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The credit growth conundrum

To increase credit demand, banks need to look beyond manufacturing

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Abheek Barua New Delhi
Last Updated : Jun 14 2013 | 2:53 PM IST
Despite a marked improvement in industrial performance over the last year, the demand for credit from the banking system has been subdued. During the industrial recovery in FY96, non-food credit demand had surged by nearly 22.5 per cent.
 
For the first half of this fiscal year, non-food credit increased by only 14.8 per cent. The latest data available for January 9, 2004, does show a pick-up in the growth rate to about 17 per cent, but it remains considerably lower than rates seen during the earlier uptick.
 
Besides, if the large retail component is netted out from current credit disbursals (this component would have been minimal in the earlier upswing), the rise in credit demand from industry would be far more sedate.
 
Thus, the link that is conventionally assumed between industrial growth and credit growth seems to have weakened perceptibly. Why has this happened and what are the implications for Indian banks?
 
Commercial credit or non-food credit, as it is called in India, consists of two distinct components. First, working capital credit that funds inventories and supports outstanding debtors and, second, term loan that funds capital expansion (capex).
 
Historically, banks have lent more for working capital than for capex, but over time, their term loan exposure has increased. For the banking sector as whole, term loans stood at about 45 per cent of total advances at the end of 2003.
 
The perception of a strong link between industrial growth and commercial credit is borne out by econometric analysis. A rise in industrial production raises the need for working capital loans; firms also expand capacity in this period and access the banking system for credit. Both translate into a rise for commercial credit.
 
An interesting way to gauge the sensitivity of working capital demand to industrial growth is through an elasticity measure (defined as the percentage change in credit demand/ percentage change in index of industrial production growth).
 
Since working capital depends on the value of output produced, and not just volume, it is necessary to control it so that the price effect gets a sensible measure of elasticity.
 
When controlling for this effect, we see a sharp drop in the elasticity of commercial credit from 0.41 in the period April 1985 to March 1998, to just 0.29 in the subsequent period.
 
Our analysis shows that the structural change in the elasticity kicked in from early 1998. The interpretation of elasticity is simple. An elasticity of 0.29 indicates that 1 per cent increase in the rate of industrial growth would cause non-food credit growth to perk up by 0.29 per cent.
 
The key question, then, is why has this elasticity fallen? Given the composition of commercial or non-food credit, an analysis of the sensitivity of commercial credit to industrial production would have to account for a decline in both the response of working capital demand as well as term loans. Let's look at the working capital component first.
 
Better working capital management has clearly played a role. Companies have seen a dramatic improvement in working capital management over the last few years. This has resulted in a drastic reduction in the demand for working capital per unit of production.
 
This decline has taken place across the board, that is, virtually in all major sectors and companies. In companies' financial statements, this gets reflected as a decline in the working capital-to-sales ratios.
 
It is difficult to identify a single factor that has motivated the improvement in working capital management. Greater contestability of markets post-liberalisation, crippling interest costs in the mid-1990s and the need to maintain margins in the wake of a drop in pricing power, have all played a role in different degrees in different sectors.
 
The bottomline is that Indian companies have streamlined their inventory and debtor management processes and this has manifested in a lower per unit demand for working capital.
 
Another important factor, particularly since FY99, has been rising disintermediation. Specifically, companies have preferred borrowing directly from the money markets through commercial paper (CPs) and other market instruments rather than borrowing directly from banks.
 
One clear reason for this is that while secondary markets have reflected the abundance of liquidity in the domestic market, banks' lending rates "" particularly the prime lending rates (PLR) "" have remained relatively sticky. Since CP rates follow secondary market yields, companies have found this a cheaper route for funding their working capital needs.
 
An important feature of the growing disintermediation is the change in the risk profile of the short-term debt market over the last one year with a growing appetite for more risky, lower-rated papers.
 
Until August 2002, the CP market was entirely restricted to companies rated P1+, the highest rating grade. The last one year has witnessed the emergence of a market for P1 rated papers, indicating banks' willingness to invest in lower rated papers.
 
Another instrument that companies have used as an alternative to commercial papers is the MIBOR-linked (Mumbai Inter-bank Offer Rate) paper.
 
These short-term instruments, which have a floating rate, usually have a 5- to 90-basis point mark-up over MIBOR. With the MIBOR declining even below the repo rate this year, these instruments have emerged as a cheaper option for corporations.
 
Two distinct advantages made MIBOR-linked papers an attractive option. First, these papers are exempt from stamp duty, making the cost of funds relatively cheaper. Second, the daily put-call option makes it a low risk option for both the lender and the borrower, who can bail out in case of adverse interest rate movements.
 
In FY03, the total number of MIBOR-linked issues with less than one year maturity was 649, amounting to a whopping Rs 217.3 crore. At present, with the Reserve Bank of India barring banks from investing in short-term debt instruments, it is mostly mutual funds that are the major investors.
 
This year, an additional factor that has helped in the shift from domestic banks is the emergence of short-term external commercial borrowings (ECBs) as a source of funds. A combination of falling global interest rates, stronger domestic currency and lower forward premia has reduced the real cost of borrowing from abroad.
 
Hence, companies find it cheaper to raise funds outside India. Largely, companies with strong financials, a good track record and can, thus, bargain for lower interest rates, have accessed this route. Total short-term ECBs rose to their highest-ever value of $ 2.2 billion in H1FY04 compared to $ 343 million in the corresponding period previous year.
 
While the industrial recovery has been underway for more than a year, Indian companies have been reluctant to invest in capacity expansion, choosing to optimise on existing capacity, rather than build capacity afresh. This has reined in the demand for long-term funds from the corporate sector.
 
As companies come close to full capacity expansion, the first sign of a recovery in physical investments is visible. The machinery and equipment component of the index of industrial production, for instance, is picking up.
 
However, this is unlikely to translate into a major growth in demand for long-term funds. A combination of improved margins, lower interest charges and higher sales has meant that companies in a number of sectors are sitting on large cash-piles that they are likely to deploy in their capacity expansion. This would obviate the need for bank funds, at least in the medium term.
 
What does this mean for Indian banks? In the short term, as international rates harden, the demand for domestic loans could increase a tad. The rise in credit off-take in January could indicate this trend. But this is unlikely to be adequate from a medium- or long-term perspective.
 
Banks today have a disproportionately large exposure to the manufacturing industry and need to look at other areas to park their funds. One response from them has been the growing emphasis on retail lending but the growth momentum here seems to be petering out.
 
Another option is to focus on service sector companies of which banks have been chary because of the absence of tangible collateral. Consequently, banks' risk management systems and the regulatory framework will have to change to facilitate this.
 

(The author is senior economist
at the Crisil Centre
for Economic Research)

 
 

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First Published: Feb 09 2004 | 12:00 AM IST

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