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

Module: 5 Bank Credit

Bank Credit to Government

The banking system is a source for funds for not only the private sector but also for the government sector. In India, with progressive widening of fiscal deficits from 1960s onwards, the burden of financing has been borne by the Reserve Bank and the banking system. As the Reserve Bank financing beyond a limit is inflationary, the increase in the Reserve Bank support to the Central Government was accompanied by an increase in cash reserve requirements (CRR). As regards the support of the banking system to the Government's borrowing programme, it took the form of a progressive increase in the SLR. Although interest rates on Government securities - initially kept artificially low to contain the interest cost of public debt - were steadily raised to enhance their attractiveness to the market, it got increasingly difficult to get voluntary subscriptions even at higher rates of return. The SLR, therefore, was raised to 38.5 per cent by the early 1990s and coupled with the increase in the CRR, statutory pre-emptions exceeded 60 per cent of total resources. This curtailed banks' lendable resources significantly and, as noted above, credit to the commercial sector (as a proportion to GDP) showed a near stagnation during the 1980s and 1990s. As a proportion to their deposits, bank credit to the commercial sector exhibited a sharp decline during the 1970s. The declining trend continued during the 1980s, albeit at a moderate pace (Chart VI.4). Non-food credit by scheduled commercial banks was as high as 76 per cent of their deposits in March 1971; the ratio fell to 60 per cent by March 1990.

As a part of the reform process, the statutory pre-emptions were cut and, at present, these are just half of their early 1990s level. The SLR, in particular, was reduced from 38.5 per cent to 25 per cent by 1997. This reduction in SLR was expected to reduce banks' holdings of the Government paper and correspondingly lead to a higher flow of credit to the private sector. Notwithstanding the flexibility provided by the new regime, the holdings of the banks in the Government securities remain significantly higher than the requirements and, in fact, tended to increase over time. By early October 2004, scheduled commercial banks' holdings of SLR securities amounted to around 40 per cent of their net demand and time liabilities (NDTL) as compared with the required 25 per cent.

A cross-country analysis shows that lending by banks in India to the Government (as per cent to GDP) is comparable to many developing economies but higher than some of the East Asian economies (Table 6.10). Illustratively, during 2001-03, bank credit to Government in India was almost 27 per cent of GDP, significantly higher than that of two per cent in Korea. This is in sharp contrast to the earlier noted trend in regard to credit extended to the private sector where the ratios for these economies vastly exceed that of India.

A number of factors explain the banks' preference for holding excess Government securities. First, demand for private credit moderated following the slowdown of the Indian economy from 1997-98 onwards. Available empirical evidence suggests that there is a co-movement between output and credit demand. Downward rigidity in the lending rates of the banks could also have reduced demand for bank credit. Econometric analysis suggests that real non-food credit is positively related to output and negatively related to interest rates. Estimated elasticity of real non-food credit of 1.6 suggests that demand for real non-food credit increases more than the increase in output (Box VI.4).

Second, capital flows from abroad have been quite strong since 1993-94 (see Chapter IV). This increased the availability of funds with the banks and, in view of weak credit demand, banks preferred to invest these surplus funds in Government securities. Third, a key factor appears to be the fiscal deficit of the Government which has continued to remain high. Market borrowing requirements of the Government sector have, therefore, been increasing. Weak credit demand coupled with increased funds due to capital inflows enabled banks to invest in the Government paper. Otherwise, the pressure to finance the fisc could have rever ted to the Reser ve Bank or alternatively, it could have led to pressures on interest rates.

Fourth, the preference of the banks for investment in Government securities was also influenced by the phased tightening of prudential norms on capital adequacy, asset classification and income recognition to international standards. These prudential guidelines could have increased risk aversion on the part of the banks to private sector lending, since the credit risk-free Government paper requires zero provisioning. Thus, capital adequacy requirements of banks increases substantially while extending credit to the private sector but no such addition is required while investing in Government paper. Fifth, in an environment of softening interest rates, which prevailed for an extended period of time - from around 1998 onwards till early-2004 -investment in Government securities also turned out to be relatively attractive. In fact, the treasury operations of banks have been a significant source of their profitability in the past few years. These profits strengthened banks' balance sheets and enabled them to provide resources for NPA provisioning. Finally, another reason of risk aversion to lending to the private sector could be that the loan officers worry about the possibility of being falsely accused of corruption. Banerjee, Cole and Dufflo (2003) find some empirical support in favour of this proposition.

The banks' preference for gilts had a few benefits. First, as noted above, in the past couple of years, it boosted banks' profitability and balance sheets. Second, excessive lending in times of poor growth could have generated problems of adverse selection. At the same time, large investments in gilts raise a number of concerns. First, it reflects dissipation of banking knowledge capital with regard to credit appraisals and runs a danger of the link between liquidity, credit, money and economic activity being severed in the long-run. Second, in view of the excess investments, the burden of funding the borrowings could revert to the Reserve Bank which makes monetary management difficult. Finally, investment in Government securities are subject to market risks arising from fluctuations in market rates of interest. With the upturn of the interest rate cycle, there could be an adverse impact on banks' profitability. In this context, it is relevant to observe that the Reserve Bank had advised banks to build-up Investment Fluctuation Reserves (IFR) to meet such eventualities.

On the positive side, the pick-up in investment activity in the economy from the second half of 2003 onwards has led to a strong credit demand from the private sector. Correspondingly, investments of the banking system in Government securities have recorded a significant deceleration. The enactment of the Fiscal Responsibility and Budget Management Act, 2003 with its envisaged reduction in fiscal deficits will help to reduce banks' investment in gilts and, correspondingly, this is expected to enhance the credit flow to the private sector.