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Financial and Real Assets in a Broad Perspective

A shift from real assets to financial assets in the portfolio of household savings can increase efficiency at the margin. This requires increased separation of ownership from management, a reduction in financial repression, a reduced dependence on self-employment, and a policy of providing infrastructure and more land for urban use.

HT Parekh finance forum

Financial and Real Assets in a Broad Perspective

A shift from real assets to financial assets in the portfolio of household savings can increase efficiency at the margin. This requires increased separation of ownership from management, a reduction in financial repression, a reduced dependence on self-employment, and a policy of providing infrastructure and

more land for urban use.


nvestment in financial assets (FAs) was a little more than 50 per cent of household savings in India in 2000-01 [Sivakumar 2002]. The remaining savings were invested in real assets (RAs).1 We will begin by discussing why it is desirable to have a higher ratio of investment in FAs to that in RAs, compared to what we actually have. Then we will focus on the difficulties in achieving this objective, and how these difficulties can be overcome.

There are several reasons why the ratio of investment in FAs to that in RAs is low in India. The first reason is as follows. If funds are freely invested in FAs (for example, deposits, equity shares, bonds, etc), then the use of these funds is, in principle, delegated to professional management, whereas if funds are invested in RAs (for example, owner-managed enterprises, or OMEs2 ), then there is relatively little effective delegation (or separation of ownership and management). The ratio of investment in FAs to RAs decreases with the cost of delegation. Given that this cost is higher in India than in developed countries, it follows that the ratio of investment in FAs to that in RAs is lower in India than in developed countries. The cost of delegation is higher in India than in a typical developed country due to problems with the legal framework, enforcement and institutions [Tirole 2006, chapter 1]. The need for improvement is more in the case of banks than in the case of financial markets, where there has been considerable improvement already in the recent past. Accordingly, our focus here will be on bank deposits within FAs. We have financial repression3 in banks, which discourages deposits. Second, the government has effectively reserved some sectors of the economy for OMEs

– agriculture, the so-called small-scale industry, wholesale and retail trade, etc, though there are changes in policy of late. These OMEs are usually effectively lacking in delegation. If this policy of reservation for OMEs is diluted, then we will have more delegation, which entails an increase in FAs. In what follows, we will not discuss this aspect any further. Third, due to various policies, RAs are more attractive in India than in developed countries.

Financial Repression in Banks

Financial repression in banks takes several forms. First, there are excessive statutory liquidity ratio (SLR) and cash reserve ratio (CRR) requirements, which reduce the income of banks. Second, there is weak lender protection. The recovery of business loans is difficult, despite the recovery of debts due to the Banks and Financial Institutions Act, 1993, and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Weak lender protection can restrict efficient investment [Tirole 2006, sections 16.2 and 16.3]. It leads to non-performing assets, encourages banks at times to invest in government securities or in cash, beyond the amount stipulated by regulation, and encourages relatively safe housing loans beyond what is optimum. Sometimes the term lazy banking is used for this. Third, though there has been some expansion, there are barriers to entry for new banks, and barriers to opening new branches for existing banks [Suja K 2005, chapters 4 and 5]. These barriers lead to sub-optimal banking.

Fourth, income on bank deposits beyond a point is taxed as interest income, whereas income on bonds is taxed as capital gains. This puts bank deposits at a disadvantage relative to bonds in attracting the more affluent. Fifth, the administered rate of interest on demand deposits is low. To some extent, this encourages the use of money market mutual funds at the expense of bank deposits. Sixth, banks are effectively not allowed to offer deposits that are indexed to the price level. To some extent, this encourages the use of gold. The reason is as follows. The importance of gold is usually attributed to a strong taste for gold. However, it is possible that this taste is partly for a simple, safe and liquid asset that is also a good hedge against inflation, rather than for gold per se. If so, then indexed deposits can also satisfy the properties that gold has, and hence, can reduce demand for gold to some extent. Seventh, in India, a borrower has little credible threat of access to the judiciary even if her claim, that she has not got a bank loan on merit, is verifiable. Eighth, in practice, financial repression is to some extent related to the public sector character of most banks.

Financial repression in banks is one possible reason why the gap between real return on deposits and that on an alternative asset such as stocks is large. Another reason is the equity premium [Tirole 2006:349].

One reason why the government may be reluctant to reduce financial repression is that its fiscal deficit is high. Given its fiscal deficit, the government needs assured access to funds at reasonable rates of interest. For this, the government finds the SLR (and even CRR) requirements useful. Moreover, it needs an alternative to subsidies to help the priority sectors, given its budget constraint. An alternative to subsidies is assured and/or subsidised

The H T Parekh Finance Forum is coordinated by Errol D’Souza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty.

Economic and Political Weekly January 20, 2007 loans. So the policy of priority sector lending by banks may be viewed as a second best policy. It follows from all this that a pre-condition to reduce financial repression in banks is to improve the fiscal condition of the government.

It is reasonable to assume that usually people are risk averse and/or uninformed on trade in assets. So banks are important because a bank deposit is liquid and gives a fixed return [Tirole 2006, section 12.4]. Banks are also important for borrowers, especially for “emerging” entrepreneurs. However, this importance of banking does not get reflected in data on bank deposits vis-à-vis other assets. This is because financial repression in banks leads to less allocation of funds to deposits and more in favour of other assets such as RAs. Next, we will see distortions in the RA market, which make RAs attractive.

Why Real Assets Are Attractive

Investment in RAs is usually not diversified, whereas investment through banks is typically well diversified. Why then is the demand for RAs high in India? Singh (2005) suggests an answer. The return obtained by diversification is based on average quality. This is usually true in the case of FAs. Similarly, under asymmetric information, the price at which an asset can be sold reflects the average quality of assets. Therefore, under some conditions, sale of an asset under asymmetric information is a useful alternative to diversification because the latter has a cost. If only RAs are sold under asymmetric information in emerging economies,4 then it can be shown that investment in RAs is higher in emerging economies than in developed countries. One rationale for asymmetric information on RAs is that a clear legal title to an RA is often a problem in an emerging economy. The seller has more information than the buyer. Though this entire argument is interesting, there is so far no empirical evidence. We need to examine further why RAs are attractive to investors. We will first consider real estate, and thereafter, OMEs.

We classify real estate into two categories

– urban and rural. It seems that the much talked about appreciation in price is primarily in the case of urban (and expected to become urban) real estate. Accordingly we will focus on urban real estate.

The high appreciation in real estate can explain why it is attractive. However, it is important to see why the appreciation has occurred. The usual reason given is that a rise in population, in incomes, etc, warrants this appreciation. Our hypothesis is different. The ratio of land in rural areas to that in urban areas is very high in India, relative to the needs of the economy. This is a manifestation of various laws, policies and regulations. There is a distortion in the use of land. Due to this distortion, the average price of land in rural areas is a fraction of that in urban areas, even after adjusting for the cost of “development” in the case of urban real estate. The government has not approved the use of land for urban needs and not provided for the infrastructure that is commensurate with actual needs. The impact of this adverse ratio is felt more and more over time. Hence, we have appreciation of urban real estate. So the appreciation is not entirely market driven. It is also an effect of the regulatory regime. The usual emphasis is on demand factors. Our emphasis is on supply that is restricted by regulation.

The government policy on urban real estate may change. As urbanisation spreads, urban vote banks will increase. Furthermore, it is only recently that we are becoming really aware of the role of, what we may call, the licence-permit-quota raj in real estate [also see Glaeser et al 2005]. If there is a change in policy, then more urban real estate will be there, and appreciation will fall.

Besides fundamentals and regulations, the price of property is also a matter of confidence in the minds of investors. If this declines, then, there can be a fall in price. This also makes real estate a risky asset. Moreover, we can have anomalies in pricing due to irrational investors [Tirole 2006: 9]. This is particularly true of upcoming cities, which is where the bulk of pure investment and trading is.

Finally, investment in real estate requires monitoring, given the risk of encroachment, if enforcement of rights is weak, if real estate is located far away, and if the market for delegated monitoring of RAs does not exist. So the investor has to use time, energy and contacts. Thus the investor is constrained to invest nearby only, thus getting exposed to unique risk in addition to market risk, unlike in the case of the stock market where one may be able to avoid unique risk.

These risks and monitoring costs are not well understood. The result is that people are taking a risk that they may not be able to deal with. This argument is consistent with the theory and evidence in behavioural finance [Tirole 2006: 9]. It is true that the

Economic and Political Weekly January 20, 2007

forthcoming real estate investment trusts (REITs) can remove some of the problems, but REITs have their own limitations. Trade in the secondary market in units sold by REITs may increase the “mis-pricing”.

Let us now consider OMEs. India is characterised by not only a high ratio of RAs to FAs, but also a high ratio of selfemployment to, what we may call, wage employment.5 Pant et al (2005) have shown that the two ratios are related, given complementarity between the two factors of production. The implication of their analysis is that to shift from RAs to FAs; we also need a shift from self-employment to wage employment. After all, one cannot delegate only capital. It has to be accompanied by “delegation of labour”. The former is a case of a shift from RAs to FAs, whereas the latter is a case of a shift from self-employment to wage-employment. More than 50 per cent of the labour force is self-employed in India [Pant et al 2005]. It is unlikely that all the self-employed agents are entrepreneurs.

It seems that the planners have for quite some time wanted to see more jobs in the economy but were in practice not really encouraging more new firms or larger existing firms in the private sector. This is a contradiction because it is these firms that offer jobs, given that it is difficult for the public sector in India to offer very many new jobs. With greater entrepreneurial activity in emerging businesses, there will be more jobs on offer and hence less need for self-employment and OMEs. In other words, there will be less demand for RAs. The implication is clear. FAs will increase. It is true that in the last 15 years or so, wage employment and wages have not increased in line with the increase in output (though even here the latest data suggests that there is reason for optimism on employment front). However, this may be because this period has seen more expansion in the established corporate sector than in emerging businesses (except in information technology-related services), which can be more labour-intensive than the former.

The policy implication is that the government needs to create a more favourable climate for business, particularly for emerging entrepreneurs and not just for established corporations. There is a need to reduce barriers to entry in business by making credit more easily available for emerging entrepreneurs, providing them independence, respect, meaningful security, and peace. Finally, at present, there is a need for black money in starting and running a business. This acts as a barrier for many new entrepreneurs. So there is a need to reduce the role of black money in the economy.

The use of black money can be a problem not only for some entrepreneurs, but also for many investors. This is because it leads to segmented markets.

Segmented Markets

One obstacle in shifting from RAs to FAs is as follows. There is considerable use of black money in the RA market, whereas the FA market operates more with white money. This makes the two markets somewhat segmented. This is because after selling an RA, the seller receives part of the sale proceeds as black money. This can be used for investing in another RA only because only the RA market involves considerable black money.6 An implication of this is that existing investors in the RA market are somewhat stuck in that market [Singh 2006]. So it is difficult to increase the ratio of FAs to RAs in the economy. However, some policy measures can be used to reduce the role of black money in the RA market. This can in turn integrate the two markets and pave the way for more FAs in the economy.

Policy measures to reduce black money can be to increase the circle rate of property, and use this rate more widely for taxation. Another policy that may be used is some variant of voluntary disclosure scheme. The latter has two effects. One is to reduce incentive to pay tax in future. The other is to bring more income and wealth under the tax net in the future. While the former negative effect has received considerable attention, the other positive impact has been relatively ignored.

Summing Up

A shift from RAs to FAs involves increased separation of ownership and management, which can increase efficiency at the margin in India. RA and FA markets are to some extent segmented in India, given the greater use of black money in RA markets. This makes a shift from RAs to FAs difficult. However, this is only a part of the problem. There are other obstacles too. So we will require a comprehensive and sustained policy change on several fronts for quite some time. More serious tax collection will ease the government’s budget constraint and hence pave the way for a reduction in financial repression in banks, which can help in increasing the ratio of FAs to RAs. An attempt at job creation can reduce dependence on selfemployment and OMEs. This in turn reduces RAs. Finally, approval of more land for urban use and providing infrastructure can reduce the appreciation in price of the urban real estate. This can make the latter less attractive and increase investment in FAs. All these changes may seem difficult. However, the problem is not insurmountable, and it is perhaps not even as difficult as the kind of changes we have already seen since early 1990s.




[This article draws on my own research and joint work with Manoj Pant, Prabal RayChaudhuri and Suja K. I appreciate the role of Shubhashis Gangopadhyay, and my family. I thank Meeta Mehra and Manimay Sengupta.]

1 The terms more commonly used are financial and physical savings. 2 We will consider RAs such as real estate and gold later. 3 Financial repression refers to the excessive or inappropriate controls in the financial sector.

4 Bank deposits up to Rs one lakh are insured and so give fixed returns. So information for small investors is not important. Large investors are anyway not interested in banks.

5 Wage employment is where a person is employed by somebody else for a fixed wage, unlike in the case of self-employment, where the return is usually uncertain. Furthermore, wage employment does not involve capital, whereas self-employment may require some capital.

6 Or one may consume after receiving black money.


Glaeser, Edward L, Joseph Gyourk and Raven E Saks (2005): ‘Why Have Housing Prices Gone Up?’ American Economic Review, Vol 95, No 2, May, pp 329-33.

Pant, M, P RayChowdhury and Gurbachan Singh (2005): ‘Financial Intermediation and Employment’, Working Paper, CITD, SIS, Jawaharlal Nehru University.

Singh, Gurbachan (2005): ‘Real Assets, Financial Assets, Liquidity, and Lemon Problem’, Economics of Transition, 13:4, October, pp 731-57.

– (2006): ‘Financial Repression, Bank Deposits, Real Assets, and Black Money’, Working Paper, CITD, SIS, Jawaharlal Nehru University.

Sivakumar, S (2002): ‘The Economics of Housing’, Business Standard, Vol IX, No 148, October 7, p 11.

Suja, K (2005): Capital Adequacy of Commercial Banks – The Supply Side, MPhil Dissertation, Jawaharlal Nehru University, unpublished.

Tirole, J (2006): The Theory of Corporate Finance, Princeton University Press, Princeton, NJ.

Economic and Political Weekly January 20, 2007

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