In its recent monetary policy statement the RBI has met analyst expectations by raising the repo rate by half a percentage point (or 50 basis points) from 6.75 to 7.25 per cent. As a result, the repo rate today is two percentage points higher than the 5.25 per cent it was set at a year back, on April 24, 2010. The central bank is clear about the intent of its manoeuvre. Its statement issued on May 3 notes: “Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.”
An increase in the repo rate by increasing the cost at which banks can access short-term capital is expected to induce them into raising their lending rates and the rates they pay the depositors from whom they mobilise much of their capital. Besides this, a change in the interest rate would affect variables such as the prices of assets (stocks and housing) and the exchange rate. But the main channel through which interest rate adjustments are expected to work their way through the economy to reduce inflation is through the impact that the policy rate has on various commercial interest rates, such as those for mortgages and consumer loans.
Thus if the expected transmission is indeed occurring, interest rates charged to borrowers must have been rising and would rise further, in response to the hike in the repo rate. This does have one implication that tends to be ignored in discussions of the possible dampening of demand and therefore of inflation that would follow the recent repo rate changes. This is the effect that hikes in interest rates can have on the ability of borrowers to meet their interest and amortisation commitments in the wake of the sharp increase in interest rates over the last year.
This problem is of particular significance because the fall-out of financial liberalisation has been a rise in the credit-to GDP ratio in the economy and an expansion of the universe of borrowers, as a result of an increase in the share of retail loans in the total. The ability of banks to lend has expanded because the Indian economy is awash with liquidity as a result of massive inflows of foreign capital. Excess liquidity has encouraged them to seek out potential borrowers and persuade them to increase their portfolio of debt. In the event, even at a time when GDP growth had been accelerating, credit had grown at an even faster rate. The schedule commercial bank credit-to-GDP ratio in the country, which rose from 20.4 per cent in 1990-91 (when the reforms began) to 25.3.4 per cent in 2001-02, had risen to 52.1 per cent by 2009-10.
Accompanying this rise in credit provision was an increase in loans to individuals and professionals (Personal Loans and Professional Services), whose share rose from 9.4 per cent to 16.8 per cent between end-March 1990 and end-March 2002, and then shot up to 27 per cent by end-March 2005. This is the direction in which credit had moved, and these were the sectors accounting for a substantial part of excess credit growth.
While a number of sub-categories such as loans for purchases of automobiles and consumer durables, especially the former, gained in terms of growth in credit provision, there is one sector that has absorbed the bulk of the increase even here: loans for housing. The share of housing loans in scheduled bank credit rose from 2.4 per cent in 1990 to 5 per cent in 2002 and then to 11 per cent by 2005.
However, after a spurt in 2005-06, the growth in retail credit (including the personal loan portfolio of banks) reflected deceleration in the subsequent years till 2009-10. However, the deceleration was largely on account of loans for automobile purchases, consumer durables and credit card receivables. Housing loans, that constitute the largest chunk of personal loans, registered robust growth in 2009-10, at 20 per cent.
It would be wrong to presume that banks turned to the retail segment only because of the “push” out of the corporate credit market. Loans to the retail segment are lucrative. Since they are distributed across a large number of borrowers the risks involved in such lending are hedged. Lending to the housing sector creates its own collateral in the form of the mortgaged property. And, finally, banks in India, like their counterparts in the developed countries, are increasingly securitising retail debt. Mortgage loans to different segments are bundled together and securitised, with the securities thus created being sold to financial institutions, insurance companies and mutual funds. Credit created by the banks disappears from their balance sheets and appears in the investment portfolios of investors and funds. This permits banks to transfer some of the risk associated with retail lending, reducing the risk they carry as a result of their high exposure to these markets.
The evidence shows that with the effects of the global crisis behind us, personal loans have risen sharply. Aggregate personal loans provided by the commercial banking sector rose by 17 per cent in 2010-11, as compared with 4.1 per cent in 2009-10. Within this category, the growth during 2010-11 in housing loans stood at 15 per cent and in loans against consumer durables at 22.4 per cent, as compared with 7.7 and 1.3 per cent respectively in 2009-10.
This is where the effects of the rise in interest rates over the last year are bound to be felt. Those taking on these loans would have in recent months been faced with significant increases in the equated monthly instalments they pay. This would not only discourage further borrowing and new borrowers, but can lead to defaults.
Given the high exposure in a single area like housing, the risks are now clearly rising. While lending to home owners may be a more secure form of credit, because housing assets serves as reasonably good collateral, a rapid increase in such credit inevitably involves features that spell risk. Finding a growing number of new borrowers to ensure credit offtake inevitably requires relaxing income criteria for those applying for loans or lending to those whose income stream is not guaranteed or secure. It may also involve lending without adequate scrutiny of income documents. The result would be an increase in the proportion of risky borrowers in a situation of rising credit provision and increased exposure to the housing market. Defaults and foreclosures could increase. Such defaults are likely to significantly higher in a period of rising interest rates, with adverse consequences for bank profitability and even viability.
This is not a prospect that seems to matter when interest rate hikes are being considered or when the likely effects of the hikes are being discussed. The focus on inflation and the belief that interest rate policy is the best instrument to address it may, however, have costly side effects that need to factored in.