Is another interest rate hike warranted?

Since credit growth itself has slowed down in the most recent quarter, it may be prudent to wait a while before hiking rates.

It is widely believed that an increase in the level of financial intermediation in an economy is associated with an increase in its trend growth rate. To that extent, the surge in credit growth recently witnessed in India is encouraging. However, the downside of this rapid growth in bank lending is the risk to financial sector stability that may arise from deteriorating asset quality that is often associated with credit expansion to housing and real estate sectors. Such an expansion increases the vulnerability of the banking system to asset price volatility.

As widely reported, a large part of the incremental growth in credit over the past year has gone into housing and real estate. The share of housing and personal loans has more than doubled, albeit from a low base, now standing at 15 per cent of outstanding bank credit. In addition, a good deal of priority sector lending is also thought to be directed to housing loans on top of the credit extended to housing finance companies by commercial banks. Overall, growth in bank credit in recent years has been accompanied by changes in the composition of loan portfolios towards relatively high-yielding (although riskier) loans, and away from more traditional options such as industry lending.

Theoretically speaking, credit typically grows more quickly than output as an economy develops through a process known as financial deepening. A relatively high rate of economic growth increases the demand for credit. The expansion of credit from relatively low levels of financial intermediation "" credit to GDP ratio of 20 per cent in 1992-93 "" supports the "catching up" hypothesis. However, credit growth in the past two years has accelerated at a much faster pace, leading to a 75 per cent increase in credit to GDP ratio since 2000-01. A key question is whether rapid credit growth, which is currently underway, is part of the ongoing process of financial deepening or whether it is a credit boom "" a situation where credit expands at an unsustainable pace as part of a cyclical upturn?

What is relevant for identifying a credit boom is not the trend in the level of credit, but fluctuations around a trend. We estimate a credit boom by identifying extreme credit fluctuations between Q1FY98 to Q1FY06, using established statistical methods. The structural changes that have occurred in India in recent years make it difficult to compute the trend level of credit. Nevertheless, our calculations show that India indeed experienced a credit boom in the last two quarters of 2005-06.

What is also critical from the economy's point of view is whether this credit boom has been accompanied by rapid consumption growth and asset price misalignment. The answer, in short, is yes. Easy credit availability has eased the liquidity constraint on households, leading to a higher demand for personal loans and housing. Given short-run supply constraints, this upward shift in credit-financed domestic demand tends to exert upward pressure on asset prices. Higher property prices stimulate more construction and increased construction activity leads to higher demand for loans. Thus, such credit expansion, while raising housing and real estate prices, tends to result in the weakening of the relationship between credit growth and GDP growth.

Statistical analysis shows that until 2003-04, credit growth appeared to lead GDP growth in India by four quarters. However, the relation between credit and GDP has weakened since the first quarter of 2004-05. While part of the reason behind this could be a structural shift in the economy towards a less credit dependent service sector, another plausible explanation could be a change in the industrial financing pattern. Higher profits have made it possible for firms to rely more on internal funds and on the stock market, decreasing industrial demand for credit. This implies that the credit boom of the last two quarters of 2005-06 is unlikely to give any extra impetus to the current momentum in GDP growth since most of the additional credit growth has gone on to fuel asset price increases, rather than additional output in either industry or service sectors.

By the same token, the moderation of credit growth that we have witnessed in the first quarter of the current financial year is unlikely to dampen GDP growth to any sizeable extent "" although we do need to know which sectors have experienced a decline in credit growth. At the aggregate level, incremental growth in non-food credit in Q1FY07 was 1.1 pe cent compared to 5.4 per cent during Q1FY06.

Since recent growth in credit is relatively higher in sectors such as retail and housing, monetary authorities face a dilemma. The Reserve Bank of India (RBI) has increased the policy rate four times since April 2005, with little apparent effect on credit growth until March 2006. A combination of three possible reasons may explain this: 1) banks did not raise their lending rates sufficiently; 2) they continued to favour high yielding housing loans with a relatively low default history; 3) and time lags involved in the policy transmission process.

Now that credit growth is slowing, what should the RBI do next? Given that data for the most recent quarter suggests a possible downturn in credit growth, the RBI should wait and watch the situation before taking any further action. In the current macroeconomic scenario with a stable inflation outlook and a moderation in credit growth, we believe that a rate hike in the impending quarterly monetary policy review of the RBI is unwarranted.

The authors are economists at CRISIL Ltd. The views expressed are personal