Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 5 Bank Credit

Credit Delivery: An Assessment

Against the above backdrop of the various recent policy efforts to improve the credit delivery mechanism, an analysis of the actual outturn in credit pattern extended by banks throws up a number of interesting facets. First, overall bank credit from scheduled commercial banks (SCBs) as a proportion of GDP stagnated during the 1990s although there are signs of a substantial increase from 1999-2000 onwards. A key factor holding down credit flow to the commercial sector was the banks' investments in Gover nment securities. As discussed later, increasing investments of banks in Government securities were initially on account of statutory requirements, but subsequently banks preferred investments on their own even as statutory requirements were scaled down significantly. At the same time, the conventional measurement of bank credit to commercial sector understates actual credit availed. Reflecting the liberalisation process, banks have been permitted to subscribe to shares, debentures of corporates and commercial paper (RBI, 1999). Investments in such instruments, at present, are around 11 per cent of the conventional credit and nearly three per cent of GDP compared to negligible levels in the early 1990s. Once such investments - termed as non-SLR investments -are taken into account, the ratio of bank credit of SCBs to GDP at end-March 2004 turns out to be 33.5 per cent as compared with 30.3 per cent based on the conventional definition.

Second, a cross-country analysis shows that bank credit to the private sector in India (inclusive of credit to public sector units) remains lower than in many developing economies. The bank credit to GDP ratio in India is one-third of that for the East Asian and Pacific region. Countries like Argentina and Indonesia that suffered from financial crises exhibit a significant decline in their credit-GDP ratios in the recent period. Even in countries like the US, where the financial systems are considered as market-based, the ratio of credit to GDP is significantly higher.

As noted above, bank credit/GDP ratio in India is lower than that in the East Asian region. This can be attributed in part to higher savings ratio in the East Asian region. High fiscal deficits and their financing by banks in India also explain the low credit-GDP ratio. This becomes clear if the total credit extended by the banking system - private sector as well as the government sector - is examined.

Third, turning to sectoral credit trends, bank credit to agriculture, as a proportion of total credit, shows a decline from its levels in the 1980s, although the declining trend has been arrested since March 2002. The share of industry in overall bank credit has also witnessed a declining trend since 1990. Amongst other key sectors, transport reveals a secular decline from its 1990 level. The decline in the relative share of the major sectors such as agriculture and industry has been predominantly on account of an increase in the sub-group "personal loans". The share of this sub-group has witnessed a multi-fold increase during the 1980s and 1990s: from around two per cent in 1980 to nine per cent in 1990 which doubled further to almost 20 per cent by 2003. Amongst the personal loans segment, housing loans have emerged as a significant category. At present, housing loans constitute nearly seven per cent of outstanding bank credit as compared with only 2.4 per cent in 1990. Apart from various policy efforts of the Reserve Bank to improve credit flows to the housing sector (noted above), the sharp growth in housing loans also reflects a softening of interest rates in the recent years and fiscal incentives.

Fourth, as a proportion of overall GDP, the declining trend in outstanding credit to agriculture has been reversed since 2001 and the ratio has exhibited a substantial increase since then. Both the components of agricultural credit - direct as well as indirect credit -have contributed to this increase. Thus, notwithstanding the falling share of agriculture in overall economic activity, credit to agriculture (as a proportion of overall GDP) at end-March 2003 was quite close to that at end-March 1990. In view of the declining role of agriculture in overall activity, it would be more appropriate to examine movements in credit to the agricultural sector in relation to its own sectoral GDP. An analysis based on this approach shows a general upward movement in credit to agricultural sector, barring a downward trend in the first half of the 1990s. Illustratively, the ratio of credit to the agricultural sector to its own GDP at around 15 per cent at end-March 2003 was higher than that of 12 per cent at end-March 1990. The analysis thus indicates that the efforts of the Reserve Bank during the last 3-4 years to improve the flow of credit to agricultural sector have been successful. The existing agricultural credit system is geared to the needs of foodgrains production. Despite the fall in the share of the foodgrains production, it is all the more creditable that the ratio of agricultural credit to agricultural GDP has not fallen. Long-term credit as a share of private investment has also been rising in the late 1990s .

The preceding analysis is based on credit extended by scheduled commercial banks (SCBs). Apart from SCBs, cooperative institutions have also been a key source of credit to this sector. Total outstanding direct credit to the agriculture sector (as a proportion to its sectoral GDP) at end-March 2002 was lower than that of the early 1990s, although the declining trend was reversed in 2001. The share of cooperatives in total outstanding direct credit to the agricultural sector was around a third in 2002 .

Fifth, credit to industry - both in terms of overall GDP as well as its sectoral GDP - has generally maintained an upward trend. This is in contrast to the earlier noted fall in the share of industrial credit to overall credit. Furthermore, credit to SSI sector also exhibits an increasing trend, contrary to popular perception. Thus, notwithstanding the pressure on banks on prudential and NPA grounds, the small-scale sector does not seem to be credit-starved although there might be pockets of SMEs that face constraints of longer-term finance. With credit to agriculture as well as industrial sector - as proportion to GDP -exhibiting an increase, the flow of credit to the services sector has concomitantly tended to fall as a proportion of GDP. Although the proportion of bank credit going to the services sector has increased since the 1980s (from about 24 per cent in 1980 to about 31 per cent by 1990 and further to about 37 per cent by March 2003), it has not kept pace with the increase in the share of the services in economic activity. This is largely a legacy of nurturing the growth of basic and heavy industries as also directing credit to the priority sector (including agriculture). Lending to services has not been favoured by traditional banking practices followed in India such as collateral-based financing, emphasis on securitised instruments, limited appetite for risks inherent in financing services and lack of standardisation and customisation of financial products. The issue of credit flow to the services sector assumes even greater importance with the growing role of the information technology sector in the economy. In the absence of collateral, a key issue is whether banks are in an advantageous position compared to other financiers with respect to access to information. The ability to assess such information crucially depends on the origin of information asymmetries and uncertainties. While banks may have superior information regarding conditions in local markets, they may lack the necessary technical expertise to evaluate such projects. This, therefore, necessitates development of specialisation skills by banks to finance such evolving sectors but, in view of their risky nature, supported by recourse to subordinated debt and appropriate credit transfer risk tools (BIS, 2002).

Sixth, the industrial sector depends upon its credit needs not only on banks but also on alternative sources such as Development Finance Institutions (DFIs) and capital markets. While banks provide short-term needs of corporates, long-term needs have been met largely by the DFIs. In the context of the dwindling role of DFIs, an analysis of the combined flow of credit from these major sources is crucial. During the latter half of the 1990s, funds available from DFIs almost halved and there was an even sharper decline in funds from capital markets. A number of factors on both the demand and supply side explain this:

• The decline in funds from DFIs reflected in part the drying-up of their sources of low cost finance. The Indian experience with DFIs has not been unique.

Most DFIs in other countries are also beset with the problems of high and growing NPAs reflecting poor cost-benefit evaluations of projects and wide spread mismatches between their assets and liabilities, especially as raising long-term resources becomes difficult with the withdrawal of state support. Many economies have now begun to restructure their DFIs. In many cases, DFIs are now expanding their areas of operations in banking, para- banking and investments. In consonance with the international experience, efforts are underway to restructure FIs in India.

• As regards capital markets, the decline of funds can be attributed to the exuberant investment activity in the mid-1990s, which led to the creation of overcapacity including some uncompetitive overcapacity. The concomitant erosion of profits explains the poor performance of the stock market in the late 1990s and earlier part of the current decade.

• Another reason for lower recourse to funds from DFIs could be the increase in the internal sources of funds. Internal sources increased from 34 per cent during the first half of the 1980s to 43 per cent in the recent period. The question, however, remains as to whether this reflects the effect of substitution of internal sources for external sources or the scale effect of an external constraint. The decline in debt-equity ratio, as a result of corporate restructuring, could also have led to a lower recourse to DFIs.

In the context of the waning of the DFIs, a key issue is: whether banks can fund long-term needs of corporates. Two factors curtail the flexibility of the banks to meet the long-term fund requirements. First, deposit liabilities of banks are of relatively shorter maturity. About four-fifths of bank deposits are of a tenor of less than five years. In view of this, long-term lending could induce the problem of asset-liability mismatches. Second, banks already hold large volumes of government paper, usually of long tenors. This further reduces the scope available to banks to fund long-term financing needs. The envisaged reduction in fiscal deficit under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 is expected to provide banks greater flexibility to lend to the corporate sector. Banks may also need to raise long-term matching liabilities through issues of bonds to fund the infrastructural projects. At the same time, there is a need to develop the corporate bond market in the country. The lack of good quality issuers, institutional investors and supporting infrastructure continue to constrain the development of corporate bond markets. Although several pre-conditions for the evolution of a successful corporate debt market such as well-functioning government securities and money markets to price paper, regulatory and legal framework, an efficient clearing and settlement system and a credible credit rating system - are now in place, there is a need to enhance public disclosure and put in place effective bankruptcy laws. Finally, the possibility of equity markets emerging as a substantial source of project finance hinges upon the expansion of the mutual fund industry and channelling of a part of contractual savings to equity markets.