INTEREST RATE HIKE
Credit typically grows more quickly than output as an economy develops through a process known as financial deepening. A relatively high rate of economic growth increases the demand for credit. The expansion of credit from relatively low levels of financial intermediation – credit to GDP ratio of 20 per cent in 1992-93 supports the “catching up” hypothesis. However, credit growth in the past two years has accelerated at a much faster pace, leading to a 75 per cent increase in credit to GDP ratio since 2000-01.
It is widely believed that an increase in the level of financial intermediation in an economy associated with an increase in its trend growth rate. To that extent, the surge in credit growth recently witnessed in India is encouraging. However, the downside of this rapid growth in bank lending is the risk to financial sector stability that may arise from deteriorating asset quality that is often associated with credit expansion to housing and real estate sectors. Such an expansion increases the vulnerability of the banking system to asset price volatility.
A large part of the incremental growth in credit over the past year has gone into housing and real estate. The share of housing and personal loans has more than doubled, albeit from a low base, now standing at 15 per cent of outstanding bank credit.
In addition, a good deal of priority sector lending is also thought to be directed to housing loans on top of the credit extended to housing finance companies by commercial banks. Overall, growth in bank credit in recent years has been accompanied by changes in the composition of loan portfolios towards relatively high-yielding (although riskier) loans, and away from more traditional options such as industry lending.
A key question is whether rapid credit growth, which is currently underway, is part of the ongoing process of financial deepening or a credit boom which is a situation where credit expands at an unsustainable pace.
The structural changes that have occurred in India in recent years make it difficult to compute the trend level of credit. Financial analysts calculations show that India experienced a credit boom in the last two quarters of 2005-06.
The critical aspect from the economy’s point of view is whether this credit boom has been accompanied by rapid consumption growth and asset price misalignment. The answer, in short, is yes. Easy credit availability has eased the liquidity constraint on households, leading to a higher demand for personal loans and housing.
Given short-run supply constraints, this upward shift in credit-financed domestic demand tends to exert upward pressure on asset prices. Higher property prices stimulate more construction and increased construction activity leads to higher demand for loans. Thus, such credit expansion, while raising housing and real estate prices, tends to result in the weakening of the relationship between credit growth and GDP growth.
However, the relation between credit and GDP has weakened since the first quarter of 2004-05. This could be a structural shift in the economy towards a less credit dependent service sector another plausible explanation could be a change in the industrial financing pattern.
Recent growth in credit is relatively higher in sectors such as retail and housing, monetary authorities face a dilemma. The Reserve Bank of India has increased the policy rate four times since April 2005, with little apparent effect on credit growth until March 2006.
A combination of three possible reasons may explain this:
1) Banks did not raise their lending rates sufficiently;
2) Banks continued to favor high yielding housing loans with a relatively low default history;
3) Time lags involved in the policy transmission process.
Higher profits have made it possible for firms to rely more on internal funds and on the stock market, decreasing industrial demand for credit. This implies that the credit boom of the last two quarters of 2005-06 is unlikely to give any extra impetus to the current momentum in GDP growth since most of the additional credit growth has gone on to fuel asset price increases, rather than additional output in either industry or service sectors.
In the current macroeconomic scenario with stable inflation outlook and a moderation in credit growth, we believe that a rate hike in the impending quarterly monetary policy review of the RBI is unwarranted.