

51. Budgetary Position of the Government of
India during the Period 1950-51 to 1959-60 297

52. Money Supply with the Public during the
Period 1950-51 to 1959-60. . . . . 305

Table PaM

53. Scheduled Bank Borrowing from the Reserve
Bank during Selected Years . . . . 315

54. Scheduled Bank Indicators for the Period
1955-56 to 1959-60 . *. . . 319




The economic policy of a nation is an ever changing

concept. During the immediate postwar period in India after

the issue of the British White Paper on the Employment Act,

full employment became the accepted objective of economic

policy in general and of credit policy in particular. More

recently economic growth has been developing as an important

objective of credit policy as the nation embarked on a pro-

gram of planned development. Economic growth frequently

enters into the economic discussions in both the developed

and developing nations. For instance in the United States

according to the Federal Reserve System, "the basic func-

tion of the Federal Reserve System is to make possible a flow

of credit and money that will foster orderly economic growth

and a stable dollar." Like developed countries, underdevel-

oped nations also emphasize the need for development. For

Federal Reserve System, Purposes and Function,
Board of Governors of the Federal Reserve System, Washing-
ton, D. C., 1954, p. 1.

instance, according to the Indian Planning Commission, India

urgently needs planning "to initiate simultaneously a process

of all-round balanced development which would ensure a rising

national income and a steady improvement in living standards

over a period."'

Although sustained economic development is a univer-

sal objective of both developed and underdeveloped countries,

the latter are more concerned with an accelerated economic

development; since they have been deprived of development for

such a long time, and are anxious to improve the living stand-

ards of the masses in the quickest possible time. In this

context the most important monetary problem becomes one of

controlling the inflationary pressures arising out of a

rapid development. It is now recognized that though credit

policy can play but a small part in stimulating flagging

demand, "it does play an important part in controlling effec-

tive demand and in the mopping up of excess liquidity."2 It

is through its effects on the aggregate demand that the

credit policy makes its contribution to economic development.

The above discussion clearly brings out the role of

the central bank in accelerating economic development. It

iGovernment of India, Planning Commission, Review of
the First Five Year Plan (New Delhi: Government of India
Press, May, 1957), p. 1.

2United Nations, Economic Bulletin for Asia and the
Far East (New Yorks United Nations, 1956), p. 7.


is interesting to observe that at one time it was believed

central banking policies could be formulated through the

mechanical application of the reserve requirements, the

eligibility provisions for the discounting of commercial

paper, etc. In recent years an increasing number of econ-

omists have come to believe that "the cardinal virtue of the

central banker is not conservatism in techniques but rather

a disposition to discover novelties and to be versatile in

technique."l It is through constant changes in the tech-

nique of monetary management and also the development of

new instruments of credit control that the central bank can

help to bring about rapid development with stability.

The present study concerns itself with the role of

the central bank in the development process of an under-

developed country, namely, India. India provides a fasci-

nating background for such a study, for the problems facing

the Indian economy today are of such a complex nature that

the answers are not readily available either in Marxian

economics or the economics of Western capitalist or social

democratic countries. The reason is that nowhere else is

there the same combination of size, of crushing growth of

numbers, a crumbling agrarian economy, a Juxtaposition of

1Richard S. Sayers, Central Banking after Bagehot
(Oxford: Clarendon Press, 1957), p. 33.

the most modern and the most primitive industrial techniques,

the existence of vast unemployment and underemployment, a

functioning democracy in its most sophisticated form, and

a planning under a federal structure.

India also has a central bank which is, in the words

of Professor Sayers, "versatile and percipient." In fact

it might not be an exaggeration to say that perhaps nowhere

else in the world has the central bank taken so active a

part in the economic development of a country, or departed

so widely from orthodox conceptions of central banking.

Precisely, then, this study attempts to determine how far

the Reserve Bank of India has been successful in assisting

the government in accelerating the economic development in

India during the period 1950-51 to 1959-60,1 and to what

extent this development has been achieved with stability.

The organization of this study takes the following

course. Chapter II entitled "The Stage of Economic Develop-

ment in India" attempts to determine if India is an under-

developed country and, if so, what is the nature and extent

of her underdevelopment. This chapter will also discuss

some of the problems of economic development facing India.

lIn India, the fiscal years cover the period April
to i'arch. The period 1950-51 to 1959-60, therefore, refers
to the period fiscal year 1950 through the fiscal year 1959.


The role of the central bank is primarily dependent

upon the financial and bankiin institutions of a country.

Chapter III will be devoted to the description of these

institutions in India.

A criticism of the monetary policy must necessarily

be based on its achievements and failures in terms of

planned development of the country over a given period.

Chapter IV will therefore record the planned development

that took place in India during the ten-year period

1950-51 to 1959-60; that is, the period covering the last

pre-Plan year (1950-51), the First Five Year Plan (1951-52

to 1955-56) and the first four -cars of the Second Five Year

Plan (1956-57 to 1959-60). The gains of economic develop-

ment will be measured in terms of such economic indicators

as national income, capital formation, production, invest-

ment, and savings.

For a proper evaluation of the role of monetary

policy it is both desirable and necessary to discuss the

scope of monetary management as also the extent to which

the monetary policy is called upon to play its role. With

this objective in view chapter V will discuss the scope of

monetary policy and will also record a brief history of

monetary management in India.

An attempt will be made in chapter VI to build a

theoretical model in terms of which the monetary policy in

India will be evaluated. In doing so a distinction will be

made between the long-run developmental role and the short-

run restrictive role of monetary policy. Chapters VII and

VIII will be devoted to the critical evaluation of the

developmental and restrictive roles of monetary policy in

India with a view to determining the extent of failure and

success of the monetary policy in bringing about a sustain-

able economic development in India.

Chapter IX, the last chapter, is devised to give

a brief resume of each of the earlier chapters. It will

summarize the study and attempt an overall evaluation.



Monetary policy plays a crucial role in shaping the

economic destiny of a nation. Money and credit influence

to a considerable degree the course of economic behavior.

Development programs and their successful implementation

largely depend upon correct and balanced policies adopted

by the central monetary authority in the country. More

recently greater emphasis has come to be placed on the cen-

tral banks as a necessary "cog" in the machinery of monetary

planning for economic growth. As Paul Einzig put it:

"Economic planning is unthinkable without monetary manage-

ment and monetary management is doomed to failure without

economic planning."

Monetary management assumes special importance in

the context of the economic development of underdeveloped

countries for more than one reason. In these countries,

because of the inadequacy of savings and the difficulty of

Paul Einzig, Monetary Reform in Theory and Practice
(New York: Macmillan Company, 1936), p. 126.

directing the low volume of savings into productive invest-

ment, there is usually a strong temptation on the part of

the government to raise the level of investment by expand-

ing credit. Development efforts of this nature by most of

the less developed countries have in the postwar period been

accompanied by inflationary price increases.1 Whether this

is inevitable and whether any relationship exists between

the rate of price change and the rate of economic growth are

questions subject to considerable debate on theoretical

grounds. Statistical studies of the rates of growth and

the rates of price change in various less developed countries

have also been made to determine whether there is any

systematic relationship between them, especially in the

postwar period.2 No definite answer has yet been found;

however, it is widely agreed3 that the policy of "development

1R. J. Bhatia, "Inflation, Deflation and Economic
Development," IMF Staff Papers, VII (1959-60), 101.

2For example, see "Inflation and Economic Develop-
ment," Federal Reserve Bank of New York, Monthly Review
(August, 1959), pp. 122-27; U. Tun Wai, "The Relation
between Inflation and Economic Development: A Statistical
Inductive Study," IMP Staff Papers, VII, No. 2 (October,
1959), 310-17.
3Many recent studies by International Organizations
have arrived at this conclusion. See, for instance,
Measures for the Economic Development of Underdeveloped
Countries (New York: United Nations, 1951); Economic
Development with Stability (Washington, D. C.: International
Monetary Fund, 1953).

through inflation" in underdeveloped countries can be suc-

cessful if the inflation is effectively controlled. It is

in this context that the monetary policy assumes special


It is important to recognize at the outset that no

one type of monetary policy is suitable in all circum-

stances. The central monetary authority of a country has

to devise a policy which will suit its country best. This,

in turn, will largely depend upon the stage of the develop-

ment of the country's financial institutions.

The Meaning of Economic Development

The present study proposes to evaluate the role of

monetary policy in the accelerated economic development

program in India under the first two government-sponsored

Five Year.Plans. It is therefore appropriate to state

briefly in the very beginning what is meant by economic

development. The stage of economic development in India

can then be determined.

1Creation of credit for development purposes may not
become purely inflationary. Inflation for the purpose of
creating useful capital is often self-destructive, since
sooner or later it is likely to result in an increased sup-
ply of goods to the market. See William A. Lewis, The
Theory of Economic Growth (London: G. Allen and Unwin,
1955), p. 217.

Defining economic developmentI is a difficult task.2

The literary meaning of development is the "passage from a

lower to a higher stage." However, it is extremely diffi-

cult to find a perfect definition of the term "economic."

In general economic development implies an improvement in

material terms that is, in terms of the goods and services

that are available to the people. But this is not enough.

The effort and sacrifice that go into achieving such materi-

al improvement must also be taken into account, for more

goods obtained by larger sacrifice would not necessarily

involve economic development. Precisely then, obtaining

"more goods and services for less [or no more ]effort and

1Joseph Schumpeter was the first among the modern
economists to separate out economic development as a
specialized area of economic analysis. This he did in his
book, The Theory of Economic Development, published in
German in 1911, and in English by Harvard University Press,
Cambridge, Mass., in 1934.

2Leibenstein brings out certain difficulties in
measuring economic development. For instance, he says that
many patterns, and not Just a constant pattern, of change
are possible. Moreover, not all the variables move in the
same direction. Finally, all macro-economic variables
involve the difficulties inherent in the aggregation of
"heterogeneous entities." Concepts like income, productiv-
ity, investment, etc. involve a very high degree of aggre-
gation. As a consequence, there arises a problem of trans-
lating the individual entities into some common value unit.
However, he concludes: "But we cannot take a perfectionist
view." See Harvey Leibenstein, Economic Backwardness and
Economic Growth (New York: John Wiley and Sons, 1960),
pp. 8-9.

sacrifice per persons"l may constitute a first approxima-

tion to a definition of development as a state of the


This study concerns itself with an underdeveloped

country. A more explicit definition of economic develop-

ment of this kind of country is therefore desirable. In

underdeveloped countries the objective is to create more or

less rapidly an economic situation analogous to that pre-

vailing in the developed nations. "Essentially, the hope

is to replace general poverty and near stagnation with

greater affluence and cumulative enrichment.*2 How this

change from the lower to the higher economic level is

brought about constitutes economic development as a process

over time.

It is necessary to make a further distinction

between "economic development" in a special sense and the

more casual use of the term to mean the kind of "economic

growth" which may be merely evolutionary. Economic growth

or improvement can take place gradually through autonomous

improvements in production techniques, increase in savings

1Henry V. Villard, Economic Development (New York:
Rinehart and Winston, 1960), pp. 15-16.

2Walter Krause, Economic Development (San Francisco:
Wadsworth Publishing Company, 1961), p. 23.

and investment, geographical expansion, rise in the net

capital formation or population increase. Economic devel-

opment, as is understood here, is economic growth"of a

different character." The essence of economic development

in our special sense is the deliberate creation within a

comparatively short period of a complex of favorable con-

ditions, so that the economy is lifted out of the economic

pit of stagnation and poverty and is able to develop

sufficient motive power to go forward on its own momentum

towards ever higher levels of production. Development also

implies a rate of real increase of output faster than the

rate of increase in population, so that the per capital

income also advances along with the increment in the real

national income. In short, economic development shall be

taken to mean an induced increase in the real per capital

income of the country (with no greater cost in terms of

effort and sacrifice by the populace), at a rate promising

an end of mass poverty in the foreseeable future. Mani-

festly, then, the problem facing modern India is one of

economic development rather than mere economic growth.

At this stage it is pertinent to ask: "Is it pos-

sible to distinguish an underdeveloped country?" An

unequivocal answer is not altogether possible; for broadly

speaking, all countries, including the most advanced

countries like the United States, to some degree are "under-

developed." However economically mature a country might be,

there still would exist some scope for further development.1

However, a distinction can still be made on a relative basis

between developed and underdeveloped nations by making a

general study of the characteristics of nations generally

recognized as underdeveloped. Let there be no misunderstand-

ing, however. Underdeveloped regions cannot be regarded as

identical. In sharp contrast they represent a group of

countries with great diversity in such matters as population

density and growth, political and social institutions, rates

of progress, economic and physical qualities of the people

and so on.2 It is because of this diversity that a pre-

cise definition of this type of country is rendered diffi-

cult. An underdeveloped country, says Singer, "is like a

giraffe -- difficult to describe but you know when you see

one."3 Concern over a precise definition of underdeveloped

countries is also expressed by a group of experts appointed

by the United Nations (UN). The group says:

1United Nations Review (February, 1959), p. 11.

2See Benjamin Higgins, Economic Development (New York:
W. W. Norton and Company, 1959), pp. 21-23.

3H. W. Singer, "Trade and Investment in Under-
developed Areas: A Reply," American Economic Review, XLI
(June, 1951), 419.

We have had some difficulty in inter- retlng
the term "underdeveloped countries." We use
it to mean countries in vhich' per capital real
income is low when compared with the per
capital real incomes of the United States of
America, Canada, Australia, and Western Europe.
In this sense, an adequate synonny would be
"poor countries."I

A more meaningful, although somewhat obscure, definition is

given by Jacob Viner. According to him, an underdeveloped

country Is one "which has good potential prospects for using

more capital or more labor or more available natural

resources, or all of these, to support its present popula-

tion on a higher level of living, or, if its per capital

income level is already fairly high, to support a larger

population on a not lower level of living."2

While a precise definition of underdeveloped

countries seems rather difficult these areas do exhibit

certain common features which justify a few limited gener-

alizations. Of necessity, however, these generalizations

have to be in terms of Western economic terminology, such as

low per capital income, low savings and investment, insuf-

ficient capital, etc., since appropriate terms have not

so far been developed adequately to describe these

IUnited Nations, Measures . p. 3.

2Jacob Viner, International Trade and Economic
Development (Illinois: Free Press, 1952), p. 125.


areas. It is im.ortaft, therefore, to rc.nemmbcr their

extreme diversity.1 Perhaps the most satisfactory defini-

tion is given by E. :. Dernstein (a former official of the

IMF) which hinges on the definition of economic development

adopted above. Bernstein says:

The best test of an underdeveloped country is its
level of real income and the rate at which per
capital real income is increasing. In short, an
underdeveloped country is one in which output
per capital is relatively low and in which pro-
ductive efficiency is increasing very slowly*
if at all,

Thus the indicator that test describes the struc-

tural characteristics of an underdeveloped country is

perhaps "per capital income." This indicator is not uni-

versally accepted, however. For instance, though the group

of experts that wrote the measures s for the Economic Devel-

opment of Underdeveloped Countries"3 agrees with Bernstein,

IFor a detailed discussion, see Leibenstein, op. cit.,
pp. 40-41; also see Lyle W. Shannon, Underdeveloped Areas
(New York: Harper and Brothers, 1957), particularly
chapters I, II, V,and VI,

2E. M. Bernstein, "Financing Economic Growth in Undez-
developed Economies," in Walter W. Heller (ed.), Savings in
the Modern Economy (Minneapolis: University of Minnesota
Press, 1953), p. 267.

3United Nations, op. Cit. The group of experts con-
sisted of A. B. Cortez (Chile), D. R. Gadgil (India),
G. Hakim (Lebanon), W. A. Lewis (England), and T. W. Schultz
(US). See also Lewis, op, cit., p. 420. Some economists
take a more cautious view. For instance, Higgins says: "In

in accepting it Viner questions the acceptability of per

capital income as an index of development, while Frankel2

is overtly opposed to it. Frankel's skepticism toward the

per capital income appears to be based on the existence of

a large non-monetary sector in the underdeveloped countries

which makes the problem of measurement of this indicator

so difficult. Unlike these economists, who never reveal

clearly the idea of "real" income, Kurihara makes the con-

cept of "real per capital income" very explicit. According

general, underdeveloped countries . are those with per
capital incomes less than one-quarter those of the United
States -- or, roughly, less than $500 per year." See
Higgins, op. cit., p. 6. It is also interesting to note
that some economists take the extreme view in this regard.
For instance, as a footnote to chapter 2 entitled "Per
Capita Output as an Index of Development," Leibenstein
makes the following remark: "The reader who is convinced
at the outset that per capital output is a good index of
economic growth may skip this chapter." Op. cit., p. 7.

1Viner, op. cit., pp. 125-26.

2Sally H. Frankel, The Economic Impact on Under-
developed Societies: Essays on International Investment
and Social Change (Cambridge, Mass.: Harvard University
Press, 1953), p. 59. Frankel remarks "What I am con-
cerned with is the basic implication that low or high
incomest per capital or low or high aggregate 'incomes' do
in fact provide criteria for investment policy in relation
to 'underdeveloped territories' at all. I believe it is
significant that the current literature on the relation
between aggregate 'income' and investment makes use of
terms like gross or net national 'income' pe i head as if
the word 'income' in such expressions has a similar
connotation as a guide for investment decisions as it has,
or had, in a money-exchange economy for a private entre-
preneur or promoter."

to him, "the most serviceable single indicator . is

low per capital real income."1 (Italics supplied.) Per

capital real income is important; since, according to Kuri-

hara, there cannot be economic development if the growth

of population exceeds the increase of output so that each

person is worse off on the average than before. The use

of low per capital real income as the indicator also has the

connotation that it is individual poverty that separates

an underdeveloped country from a developed nation.

A general acceptance of the concept of measuring

economic development by comparing per capital income of

different nations is reflected in the frequent attempts

made by many organizations to determine the extent of under-

development in a country by applying this indicator. For

instance, a United Nations study was conducted in 1949 to

compare the national income ner capital in United States

dollars for seventy countries.2 A comparable set of

estimates for 1953 was also prepared by the Center of Inter-

national Studies of the Massachusetts Institute of Technology.3

1Kenneth K. Kurihara, The Keynesian Theory of Economic
Development (New York: Columbia University Press, 1959), p.26.
2United Nations, National and Per Caoita Incomes of
Seventy Countries -- 1949 (New Yorki United Nations, 1950),
p. 13.
3Reproduced in Charles P. Kindleberger, Economic
Development (New York: McGraw-Hill Book Company, 1958), p. 6.

One consequence of the low level of per capital real

incomes is the low rate of savings and investment. Typ-

ically, underdeveloped countries channel less than 10 per

cent of their low incomes into net investment every year.

Six or 7 per cent would seem to be the average figure for

the underdeveloped countries in Asia. In the ECAPE

(Economic Commission for Asia and the Far East) region,

only Japan with a net capital formation of 20 to 26 per

cent of national income, and Burma, to a lesser extent,

have a rate of capital formation sufficient for improving

the level of living of the population.1 A small ratio of

investment to national income permits only a small annual

rise in the national income*

A low level of per capital income with a low rate of

investment becomes at once the cause and the effect of

what is known as the "vicious circle of poverty." Under-

developed countries are caught in a low-saving low-income

vicious circle which they are not able to break through by

themselves and hence they perpetually stagnate. For

instance, Samuelson writes: "They [underdeveloped countries]

cannot get their heads above water because their production

1United Nationsj Economic Bulletin for Asia and the
Far East (New York: United Nations, 1954), p. 1.

is so low that they can s)arc nothing for capital formation

by which their standard of living could be raised.'' A

study prepared for an official US committee by the Center

for International Studies of the IMassachusetts Institute of

Technology (MIT) also expresses similar views. The study


The general scarcity relative to population
of nearly all resources creates a self-
perpetuatin( vicious circle of poverty.
Additional capital is necessary to increase
output, but poverty itself makes it impossible
to carry out the required saving and invest-
ment by a voluntar2j reduction in consumption,2

The widespread poverty, low levels of investment and

income, and perpetual staGnation are all closely related to

an important economic3 characteristic of underdeveloped

countries, namely, the predominance of aCriculture. Most

of these countries have a very high proportion of the

population engaged in agricultural operations with the

1Paul A. Samuelson, Economics: an Introductory
Analysis (2nd ed. rev.; New York: McGraw-Hill Book
Company, 1951), p. 49.

Quoted by Peter T. Bauer, Some Economic Aspects
and Problems of Underdeveloped Countries (Bombay: Forum of
Free Enterprise, 1958), pp. 7-8.

3Leibenstein classifies the characteristics of
underdeveloped countries into four categories, namely,
(1) Economic, (2) Demographic, (3) Cultural and Political,
and (4) Technological and Miscellaneous. See Leibenstein,
op. cit., pp. 40-41.


result that there is "absolute overpopulation" in agri-

culture. This means that a stage is reached in agri-

cultural industry when it is possible to reduce the num-

ber of workers in agriculture and still obtain the same

total output. This in turn gives rise to an entirely

different kind of unemployment, known as "disguised un-

employment." The term "disguised unemployment" in the

context of underdeveloped areas means that the problem of

unemployment in these countries primarily consists of the

accumulation of labor in occupations and in types of work

with extremely low or even negligible productivity. The

supply of land being limited owing to a high man-land

ratio, and the rate of capital formation being low, growth

of population is seen as causing the onset of diminishing

returns. Each successive addition to the labor force thus

reduces the productivity of labor until a point is reached

where the marginal productivity of labor becomes virtually

zero and conceivably even negative. While this could be

considered r~" red signal for a developed economy the

institutional framework, such as custom, conventions, and

techniques, of backward countries permits the absorption

of labor even beyond this point. As a result there does

not exist any prima facie unemployment in the economy. In

the technical sense, however, since the productivity of

labor is nil and even negative the situation is analogous

to a condition where unemployment does exist. This is what

is moiwn as disguised unor.iloyment. This type of unemploy-

ment is a ubiquitous phenomenon in all sectors of the

economy and is, by its very nature, conspicuous in the

agricultural sector. This fact becomes all the more impor-

tant when it is recalled that most backward economies are

primarily agricultural in character.

Poor credit facilities and poor marketing facilities

are yet another characteristic of underdeveloped economies.

Domestic industry is likely in most cases to develop in

response to growing local demand. This demand depends in

turn to some extent on how effectively manufacturers can

take their products to the consumer. Where the mass market

is unduly restricted industry will find it difficult to

operate at a profit because it will be unable to cut its

costs by working at optimum size and with equipment which

will help to reduce outlay. But the low purchasing power

of the people acts as the primary deterring factor to the

growth of industries. It is true that as the economic

development proceeds and as new employment is created in

industry more people rise in the financial scale, creating

an expanding demand for manufactured goods. Nevertheless

the demand for goods is still likely to be limited in most

cases by the low personal incomes. Hence for them the

attainable level of industrialization is not likely to be


There are other important characteristics of under-

developed countries which deserve mention here. As men-

tioned before low savings is a common feature of these

countries. A large portion of the low savings is frequently

diverted from industrial and commercial undertakings into

the particularly attractive avenues of real estate, specula-

tive holdings of profitable stocks, precious Jewels,and

foreign assets, to the detriment of productive investment.

Another important feature is the technological backwardness,

which is primarily the result of the low productivity of

labor and capital. The reason for such a state of affairs

is twofold. First, developments in the field of technology

in underdeveloped countries have been rather slow owing to

their being politically dependent till recently, which

seriously hampered the technical education of the people.

Second, there has frequently been an unintelligent and

uncritical application of the technological methods suitable

for developed nations to these backward areas; the conse-

quences have therefore been rather disappointing. Both

these factors have caused technical backwardness in under-

developed areas.

General Problems of Economic Development

of Underdeveloped Areas

According to Buchanan and Ellis, in the western

world economic growth has been associated with four

dynamic factors, namely, entrepreneurship; innovations

and technical change; capital accumulation; and increasing

specialization and exchange between persons and regions,

nationally and internationally.1 In underdeveloped areas,

where the distinguishing feature is the low per capital

income, economic growth has not taken place at a rapid

pace. And whatever growth in the aggregate output has

occurred has been matched, or more than matched, by a

growth of numbers in the population. As a result, most

underdeveloped regions have continued to stagnate over

long periods of time.

The question as to why the dynamic factors func-

tioning in developed nations have operated with so little

force in undeveloped regions seems to be "answerable only

in terms of the value scales that guide and motivate people

in those societies."2 However, the course of history now

1Norman S. Buchanan and Howard S. Ellis, Approaches
to Economic Development (New York: Twentieth Century Fund,
1955), p. 406.
2Ibid., p. 407.

seems to be taking a definite turn. Since World War II,

many of these undeveloped countries have achieved freedom

from colonial powers. As the general masses of these

young nations are being exposed to the remarkable growth

of the developed countries, a tremendous desire to achieve

higher standards of living is gathering momentum. These

forces are crumbling the barriers to rapid development,

and material values are replacing the aesthetic values of

the people. Thus on the one hand material values are

being more fully appreciated and, on the other, the intensi-

fication of the desire of better living standards is tak-

ing place: both of these, inter alia, are conducive to

rapid economic development.1

The problems of economic development in under-

developed areas are numerous and varied. Although social

values are undergoing rapid transformation pre-industrial

cultural patterns and institutional arrangements appear

to change very slowly. Entrepreneurial skills are lacking.

Institutions which could mobilize the savings of the

nations for growth purposes are ill developed, and so on.

A study of an overall economic development of a country

1Economic development is used here in the material


will have to take into account all of these deficiencies,

and conceivably many more.

Since our prime index of economic development is

the rate of increase of real income per capital, economic

development can be expressed, inter alia, "as a function

. .of the rate of new capital formation."1 An inference

that can be drawn from the foregoing is that the under-

developed areas might improve their aggregate output

mainly by means of additions to their productive capital

stock,2 and to a lesser degree by means of entrepreneur-

ship, innovations,and increasing specialization. Further-

more, the rate of capital formation has to exceed the rate

of population growth if development is to take place.

Unfortunately, in many of the underdeveloped

countries savings are barely sufficient to keep up with

population growth; so that a negligible amount of new

capital, if any, actually becomes available to increase

the end product of the economic system. How to increase

the rate of capital formation has therefore become a

question of great urgency.

1United Nations, Measures .., p. 35.
2Capital formation is used here to mean: (1) increas-
ing the volume of utilizable resources, such as land recla-
mation, roads, etc., and (2) increasing the volume of
capital equipment.

The stepping up of capital formation requires an

increased supply of savings. In underdeveloped countries,

by definition, private savings are very limited. Due to

the low level of income the propensity to consume is very

high and is all the more intensified by Duesenberry's

"demonstration effect."' According to him, an increase in

consumption expenditures on ordinary goods leads to an

increased contact with luxury goods. When that occurs

"impulses to increase expenditure will increase in fre-

quency, and strength and resistance to them will be

inadequate. The result will be an increase in expenditure

at the expense of saving."2 In recent years, it may be

noted, due to rapid international communication and contact

the people in these countries have been influenced to a

considerable degree by the high consumption standards of

western nations. This is an additional factor leading to

the lower propensity to save. Thus, on the one hand, the

vast majority of the population on a low level of income

have hardly the capacity to save; and on the other, their

consumption pattern has a tendency to rise which sets a

limit to their desire to save.

James S. Duesenberry, Income, Saving and the Theory
of Consumer Behavior (Cambridge, Mass.: Harvard University
Press, 1949), p. 27.

There is an additional reason accounting for low

savings that deserves special mention here. People with

low incomes are more likely to save through savings banks,

cooperative savings societies, mutual societies, and

similar institutions Savings of these people could be

augmented if more persons were employed by governments to

organize savings institutions and to urge the people to

step up their savings.2 The middle classes save through

such institutions and also through insurance companies

and, to a lesser extent, through investment in their own

enterprises or in bonds and stocks. It is also possible

that organization of the stock market, where business is

potentially large, might further stimulate middle-class

1United Nations, Measures . p. 36.

21t may be argued that the ability of the people
to save has to be increased before the savings institutions
are developed. It is also conceivable that efforts to
develop these institutions without first attempting to
increase the propensity to save might divert the savings,
at least in part, from more productive to less productive
investments. These arguments do not, however, undermine
the importance of developing savings institutions to
mobilize the meager savings resources of underdeveloped
countries. See, for instance, the memorandum prepared by
the International Bank for Reconstruction and Develop-
ment (IBRD). It says: "In low-income countries it is
difficult to increase the volume of current domestic
saving. Much can be done, however, to institutionalize
saving . Quoted by United Nations, Methods of
Financing Economic Development in Underdeveloped Countries
(New York: United Nations, 1949, p. 6.

saving. Higher income classes are not too much handicapped

for lack of institutions; however, appropriate institu-

tional developments can still divert a nart of their savings

from less to more useful purposes and further increase their

propensity to save.

In most underdeveloped countries savings institu-

tions, widespread banking habitat and developed money and

capital markets are seriously lacking. Consequently what-

ever little savings do exist have a tendency to go either

into hoards of gold or foreign exchange, or else into a

limited range of investments.1 Thus malinvestment of

savings becomes an important problem in these countries.2

Not only is it hard substantially to increase

savings in countries where the standard of living is very

low, but also a compulsory reduction of consumption by

It is estimated that in underdeveloped countries
private gold hoards are as large as 10 per cent of the
national income6 Moreover, investments tend to be
limited to land ownership and to real estate. See United
Nations, Measures .* . p 37

20ne must not emphasize too heavily, however, the
lack of savings as a result of the absence of savings
institutions. Viewed differently, lack of savings insti-
tutions could be treated as the result of the low-savings
low-investment capacity of the people.

means of taxation is unpopular and impractical.1 In

underdeveloped countries where people are organized to

protect their standard of living it is unlikely that they

will permit the government to increase the rate of taxa-

tion. And even where such an organization does not

exist, because of the extreme poverty of the masses an

increase in the tax revenue is very unlikely without

1United Nations, Measures p. 42.

The following table, which brings out the relation-
ship between tax receipts and national income in India,
only reiterates this point.


National Income Total Central and % of (1) to
Year Million Rupees State Tax Receipts (2)
Million Rupees
(1) (2) (3)

1951-52 99,700 7,387 7.4
1952-53 98,200 6,778 6 9
1953-54 104,800 6,723 6.4
1954-55 96,100 7,204 7.5
1955-56 99,800 7,675 7.7
1956-57 113,100 8,917 7.9
1957-58 1130900 10,476 9.2
1958-59 126,000 10,898 8.6
1959-60 128,400 12,199 9.5

Source: V. K. R. V. Rao, "Relation to the National
Income," Illustrated Weekly of India, LXXXII, No. 33
(August 13, 1961), 37.

making the tax rates highly progressive.1

If "voluntary savings" (private savings)2 fall

short of the level of savings required to step up the

investment for accelerating economic development, there

still remains the possibility of supplementing these

savings by "forced savings" that can be made by the

government.3 Forced savings can take various forms, such

as, government borrowing4 or direct money creation to

finance deliberately created budgetary deficits, foreign

exchange controls and so on. In the particular case of

underdeveloped economies savings by the government assume

a very important form since, as mentioned above, owing to

the deficient voluntary saving there frequently arises in

these countries the necessity of public investment com-

plementing private investment.

11n the context of underdeveloped countries it
has to be recognized that although the average per capital
income is very low, the wealthier classes do possess the
capacity to save. It is therefore possible for the govern-
ment to tap these resources by making the tax rates
steeply progressive.

2Taxation is treated here as a part of forced
(or involuntary) savings.

3External assistance is not considered here as a
possibility of augmenting the domestic savings.

4It may be noted that not all government borrow-
ing is forced savings, since government may attract

India: An Underdeveloped Country?

A cursory glance at the Indian economy reveals

that most of the characteristics of underdeveloped countries

mentioned above are very applicable to India, A mention

has been made earlier regarding the diversity in the char-

acteristics of underdeveloped countries. This is particu-

larly true in the case of India. In thinking about India

as an underdeveloped country, it is advantageous to think

of her as two distinct sectors -- "Urban India" and

"Rural India."2

Urban India comprises about 70 million people, or

about 16 per cent of the entire Indian population. But

this sector holds India's sophisticated business community

with all its analysts, forecasters, investment counselors,

bankers and economists. Stock exchanges in Bombay and

voluntary savings as well. However, owing to the low
levels of income of the people, the scope of such borrow-
ing is rather limited. The reference here is particularly
made to the government borrowing from the central bank.

1Wladimir S. Woytinsky, India: the Awakening Giant
(New York: Harper and Brothers, 1957), PP. 34-55.

2This is also the view of Alvin H. Hansen, who
spent the academic year 1958-59 as the fist Yale-Ford
Professor in India. See his Economic Issues of the 1960's
(New York: McGraw-Hill Bool Company, 19E,), pp. 151-66.

Calcutta are highly developed. Big cities in India have

attracted a large number of industries -- the great tex-

tile industry, the jute industry and the movie industry.

There are technical schools and universities. And not to

mention the least, there is a wide range of cultural

activities. It is thus evident that urban India can

scarcely be called underdeveloped.

Rural India, on the other hand, is indeed on the

lower level of underdevelopment. Rural India, including

the smaller towns, has an aggregate income of about

Rs. 6,000 million to be divided among a population of

some 360 million. The economic conditions existing in

rural India are both deplorable and appalling.

To sum up, urban India can be better described

as semideveloped, while it is rural India that makes the

country as a whole unmistakably an underdeveloped country.

A glimpse of the Indian economy might be helpful at this

stage to determine the extent of development in both

urban and rural India taken together.

At its broadest extremities India, which occupies

an area of 1.3 million square miles, covers one-fifteenth

of the earth's circumference. She is approximately thirteen

times as large as the UK, eight times the size of Japan,

but a seventh the size of the USSR.

Of India's total land area of 811 million acres

only 470 million acres are cultivable. Nearly 70 per cent

of both the total population and the working force are

dependent on agriculture. The number of persons in India

(438 million) is the second largest among the national

populations of the world. The rate of increase in popula-

tion is also very high (2 per cent a year) as compared to

the rate of increase in the national production, which

poses many economic problems.

As India covers a diversified and a large area,

few generalizations hold true for every part of it. Not

only do the climate, the geography and the resources vary

from region to region, but the languages and customs of

the people vary as well. Regional differences are them-

selves a prominent characteristic of the Indian economy.

However, a few generalizations can be made that would be


Agriculture is the major occupation in India,

employing about 70 per cent of the labor force, and contrib-

uting towards one-half of the national income. About 40

per cent of India's exports are food and agricultural raw

materials. India also relies on agricultural raw materials

for some of her most important industries such as jute and

cotton spinning and weaving. The main items of agricultural

production in India are shown in Table 1.



In Thousands

Commodities Units 1950-51 1955-56 1959-60

Foodgrains (tons) 50,022 65,794 71,750
Total cereals (tons) 41,744 64,923 60,514
Total pulses (tons) 8,278 10,871 11,236

Non-food grains
Sugar (cane) (tons) 56,150 59,587 75,038
Oilseeds (tons) 5,076 5,643 6,352
Cotton (lint) (bales of 2,910 3,998 3,835
392 lbs.)

Jute (bales of 3,283 4,198 4,548
400 Ibs.)

Tea (lbs.) 607,318 635,000 .

Rubber (l1s.1 31,829 50,000 .

Source: Reserve Bank of India Bulletin,(October, 1960),
p. 1500.

Note: . means data not available.

The industrial revolution has just begun in India

although certain industries have long been established.

About one-sixth of the total national income is generated

by factories and small-scale industries. However, the

rural sector is fast developing as industrialization of

the country takes place under the Five Year Plans. The

growth of industrial production of selected commodities

since 1951 is shovm in Table 2.




Industry Unit 1951 1960

Cotton Textiles
(a) Yarn 00,000 K0s. 493 657
(b) Cloth 00,000 Meters 3,106 3,847

Jute Textiles 000 Metric Tons 71 82

Coal 000 Metric Tons 2,905 4,384

Sugar 000 Metric Tons 94 207

Cement 000 Metric Tons 271 653

Iron and Steel 000 Metric Tons 246 533

Sewing Machines Numbers 3,705 24,649

Automobiles Iumbers 1,856 4,305

Source: Reserve Banic of India Bulletin
Statement No. 33, P. 1142

It will be observed from the above table that the

textile industry is throuGhout by far the largest component

of the total. Other important industries are sugar, oil

-I I ___.._., --

(July, 196.,

seeds, jute, tea and rubber products.

The foreign trade of India is small relative to

the huge internal trade moving between various parts of

the country* The imports and exports in India during

1950-51 and 1959-60 are shown in Table 3.



Million Rupees

Year Imports Exports Trade Balance
(ce..f.) (f.o.b.)

1950-51 6,503 6,468 35

1959-60 9,237 6,233 -3,004

Source: Reserve Bank of India, Report on Currency and
Finance, 1950-51 and 1959-60.

Until recently the imports and exports of India

each formed about 5 per cent of the national income. The

trade pattern has undergone a change in recent years,

however, with industrial raw materials and capital goods

figuring more prominently in imports and manufactures in

exports. In recent years marginal imports of foodgrains

have helped to maintain food consumption, especially in

urban areas; and imports of capital goods have become

essential to the country's development program. At the

present time not only has the foreign trade increased

quantitatively in relation to the size of the economy, but

it has become a significant factor in determining the

pace of development. To conclude, although "urban India"

is far more developed than "rural India," India as a whole

can be identified with an underdeveloped country.

The Stage of Economic Development in India

In the preceding paragraphs an attempt was made

to show that India still remains an underdeveloped country.

Her stage of development may now be determined. Rostow

lists five stages of development; namely, the stage of

the traditional society, the stage establishing the pre-

conditions for take-off, the take-off stage, the stage of

the drive to maturity and the stage of high mass consump-

tion.I Any given society in a given time falls into one

of these five economic stages. According to Rostow, India

launched "take-off" during the 1950's.2 It is therefore

desirable to look into Rostow's take-off stage more closely.

1W. W. Rostow, The Stages of Economic Growths
a Non-Communist Manifesto (London: Cambridge University
Press, 1960), p. 4.

The stage of take-off is "the interval during
which the rate of investment increases in
such a way that real output per capital
rises and this initial increase carries
with it radical changes in production
techniques and the disposition of income
flows which perpetuate the new scale of
investment and perpetuate thereby the rising
trend in per capital output."1

This stage implies five things. The "take-off,"

first, must be preceded by a sufficient accumulation of

inner force of the system; second, the change must be

conspicuous to show the characteristics of an economic

revolution; third, it must culminate in self-sustained

growth; fourth, take-off refers to a stage, which can

extend over a number of years; and fifth, when a country

is on the verge of passing from the take-off stage to the

stage of "drive to maturity," it is in the process of

what Rostow calls "break-through."

Rostow lays down the basic conditions which must

be fulfilled if a country is to be classified in the take-

off stage. A recent study, made by Sahota, reformulates

Rostow's conditions in the following manner in order to

evaluate the Indian economy vis-a-vis the stage of take-off:2

lRostow, "The Take-Off into Self-Sustained Growth,"
Economic Jnurnal, LXVI (March, 1956), 25.

2G. S. Sahota, "Is Indian Economy in the 'Take-Off'
Stage?" Indian Economic Journal (July, 1960), pp. 44-45.

1. Whether investment rates have risen at least

to the proportion where the output consequent upon this

investment is increasing at a rate higher than the rate of

growth of population.

2. Whether these investment rates are high enough

to create employment opportunities at a rate higher than

the rate of growth of the labor force.

3. Whether these increasing investment rates are

being sustained. The rule-of-thumb test for this is how

far is investment being financed by domestic savings

derived from current income.

4. Whether one or more new manufacturing sectors)

is (are) rapidly growing.

5. Whether built-in factors of economic develop-

ment are being constructed on the side of guaranteed

demand for the economy's surplus, by the growing supply-

potential of investment goods. In other words, whether

one or more heavy industry manufacturing sectors are

rapidly developing.

6. Whether, and the extent to which, per capital

income is rising.

7. Whether an entrepreneurial class is quickly


8. Whether production techniques and income flows

are changing in such ways that the growing entrepreneurial

section is getting control over the nation's surpluses.

9. Whether expansion of institutions is taking

place conducive to high rates of investment.

Sahota examines in detail the above conditions in

the light of the developments that took place in India

during the ten-year period under study and comes to the

conclusion that India is "doing pretty well in so far as

the qualitative transformation for the 'take-offi"l is

concerned. However, the study continues, "the slow

progress, particularly in the field of domestic savings,

casts doubts on the consolidation of achievements of

investment rate already made and to be used as spring-

board for further progress towards the 'self-sustained'


In 1950 the Indian planners, independently of the

Rostowian thesis and Rostow's analysis of the historical

process of economic growth, planned to achieve a "self-

sustained growth" in a period of 25 years or so, that is,

around 1975. By the middle of the Second Five Year Plan

1Ibid., p 55.

2ibid., pp. 55-56.

(in 1958) the Indian Planning Commission expressed doubts

as to whether it was possible to continue the Plan in

order to maintain the rate of growth as originally planned.

After much deliberation the Second Five Year Plan was

revised in 1958, bringing it down to its "hard core." In

view of the slow rate of savings and investment in the

Indian economy Sahota also expresses similar doubts. He

concludes thus:

. the current rate of saving is less
than 8% of national income. In order that
it should rise to 15I in the next 15 years,
so as to complete the "take-off" in 25
years as was planned on the eve of the First
Five Year Plan, we must generate an incre-
mental saving rate of 47% or nearly half of
every increment in income. During the last
9 years of development planning we have
never been able to cross the 30% limit,
while currently we seem to be saving only
between 15-205 of the increments of income.
Evidently, we have yet to make a "critical
minimum effort" if the objective of complet-
ing the "ake-off in 25 years is to be

To conclude, then, India today is in the stage of

Rostowian take-off. As the statistics show, she is in

the very early part of the take-off stage, and doubts are

being expressed by official and unofficial bodies as to

whether she will be able to 'break through" in 1975, as

1bid., p. 56.

was originally planned by the Governriint of india.

It has been shown above that India belongs to the

underdeveloped world, her stage of development being

that of Rostow's take-off. In order to sharpen the issue,

a comparison of a few selected indicators in the Indian

economy with those of the USA and the UK is attempted


The extent of underdevelopment in India is clearly

revealed in Tables 4 and 5.



US Dollars

USA 2,343

UK 998

India 72

Source: Foreign Aid Program, US Senate Document No. 52,
Washington, July, 1957, Table 1, pp. 239-40.



Country Caloric Protein Infant Literacy Inhabitants
Intake Consump- Niortality (Per Cent per
per Person tion (No. of of Popu- Physician
per Day per Day Deaths lation (Number)
(Numbers) (Grams) per 1,000 10 Years
Live Births) and Over)

USA 3,090 92 27 98 770

UK 3,230 86 26 98 1,200

India 2,004 50 119 18 5,700

Foreign Aid

Program, Table 3, p. 242.

Problem of Economic Development in India

India, the massive subcontinent of Asia, is in the

midst of social, economic, political and religious changes.

This transformation is not Just a straight and simple leap

from a state of being undeveloped to that of developed. It

is rather a change from an unevenly developed to a more

evenly developed country.

India has the prerequisites for a rapid economic

expansion. She has the natural resources on which to build


" i . ..

an industrial society -- water power, coal, metals, fuel

etc. Her land, climate and other physical resources are

favorable to solve the food problem. She also has an

able arid experienced commercial class and an expanding

technical manpower reservoir to staff a complicated tech-

nological society. In short, India has the preconditions

for rapid economic development.

While on the one hand India has great potentials

for development, on the other, she faces immense problems.

Eighty-two per cent of the population is illiterate.1 The

population is increasing at a rate of approximately 2 per

ce nt per annum.2 Agriculture, in which three-fourths of

the population is employed, is overmanned and underproducing,

barely providing the per capital daily food. Above all,

capital accumulation is too slow to finance the capital

expansion that is imperative to reach a sustained indus-

trial take-off. Some of the major problems that confront

the developing India may be reviewed here briefly.

The problem of population in India in the context

of her economic development is immense. According to an

1According to the 1961 census, the percentage of
literacy increased to 23.6 per cent. See Reserve Bank
of India Bulletin (June, 1961), p. 901.


authoritative source a couLtry with a population growth

of 1 per cent a year needs to invest something like 4 to

5 per cent of its national income merely to maintain its

wealth-population ratio. An investment rate of around

8 to 10 per cent a year is required to enable a population

to grow 1 per cent a year and at the same time experience

an increase of something like 1 per cent a year in per

capital income, unless technological progress is very great

and not very capital-absorbing.

The number of persons in India, as mentioned

earlier, is the second largest among the national popula-

tions of the world. The rate of increase in population

is currently estimated to be around 20. per cent per annum.

This means that if the economic development of some

measure is to be achieved, investment will have to be

made at a rate much higher than the current rate of invest-

ment. This is one of the major problems facing the

country today.

India's large population also creates serious

employment problems for her. At present India is faced

with a seeming paradox. On the one hand there is acute

and chronic unemployment; on the other, there is a severe

Population Bulletin, XVI (March, 1960), 32.

shortage of trained men and women. Put briefly, India's

population problem is one of quantity, quality and

orGanization. Creating new employment is therefore one

of the key objectives of planning in India. Heavy

unemployment and underemployment in the cities and the

villages are among India's most serious human and social

problems. These problems need a threefold attack. First,

jobs need to be created for those who each year will

come of age to seek work. Second, India must develop

job opportunities for those who are now unemployed, both

in the cities and in rural areas. Finally, opportunities

for additional work must be created for those who are

underemployed, that is, those who have employment for

only part of the time they wish and need to work.

Another important aspect of unemployment in India

is the regional unemployment. In certain areas of India,

chiefly those with few natural resources, or with very

large populations, chronic underemployment exists, and

incomes are below the all-India average. Migration of

surplus labor is not a generally workable solution because

of language differences and other reasons. The solution,

therefore, seems to lie in the efforts to develop regional


India is attempting through her government-

sponsored Five Year Plans to industrialize the country.

The emphasis placed on heavy and capital goods industries

in the Five Year Plans, and especially in the Second Five

Year Plan, poses a special problem in regard to the

financing of small industries. The development of heavy

industries calls for large investments but the resources

of capital at the disposal of the government are low. In

these circumstances it becomes necessary to economize as

far as possible in the capital requirements of other

types of industries and severely restrict capital invest-

ments in durable consumer goods industries. It is common-

place that large investments in heavy industries cause an

increased demand for consumer goods by creating additional

incomes. But these heavy industries do not produce the

required consumer goods and, being capital intensive, are

also unable to provide employment for the growing popula-

tion. The problem therefore is twofold: first, to pro-

vide an outlet for the increasing purchasing power generated,

and second, to create more employment opportunities.

A possible solution to each of the problems mentioned

above is to develop some special types of industries, such

as handicrafts, handloometc., commonly known in India as

"small-scale industries." These small-scale industries

require very little working capital and, primarily with

the help of human labor, can produce consumer goods

which can readily absorb the additional purchasing

power generated by large-scale investment. However,

attempts to develop small industries in turn pose two

other important problems. First, a source of liberalized

credit facilities for small industries has to be found.

This may be done either by extending the scope of the

existing institutions or by establishing new institutions.

The second problem is to provide technical assistance

to small industries so that these industries can grow

rapidly in desired directions.1

According to the Reserve Bank of India, a major
impediment to the development of small-scale industries
in India has been the paucity of institutional credit to
this sector. Though the problem has to an extent been
met by the setting up of several State Financial Corpor-
ations, it has been recognized that a greater flow of
credit to these industries can be facilitated only if the
commercial banks with their large resources, wide branch
network and local knowledge are induced to Darticipate
substantially in the financing of small industries. The
reluctance of the commercial banks to enter this field
has been mainly due to the larger element of risk involved
in lending to small units. Consequently, the government
of India formulated a Guarantee Scheme for advances to
small-scale industries. This Scheme was sanctioned on an
experimental basis for a period of two years and came
into force in July, 1960. The objective of the Scheme
was to enlarge the supply of institutional credit to

Another factor which complicates the task of

development of the country is the problem of regional

disparities. In India there exist great disparities not

only in average income, standards of living and employ-

ment, but also in the levels of development as between

different regions in the country. It is therefore imper-

ative that in a comprehensive plan of economic develop-

ment the special needs of the less developed areas have

to be kept in view, so that the entire pattern of invest-

ment is adapted to the securing of a balanced regional

development in the country.

The problem of a balanced development in different

parts of the country can be approached in a variety of

ways. First, decentralized industrial production may be

set up. Second, in the location of new enterprises, whether

public or private, consideration may be given to the need

for developing a balanced economy for different parts of

the country. Some industries may be located in particular

areas in view of the availability of the necessary raw

small-scale industrial units by granting a degree of
protection to the lending institutions against possible
losses in respect of such advances.
For details, see Reserve Bank of India Bulletin
(June, 1960), p. 813.

materials or other natural resources. Third, steps may

be taken to promote greater mobility between different

parts of the country, including organization of schemes

of migration and settlement from more to less densely

populated areas*

A review of some of the major problems confronting

India in her effort to develop the country clearly brings

out one fact. These myriad problems are "two dimensional."

Some of these problems are sectoral, while others are

aggregative, Although the former are no less important

than the latter, this study confines itself to the

aggregative problems only.

More specifically, this study proposes to examine

the aggregative problems created by an effort to achieve

an accelerated development in India through government-

sponsored Five Year Plans and the role of monetary policy

in solving these problems.



An understanding of the nature and details of the

banking structure and the money and capital markets in

India is essential for developing the framework for evalu-

ating the role of monetary policy in the economic develop-

ment of that country. In this chapter an attempt will be

made to accomplish two basic objectives: (1) description

of the banking structure,(2) delineation of the money and

capital markets in India.

The Banking System in India

The banking system of India is one of the most

highly developed aspects of the economy. At the apex is

the Reserve Bank of India which was established in 1935

as the central bank for India. Originally the Bank was

fully owned by private shareholders. However, in 1948

the Bank was nationalized with the prime objective of

fulfilling the need for a closer integration between its

policies and those of the government. The Bank's opera-

tions are approved by the Central Board of Directors of

the Bank. The Chairman of the Board is the Governor of

the Reserve Bank, who is assisted by three Deputy Gover-

nors. The Governor and the Deputy Governors, it may be

noted with interest, are the nominees of the central

government, which makes the Bank to a considerable degree

subordinate to the government.

The primary function of the Reserve Bank is to

regulate the monetary system of the country so as to pro-

mote the maintenance of economic stability and also to

assist the government in its task of economic development

of the country. For this purpose the Bank is given the

sole right of note issue. Besides, for the performance

of its duties as the regulator of credit it possesses

both the general and selective powers of credit control.

In addition the Bank also acts as the banker to the com-

mercial banks and to some other financial institutions

including the state cooperative banks.

Since one of the primary objectives of the Reserve

Bank is to assist the rapid growth of the economy, the

Bank performs a variety of developmental and promotional

functions. Thus the Bank actively pursues a policy for

the development of an adequate and sound banking system

designed not only to satisfy the needs of trade and

commerce, but also of agriculture. The Bank is also

responsible for expanding the facilities for industrial


The balance sheet of the Reserve Bank is presented

in Table 6 with a view to throwing some light on its

expanding activities during the ten-year period under

study. Of special interest are the items entitled "Notes

in Circulation" on the liabilities side, and "Loans and

Advances" on the assets side. It may be observed that

over the nine-year Plan period (1950-51 to 1959-60), notes

in circulation increased by Rs. 5,677 million (48.8 per

cent). During the same period, loans and advances of

the Reserve Bank to the government increased by Rs. 232

million (977.2 per cent), while other loans and advances

of the Bank showed a much more conspicuous increase of

Rs. 822 million (1213.4 per cent).

A mention may now be made of the commercial bank-

ing system in India. With the inauguration of the Reserve

Bank in 1935 the commercial banks in India came to be

classified into two main groups, namely, scheduled banks

and non-scheduled banks. Scheduled banks are those banks



Million Rupees

Average Notes in Central Foreign Loans and Other Loans Bills Pur- Total
of Friday Ciroula- Govt. Assets Advances and chased and Liabilities
Figures tion Deposits to Govts. Advances Discounted or Assets

1950-51 11,632 1,486 8,324 24 68 31 14,994

1955-56 13,394 601 7,235 17 370 98 15,541

1959-60 17,309 555 1,966 255 889 155 22,008

Sources Reserve Bank, Report on Currency and Finance, 1959-60, Statement Io. 33.

which are included in the second schedule to the Reserve

Bank of India Act and may be broadly compared to the

member banks in the USA. They are eligible for certain

facilities, especially the facility of obtaining accommo-

dation from the Reserve Bank; consequently they bear cer-

tain obligations toward the Bank. The Reserve Bank Act

lays down the conditions which a bank must fulfill to

qualify for the inclusion in the second schedule. These

are as follows:

1. The bank must have paid-up capital and surplus

of an aggregate value of at least Rs. 500,000.

2. It must satisfy the Bank that its affairs are

not being conducted in a manner detrimental to the

interest of its depositors.

3. It must be a company as defined in the Companies

Act of 1956.

Scheduled banks are required to keep with the Reserve Bank

a minimum of 5 per cent of their demand liabilities and

1Demand liabilities are not the same as demand
deposits, for the former include besides demand deposits
all other liabilities which are payable on demand, like
outstanding telegraphic and mail transfers, demand drafts,
that portion of the savings deposits payable on demand,
overdue fixed deposits, bills payable and borrowings from
banks (other than from the Reserve Bank and the State
Bank) repayable on demand.

2 per cent of their time liabilities1 as shown by their

weekly returns to the Bank.2 Scheduled bans enjoy

certain facilities of the Reserve Bank, for example, the

rediscounting of eligible paper, advances against approved

securities, and remittances of funds at concessional rates.

At the end of March, 1960, there were 95 scheduled

banks with 3,996 branches out of a total number of 444

banking companies in India with 4,862 branches. Generally

speaking, scheduled banks account for by far the greater

proportion of deposits and the total bank credit in India.

In March, 1960, for instance, the share of these banks in

the total deposits of all commercial banks was a little

over 85 per cent; also in the total credit outstanding,

their share was about the same. The comparative position

of scheduled banks in relation to all commercial banks in

India is presented in Table 7.

Scheduled banks constitute a continuous spectrum in

'Time liabilities include fixed deposits, time
borrowings from banks (other than the Reserve Bank and
the State Bank)and other outside liabilities not payable
on demand. For details, see Reserve Bank of India,
Supplement to the Reserve Bank of India Bulletin (Bombay:
Reserve Bank of India, February, 1961).

21n 1956, the Reserve Bank was empowered to
increase the required reserves from 2 per cent to 5 per
cent on demand liabilities and from 5 per cent to 8 per
cent on time liabilities.



Million Rupees

Aggregate Bank Investments
Deposits Credit in Govt.
Liabilities Securities




(2) (3)
to to
(1)% (1)


of Sched-
uled Bank
Deposits t4


of Sched-
uled Bank
o Credit to
All Bank


of Sched-
uled Bank
to T:tal
in Govt.

Scheduled 16,911 9,305 6,729 5540 39.8
banks 86,8 83.6 92.8

All com- 19,487 11,129 7,253 57*1 37.2

Source: Reserve Bank of India Bulletin,(April, 1961),pp4 576-77; 584-85.

terms of size. Among them the State Bank (formerly the

Imperial Bank of India) stands in a class by itself. It

is the biggest commercial bank, accounting for over 30

per cent of the net deposits of all scheduled banks. It

has close association with the Reserve Bank and it acts

as the agent of the Bank.

Nationalization of the Imperial Bank of India

deserves special mention here. The Rural Banking Enquiry

Committee, appointed in 1949, pointing out that the

Imperial Bank continued to enjoy most of the benefits it

had prior to inauguration of the Reserve Bank but that

most of the government's powers over it had lapsed in

1934, recommended that the government should resume

effective control over the Bank. The Committee asserted

that entrusting the government cash work and currency

chests, with all the prestige and other benefits they

carry, to a single commercial bank created a powerful

private monopoly which could disregard the interests of

the public or jeopardize the working of the other banks;

consequently this monopoly should be strictly regulated

by the state. The role that the Committee envisaged for

lReport on the Rural Banking Enquiry (Purushottam-
das) Committee (Bombay: Reserve Bank of India, 1954),
pp. 94-95*

the Imperial Bank was that of an auxiliary to the Reserve


The All-India Rural Credit Survey in 1955 went

much further and recommended that as part of an integrated

scheme for the provision of rural credit facilities the

Imperial Bank and seven other "state-associated" banks,

that is, banks associated with the governments of the

former princely states, should be amalgamated into a

single "State Bank of India," so as to create a single,

strong commercial banking institution with branches all

over the country. Significantly, it added that the process

of integration need not end with the amalgamation of these

specified banks, but might extend, if considered necessary

and appropriate, to "similar compulsory amalgamation with

the State Bank of India of suitable, relatively small

commercial banks whose branches are so situated as to be

complementary in the point of area of operation to that

of the State Bank." The Imperial Bank was nationalized

in 1955 and with that the government assumed direct

responsibility for the urgently needed extension of bank-

ing facilities. The nationalized Imperial Bank (which

1Report of the Committee of Direction of the All-
India Rural Credit Survey (Bombay: Reserve Bank of
India, 1955), PP. 94-95.

established a closer relationship between the Bank and

a large number of branches of the State Bank spread all

over the country) also provided the Reserve Bank with

the means of determining more effectively credit condi-

tions in the market. Since 1955 when the Imperial Bank

was nationalized until the end of March, 1960, the State

Bank opened 374 branches throughout the country.

Another category of scheduled banks comprises

16 foreign banks, which specialize in the finance of the

foreign trade and are commonly called "exchange banks."

In 1949 when the Banking Companies Act was enacted,

foreign exchange business was almost a monopoly of these

banks. However, over the years exchange banks have

extended their activities to internal trade and industry

also, and to this extent they form an integral part of

the domestic banking system. In March, 1960, for instance,

exchange banks had Rs. 418.5 million invested in the

securities of the Government of India and their advances

were Rs. 155.1 million. As against this, they tied up

only Rs. 21.1 million in 'foreign bills purchased and


Non-scheduled banks, as the term implies, include

all banks which are incorporated companies but are not

included in the Second Schedule to the Reserve Bank Act;

also they have less than Rs. 500,000 of paid-up capital

and surplus.1 They are divided into four groups (called

A2, B, C and D class banks), depending upon their paid-up

capital and surplus. Although these banks are not

official members of the Reserve Bank, in practice many

non-scheduled banks receive a number of scheduled bank

privileges. Moreover, inasmuch as most of the provisions

of the Banking Companies Act of 1949 apply to all banks,

the distinction between scheduled and non-scheduled banks

vis-a-vis the Reserve Bank is more technical than real,

and is expected gradually to lose much of its importance.

While the non-scheduled banks are the most numerous

6roup in the Indian banking system they are typically

small and frequently are unit banks. Their share in the

total deposits and advances of all commercial banks is

less than 15 per cent. At the end of March, 1960, there

were 349 non-scheduled banks with 866 offices. On that

date their deposits were Rs. 501 million, while their

total advances aggregated Rs. 341 million.2

1There are some non-scheduled banks with paid-up
capital and surplus above Rs. 5000,000.

2These data relate only to reporting banks which
are less than the total number of non-scheduled banks.

Commercial banks in India grant loans in the form

of overdrafts and cash credits. Such loans are based on

demand promissory notes, which permit the banks to control

or withdraw the credit at any time. It is not uncommon

for foreign firms with good credit standing to finance

trading operations with funds borrowed in this manner.

Commercial banks traditionally charge a much higher rate

of interest on their advances than they pay on their

deposits, as is evident in Table 8.



Per Cent

Deposits Advances Spread Be-
tween Rates
Half Year Annual Rate Annual Rate on Advances
Ended of Interest of Interest and Deposits
(2 -1 )
(1) (2) (3)

June, 1959 2.183 5.579 3.396

Dec., 1959 2.191 5.7)5 3.514

June, 1960 2.072 i.,21 3.709

Sources Reserve Bank of India Bulletin (October, 1960),
p. 1469.

Indian banks with the exception of some of the

smaller ones generally follow a conservative lending

policy. A second signature is usually required even on

secured loans. Much of the conservativeness of Indian

banks results from their inability to ascertain credit

worthiness of lenders with the same degree of certainty

that is possible in more highly developed countries.

Thus while the large, well-known firms have little diffi-

culty in obtaining credit, the smaller, newer or less

well-known companies experience considerable difficulty

in this regard. The latter must frequently rely on the

smaller banks, where the conditions of credit are easier

but the rates of interest are higher.

A novel feature of Indian banking is the distri-

bution of deposits of scheduled banks as shown in Table 9.

It will be observed from Table 9 that at the end of 1959

demand deposits were about a third of the total deposits,

whereas the time deposits were well over half of these

deposits. The position was almost the reverse at the end

of 1955. It is also evident from the table that savings

deposits consistently formed about 15 per cent of total


A look into the investment portfolio of scheduled

banks as revealed in Table 10 may also be desirable at

this point.


DURING THE PERIOD 1955 to 1959

End Demand Time Savings Total

of Amount Percentage Amount Percentage Amount Percentage Amount
to Total to Total to Total
Deposits Deposits Deposits
Million Million Million Million
Rupees Rupees Rupees % Rupees

1955 4,970 50.0 3,341 33.6 1,625 16.4 9,937
1956 5,221 48.6 3,690 34.3 1,837 17.1 10,748
1957 5,663 42.0 5,794 43.0 2,020 15.0 13,476
1958 5.509 35.7 7,684 49.9 2,120 14.4 15,413
1959 5,663 30.9 10,161 55.5 2,482 13.6 18,306

Source: Reserve Bank of India Bulletin (July, 1960, p. 949.


Million Rupees

Government Securities Maturing in

End of 1 Year 1-5 Years 5-10 Years 10-15 Years 15-20 Years Over 20 Years Total

1956 :I1 1,357 1,532 164 196 48 3,778
1957 126 2,237 1,406 511 128 65 4,473
1958 578 2,688 2,573 560 130 107 6,636
1959 976 2,480 3,151 876 178 170 7,832
1960 734 2,344 3,105 864 152 18o 7,379

Percentages to Total (%)

1956 1.3 35.9 40.5 17.6 3.3 1.3 100.0
1957 2.8 50.0 31.4 11.4 2.8 1.5 100.0
1958 8.7 40.5 38.8 8.4 2.0 1.6 100.0
1959 12.5 31.7 40.2 11.2 2.3 2.2 100.0
1960 9.9 31.8 42.1 11.7 2.1 2.4 100.0

Reserve Bank of India Bulletin (Seatember, 196), p. 1326.


It will be seen from Table 10 that the maturity pattern

of investments of scheduled banks in government securities

showed some marked changes over the period December, 1956,

to March, 1960. The proportion of short-term government

securities (that is, maturing within 5 years), which rose

from 37 per cent at the end of 1956 to 53 per cent at the

end of 1957, declined thereafter reaching the level of 42

per cent of the total investment at the end of March,

1960. On the other hand, the proportion of investments

in medium-term securities (that is, maturing between 5

and 10 years), after declining from 40.5 per cent in

1956 to 31.4 per cent in 1957, rose to 42.1 per cent at

the end of March, 1960. It is also notable that invest-

ments in securities maturing between 10 and 15 years

accounted for about 12 per cent in March, 1960, as against

18 per cent in 1956, while those in the maturity range of

over 15 years showed negligible percentage change (from

4.6 to 4.5 per cent) over the period December, 1956, and

March, 1960.

A unique feature of Indian banking is that branch

banking and unit banking have developed side by side.

Although many banks in India are unit banks, they are

typically small and together control only a small part

of India's total banking resources. Most of India's

banking business (attracting deposits and granting loans)

is concentrated in a relatively small number of banking

companies with numerous branches. At the end of March,

1960, there were 444 banking companies with 4,862 offices.

Of the total offices, 95 scheduled banks had 3,996

offices, while non-scheduled banks numbering 349 accounted

for only 866 offices. It is also interesting to note that

the State Bank alone had 823 offices on that date.

Another important characteristic of the banking

system is that in India the availability of credit fluc-

tuates in accordance with the seasonal requirements of

currency and credit. The year is usually divided into two

seasons of fairly equal length. The "busy season,"

roughly covering the period of November to April, coincides

with the period of greatest stringency when crops are

harvested and moved. The months of May to October, known

as the "slack season," on the other hand, experience easy

credit conditions.

A third point of interest to us is the fact that

the Indian banking system is relatively inflexible in its

loan policies. Consequently during periods of rapidly

rising prices credit expansion usually lags behind the

rising demand for larger volume of loans. During such

times and in the absence of capital the tendency is for

industrialists to rely on short-term credit to finance

industrial expansion, and for speculators to expand their

operations by the use of bank credit. Both practices put

heavy drains upon the supply of credit by commercial

banks on top of the increased demand for loans which

normally accompanies rising prices, Under such conditions

a tightness in the credit market is reflected not only in

a rise in the interest rates but to an even greater

degree in the increased difficulty of obtaining credit.

For a better understanding of the banking system

it is imperative that a discussion be undertaken regarding

the role of the banking system in the expansion and con-

traction of the money supply. The creation of deposit

money by the banks is basically dependent on their cash

reserves, which consist of:

1. Cash in vault.

2. Balances (required reserves and excess reserves)

with the Reserve Bank.

The ratio of these two items to deposit liabilities

of scheduled banks is usually called, in India, the

"reserve ratio." At the end of March, I960, the reserve

ratio of all scheduled banks was 8.0. This ratio may

vary from bank to bank and also from time to time. If

an average reserve ratio of, say, 10 per cent is

assumed, the banking system will have the potentials

for a multiple credit expansion to the extent of many

times the extension of credit by the Reserve Bank to the

commercial banks, The above statement regarding the

multiple credit expansion by the banking system needs to

be duly qualified. The most important factor which

restricts the credit expansion is what Whittlesey calls

the "external drain."1 When the Reserve Bank extends

credit of, say, Rs. 10,000 to the banking system, part

of it may be drained off th1i. banking system entirely.

On the basis of the additional reserves obtained from

the Reserve Bank the commercial banks can expand their

credit by creating demand deposits, for example. Some

of the borrowers from these banks are likely to withdraw

part of their deposits in currency. Every rupee currency

that is taken away from the banking system lowers the

reserves of the banks, and thus checks further deposit

expansion. In short, when the Reserve Bank extends credit

'Charles R. ihittlesey, Principles and Practices
of Money and Banking (New York: Macmillan Company, 19W8),
p. 121.

it increases the reserves of the banking system; when cur-

rency is withdrawn from the banking system by the public it

lowers the reserves of the banking system and partly destroys

the power of the banks to create credit.

The important question therefore becomes: "What por-

tion of the new credit extended by the Reserve Bank is likely

to be withdrawn from the banking system?" This question in

turn is closely related to the liquidity preference of the

Indian people. No official studies have been made in India

to determine the liquidity preference of the people under

normal conditions, nor have there been any statistical studies

to estimate the expansion possibilities of the banking system

as a consequence of a specific addition to the reserves of

the banks. However, a comparison of the total deposit money

with the public (that is, demand liabilities and other depos-

its with the Reserve Bank) with the total money supply (that

is, currency plus deposit money with the public) may give a

rough approximation of the demand for currency relative to

the deposit habits of the people. This comparison is shown in

Table 11, This Table does suggest that in the composition of

the total money supply the share of the deposit currency is
small relative to Western standards and has been on the de-

cline. This high liquidity preference of the people in favor

of currency has set up a monetary pattern making a difficult



Year Deposit Money Money Supply Ratio of (1)
with the Publica with the Public to (2)

Million Rupees Million Rupees Per Cent (%)
(1) (2) (3)

1950-51 6,403 19,795 32.3

1955-56 6,792 21,843 31.1

1959-60 8,390 27,010 30.1

Source: Reserve Bank, Report on Currency and Finance,
1959-60, Statement No. 20.
aDeposit money with the public comprises demand
liabilities and other deposits with the Reserve Bank.

task for the Reserve Dank to exercise an effective and

prompt credit control by directly regulating the banking


To conclude, in India the currency in circulation

forms about two-thirds of the total money supply, while the

deposit money accounts for only one-third of the money

supply. This makes it easier for the Reserve Bank to

control the money supply by directly influencing the cur-

rency. On the other hand, however, it makes the task of

the monetary authority to regulate credit creation by

the banking system more difficult. To quote the Governor

of the Reserve Bank:

S. the framework in India is not comparable,
either in coverage or in the degree of integra-
tion, to that in the West. Currency is more
dominant than bank credit; in 1951-52, when the
First Five Year Plan was inaugurated, currency
formed 67 per cent of the total money supply,
and today after six years it still forms the
same percentage. This sets limitations on the
extent to which monetary policy of the central
banking authority can make itself felt.

In view of the importance of currency in circula-

tion in the total money supply a mention may be made here

of the system of note issue in India. According to the

Reserve Bank of India Act, the assets against which bank

notes may be issued should consist of gold coin and

bullion, foreign securities, rupee coin, government of

India rupee securities, and such bills of exchange and

promissory notes payable in India as are eligible for

purchase by the Bank. The Act originally prescribed a

"proportional reserve" of gold and foreign securities

against note issue whereby, of the total assets, not less

H. V, R. lengar, "Current Problems of Credit and
Fiscal Policy" (Washington, D.C.: Privately Printed,
1957), P. 9. (Speech delivered at the Twelfth Annual
Meeting of the Board of Governors of the IBRD and the IMF
at Washington, D.C., September 27, 1957.)

than 40 per cent was to consist of gold coin and bullion

and foreign securities, with the further provision that

gold coin and gold bullion should always be equal to, or

more than, Rs. 400 million in value.

In 1956 in anticipation of a large expansion of

currency under the impetus of the development plans, the

Reserve Bank of India (Amendment) Act was passed which

established the "fixed minimum" for note issue. The 1956

Act provided for a reserve consisting of Rs. 4,000 million

in foreign securities and Rs. 1,150 million in gold coin

and bullion, or a total of Rs. 5,150 million. The pro-

visions regarding the maintenance of assets were further

amended in October, 1957, to prescribe that the aggregate

value of gold coin, gold bullion, and foreign securities

held by the Reserve Bank should not be less than Rs.

2,000 million; of this, the value of gold should not be

less than Ra. 1,150 million. In short, these amendments

to the Reserve Bank Act paved the way for a less restricted

expansion in currency.

Money and Capital Markets in India

The money market

In the broad sense money market includes, inter

alia, financial institutions li:e investment banks, insur-

ance companies and other long-term financing agencies.

However, the more ordinary usage of the term "money market"

is generally restricted to borrowing and lending of short-

term funds. In India money market is defined as the "centre

for dealings, mainly of short-term character, in monetary

assets; it meets the short-term requirements of borrowers

and provides liquidity or cash to the lenders."l

The outstanding characteristic of the Indian money

market is its dichotomy into what may broadly be termed a

developed market and an undeveloped or bazaar market, with

a divergence in the structure of interest rates in the two

markets. The developed market comprises the Reserve Bank,

the State Bank, the exchange banks, and other Indian bank-

ing companies; while the unorganized market is primarily

made up of indigenous bankers and, next in importance,

moneylenders. The cooperative institutions occupy a some-

what intermediate position between the developed and the

undeveloped sectors of the money market.

In the undeveloped sector there is no clear demar-

cation between short-term and long-term finance, nor even

1Reserve Bank of India, Functions and Working
(rronbay: Reserve Bank of India, 1959), pp. 21-22.

between the purDoscs of finance, inasmuch as there is

usually nothing on a hundi (that is, the indi inous bill

of exchange) to indicate whether it is for financing

trade or for providing financial accomnodation; in other

words, whether it is a genuinee trade bill or financial

paper. However, eve: in the .ndevelocpd sector of the

market some established practices are followed; as such

it would be erroneous to call this sector totally undevel-

oped. A detailed analysis of each of the components of

this sector of the market is undertaken below.

The chief source of the su)ply of credit in the

undeveloped sector of the Iarket is what is known as

"indigenous bankers." These bankers are known by different

nanes in different parts of India. They may be individual,

proprietary, or partnership banks which usually render

normal banking services, including the purchasing or dis-

countiin of local bills of exchange. They provide finance

for traders and small manufacturers on the basis of

simpler and less formal requirements than are typical of

the joint-stock bankAs. Indigenous banks are, however,

frequently linked to the Joint-stock banks through their

1lbid., p. 23.

dependence on thera for loans and the discounting. of bills.

It is interesting to note that d3e.)itc a rapid

development of organized bankiin and cooperative credit

during the last twenty-five years in India indigenous

bankers still retain a significant place in the Indian

money market. The .iain characteristics Uhich distinguish

t'e..1 'rom organized banks are informality in dealings,

direct personal contact with customers, a simple primitive

(s.incle-entry) system of accounts, and the combination of

bankling or money lending with other business. It is on

account of these characteristics that indiconous bankers

(and moneylenders) have not yet been integrated with the

organized money market.

Indigenous bankers provide finance to the smaller

industrialists and traders in urban areas who are not

regarded as credit worthy by banks. They discount their

indigenous bills (hundis) and advance loans against stocks

or bullion or on personal security. These banks do not

provide direct finance to agriculturists except in the

case of larger landholders. They primarily finance the

movement of crops by lending money to local aierchants and

moneylenders, who in turn finance the agriculturists.

The larger indigenous bankers who are on the

approved list of scheduled banks, including the State Bank

of India, borrow from them either against promissory notes

bearing the signature of two indigenous bankers or by

rediscounting usancee" bills (multani hundis) endorsed by

them. Thus, although indigenous bankers do not form an

integrated group in the money market, they are indirectly

connected with the banking system and form an integral part

of the market in the broad sense of the term.

Various attempts have been made from time to time

by the Reserve Bank to coordinate indigenous bankers with

the organized sector of the market; but so far the Bank has

not been fully successful in its attempts, primarily

because indigenous bankers have refused to conform to the

basic rules and regulations of conducting their business

that the Reserve Bank has laid down.

Moneylenders also provide an important source of

finance in the money market. India is primarily an agri-

cultural country and there always exists an acute demand

for funds for the marketing of crops. The indigenous bankers

provide only seasonal finance for the marketing of crops,

and that only indirectly through moneylenders and mer-

chants, except in the case of very large land holders.

The moneylenders, on the other hand, have direct contact

with all classes of agriculturists. Besides providing

finance for the marketing of crops they also extend short-

term credit for seasonal requirements and long-term credit

for permanent land improvement. Interestingly, these

moneylenders make loanE Oven for consumption purposes.

Mention may now be made of the development of

cooperative societies in India which, as pointed out before,

occupy an intermediate position between the developed and

the undeveloped sectors of the market. The history of

cooperative societies in India goes back to the year 1904

when, primarily to encourage the cooperative movement, the

government of India enacted the Cooperative Credit Societies

Act. Since then growth of these societies has been very

slow, almost disappointing. In recent years, however,

under the direction and initiative of the Reserve Bank

rural credit has gained considerable importance and steps

are continually being taken to develop cooperative banks.

In fact, in recent years borrowing of cooperative banks

from the Reserve Bank has exceeded that of scheduled

banks, as revealed in Table 12.

The structural setup of the cooperative credit

movement is federal. At the bottom there are the small

primary societies established mostly in villages. Primary



Million Rupees

Outstanding Scheduled State Coopera-
at the End of Banks tive Banks

1951-52 546 78

1955-56 638 130

1959-60 664 745

Source: Reserve Bank of India Bulletin.(July, 1961),
Statement No. 20, p. 1131.

societies within a certain district Join together and

form a cooperative central bank. In turn all the

cooperative central banks in a state combine to form the

state cooperative bank. It is really the state coopera-

tive banks which connect the cooperative movement to the

money market. They borrow funds from the Reserve Bank,

commercial banks, the government, and the public; these

banks advance loans to the cooperative central banks which

in turn lend to primary societies. These primary societies

ultimately advance money to individual borrowers.

The Reserve Bank is authorized to grant financial

assistance to state cooperative banks, who are obliged to

meet certain requirements in the form of deposit of a

percentage of their demand and time liabilities with the

Reserve Bank. The Bank provides accommodation to these

banks in the form of rediscounts and advances against

eligible bills, as also advances against government and

trustee securities. In addition the Reserve Bank is author-

ized to grant medium-term loans to state cooperative banks

from the National Agricultural Credit (Long-Term Operations)

and the National Agricultural Credit (Stabilisation) Funds.

Finally, the Reserve Bank makes agricultural finance avail-

able to the rural sector through state cooperative banks on

a more liberal scale as well as cheaper rates. On March 31,

1960, aggregate liabilities of state cooperative banks

amounted to Rs. 484 million and their borrowings from the

Reserve Bank totaled Rs. 752 million.1

The developed sector of the Indian money

It may be of interest to note that in June, 1960,
the Committee on Cooperative Credit was appointed by the
government of India to examine the existing standards for
credit limits of cooperative institutions at different
levels and to make recommendations on the revision of
these with a view to providing more effective credit for
agricultural production plans.

Among the external resources to cooperatives, the
rate of the Reserve Bank was considered to be vital to the

market, which comprises the Reserve Danl:, exchange banls,

and other scheduled and non-scheduled banks is well knit

with a high decree of integration.1 In India the component

parts of the money market may be broadly stated as fol-

lows: (1) Call Money Ilarket, (2) Bill Market, (3) Market

for Short-Term Government Securities, ard (4) Market for

Collateral Loans. Each of these is dealt with separately

in the following paragraphs.

All important commercial banks in India (except

the State Bank) borrow money from one another in the call

money market2 to meet temporary requirements. These loans

are payable on call at the option of the lender, and the

cooperative movement as, in the opinion of the Committee,
it would be unrealistic to expect the cooperatives in the
near future to raise the necessary resources, wholly or in
bulk, from owned funds and deposits. With a view, there-
fore, to augmenting the supply of credit from the Bank,
the Committee suggested liberalization of the existing
standards adopted by the Bank for sanctioning short-term
as well as medium-term credit limits to cooperative banks.
See Reserve Bank of India Bulletin (July, 1960), p. 946.

1In certain respects, the main Indian money markets
are more highly developed than those in existence in all
but the most mature financial centers. See Richard S.
Sayers, Banking in the British Commonwealth (Oxford:
Clarendon Press, 1952), p. 203.

2In the New York Money Market, "call loans" refer
to loans by commercial banks to stock market brokers.
Regular traders in stocks usually supply the broker only
with a margin to cover possible losses arising from a fall

rate for call money1 varies between 1 and 4 per cent,2

depending upon the season of the year. In Table 13

average money rates in selected years are recorded.

Turning to the bill market, it may be observed

that prior to 1952 there was no bill market in India. The

factors responsible for impeding the growth of such a

market were, according to the Reserve Bank,

.* the lack of uniformity in drawing
bills as between different parts of the
country, the practice of extending credit
not subject to any specified time limit
but collected by travelling salesmen, the
large use of cash credit as the main form
of borrowing from banks which in India
have a wide network of branch organization,
the preference for cash transactions in
certain lines of activity, the absence of
adequate warehousing facilities for stor-
ing agricultural produce and the high
stamp duty on usance bills.

The fact that an attempt to develop a bill market

in the value of securities, and the broker supplies the
rest of the money by borrowing from banks against these
securities. The Indian call money market is somewhat
similar to the Federal Funds market in New York, where
banks with excess reserves lend them for one day to other
banks with insufficient funds.

1Call money rate is the rate at which banks
advance their day-to-day surplus funds to other banks,
bullion merchants, or stockbrokers.

2or details, see the respective issues of the
Report on Currency and Finance.

3Reserve Bank, Functions and Working, p. 23.


Per Cent Per Annum

Call Money Ratea Deposit Rates (3 Mos.) Deposit Rates (12 Moss)

Highest Lowest Highest Lowest Highest Lowest

1950-51 1-1/4 1/2 2-1/4 1 2 1-1/

1955-56 3-3/8 1-1/4 3-1/2 2-1/2 3-1/4 2-1/4

1958-59 4-7/16 1 4-11/16 2-1/4 4-1/2 2

Source: Reserve Bank, Report on Currency and Finance, 1959-60, Statement No. 33.

Notet Rates for the year 1959-60 are not available,
aRate at which banks advance their day-to-day surplus funds to other banks.

was made early in 1952 owes its explanation to the new

monetary policy that was initiated by the Reserve Bank in

November, 1951. In fact, the "Bill Market Scheme" intro-

duced by the Bank in January, 1952, seemed more an integral

part of the new monetary policy. The grant of accommoda-

tion in the busy season, since the Bank's decision in

November, 1951, to refrain from the purchase of securities,

had naturally become very restricted in relation to the

increasing demand for funds arising out of the accelerated

tempo of development and the advancing of the 1951-52 busy

season. Total scheduled bank credit, which had touched Rs.

5,776 million in the first half of January, 1952, and which

was expected to rise progressively, constituted 67 per cent

of total demand and time liabilities -- a level regarded

as considerably in excess of what was demanded by canons of

prudent banking. This stringency could no longer be relieved

through the unlimited purchase of government securities as

was done by the Bank prior to November, 1951. At the same

time the Bank had felt the responsibility to insure that

legitimate demands of bona fide trade and commerce were not

hampered. This dilemma was sought to be resolved, or at

least obviated, by the introduction of the Bill Market

Scheme. The Scheme was designed to (1) introduce credit

elasticity, cepcciall:r during the busy season, (2) improve

the Reserve Bank's control machinery by making the Bank

rate more effective, and thereby enabling it to exercise a

qualitative type of control over the ex-ansion of bani

credit and vesting in it the power to meet the seasonal

needs of the market independent of the gilt-edged market,

and (3) create a bill market in India comparable to the bill

markets in the UK and the USA, thus laying the basis for

future developments in the market mechanism.

It may be noted here that the rediscounting of

bills by the Reserve Barn was an insignificant aspect of

its lending operations. And even in regard to advances,

scheduled banks took advantage of borrowing only against

government securities [Section 17(4)(a)l which made

Section 17(4)(c) (that is, advances against usuance bills)

a defunct clause. Ironically, in an attempt to develop a

bill market to facilitate rediscounting of bills by the

central banking authority the Reserve Bank favored Section

17(4)(c), which did not refer to rediscounting of bills

by the Bank but to accepting them as security against

advances made by it to scheduled banks. The Scheme thus

primarily sought to enlarge the list of securities accept-

able under this Section rather than lay the basis for

rediscounting of bills.

The salient features of the Bill Market Scheme

were not novel. The Scheme followed the system that pre-

vailed prior to the establishment of the Reserve Bank

(1935), under which the Imperial Bank of India could

borrow, during the busy season, funds from the Currency

Department against internal bills or hundis drawn for

financing bona fide trade or by conversion of advances

granted for the same purpose into usance bills. Under the

present Scheme the Reserve Bank decided to advance credit

in the form of demand loans to "eligible" scheduled banks

against the security of usance promissory notes of their

constituents in a way that would satisfy the requirements

of Section 17(4)(c) of the Reserve Banir of India Act.

Since the Section required the Bank to accept only bills

which embodied a definite currency, banks were required to

convert their demand bills into time bills/notes before

they could be accepted for this Scheme.

When the Scheme was first introduced it was

restricted to banks with deposits of Rs. 100 million or

above. While introducing the Scheme the Bank offered

several inducements to popularize it. For instance, the

Reserve Bank undertook to make advances under this Scheme

at 0.5 per cent below the Bank rate (i.e., at 3 per cent).

The Bank also a-reed to bear one-half the cost of stan-

duty incurred by banks in converting demand promissory

notes into usance bills. As the Scheme obtained popularityy

it was extended to banks with lower deposits. The con-

cessions which were granted to popularize the Scheme in

the exne, mental stage were later withdrawn. In fact,

since May 16, 1957, when the Bank rate was raised to 4

per cent and the stamp duty on usance bills was lowered to

1/5 per cent, the effective borrowing rate under the

Scheme continued to rule at 4-1/5 per cent.

The limited success that the Scheme achieved

during its operation for eight years and its decreasing

popularity are summarized in Table 14. In view of the

declining popularity of the bill market in India it seems

appropriate to conclude that "the flexible and convenient

mechanism of borrowing through cash credit or overdraft

arrangements remains the predominant form of borrowing;

and the growth of an active bill market . is not likely

to be reproduced on a significant scale."l

In the absence of a well-developed bill market, as

Ibid., p. 24. Other bankers have also expressed
similar views. For instance, see M. S. Nadkarni, 'The
Bill Market Scheme in India: An Appraisal," Reserve Bank
of India Bulletin (September, 1955), PP. 973-79.

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