Posted by: Deepa Vasudevan on Wed, Sep 3rd, 2014
Can Bank Credit Provide Enough Impulse to Investment?
Bank credit is an important indicator of economic activity. The banking system is the chief intermediary for the flow of funds from households (usually net savers) to the corporate sector (net borrowers). During a boom, bank credit grows rapidly to finance new investment projects. During a downturn, credit growth declines due to a slowdown in demand. Clearly, then, bank credit and investment should be closely related. Since investment data is available only with a lag, growth in bank credit is often used to predict investment trends.
Pic 1 shows a steady decline in the growth of bank credit to the commercial sector since 2011.. For the fortnight ended Aug 2, 2014, the year-on-year growth in bank credit was merely 11.2%, less than half of the 30% plus growth seen during the boom year of 2005. Could this indicate that the much anticipated investment recovery is not likely to take place soon? There has been some discussion in the press that unless bank credit is stepped up quickly, India will not be able to achieve its investment targets for 2014-15.
Pic 1 Growth in Bank Credit to the Commercial Sector
To get a more nuanced understanding of credit dynamics, we look at the credit impulse, rather than simply growth in bank credit. The credit impulse is measured as the change in the flow of bank credit relative to economic activity. Conceptually, it measures the stimulation that growth in the flow of bank credit gives to investment spending. The central idea here is that it is the change in the stock of outstanding bank credit, or the flow of new bank credit, that is relevant to investment. By measuring the change in the flow as a percentage of GDP, we can identify by how much new credit has grown relative to the size of the economy.The following example illustrates the concept of credit impulse in a simplified way. Consider a hypothetical economy with one corporate entity and one bank. The corporate invests by borrowing from the bank. The table below shows two scenarios (I and II) over 3 years. In scenario I, the entity borrows Rs.100 each year. In Scenario II, it borrows 100, 220, and 350 respectively in the three years.
Table 1 Bank Credit: Outstanding, Flow, and Change in Flow
Source: This table is based on an idea put forward in “The Macroeconomic Project: Detailed Analysis of the Australian economy”. Website: http://themacroeconomicproject.wordpress.com/category/credit-impulse/
In both scenarios, the stock of outstanding bank credit has increased, and the flow of bank credit is positive. But notice that the change in the flow of credit differs. In scenario I, the flow of credit remains constant in the last two years, so the change in the flow of credit is 100 in year 1, and zero in years 2 and 3. But under scenario II, the economy has an additional flow of credit (and additional investment) of 100 in year 1, 120 in year 2, and 130 in year 3. Clearly, Scenario II is more favourable for investment. This does not become apparent until we observe the change in the flow of bank credit. The growth in the flow of bank credit in Scenario II provides an “accelerator” to investment and GDP.
Picture 2 plots a measure of credit impulse against growth in investment. It shows that the credit impulse rose sharply (i) in the mid-nineties, (ii) during the 2003-07 boom, and (iii) in 2009-10, in response to the steep interest rate cuts announced by RBI after the crisis. Each spike in credit impulse was accompanied by a rise in investment. Since final investment figures for 2013-14 are not available, we assume an investment rate of 35% of GDP. resulting in an estimated investment growth of 12.9% for 2013-14 (shown with a dotted line in Pic 2). There is a strong co-movement between impulse and investment growth.
Pic 2 Credit Impulse and Investment
Sources: RBI, Economic Survey of India 2013-14, CSO
Next we plot the simple growth in bank credit against credit impulse (Pic 3). Note that the credit impulse shows a rising trend in the three years to 2013-14, when bank credit growth actually declined. In other words, the bank credit growth engine is still slowing down, but its deceleration is becoming lesser each year! The declining growth in bank credit suggests a slowdown in investment; but the rising credit impulse indicates exactly the opposite.
Pic 3 Credit Impulse and Credit Growth
Source: RBI, CSO
Studies have shown that credit impulse is better able to predict recoveries from a recession than other credit variables. A demand recovery can occur if new borrowing is growing at an increasing rate; it is not necessary that credit growth itself should be rising. This is a positive indicator for India, and may justify some of the buoyant market sentiment in recent months. Yet, despite their historical co-movement, a rising credit impulse does not guarantee acceleration in investment growth. Much will depend on the policy environment, and developments in US and Europe, and their impact on foreign investment into India. The only certainty is that implementing policies that stimulate investment will ensure that the rising trend in credit impulse is carried forward.
 Bank credit to commercial sector represents that part of bank credit that does not go to the government. Hence it is a proxy for bank credit to the private sector.
 See, for example, the detailed arguments put forward in “Bank Credit: A Key Leading Indicator?” by Ms.Renu Kohli in a column in Financial Express, dated Aug 26, 2014. Downloadable from http://www.financialexpress.com/news/bank-credit-a-key-leading-indicator-/1282189.
 The concept of credit impulse gained popularity after the 2008 crisis when it was used by Biggs et al to explain how economies appear to recover from a recession without credit growth. See Michael Biggs, Thomas Mayer and Andreas Pick (2009), “Credit and Economic Recovery”, DNB Working Paper No. 218, July. Available online at http://www.dnb.nl/binaries/Working%20paper%20218_tcm46-220409.pdf.
 In mathematical terms, the growth in flow of credit is the second derivative of outstanding bank credit. That is the reason why it is an “acceleration” variable.
 The credit variable is bank credit to commercial sector as explained in Footnote 1. Credit impulse is defined as the change in the flow of bank credit to commercial sector as a % of GDP at current prices. Investment is Gross Capital Formation at current prices = Fixed Investment + Change in inventories + Valuables.
 RBI estimates show that investment rate (GCF as a % of GDP) was 35.5% in 2011-12, and declined to 34.8% in 2012-13. Given the slowdown in investment in 2013-14, an average of the investment rate of the two previous years- about 35%- seems a reasonable assumption for 2013-14.