Rashmi Shankar Mishra: The ongoing credit crisis

The missing link in macroeconomics is a coherent theory of the impact of dual credit markets on the transmission mechanisms of monetary policy. The not-so-formal financial sector provides loans on flexible terms, is unregulated so there is no troublesome paper work, and is typically there, with the cash, when needed. The bulk of consumption smoothing and emergency finance for the poor is handled informally, in both rural and urban India.

The problem is the terms at which credit is available. Interest rates vary depending on how well the lender knows the borrower, maturity, the size of the loan and seem to range between 60 per cent and 120 per cent. A loan of Rs 2,000 taken to tide a family over a crisis (or a celebration), may carry an interest burden of Rs 200 a month or about six days of food for a family of four. Very short term loans could carry even higher interest rates. Lending rates in the formal financial sector, on the other hand, are currently between 10.75 and 11.5 per cent. These numbers suggest that credit markets remain deeply segregated. But should monetary policy be designed for only one set of market participants?

Duality in credit markets reflects sectoral and locational imbalances in the economy, but also serves to perpetuate these imbalances. In the interests of both sustained growth and greater equity, there has to be considerably higher capital formation, growth and employment generation in non-agricultural activities in rural India. That would be impossible without credit on easier terms and for more borrowers.

A study published by the World Bank (Basu and Srivastava 2005) found, based on a 6,000 household survey, that most rural households (over 60 per cent of the population) do not have access to formal finance. Liquidity constraints are, therefore, widespread, in spite of the potentially high returns on capital in conditions of scarcity. Any assessment of the impact of nominal money supply growth on inflation and of the impact of growth in money supply on growth in income in such conditions must take this persistent credit crunch into consideration. The implications for monetary policy design would be very different in India than in any industrialised country with integrated credit markets. Unfortunately, almost all macroeconomic theory is geared to the working of developed economies, so we don't really know what the correct levers are for monetary policy in the Indian context.

The numbers support the idea that crippling interest rates in the informal sector are the result of too little credit. Total financial assets per capita were estimated by Basu and Srivastava to be $430 in India in 2000, relative to $14,000 in Malaysia. Malaysia's per capita income is roughly eight times that of India currently, but its per capita financial assets are close to 20 times larger, even if we assume India's financial assets have doubled over the past five years and Malaysia's are unchanged. China's per capita financial assets stood at about $1,500 or more than thrice the number for India, while China's per capita income is less than twice India's currently.

Branch expansion by both commercial and rural co-operative banks has significantly improved the potential distribution of financial services over the past 40 years. How many of the, on an average 12,000 people, covered per branch can get credit out of their local friendly bank manager? Twenty per cent, according to World Bank-NCAER RFAS-2003, as cited by Basu and Srivastava (2005). According to them, microfinance institutions and self-help groups still reach only tiny numbers of borrowers in India compared to the overwhelming requirement and relative to countries such as Bangladesh, and distribute a relatively small amount of credit overall.

In addition to well-known policy recommendations by the World Bank and various NGOs such as rural business support services, regulation of informal finance and greater government flexibility, there is no getting around higher domestic credit to micro-finance institutions and self-help groups. Potential returns are high, but the Reserve Bank of India may be tightening monetary policy for fear of inflation without fully accounting for the possible sources of inflation. It is even possible that more credit to the private sector for rural based activities will lower inflation by easing supply side constraints and thereby the inertial and structural factors that are believed to drive inflation in developing countries.

The author is Assistant Professor in the Department of Economics at the Brandeis International Business School