Do RBI rate cuts matter?

TK Arun                                                              01 November 2012, 10:11 AM IST

To debate the relevance of the country's central bank might seem facetious or plain dumb. But too much is being made of the central bank's failure to cut policy rates. It is being accused of being dogmatic on inflation, of not seeing the parlous state of growth. All such passion stems from assuming that the RBI's policy rates matter the way central bank action matters in the US or Europe. This assumption is fatally flawed. The RBI is largely irrelevant to large swathes of the economy.

Bank lending, defined to include credit and investment in bonds, is some 67% of the total value of economic output or GDP in India. It is about145% in China, way above 200% in Europe and the US, and some 340% of GDP in Japan. Does this mean that India is a strange kind of economy that makes do without credit? Hardly. India's is amarket economy where credit has a hoary history and an elaborate institutional structure involving hundis and entire castes whose sole occupation was usury. Bank lending's lack of heft only means that the Indian economy draws its lifeblood from sources other than the banking system.

What might be the actual extent of credit in India? We can only guess. Since ours is a market economy, it must be similar to US and European levels. But these economies are way too over-leveraged, so our credit level must be lower. China, too, would have a large informal credit network, but probably smaller than India's. So, it would be fair to estimate India's credit requirement at about 150% of GDP. If we take out what banks lend the government, bank lending is about 50% of GDP.

In other words, banks account for only a third of the economy's credit requirements. The informal credit system takes care of the remaining two-thirds. The rates in the informal market are way above the rates in the formal market, 50% more in the larger organised segments to several times as high as formal sector rates in retail loans (a vegetable vendor who borrows Rs 900 in the morning and pays back Rs 1,000 in the evening bears an annualised rate of interest of 406%).

Indians have a culture of segmenting the credit market and creating differential interest rates for different borrowers. A chit fund, called a committee in many parts of the country, is a pool of savings available to a closed group of savers-cum-potential borrowers. The intensity of credit need within the group determines the interest rate within the chit fund. Since the savers have no ready access to another source of credit, they do not benchmark their rate against anything else. Earlier, when stock markets had badla, the interest rate on the financing needed to carry the trade forward varied from stock to stock, from trade to trade.

Shopkeepers have their own system of credit and rates of interest. Property dealers and real estate players who access large amounts, typically from corrupt but powerful politicians whose power is the only guarantee against default, have their own credit framework. Farmers who borrow some from banks and the rest from the powerful coterie of buyers licensed by the Agricultural Produce Marketing Committee, have their own interest cross to bear (a fair share of so-called agricultural credit goes to realtors). The small and medium enterprise sector also obtains only a tiny portion of their credit from the banking system. The rest comes from informal sources whose lending rates are way above what the banks offer.

India's credit market is both stunted and fragmented. For two-thirds of economic activity based on informal credit, a quarter of a percentage point reduction in the RBI's repo rate means next to nothing. Sure, for consumer finance and home loans, these rates do matter. For stock markets and foreign institutional investors, the central bank's policy rates serve the purpose of signalling. The biggest impact is, of course, on the biggest formal sector borrower, the government. But this apart, the RBI and its lending rates are a part of a west-centric public discourse, where suited men talk of Greece and Spain and other tardy matters, whose only purpose, as far as the bulk of the Indian economy is concerned, is to provide gender parity for the women who come and go, talking of Michelangelo.

Let us stop making a big fuss of either the credit policy or its supposed failings. The RBI needs to embrace the opportunity offered by Aadhaar-based cash transfers to begin full-fledged mobile banking in the country through new licences to joint ventures between phone companies and banks. This will extend the reach of formal finance and make policy rates more relevant to more people.

The government should focus on stepping up investment, which is stalled not so much by the cost of money as by dither in official project clearance action, owing to irrational, rent-maximising procedure and civil servants putting a premium on their own tender posteriors over the capital formation they are entrusted with.

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