Betting on a credit boom

Print edition : November 01, 1997

In pursuit of easy and cheap credit conditions aimed to spur industrial growth, the busy season credit policy pushes banks to pursue a high-risk lending strategy.

C.P. CHANDRASEKHAR

CLAIMING success in moderating inflation, Reserve Bank of India Governor C. Rangarajan has apparently chosen to focus his attention on triggering an industrial recovery. His public posture is, of course, more cautious. In an interview to Business Line he stated, in typically monetarist fashion: "There are two objectives of monetary policy - one is to moderate money supply growth so as to achieve a reasonable degree of price stability, and the second, to provide the necessary credit to support the growth process."

Official figures show that inflation is down to unusually low levels by recent Indian standards. And few would argue that liquidity conditions in Indian markets are inadequate to support current growth rates. This would suggest that monetary policy is on track. Yet he has chosen to make significant changes in the busy season credit policy to enhance liquidity substantially, with the explicit intention of reversing the sluggishness being experienced by the industrial sector.

The current easy liquidity situation is, of course, the result of initiatives taken under Rangarajan's stewardship. As a result of repeated reductions in the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR), which earlier substantially preempted bank funds, and because of other measures that increased the flexibility of financial agents, the credit-creating potential of the financial system has been considerably enhanced over the last couple of years.

Yet the recession persists because of sluggish demand. From a monetary point of view, the problem, therefore, is not one of inadequate funds but of inadequate credit offtake, because of the lack of a sufficient number of creditworthy borrowers. Mid-segment borrowers who complain of inadequate access to credit are in fact ruing the fact that banks do not consider them to be reliable borrowers. The recession only aggravates the problem as a larger number of those who would have liked to borrow are seen to have crossed the threshold of reliability because of poor performance.

The persistent recession thus reveals the limits of monetary policy. The latter can only enhance the credit-creating potential of the system, while actual credit-creation depends on the existence of an adequate amount of demand for credit from reliable borrowers. However, with inflation under control, Rangarajan has chosen to seek a greater role for monetary policy. In its recent credit and monetary policy the RBI has chosen to pressure banks into providing existing borrowers with more credit than they earlier considered prudent, and into lending to a wider range of borrowers than they earlier considered creditworthy, with the aim of stimulating credit-financed investment and consumption demand. This it plans to do by a further reduction in the CRR to 8 per cent from 10 per cent over the next six months, releasing in the process an additional Rs.9,600 crores of liquidity, and a reduction in the SLR to 25 per cent, which increases the banks' flexibility in choosing its borrowers.

The point to note is that this increase in liquidity is being engineered at a time when the Central Government has already borrowed Rs. 50,005 crores out of the Rs. 52,963 crores targeted in the Budget. Even if that target is exceeded by a small margin, the Government would not be a major borrower in the coming months. Hence, banks would have no option but to lend to the commercial sector if overall credit is to increase substantially. The understanding possibly is that when banks are flush with funds their perceptions of risk are bound to be less strong than otherwise, translating a liquidity increase into a credit boom.

One consequence of a changed perception of risk would of course be that banks would be willing to lend long-term for investment purposes, rather than merely short-term for the working capital requirements of industry, as is conventionally the case. This would obviously put the banks in competition with financial institutions such as the Industrial Finance Corporation of India (IFCI), the Industrial Development Bank of India (IDBI) and the Industrial Credit and Investment Corporation of India (ICICI), which have hitherto dominated the market for long-term credit. Competition among lenders obviously takes the form of rate cuts, with the newer entrants like the banks having to offer more competitive interest rates. Expecting this, the RBI, which requires banks to declare their prime lending rate (PLR) or the rate at which they lend to most-favoured borrowers, has allowed in its policy for the possibility that banks would like to specify a different PLR on long-term credit (where competition is greater) than on short-term credit.

However, changed perceptions of risk alone would not do. Banks would also have to reduce interest rates if they have to exploit the 'benefit' of greater liquidity provided by the central bank. Not surprisingly, immediately after the release of the new credit policy, banks declared a reduction of their PLRs by one-half to one percentage point. What was not so expected was that the very next day the State Bank of India (SBI), possibly influenced by the central bank, not only reduced its PLR from 13.5 to 13.0 per cent but announced a new medium-term prime lending rate (MTPLR) which was fixed at 12.75 per cent. This was surprising because, conventionally, the risks associated with long-term lending are seen as higher than that characteristic of short-term lending, because of the time period and the purposes for which long-term credit is provided. As a result, the long-term interest rate normally rules above the short-term rate. By declaring an MTPLR lower than its PLR, the SBI is declaring that in its effort to compete with the financial institutions in the long-term market, it is willing to cut rates by an amount greater than the premium which long-term lending normally commands.

Given the huge infusion of excess liquidity into the system, other banks and the financial institutions would have no option but to cut their long term rates in response to the SBI's action. This does suit the RBI, which found that its past efforts to increase liquidity and use cuts in the bank rate as a mechanism of reducing market interest rates had more of an effect on short-term rather than long-term rates. As the RBI's Annual Report had made clear, long-term rates were proving unusually sticky. Seen in this light, the thrust of the RBI's recent policy appears to be that of forcing long-term rates down.

Higher volumes of and reduced rates on risky, long-term lending threaten bank profitability in two ways: first, they tend to reduce the "spread" between the interest the banks pay depositors and that they charge their lenders; second, they raise the possibility that the share of "non-performing" assets in the banks' portfolios could increase because of default. Banks have responded to the first of these possibilities by reducing deposit rates across the board. They have also been helped by the RBI, which, concerned with bank profitability, has sought to reduce partially the cost of resources to banks. The proposed 2 per cent reduction in CRR would reduce the "idle" resources held by banks, if they find suitable borrowers. Further, the Bank Rate at which the central bank provides refinance facilities to the banking system has been cut by one percentage point from 10 to 9 per cent. Finally, on that part of idle resources held as deposits with the central bank, banks would earn a higher average interest rate of 4 per cent.

However, reduced interest rates on bank deposits could see a shift away from such deposits on the part of savers who may be offered better terms by small savings schemes (which even now offer a pre-tax return of 12 per cent), non-banking financial companies (NBFCs) and corporations issuing equity or accepting fixed deposits. Such a process of "disintermediation" had been experienced in the early 1990s. It is true that with the stock market down and many NBFCs proving unreliable, bank deposits have recently found favour. Based on this and the fact that bank deposits have risen by 7.5 per cent till October 10 this financial year as compared with 6.5 per cent during the corresponding period of the previous financial year, banks and the RBI have taken the risk of letting deposit rates fall further. But the fact that the RBI has in its current policy removed the cap on interest paid even on short-term deposits of three months to a year points to the fact that it wants to give the banks the flexibility of responding to changing saver preferences. It also is a recognition that adequately profitable spreads, even if a reality now, may not remain so in the medium term, since competition for depositors would raise deposit rates while competition for borrowers would reduce lending rates.

Further, the RBI has no way of dealing with the threat to bank profitability which comes from the risk of increased default in the wake of a more liberal lending environment. In a half-hearted recognition of this possibility, the RBI has promised to issue new guidelines for asset-liability management, or an appropriate matching of the structure of risks associated with assets and liabilities. The significance of financial institutions like banks is that they take on liabilities which offer certain returns with low lender's risk and high liquidity, and invest in assets with much higher risks and relatively low liquidity. The current policy both increases risk and reduces the liquidity of bank assets by forcing them to lend long-term and to lend to less creditworthy borrowers. While banks may be able to play with spreads to an extent, they can hardly improve the asset-liability match in the new environment.

Thus, what the busy season credit policy does is that in pursuit of easy and cheap credit conditions aimed at spurring industrial growth, it pushes banks that hold deposits from small investors to pursue a high-risk lending strategy. To the extent that the recession in industry is due to sluggish demand and a consequent low inducement to invest, there is no guarantee that easier and cheaper credit would spur investors looking for a demand-side rather than a supply-side stimulus. Industrial recovery may require fiscal rather than monetary stimuli, or an exogenous recovery in export demand which is unlikely. If such a recovery does not occur, the chances that banks would be stuck with larger non-performing assets is all the greater. That could easily trigger a major financial crisis.

An important factor underlying the financial crisis in many South-East Asian countries today is the fact that, in the wake of financial liberalisation, banks built up a huge portfolio of non-performing assets. This does not seem to deter the RBI, as the recent credit policy suggests. Rather, despite his veneer of caution typical of central bankers, Rangarajan is choosing to take a gamble. This is not to suggest that he likes a good bet. What seems to drive the central banker today is his fascination with liberalisation and the market and his unfounded belief in the ability of monetary policy to provide a solution to India's economic problems.

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