Banking up the wrong tree

P Chidambaram obviously believes that the banking sector shares the responsibility for delivering on the promises made by the UPA government. Last year, he announced a doubling of credit to the agricultural sector over three years. Last week, at the annual Bank Economists' Conference in Kolkata, he expressed the view that total bank credit should achieve the benchmark of 50 per cent of GDP; it currently stands at about 30 per cent. While it certainly may be true that the inadequacy of credit delivery to agriculture, small enterprises and various other sectors may be impeding their growth, it is far from obvious that increasing the flow of credit to these sectors by diktat will solve the problem. Indeed, the long experience with directed lending suggests that the pursuit of sectoral targets often gets the better of prudence and results in money being advanced to the wrong kinds of borrowers. A fundamental objective of banking sector reforms was to give banks the space to balance the profit motive with the management of risk. While there is some way to go yet, particularly with regard to priority sector lending limits, the direction of change has been unambiguously positive. Asking banks to meet quantitative lending targets is not in tune with these changes. Public sector banks, who still account for the bulk of banking activity, will be under pressure to comply, and poor-quality assets could well be the result.

This is not to deny that India stands at the lower end of the range as far as the ratio of bank credit to GDP is concerned, when compared with other emerging economies. But there is a very good reason for this. Traditionally, growth in bank lending has been closely associated with industrial growth. Given any reasonable requirements for collateral, banks will lend only against "hard" assets""inventories of raw materials and finished goods, or machinery. India's industrial sector as a share of GDP has remained more or less constant over the past two decades. Services have been the primary driver of economic growth; these activities typically have little by way of hard assets and so have a low dependence on banks for capital. In fact, given the constancy of industry's share of GDP, it would not have been surprising to see the bank credit to GDP ratio also remain quite stable over this period. What accounts for its recent growth is the surge in retail lending""for housing, automobiles, consumer durables, education, tourism and other things"" which have been such important contributors to GDP growth.

Besides this structural factor, there is the point that industry has become more efficient at using working capital through better supply chain management. Companies can also meet their requirements from the market by issuing commercial paper, and financial disintermediation has become a fact of life. All these point to the futility of mandating bank lending in any way. In today's environment, bank credit is more likely to be the follower than the leader. If the government can create the right policy climate and infrastructural facilities to support efficient manufacturing, the bank credit to GDP ratio will probably improve on its own.