A casual observer might infer from India's flourishing stock markets, fast-growing mutual funds, and capable private banks that the financial system is one of the country's strengths. But closer inspection reveals that while policy makers deserve credit for liberating these high-performing parts of the system, tight government control over almost every other part is undermining India's overall economic performance. To sustain rapid GDP growth and spread its benefits more broadly, the country needs a financial system that is comprehensively market oriented and efficient.

The financial system's shortcomings fall largely into three areas. First, formal financial institutions attract only half of India's household savings and none of the $200 billion its people keep tied up in gold. Second, these financial institutions allocate more than half of the capital they do attract to the economy's least productive areas: state-owned enterprises (SOEs), agriculture, and the unorganized sector (made up mostly of tiny businesses). The more productive corporations in India's dynamic private sector receive only 43 percent of all commercial credit. Third, since the financial system is inefficient in both of its main tasksÁ»mobilizing savings and allocating capitalÁ»Indian borrowers pay more for capital and depositors receive less than they do in comparable economies.

These...