Are we starving the proverbial goose?

NON-food credit off-take has boomed, growing by 33% and 32% in 2004-05 and 2005-06. And there was some increase in policy rates, though the pass-through to lending rates was significant only from the second half of fiscal 06. Indian banking has become competitive, which may have discouraged players to hike rates; then again liquidity was easy till about the middle of last year, and the increase in bond yields had caught many banks off-guard, prompting them to push loans at low rates. There has also been some forbearance presumably in the apprehension that increasing lending rates may be akin to killing, or at least starving, the goose that lays the proverbial golden egg, ie economic growth.

At one level, the loan market is similar to other markets. If the demand for credit is strong and outstrips the supply of funds (savings), the interest rate (like any other price) will be driven upwards, which in turn will moderate demand and raise the supply, generating a new market-clearing level with lower credit volume and higher interest rate. Real life is much more complicated. The central bank, since it can influence the supply of liquidity at the margin, can also set short-term rates. To that extent, the interest rate is exogenous to the funds market. Central banks move rates to contain volatility in financial markets?moving rates down when economic conditions weaken excessively and moving them up when conditions improve.

Investors borrow to finance assets. Businesses borrow to finance both working and fixed capital. Individuals borrow to finance homes, cars and other durable goods. Governments borrow to finance the shortfall of their revenues against spending. The impact of changes in interest rates on their borrowing varies.

Businesses are driven by their assessment of the profitability of borrowing. If market conditions warrant aggressive expansion, they will borrow more, reckoning that the returns on their incremental business revenues will more than compensate for their higher interest burden. Note that the incremental profits are at best, educated guesses, while the higher interest burden is a certainty. If general conditions weaken, businesses will cut back on their borrowing to reduce financial risk and interest cost.

What happens to interest rates has thus a smaller impact on business borrowing decisions, than their view on the profitability of expansion and the risk in assuming greater debt. Then again, businesses are alive to the interest rate cycle and know that rates do not follow one trajectory for ever and fixed assets have a long economic life.

For home buyers, a lower interest rate or, more directly, a lower EMI (equalised monthly installment) is important and an increase in rates may cause some deferral. Real estate purchases are also influenced by asset price; to the extent that it offers a leveraged asset play, the impact of interest rate changes on the demand can be compounded. Credit demand for financing consumer durables is likely to be directly affected by changes in interest rate. Government decisions to borrow are mostly governed by other factors.

But does this happen? In India, interest rates began to decline since 2001, but that did not bring as rapid a recovery in credit off-take as did the recovery in economic growth in 2003-04.

The evidence is more vivid in the US. Commercial and industrial (C&I) credit grew rapidly in 1997 and 1998 and again in 2000?periods of strong economic growth and high interest rates; the US Fed rate was at its recent all-time high of 6.5% in summer 2000, and it was also quite high in 1997 and 1998 (5.25-5.50%). When the recession began in 2001, it was progressively lowered to below 2% by late 2001 and to 1% in June 2003. But, C&I lending declined over 2001 to the middle of 2004. It revived in late 2004 and registered explosive growth in 2005 and 2006.

Real estate credit, on the contrary, shows strong growth both in economic good times and high interest rates (1999 to 2000 and 2004 to 2005) and when economic conditions are not good, but interest rates are low (2002 and 2003). There are other channels of debt in addition to bank credit?from commercial paper to bonds to loans from finance companies. The picture is the same. Data show that the growth of business debt dropped precipitously in 2002 and 2003 and recovered very strongly in 2005 and the first quarter of 2006. Aggregate household debt, on the other hand, received a big boost with lower interest rates; the annual rate of increase jumped to over 11% in 2003 and remained at such high levels in 2004, 2005 and the first quarter of 2006.

So, if lending rates rise in India, they are likely to curb the appetite for personal credit and, to that extent, reduce aggregate demand and hence, growth. To offset this, investment to create manufacturing capacity and infrastructure needs to be made, as capacities are deficient anyway in many cases. This will generate additional aggregate demand. Credit demand may not be offset, since investment has a greater array of financial sources to choose from. In any case, a third year of 30% credit growth may not be desirable. In the first 4 months of 2006-07, credit has grown by 3.2%, much more than the 2.2% in the comparable period last year. That RBI has, since July 28 this year, begun to report credit increase in the comparable period of last year with respect to April 1, and not the last reporting Friday as earlier, is welcome. This helps to focus more clearly on the dimension of credit expansion in the current fiscal.

?The writer is economic advisor, Icra