With a gross domestic product that is growing by more than 7 percent a year, India has made remarkable progress since opening its economy, in 1991. The country has accomplished this feat despite the substantial handicap of an underdeveloped financial sector.

At about $900 billion, India's stock of financial assets—including bank deposits, equities, and debt securities—is one-fifth the size of China's (Exhibit 1).¹ The gap is widening: by 2010, China's financial stock will reach $9 trillion, while India's will remain below $2 trillion.

But in allocating capital, particularly to private companies, India's financial system is more effective than China's, largely because the market share of more efficient foreign and privately owned banks in India has crept up to 25 percent. Many nonperforming loans have been cleaned up, and while the true figure is hard to determine, they are now estimated at around 9 percent of all lending,² compared with up to 40 percent in China. India's stock market is booming, and its best companies list shares abroad.

Still, to finance economic growth, India must raise its investment rate substantially, as McKinsey Global Institute (MGI) research shows. If...