The Hindu Business Line : The story behind runaway credit

Till October 2004, there was a large extension of credit for the housing and retail sectors. Now, it appears that credit to both industry and agriculture too has gone up sharply partly due to the express wishes of the Government and the RBI. The saga of the runaway credit has implications for monetary policy-making, says A. Vasudevan, who explains the phenomenon.

BANK CREDIT growth in the first ten months of 2004-05 has been phenomenal. By end-January 2005, it was little over 30 per cent on a year-on-year basis — a record growth since 1970-71. Non-food credit at end January 2005 expanded by 30.9 per cent on a year-on-year basis, again a record never reached in the last 35 years.

Investments in government and other approved securities, however, decelerated on a year-on-year basis; they posted a growth of about 7 per cent. If this trend continues, it would set a record for the last 35 years.

The story behind the runaway credit has implications for monetary policy making.

Till October 2004, it was said that there was large extension of credit for housing and retail sectors. Now, it appears that credit to both industry and agriculture too has gone up sharply partly due to the express wishes of the Government of India and the Reserve Bank of India.

However, how much of credit to industry is to agriculture, and small and medium enterprises (SMEs) is not known and this would hopefully receive priority attention in the forthcoming Annual Monetary Policy statement.

The runaway credit to the commercial sector needs to be explained in terms of the commercial bank survey. The latest data on this survey (see the February Bulletin of the Reserve Bank) pertains to end-November 2004. The survey shows that the increase in total liabilities of the banks (that is, the aggregate deposits of residents, call/term funding from financial institutions, capital account, and other net demand and time liabilities) was higher at Rs 1,97,525 crore this year than Rs 1,63,444 crore recorded in the corresponding previous period, despite the fact that the aggregate deposits of residents expanded by a lower amount this year than in the previous year.

The increases in the other three types of liabilities were sharply higher in the current year than in the previous year. On the assets side, a sharp reduction in the credit expansion to the government sector and reduction in net foreign exchange assets have contributed to the runaway credit expansion to the commercial sector.

One of the beneficiaries of the runaway credit is the industrial, in particular the organised corporate sector. Apart from getting increased bank credit, the industrial sector could mobilise rupee resources through the issue of commercial paper (the outstanding amount being valued at Rs 12,107 crore at the end of December 2004 compared to Rs 8,762 crore at end-December 2003).

Besides, the new capital issues of non-government public limited companies in the first 11 months of 2004-05 amounted to Rs 8,369 crore compared with Rs 3,210 crore in the comparable period of 2003-04. In more recent months, the amounts mobilised through new capital issues have been much larger. However, the industrial units have shown less dynamism in mobilising resources through floatation of bonds.

These facts show that the availability of resources has not been a problem in making business decisions. The private corporate business sector, in fact, fared better in 2004-05 than in 2003-04. The latest data for the first half of 2004-05 (see the February bulletin of the RBI) show that `gross profits to sales' as well as `profits after tax to sales' have gone up sharply compared with the first half of the preceding year. The interest cost incurred by the sector turned out to be lower in 2004-05. Expenditures on account of stock of tradable goods and consumption of raw materials, however, increased owing to rise in prices and perceived uncertainties about availability of some raw materials at reasonable cost. On the other hand, the staff cost in relation to total expenditure was lower partly reflecting the sector's rationalisation of human resource use.

The real sector data show that the Index of Industrial Production recorded an increase of 8.4 per cent in the first 11 months of this year compared with 6.4 per cent in the corresponding period of 2003-04. There have been gains in all the areas — mining and quarrying, manufacturing and electricity or going by the use-based classification, basic, capital, intermediate and consumer goods. On this basis, the expectation is that the industrial sector would register high growth in the current year.

The agricultural sector growth, on the other hand, is not likely to be high; some estimates place it around 1 per cent for 2004-05. The services sector is expected to continue posting a high growth rate of about 8 per cent. The overall growth rate is thus placed at 6.5-7.0 per cent.

It is not yet definitively proved that bank credit expansion has lagged effects on real growth. Intuitively speaking, the effect should be contemporaneous since much of bank finance is for working capital purposes. Even if lags exist, they should not exceed more than a quarter of a year. In this context, one should remember that real growth rates of over 6.5 per cent were recorded in the 1990s in only three years when the average bank credit growth was also high.

In 1994-95 to 1996-97, growth rates in real income and bank credit were respectively 7.3 per cent and 28.7 per cent, 7.3 per cent and 20.1 per cent, and 7.8 per cent and 9.6 per cent.

The sharp rise in bank credit in these years followed the low average credit growth in the preceding three years when demand management was strictly followed as part of the overall reform package following the foreign exchange crisis of 1990-91.

However, as market financing increases, bank credit should decelerate. But when both market and bank financing are active, the output dividend should be rich but this has not happened in the current year.

It is difficult to predict high output growth next year based only on the basis of the large bank credit and market financing this year.

But the high scale of overall financing without a balanced direction towards agriculture, SMEs and other activities would be a source of worry for central bank governors for several reasons.

First, unbalanced large scale of financing would not lead to employment expansion that the Government desires. Second, large credit financing could result in adverse selection and moral hazard and raise concerns about financial stability. Finally, the current commodity and asset price increases caused as much by excess liquidity as by other factors would persist when the scale of financing is excessive. The situation could worsen if government resorts to larger credit from both the banks and other financial markets.

In this background, the RBI can be expected to direct banks to ensure that credit flows are balanced as between sectors/sub-sectors.

But to ensure that the directive is effective, it should impose severe penalties on banks that are found to give data on sectoral credit flows without following appropriate loan-classification, in order to be directive-compliant. The central bank should also encourage banks to go in for asset securitisation in larger measure than before to limit the adverse impact of adverse selection.

In addition, it should restrain the scale of credit expansion by moving up the interest rates in a measured way. Also, the Bank should as a matter of policy direct the banks to support credit growth generally from the deposit resources.

Recent evidence shows that there has been some financial disintermediation and this needs to be corrected by signalling improvements in the deposit rates. Such an interest rate policy would be consistent with the present international policy postures, and the policy of building up of international reserves.

Besides, it would obviate the need to resort to instruments such as raising the cash reserve ratio or using selective controls that often convey the impression of taking a step backward in the reform process.

(The author, a former Executive Director of the Reserve Bank of India, can be accessed at asurivasudevan@hotmail.com)

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