Coiled for a comeback: Credit revival likely faster this time due to stronger fundamentals

Economic Times

5 days ago

Two to tango RBI has eased monetary conditions, with MPC members talking of 'the need to support growth'. The focus now shifts to the first step in growth restoration-a revival in credit growth, that is, monetary transmission.How fast can credit growth pick up, and by how much? Several commentators lament the current weak demand for loans and point to prolonged lags with which credit growth picked up in the monetary-easing episodes of 2002 and 2014. Whereas their concerns and observations hold merit, current conditions are meaningfully different than in prior cycles and so should outcomes. Let us assess four major channels of monetary transmission: rates, credit, asset prices and exchange rates. Exchange rate
When interest rates fall, a country's currency tends to weaken, which becomes a growth stimulus (exports become more competitive and import substitution becomes an opportunity), boosting demand for credit. However, given that the rupee is not fully convertible, it is only weakly affected by interest rate differentials, limiting the impact of this channel. Asset price
A reduction in interest rates boosts prices of both financial and real assets. Borrowers then feel more emboldened, and lenders have more collateral to lend against. This channel is also not potent here, as the economy is far less financialised than other major economies, and interest rates have, at best, a marginal impact on asset prices. Rates Lower interest rates increase demand for loans. Rates on new loans change in the same direction as policy rates, though the gap between them varies, reflecting transmission lags. For example, interest rates on term deposits (TDs), which account for 60% of funds for banks, would only come down over a year, as 75% of TDs are of greater than one year duration currently.That said, most banks have cut interest rates they pay on savings account balances and wholesale funding rates, as measured by rates on certificates-of-deposit (CD) of 12-month duration are down more than 1.75%. Thus, banks are now cutting interest rates on new loans, which should boost loan growth. Credit channel In their 1995 paper, Inside the Black Box: The Credit Channel of Monetary Policy Transmission, Ben Bernanke and Mark Gertler wrote that monetary easing helps credit availability via its impact on borrowers' creditworthiness as well as lender's risk appetite. Given that banks are also businesses, their willingness to take on credit risk also depends on economic momentum. Usually, monetary easing starts when the momentum is weak, like it is now, so naturally at such points banks are less willing to take business risk.This is the most potent channel of monetary policy transmission in India. The low debt-to-GDP ratio in India indicates demand for loans far exceeds their supply at all points of time. There is also evidence that the loan slowdown last year was supply-driven.Whereas many believe that credit growth slowed last year only due to curtailment of unsecured personal loans (PL), data shows a broad-based slowdown driven by banks de-risking. Unsecured PLs contributed to only a fifth of the growth decline; bigger contributors were bank loans to non-banking finance companies and agriculture.In fact, a 2018 St Louis Fed paper found that in the US, shocks to unsecured firm credit explain more of economic fluctuations than shocks to secured credit, demonstrating how banks' risk appetite affects economic momentum. They found unsecured firm credit is pro-cyclical and tends to lead GDP (meaning growth in risky loans occurs before economic growth), whereas secured firm credit is a-cyclical.Whereas in 2014 nearly 60% of bank loans were at interest rates higher than 12% (loans at higher rates are considered riskier), today that ratio is just 11%. Over the past year, the banking system curtailed loans at rates above 10%, collectively de-risking further. For these loans to grow again, banks' risk appetite must improve, and that may not occur immediately after the start of monetary easing.We expect this to be a gradual process that slowly gains momentum-the first percent point increase in loan growth would improve economic momentum, which, in turn, would affect the demand and supply of higher-interest-rate (riskier) loans.It is also likely that improvement should be meaningfully faster than in prior cycles due to three reasons. There is no overhang of unrecognised bad loans, whereas in 2002-04 due to SARFAESI Act, and in the 2014-16 period due to the Asset Quality Review (AQR) and then the new IBC, borrowers as well as lenders were cautious.
There is much more capacity to lend and borrow, as lenders are well capitalised and borrowers have low debt-equity ratios.
Market share in the banking system has shifted towards the private sector. In the 2002 and 2014 cycles, PSBs held nearly three-fourths of assets and liabilities, but their share is now just half. As private banks have more incentives to take risk, once economic momentum builds, the credit channel of transmission should work faster in this cycle. The first signs of improvement could be visible in a few months. The acceleration thereafter can be faster, as regulatory easing (cuts to risk weights as well as the cash reserve ratio) is likely to amplify the recovery, and bank capital buffers are strong.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.) Elevate your knowledge and leadership skills at a cost cheaper than your daily tea. Just before the Air India crash, did India avert another deadly mishap?
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