Financial Inclusion and Digital Transformation in India | Understanding Indian Cities

Source: IDEAS AND INSTITUTIONS | ISSUE #39

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1. Analysis
2. Review

Analysis

The Complicated Story of Financial Inclusion as a Success for Digital Transformation in India

There seems to be an emerging consensus that India is undergoing a rapid digital transformation that is delivering impressive improvements in the working of the government and the economy with the help of a digital identity system, a fast payment system, and various systems for accessing and exchanging data and information in domains ranging from health to credit. This is working up to be a remarkable story. However, it often happens that we go overboard in telling such stories. Certain nuances and details are missed out. In this essay, we contextualize India’s achievement in one domain—financial inclusion—to highlight some of the nuances that are important for interpreting the headline numbers and to understand what is worth learning from India’s experience and what is not.

It has been claimed that India has accelerated progress on financial inclusion to such an extent that it has achieved in less than a decade what would otherwise have taken half a century. The headline numbers support this claim. According to the World Bank’s Global Findex Database (“GFD”), back in 2011, only 35 percent of those above fifteen years of age in India had accounts with a bank, other financial institution, or mobile money service provider. By 2014, this had increased to 53 percent and to 81 percent in 2017. In 2021, this was 78 percent. Based on this, some have argued that India’s approach to financial inclusion is worth emulating.

To Understand, We Must Compare

This achievement needs to be placed in a comparative perspective. Table 1 covers seventy middle-income countries for which data on this measure is available in the GFD. The table shows that, in the decade between 2011 and 2021, most countries have seen impressive progress in opening accounts. The achievement, or lack thereof, should be seen in the context of the country’s starting point. Arguably, Mongolia going from 78 percent to 98 percent within a decade is no less impressive than the Kyrgyz Republic going from 4 percent to 45 percent during the same period or Kenya going from 42 percent to 79 percent.

Many of the countries started with a relatively low base (that is, less than a quarter of the population had accounts in 2011) and made impressive progress. In total, there are twenty such countries, including Armenia, Azerbaijan, Bangladesh, Cambodia, Cameroon, the Republic of Congo, Egypt, El Salvador, Gabon, Indonesia, the Kyrgyz Republic, Lesotho, Moldova, Paraguay, Peru, Senegal, Tajikistan, Tanzania, Vietnam, and Zambia. Then there are countries that started with a high base (that is, more than half of the population had accounts in 2011) and achieved impressive improvements. In total, there are twelve such countries, including Bosnia and Herzegovina, Brazil, Bulgaria, China, Iran, Malaysia, Mongolia, Serbia, South Africa, Sri Lanka, Thailand, and Turkey. There are also those countries that started with a moderate base (that is, between a quarter and half of the population had accounts in 2011) and achieved huge improvements. In total, there are sixteen such countries, including Argentina, Bolivia, Botswana, Colombia, Ecuador, Georgia, Ghana, India, Kazakhstan, Kenya, Mexico, Nepal, the Philippines, Romania, the Russian Federation, and Ukraine.

Put together, these add up to forty-eight countries, or about 70 percent of the middle-income countries covered by the database. Most of the remaining twenty-two countries have also seen significant improvements on this measure. Only two countries, Lebanon and Jamaica, seem to have made no progress on this measure.

As the table shows, on this measure, the median for the middle-income countries almost doubled between 2011 and 2021. The unweighted mean also registered a similar growth. Since it more than doubled the percentage of the population with accounts, it might seem like India did better than the median for middle-income countries. However, it is important to consider how many of the accounts are active and how many people are using them for fulfilling their financial needs.

Table 1: Financial Inclusion in Middle-Income Countries
 

The GFD reports that in 2021, 35 percent of those who had reported having an account in India had inactive accounts (that is, they had neither made a deposit into nor a withdrawal from their account during the year, either in cash or digitally). This was 33 percent and 38 percent in 2014 and 2017, respectively. No other country had such a high percentage of inactive accounts. The median for middle-income countries was only 6.5 percent, and the mean (unweighted) was 8.1 percent. If we exclude the inactive accounts, the number of those with accounts in India would be just over half of the population. This is less than the median for the same measure among middle-income countries.

Regulatory and Technological Innovations Driving Inclusion

The table shows that in the last decade, progress on account opening has accelerated sharply in most countries. Countries with very different starting points, located all over the world, with considerable variety in political regimes, economic structures, and demographic profiles, have been able to achieve significant progress on this front.

Technological advances have made this possible in such diverse contexts. Among others, the improvements in and spread of internet connectivity, mobile telephony, handheld point of sale devices, core banking, authentication, and encryption technologies have changed the technological context in which accounts are opened and operated, making it less expensive to open and service bank accounts. This is one side of the story. The other is that the countries have adapted their institutional frameworks to make the development and adoption of technology possible. Each country has done so in its own way. There are country-specific institutional paths that were taken because of the unique context in each country. How should we describe India’s journey?

First, India has seen several regulatory adaptations to enable the use of technological advances and new business models for financial inclusion. For instance, a regulatory path was cleared when, in 2006, the banking regulator allowed banks to appoint agents who could provide routine banking services on their behalf, and this model evolved over time. For the routine transactions, the costs in bank branches were much higher than those made possible by the agents. Agents with handheld devices could do many routine transactions that bankers in branches did but at a fraction of the cost and at times and places convenient for the customers. The number of agent-based banking outlets increased from 34,621 in March 2010 to 32,57,261 in December 2021. Without this agent-based model, some of the advantages of the technological advances would have been slow to accrue to financial inclusion. Similar regulatory innovations were made in many other countries.

Second, India has developed certain digital systems that help overcome some of the barriers to financial inclusion. Due to many people not having the individual identification documents required for account opening (many had only family-based documents, such as ration cards) and a rather simplistic and excessively prescriptive application of know your customer rules, the development of Aadhaar, a digital identity system, played an important role in easing the process of account opening in India.

Third, the development of new services, which combined regulatory innovation, technological advances, and business process changes, has helped financial inclusion. A prominent example is the development of the Unified Payments Interface (UPI), India’s flagship fast payment system. It has improved the experience of digital payments and thereby enhanced the value proposition of an account. UPI required as many technological innovations as it did regulatory innovations—allowing the transaction of a payment by an account through a third-party application—and business process innovations—for example, the use of a key linked to a directory to address the payee. By 2021, more than sixty jurisdictions had launched such fast payment systems, with a variety of different regulatory, technological, and business process designs. This suggests that the story of fast payments is also a global one, albeit with local variations.

It is not easy to build and implement such systems at India’s scale. In most of these stories of innovation and adaptation, there are many stories of visionary leadership, exemplary volunteer effort, and employees going above and beyond, in addition to organizations simply doing their job well. However, since most countries have seen impressive improvements in financial inclusion, it is likely that if we look closely at other countries, we will see such stories that contributed to their achievements on financial inclusion.

An Uneasy Mix of Innovation and Coercion

A key aspect of the story of financial inclusion in India is the uneasy mix of the kinds of creditable innovations discussed above with gratuitous acts of coercion by the government. These acts have come in various forms.

First, many accounts have been opened through top-down campaigns enforced by the government. The biggest of these is the Pradhan Mantri Jan Dhan Yojana (PMJDY). Since these campaigns were implemented mostly by government-owned banks, with the help of bank agents, handheld devices, and Aadhaar, it was relatively easy to deliver many account openings. It soon became clear that many accounts were inactive—a year after the launch of PMJDY, almost half of the accounts had zero balance. Once the focus shifted from opening accounts to showing them as active, there were reports that in some places bankers were depositing Re. 1 to show the accounts as active. All these are signs of responding to the incentives set by the political leadership. However, delivering quality of service is a different matter. Just as looking at the amount spent is inadequate to understand the effectiveness of the expenditure, looking at the number of accounts is inadequate for understanding the effectiveness of the financial inclusion measures. Finance is subtle—it requires understanding the needs of consumers and providing them services that meet those needs efficiently. Top-down campaigns can only go so far in improving financial inclusion. While the average balances in these accounts have increased over time, the problem of inactive accounts persists. Since there are costs involved in opening and maintaining accounts, each inactive account represents a waste of resources.

Second, when UPI was launched, it was a leap forward for fast payments in India, but the government used coercive measures to promote its usage without offering justification for why these were necessary. The government has banned charging any fees to customers or merchants for UPI transactions. It has also made it mandatory for businesses with more than Rs. 500 million (about $6 million) in annual sales to accept UPI payments at all their outlets, with a penalty to be enforced by the joint commissioner of income tax for each day of non-compliance. The economic rationale for such coercion was never given. UPI had been growing well even before these measures were announced. Such restrictions and mandates impede further innovation in the payments market because the commercial incentives for investing in totally different systems have been considerably weakened. Further, as the experience of similar systems in other countries shows, such coercion is not necessary. Brazil’s Pix payment system has done better than UPI in less time without the use of comparable coercive measures.

Third, while Aadhaar was developed as an enabler, it later became mandatory to link Aadhaar with bank accounts. In 2017, the government issued a notification to mandate the linkage of all bank accounts with Aadhaar. In 2018, this decision was struck down by the Supreme Court, which found that it did “not meet the test of proportionality and, therefore, violates the right to privacy of a person which extends to banking details.” However, recent reports suggest that the judgment is not being properly implemented in bank branches, where Aadhaar continues to be mandatory de facto.

Finally, a subtle aspect of coercion is that central planning has led to specific technological and business model choices that preclude the emergence of other choices. When accounts are opened through large-scale campaigns driven by the government, more gradual, business-driven approaches to financial inclusion may be crowded out. We have seen this in rural credit markets for decades, where heavy government intervention in directing and pricing credit made it difficult for a credit market to develop. Further, when only one national champion like the National Payment Corporation of India (NPCI) is entrusted with the fast payment system, it restricts competition in the sector, thereby impeding possibilities for future innovation.

The use of coercion must always come with a well-reasoned justification. The government must show, with plausible arguments, that without the use of such coercion, there would be a significant inefficiency in the system. Such intervention is typically justified based on some market failure, such as the existence of monopolies, information asymmetry, externalities, and so on. Market failures require subtle regulatory responses and not broad-brush coercion around business decisions, such as when to open an account, which service to provide, and whether to charge for the services.

An unnecessary paternalism has partly underwritten the scaling up of India’s digital systems. When we call it unnecessary, we mean this in the economic sense—it is hard to see the specific market failures that justify these coercive interventions by the government. However, in another sense, these interventions may have been necessary. As the political rhetoric around India’s digital transformation shows, the government is keen to take credit for what has been achieved. To do so, it must show some direct causal linkage between its actions and the successes of digital transformation. This would be hard to do if the government had simply allowed these innovations to scale on their own. Politicians will do what they must to win elections, but even many experts in the private sector who helped build these digital systems have either remained silent about the use of coercion or actively supported it. In 2016, some even cheered the draconian decision to demonetize high-value currency notes, because the move was expected to boost digital transformation.

In summary, India’s performance on financial inclusion is creditable but not exceptional, and the achievements have resulted from a mix of useful innovations and unnecessary acts of coercion. The countries looking to learn from India should pick and choose the better aspects—regulatory adaptation, technological advances, business process innovation—and be wary of the other aspects of this story. Further, to realize the full benefits of digital transformation in India, our elites should consider eschewing their tendency to support the use of coercion and allow sound principles to inform the respective roles of the state and the markets. But will politics allow this?

Looking Forward

One possibility is that as India tries to take its digital transformation story global, it might need to revisit the principles. As India’s digital transformation story was told and retold in this year of its G20 presidency, the language broadened and became more normative. In the recently issued outcome document, the G20’s Digital Economy Working Group (DEWG) has welcomed a “G20 Framework for Systems of Digital Public Infrastructure (DPI)” as a “voluntary and suggested framework for the development, deployment, and governance of DPI.”

The framework goes beyond technology to include governance to establish trust and vibrant and inclusive community participation to enable value creation. It suggests certain principles for developing and deploying DPIs, such as inclusivity, interoperability, collaboration with community actors at different stages to promote a culture of openness and collaboration, the development of user-centric solutions, a building block or modular architecture to accommodate changes or modifications without undue disruption, and so on. However, it does not suggest “open source” as a principle, perhaps because most of India’s own DPIs are not open source. It is possible that as India tries to take its digital transformation story global, it may need to promote better principles. But that will depend on the political economies of the respective funders and countries.

—By Suyash Rai

Review

Understanding Indian Cities

The onslaught of COVID-19 renewed a debate on the virtues and vices of city life. More than a few commentators argued that the success of remote working signaled the demise of the city, while others blamed the spread of the pandemic on the patterns of agglomeration within cities. The survival of cities in the wake of the pandemic was posited as an open question.

Devashish Dhar’s book, India's Blind Spot: Understanding and Managing Our Cities, is an unequivocal response to this question, arguing that not only are cities here to stay but that they are essential to modernity. Dhar’s book is accessible, all-encompassing, and unapologetic about the virtues of cities, especially in India. It is also clear-eyed about the problems of Indian cities and the multiple gaps in our planning and policy processes that hinder efficient and equitable urban development.

The book is divided into ten chapters, each focused on a specific aspect of India’s cities. The first chapter provides a quick overview of the historical development of Indian cities and the ideas that informed city building in India’s recent history. Dhar rightly places the development of Indian cities within a global framework of rapid urbanization and brings attention to the lack of comprehensive policy formulation regarding urban India.

The second chapter highlights the importance of Indian cities to the world as well as the importance of studying Indian cities; this is an economic and ideological argument that emphasizes India’s growing economic and ideational importance to the world. It argues that as India’s economy grows, key developments and negotiations within Indian cities will become more and more globally relevant. For example, he highlights the clear political divide between urban and rural USA and argues that Indian cities may also start exhibiting clearly distinct political and cultural preferences as opposed to the hinterland. Indian cities have also been commonly understood to be more emancipatory for lower castes in India. Because of their sheer size and numbers, labor and migration flows and their assimilation within urban areas are relevant not just for India but also globally. While Dhar is clear-eyed about the challenges and problems in each of these areas, he makes a compelling case for focusing greater attention on each of these issues.

The next chapter provides an explanation of the agglomeration benefits of cities in an accessible and contextual manner. Dhar highlights the importance of planning, economic dynamism, and adaptability as important ingredients of success within cities. To do so, he contrasts the relative success of Bengaluru with the gradual decline of Kanpur and Detroit in the USA. In order to sustain the growth and dynamism of cities, Dhar argues, attention must be paid to their inclusiveness. Dhar highlights the housing, health, education, and credit-related challenges that exist for new entrants to Indian cities. As he correctly highlights, the urban social safety net in India is dwarfed by social security programs for rural India. This rural bias may be one reason why urbanization in India is not actually faster than it currently is.

The next two chapters in the book are detailed explorations of infrastructure issues within Indian cities. Dhar highlights, through detailed data, the degree to which urban India faces a shortfall of essential public infrastructure for transport, health, and sanitation. He highlights the current paucity and continuing dwindling of water resources and the inability of the state to improve these services at the required pace. For the uninitiated, these chapters provide a comprehensive overview of the sheer scale of urban service delivery issues in India, ranging from drinking water, waste management, and affordable housing to transportation facilities.

In these chapters especially, but throughout the book, Dhar provides many examples of well-performing Indian cities on the one hand and relative failures on the other. He explains, for example, the success of the cities of Indore and Chennai in waste management. These are informative on the one hand and unsatisfying on the other. What were the key ingredients that allowed Indore to be more successful in waste management than Delhi? While the book provides details of the main policy measures, the reader is left with questions about how and why Indore was able to imagine and implement these measures.

The book’s sixth and seventh chapters focus on urban land and urban planning. Again, Dhar provides a comprehensive overview of the key policy issues in the use of urban land and city planning. Urban land is used extremely inefficiently, resulting in low land supply and consequently high land prices. Similarly, Dhar accurately highlights just how inefficient and suboptimal India’s urban planning processes have been. If anything, he is too kind when it comes to the failures of planning in Indian cities and the degree to which planning and zoning regulations have imposed economic costs on Indian cities, especially on the poor.

A minor quibble with these chapters is the degree to which Dhar emphasizes the role of policies as opposed to politics. While the book tackles the issues of urban governance later in the book, political contestation over land and real estate, which influences policies, is at least as important an explanatory factor as the actual policies themselves. The two penultimate chapters of the book, on safety issues in India’s cities and urban resilience, respectively, are novel inclusions in books dealing with urban development, and Dhar deserves credit for covering these subjects. Urbanization is a relatively recent phenomenon in human history, and safety and resilience are both inadequately explored through the prism of urbanization. Dhar stresses the importance of ensuring citizen safety, especially for women, and also highlights the challenges of designing cities friendly to children and child-rearing.

Dhar’s book is comprehensive and accessible. His treatment of the subject is pragmatic and solution-oriented. This is a welcome change, given that a considerable volume of literature on urban development in India is either a litany of criticism or is content merely to problematize without providing any insightful solutions. At the same time, and this is probably to the credit of the book, Dhar sacrifices depth for breadth. This is more noticeable in the chapters on land use and urban planning, where the why questions are often just as interesting as the what questions. Nevertheless, Dhar’s book is a welcome contribution to the literature on Indian cities and should hopefully popularize and stimulate greater debate on the design and future of Indian cities.

—By Anirudh Burman