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Posted by: Deepa Vasudevan on Mon, Nov 26th, 2018

Cautious Optimism on Bank Credit

In a year that has been marked by scandals, fraud and non-performing loans in the banking sector, there is finally some positive news: the gradual rise in bank credit that started in mid-2017 has turned into double-digit growth in the first half of 2018-19 (See Pic 1). This signals an end of the post-demonetisation decline; if sustained, it may even reverse the prolonged slump in bank credit growth seen since the 2008 global financial crisis. Strong growth in bank credit is often associated with an economic boom, but a mere half-year of 10% plus credit growth does not necessarily indicate a growth pick-up. Instead, it draws attention to issues such as the deployment of bank credit and its implications for output and employment.

 

Pic 1: Bank Credit and Deposits

 

First, the sectoral break-up of bank credit has changed quite a lot in the last decade. The share of industry in bank credit has dropped by 10 percentage points since FY11; and the combined share of services and personal loans has gone up by a matching amount. This pattern has not changed in the latest Apr-October 2018 growth spurt.

 

Pic 2: Deployment of Bank Credit by Sector

 

A quick look at growth rates of bank credit by sector gives a more nuanced understanding of the credit story. Lending for personal loans grew at 15% plus levels since FY15. This category, which includes retail loans for housing, consumer durables, vehicles, education or other personal needs is popular with banks because retail borrowers are less likely to default on loans as compared to corporate borrowers. Lending to the services sector is dominated by loans to NBFCs (roughly one-fourth of the services loan portfolio) and loans to traders, reflecting the rising importance of these sub-sectors in the economy.

 

Pic 3: Growth in Bank Credit by Sector

 

But the most damning data comes from credit to industry. In FY17, caught between demonetisation and restructuring of bad assets, lending to industry actually shrunk across small, medium and large companies; the following year lending to industry remained stagnant. The 2.3% y-o-y growth in industrial credit for September 2018 is an encouraging development, but loans to micro and small firms continue to shrink. This is a worrying trend, because the MSME sector employs over 100 million people and contributes about 31% of GDP. The sector is an important source of job creation and self-employment and is still recovering from the adverse impact of demonetisation. In this context, the RBI plan to consider restructuring of stressed MSME assets with aggregate credit facilities of up to Rs 25 crore is a positive step that should ease the credit needs of this sector.

Second, NBFCs have taken up a greater role in lending in recent years, particularly in sectors such as housing loans. The expansion of non-bank financing occurred for two reasons: risk-averse banks were hesitant to lend to non-retail borrowers, and low interest rates allowed NBFCs to fund their operations cheaply. The recent rate tightening, along with the repercussions of the ILFS crisis on the NBFC sector are likely to shift the balance back towards banks. For instance, as the commercial paper market dried up, it has been reported that public sector banks are buying up loan portfolios of NBFCs and housing finance companies to provide liquidity to the sector. The recent RBI decision to relax capital provisioning norms should free up more bank funds for lending. Thus, banks will benefit from substitution credit demand as well as more lending capacity.

Finally, bank credit is not a leading indicator, but a concurrent or lagging indicator of economic growth. When demand picks up sufficiently for corporates to consider greenfield investment, they turn to bank financing. In other words, an investment pick-up requires a sustained rise in bank credit, not just a temporary lending upsurge.

Conditions seem in place for bank credit to revive, and to support investment and consumption. Whether that takes place or not will depend on a varied set of factors including but not limited to the outcome of the 2019 elections, the fallout of the US-China trade war, crude price dynamics, and US interest rate movements.  As of now, one should view the growth in bank credit with cautious optimism, rather than misplaced enthusiasm.

For better understanding of these macro events, subscribe to our Macroeconomics Indicators – Output and Growth course.

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