A key barrier to India’s aspirations of becoming a global manufacturing and investment powerhouse is the structural cost of capital, which remains prohibitively high. In this post, Agarwal and Vardhan locate the reasons in weak domestic financial savings, heavy public-sector borrowing, and a fragmented regulatory system. They outline a reform agenda that can enable the country to finance growth more productively.
No modern economy can sustain high growth without abundant and affordable credit. Capital is the bloodstream of commerce: it finances factories, inventories, infrastructure, technology, housing, and consumption. When credit is scarce or prohibitively expensive, economic activity slows, private investment weakens, and competitiveness deteriorates. The price of credit, therefore, is not merely a financial variable; it is a strategic determinant of national economic power.
The hidden tax on Indian enterprise
India’s long-term developmental ambitions rest upon becoming a globally competitive manufacturing and services economy. Yet Indian firms continue to labour under a structural handicap: the cost of borrowing. Relative to their counterparts in China, Europe and North America, Indian companies often face a financing disadvantage of between 300 and 500 basis points. In industries where margins are thin and capital intensity high, such a differential is not incidental – it is decisive. It shapes export competitiveness, investment appetite, technological modernisation, and ultimately the pace of economic expansion itself.
For a nation aspiring to become a developed economy over the next two decades, persistently high borrowing costs constitute a serious structural vulnerability. The issue is especially acute because the problem is not cyclical. India’s elevated cost of credit is not simply the result of transient inflationary pressures or temporary monetary tightening. Rather, it is deeply embedded in the architecture of the country’s macroeconomic framework and financial system.
Two broad forces lie at the heart of this problem. The first is macroeconomic: weak domestic financial savings, heavy public-sector borrowing, and a prolonged regime of financial repression that channels scarce savings toward the State at the expense of private enterprise. The second is institutional: a fragmented and heavily regulated credit delivery system whose architecture often impedes efficient allocation of capital and raises the cost of financial intermediation.
Unless both sets of constraints are addressed simultaneously, India risks entering the next phase of its growth journey with a structurally expensive cost of capital – a disadvantage that could undermine its industrial ambitions at precisely the moment it seeks to integrate more deeply into global supply chains.
The savings constraint
India’s credit system remains overwhelmingly dependent on domestic savings. Unlike many advanced economies, the country does not finance itself materially through foreign borrowing. Government deficits are largely funded domestically through the issuance of sovereign securities purchased by banks, insurance companies, pension funds, and mutual funds. Corporate borrowing from overseas sources remains limited and highly concentrated among a small set of large firms through the External Commercial Borrowing (ECB) framework. For the overwhelming majority of Indian businesses, therefore, access to credit depends almost entirely upon the availability of domestic financial savings.
This reality has profound implications. In any economy, the aggregate pool of credit is ultimately constrained by the volume of savings available for intermediation. In India, that pool is neither sufficiently large nor expanding rapidly enough to support the scale of investment required for sustained high growth.
Over the past decade, India’s gross domestic savings rate has declined to roughly 30% of GDP (gross domestic product). More strikingly, only around a third of this constitutes financial savings; the remainder flows into physical assets such as gold and real estate. The deterioration in household financial savings is particularly concerning. Gross household financial savings have stagnated, while net household savings – after accounting for rising household liabilities – have fallen sharply to multi-decade lows.
This decline reflects an important structural shift in the Indian economy. Over the past decade, household leverage has risen meaningfully as retail credit expanded aggressively across housing, consumer durables, and unsecured lending. A growing proportion of household cash flows is now devoted to servicing debt rather than generating fresh savings. Consequently, the domestic pool of lendable resources is likely to remain constrained even as investment demand rises. The implications for the cost of capital are straightforward. When savings are limited and credit demand remains robust, interest rates remain structurally elevated.
Financial repression and the crowding out of private capital
The scarcity of domestic savings is compounded by India’s longstanding regime of financial repression. Large pools of savings – particularly bank deposits, insurance premiums, and pension contributions – are subject to regulatory mandates requiring substantial investment in government securities. In effect, the State enjoys privileged access to domestic savings through statutory mechanisms that create a captive investor base for sovereign borrowing.
Banks are required to maintain substantial holdings of government securities under the Statutory Liquidity Ratio (SLR) framework. Insurance companies and pension funds face similar investment obligations. Moreover, large segments of these sectors remain State-owned or State-influenced, reinforcing the tendency to channel savings toward sovereign financing.
This creates a classic crowding-out dynamic. Every rupee absorbed by government borrowing is a rupee unavailable to the private sector. More importantly, by compelling financial institutions to allocate large portions of their balance sheets toward relatively low-yielding sovereign instruments, the system distorts the pricing of capital across the broader economy.
The effect is amplified by the borrowing activities of State-owned enterprises. Central and state public-sector undertakings increasingly tap the domestic bond market at spreads only marginally above sovereign yields because investors implicitly assume government backing. Over the past decade, these entities have accounted for a substantial share of total corporate bond issuance.
The result is a debt market in which the State – directly or indirectly – dominates capital absorption. Private firms must compete not merely with each other, but with the sovereign and its affiliated entities for a limited pool of domestic savings.
This is perhaps the most underappreciated driver of India’s high cost of credit.
Opening the door to global capital
Given the structural limitations of domestic savings, India cannot rely exclusively upon internal capital formation to finance its next stage of economic expansion. The country must increasingly access global pools of debt capital. India’s approach to external borrowing has historically been cautious, shaped by memories of balance-of-payments crises and concerns over currency volatility. While prudence is understandable, excessive conservatism now carries its own economic costs.
The ECB regime remains restrictive, operationally cumbersome, and accessible primarily to larger firms with established international relationships. Smaller and mid-sized companies continue to depend almost entirely upon domestic credit markets.
A calibrated liberalisation of external borrowing could materially alleviate domestic capital scarcity. Deeper integration with global debt markets would expand the availability of credit, reduce dependence on domestic savings cycles, and introduce greater competitive discipline into domestic lending markets.
Such liberalisation must naturally be accompanied by prudent safeguards relating to currency mismatches and external vulnerabilities. But the broader direction is unavoidable: an economy of India’s scale cannot sustainably finance itself through domestic savings alone.
The dual structure of credit delivery
India’s credit system operates through two principal channels: financial institutions and capital markets. The institutional channel consists primarily of commercial banks and non-banking financial companies (NBFCs). Historically, banks dominated credit delivery, while NBFCs emerged to serve sectors and borrowers inadequately addressed by traditional banking institutions. Over the past two decades, however, NBFCs have grown rapidly and now play a critical role across retail, infrastructure and specialised lending segments.
The market channel comprises the corporate bond market. While this market has expanded considerably, its depth remains limited and highly skewed toward top-rated issuers. More than four-fifths of outstanding corporate bond issuance is concentrated among firms rated AA and above. Consequently, market-based borrowing remains inaccessible to the overwhelming majority of Indian enterprises.
In addition to the concentration of higher rated issuers, bond markets suffer from several other irritants for investors. Withholding taxes deter foreign investors from fully participating in the market. Absence of a centralised counter party (that is, clearing corporations acting as centralised counter party) on the exchanges creates a degree of uncertainty in secondary market trades. Even in case of high-rated borrowers the liquidity is very thin resulting in inadequate price discovery in the secondary market, especially in the absence of formal market makers in bonds.
Recently there has been a sharp growth in private credit in India. These new funds raise money from capital pools willing to take on higher risks in corporate lending for higher returns. These funds tend to invest chiefly in the below-A rated firms, creating an alternative source of credit for these relatively lower rated funds who have historically depended on institutional credit. However, the overall capital with private credit funds is too small presently to make a meaningful impact on overall commercial credit.
Understanding India’s elevated cost of credit requires examining not merely these individual components, but also the regulatory architecture governing their interaction.
Architectural regulation: A fragmented system
One of the defining features of India’s financial regulatory system is its fragmented, entity-based structure. The banking system is regulated by the Reserve Bank of India (RBI). Corporate bond markets fall under the jurisdiction of the Securities and Exchange Board of India (SEBI). Insurance and pension sectors are separately supervised by their respective regulators. Government securities markets operate under yet another regulatory framework. This fragmentation creates significant coordination failures.
Efficient credit systems require seamless movement of capital and risk across institutions and markets. Yet regulations developed within sectoral silos often impede precisely such interactions. Rules designed to protect individual sectors may unintentionally weaken the efficiency of the broader credit architecture.
At its core, lending involves two distinct risks: credit risk and market risk. Credit risk concerns the possibility of borrower default. Market risk concerns fluctuations in interest and exchange rates and broader financial conditions. A sophisticated financial system enables these risks to be separated, redistributed, and priced efficiently among participants best equipped to bear them. Credit derivatives, interest-rate swaps, guarantees, insurance structures, and securitisation mechanisms all serve this function.
In India, however, the ability to unbundle and transfer risk remains underdeveloped. Regulatory barriers frequently inhibit participation in these markets. Insurance companies face restrictions on offering meaningful credit insurance products. Derivatives markets remain relatively shallow. Institutional participation is constrained by overlapping regulations and inconsistent supervisory approaches.
The consequence is inefficient risk concentration. Financial institutions are forced to retain risks that could otherwise be distributed more efficiently across the system. Inevitably, this raises the price of credit.
The challenge is fundamentally architectural. As long as regulation remains compartmentalised along sectoral lines, the broader credit system will struggle to evolve into a deeply integrated and efficient capital allocation mechanism.
The burden of component regulation
Alongside architectural constraints lie the regulations governing individual sectors themselves. These “component regulations” directly shape the economics of lending institutions and capital markets.
The banking system provides the clearest example. Indian banks operate under multiple statutory obligations that materially constrain balance-sheet flexibility. High Cash Reserve Ratio (CRR) requirements compared to peer jurisdictions, compel banks to maintain a portion of deposits with the central bank without earning interest. SLR mandates require substantial investment in government securities. Priority Sector Lending (PSL) norms oblige banks to direct a large share of credit toward designated sectors regardless of commercial attractiveness. The cumulative effect is substantial.
For every Rs. 100 mobilised through deposits, less than half remains available for unconstrained commercial lending, after accounting for reserves requirements and priority sector lending obligations. Moreover, mandated investments often generate lower returns than market-based lending opportunities. This creates an unavoidable economic reality: banks must earn higher spreads on commercially viable loans to compensate for lower returns elsewhere on their balance sheets. The result is structurally elevated borrowing costs for productive private-sector enterprises.
Comparable dynamics exist within insurance and pension regulation, where investment mandates similarly channel savings toward sovereign and quasi-sovereign assets.
The productivity problem in banking
India’s banking system also suffers from persistently high intermediation costs. Measured as operating costs relative to average assets, Indian banks remain materially more expensive than many international peers. This is particularly striking given India’s apparent advantages in labour and technology costs. The issue is not primarily one of expensive inputs, but weak productivity.
Indian banks generate lower volumes of business relative to the resources deployed. Economies of scale have not materialised to the extent one might expect from a banking system whose balance sheet has expanded dramatically over the past two decades.
Part of the explanation lies in regulatory restrictions on permissible banking activities.
Indian banks remain constrained in financing several categories of economic activity that constitute significant business segments internationally, including certain forms of acquisition finance, land acquisition for development, and segments of capital markets activity.
Many such restrictions are historical vestiges of an earlier era when banking was overwhelmingly State-owned, financial markets underdeveloped and economic policy deeply interventionist. Yet while the Indian economy has transformed dramatically since liberalisation, elements of the regulatory framework remain anchored in the assumptions of a different age.
By limiting the scope of business activity, these restrictions reduce asset productivity and inhibit the development of diversified revenue streams. Inevitably, fixed costs are spread across narrower lending activities, increasing the overall cost of intermediation.
The rising cost of compliance
The post-global financial crisis era has witnessed a substantial expansion in financial regulation worldwide. India has been no exception. Following the surge in non-performing assets during the previous decade, regulatory intensity increased sharply across the financial sector. Compliance obligations multiplied. Supervisory scrutiny deepened. Reporting requirements expanded materially.
While stronger oversight has undoubtedly enhanced systemic stability, it has also generated significant economic costs. Financial institutions today devote vast managerial and operational resources toward regulatory compliance. Internal control functions have expanded rapidly. External audits, risk reviews, and supervisory engagements consume growing amounts of time and capital. These are not trivial expenses. They ultimately feed into the pricing of financial products, including credit.
More subtly, regulatory complexity also imposes strategic costs. Senior management teams increasingly devote disproportionate attention toward navigating regulatory uncertainty rather than pursuing innovation, operational efficiency, and long-term business development. The opportunity cost is difficult to quantify but economically meaningful.
The missing enablers of efficient credit
Beyond macroeconomic policy and regulation, the broader ecosystem supporting credit delivery also remains underdeveloped in critical respects. Credit rating agencies, market infrastructure institutions, clearing systems, insolvency frameworks, legal enforcement mechanisms, and taxation policies all influence the efficiency and pricing of credit.
India has undoubtedly made considerable progress in several of these areas. The Insolvency and Bankruptcy Code (IBC) represented a major institutional advance. Digital public infrastructure has significantly improved aspects of retail credit delivery. Securities market infrastructure is comparatively sophisticated by emerging-market standards.
Yet, important deficiencies persist. Corporate bond market liquidity remains shallow. Secondary market participation is limited. Credit enhancement mechanisms remain underdeveloped. Legal enforcement processes continue to be time-consuming and uncertain. Tax treatment across financial instruments is often inconsistent and distortionary.
These institutional frictions cumulatively raise the cost of risk transfer and capital allocation across the system.
Toward a comprehensive reform agenda
Reducing the cost of credit in India requires more than marginal policy adjustments. It demands a comprehensive restructuring of the country’s financial architecture.
The starting point must be macroeconomic. India must encourage higher domestic financial savings through stable inflation, improved household financial instruments, and taxation policies that incentivise long-term savings. Equally important, the country must gradually reduce excessive sovereign pre-emption of domestic capital through fiscal consolidation and rationalisation of mandatory investment requirements.
Second, India must pursue a calibrated opening of external debt markets. Greater access to global capital pools is essential if domestic investment ambitions are to be financed sustainably.
Third, financial sector regulation requires deep structural reform.
Architectural regulation must become more coordinated and system-oriented rather than narrowly sectoral. Regulators must increasingly view themselves not merely as supervisors of individual entities, but as stewards of an integrated financial ecosystem.
Simultaneously, component regulations governing banks, insurance companies, pension funds, and capital markets require rationalisation. Legacy restrictions that no longer serve meaningful prudential purposes should be reconsidered. The objective should be to enhance productivity, competition, and efficiency without compromising stability.
Fourth, India must deepen its corporate bond markets and associated risk-transfer mechanisms. A modern economy cannot rely excessively upon banks as the sole providers of long-term capital. Broader institutional participation, more sophisticated derivatives markets and stronger credit enhancement structures are essential.
Finally, the supporting ecosystem – including insolvency systems, market infrastructure, rating frameworks and taxation policy – must evolve toward greater consistency, transparency, and efficiency.
Conclusion: Capital as a strategic imperative
India today stands at a pivotal economic moment. The country possesses favourable demographics, rising geopolitical relevance, and expanding entrepreneurial capacity. Yet, aspirations of becoming a global manufacturing and investment powerhouse cannot be realised without addressing the structural cost of capital.
High borrowing costs are not merely a financial inconvenience. They are a tax upon enterprise, investment, and competitiveness.
Countries that industrialise successfully do so not simply because they possess labour or markets, but because they create financial systems capable of allocating capital efficiently, abundantly, and at scale. India’s challenge is therefore not only to grow faster, but to finance growth more intelligently.
The next phase of financial reform must move beyond questions of stability alone and focus equally upon efficiency, productivity, and competitiveness. A credit system designed primarily around sovereign financing needs and regulatory compartmentalisation is increasingly incompatible with the ambitions of a globally integrated economy.
If India is serious about becoming a developed nation by mid-century, lowering the structural cost of credit must become a central pillar of economic policy. For in the final analysis, the price of capital determines the price of ambition itself.
The views expressed in this post are solely those of the authors and do not necessarily reflect those of their organisations or of the I4I Editorial Board.
