The Chidambaram solution

P. Chidambaram, as Finance Minister once again, seems a man in a hurry. Many are concerned that India’s growth is slowing, and that this (and other) evidence is hurting the government’s image among so-called “investors”. “So called” because they clearly are not investing enough, and blame that on the failure of the government to generate the necessary confidence (read, “guarantee profits”). So Chidambaram has offered a solution. He brought the nation’s bankers, especially the unavoidably pliant public sector bankers, to the table and advised them to lend more, at lower interest rates (and therefore lower EMIs or equated monthly instalments), to potential consumers, to induce them to purchase durables, and everyone else, to induce them to spend. That would revive demand and stimulate growth, he argues.

It is surprising he chose to do this. Finance Ministers should focus on fiscal policy and the central bank should deal with monetary matters. Besides, bankers receive deposits on which they pay interest or borrow to mobilise resources at a cost. They, therefore, cannot afford to sit on that money but must necessarily lend or invest. The difference between the interest or return they earn from such activity and the cost of their capital determines profit (after adjusting for operational costs). So what bankers do is lend or invest. In which case, what more is Chidambaram requiring from them other than their normal practice?

Clearly, the Finance Minister is calling on banks to lend more to certain kinds of borrowers (namely, households) to finance spending in particular areas (varying from durables to automobiles and housing). Such debt-financed expenditure seems to be his solution to address the slowdown. In recommending such a solution Chidambaram is indeed learning from the recent past. Ever since fiscal conservatism gripped governments in India and elsewhere, policy makers have been searching for an alternative to debt financed public or government expenditure as a stimulus for growth. In practice, easy money and low interest rates in pre-crisis America and Europe, offered debt financed private expenditure as a substitute.

India too had adopted that trajectory. This was reflected in two tendencies in the country. The first was a sharp increase in the credit provided by the banking sector from 37 per cent of GDP in 1970 to 50 per cent in 1980, and then from 51 per cent of GDP in 2000 to 75 per cent in 2011. Clearly the years of high growth since the 1980s were ones in which credit as a ratio of GDP was high and rising.

The second and more relevant tendency was a rise in the share of personal loans in gross bank credit provided by the scheduled commercial banks. That ratio rose from 9.3 per cent in 1996 to 11.2 per cent in 2000 and then on to an average of 25 per cent during 2005-07. Thus, in the period when debt provided by the banking system was rising sharply, the share of personal loans in total bank credit also spiked. These loans went largely into housing, automobile purchases and purchases of durable. In the process they stimulated direct and indirect demands for manufactured goods and helped stimulate manufacturing growth.

The problem is that the crisis years have seen a downward trend in the share of personal loans in bank credit, with the ratio placed at a lower though significant 17.6 per cent in the financial year ending March 2012. Clearly, Finance Minister Chidambaram sees in this an opportunity. If the ratio can be restored to and taken beyond its previous peak, he seems to think, demand would grow and the downturn in growth can be reversed.

That, however, ignores the factors underlying the slide in the retail credit to gross credit ratio. Part of the reason for that slide was recognition in different quarters of the unsustainability of the rapid rise in exposure of the Indian banking sector to the retail segment and the dangers thereof. The crisis in the West only encouraged the regulator to act in this area. To quote the Reserve Bank of India: ”Housing loans constitute around half of the total personal loans in India and as a result a boom and bust in the housing market can affect quality of assets. The build-up of systemic risk in this area in India was avoided mainly due to implementation of macroprudential policy by the Reserve Bank like changing the risk weights for loans to real estate. “

Besides the RBI’s intervention, the slide in credit to the retail segment was also the result of the recognition by the banks themselves (including some foreign banks) of the dangers of excess retail exposure. In its most recent Financial Stability Report released in June the RBI had flagged the evidence that besides the priority sector, the increase in gross NPAs for the year ending March 2012 was largely contributed by retail and real estate. Moreover, that problem appeared to be differentially distributed. “Expansion of credit to retail and real estate sectors accounted for the bulk of the growth in credit among the old private sector banks – a trend which would need to be carefully monitored, if sustained,” it noted. Thus, the central bank is not in favour of a runaway increase in retail credit. And the crisis in the developed world affords ample explanation as to why it is being cautious.

Given this background, the Finance Minister’s effort to use the banks as an instrument to reverse the growth downturn seems misplaced. He may be refraining from increasing public expenditure because of his own fiscal conservatism and his desire to convince financial markets that he can reduce the fiscal deficit on the central budget. That obviously limits his ability to deliver on the objective of reviving growth. But it is a bit cynical to try and achieve the latter objective by making the banks take on excessive credit risk. He should stick by the view that bank managements, including those in public sector banks, must be given their autonomy when deciding on their lending practices and the task of regulating them and influencing their behaviour must be left to the central bank.