The money flows

With the economy galloping along, the record credit growth in the fourth quarter of FY 2004 should come as no surprise.

A few months back, the sluggish growth in non-food credit had been attributed to Corporate India's becoming more efficient, resulting in a reduced need for working capital; to the large cash reserves built up by companies, since investment in fixed assets had stagnated for several years; and to several companies raising money abroad through external borrowings. Because of these factors, the lag in credit growth in the current recovery has been longer than usual.

Nevertheless, the magnitude of the credit growth in the fourth quarter is a reflection of the strength of the upturn. Apart from continuing growth in housing and retail credit, credit to the infrastructure sector has also increased sharply.

Further, once investment demand by corporates picks up, as it is bound to do in the months ahead, the demand for bank credit will rise substantially.

Also, funds sanctioned and disbursed by the Life Insurance Corporation of India and development banks are far higher than in the same period of last year, indicating that total demand for credit has gone up dramatically.

Thankfully, the rise in bank credit has so far had no effect on interest rates. That's because deposit growth too has been sharp in the fourth quarter, the result of foreign exchange inflows into the country and of the central bank's attempts to mop up dollars in an effort to hold down the value of the rupee.

Last quarter, the Reserve Bank's lack of government securities prevented it from sterilising the inflows, with the result that money supply growth was far higher than the target. Till March 19, M3 (i.e. broad money) growth in FY 2004 was 16 per cent, far higher than the 13.4 per cent growth in the previous year, and well above the 14 per cent target for the year.

The source of this growth was the increase in net foreign exchange assets of the banking sector, which grew by 34.7 per cent during the year. So long as the foreign exchange inflows continue, the banking system should not have any problem in lending to industry, without any upward pressure on interest rates.

The big question, of course, is whether a rise in interest rates in the US will lead to an outflow of funds from emerging markets like India. The consolation is that even if the pace of FII inflows slackens, services exports and remittances continue to be a stable source of dollar inflows.

Furthermore, the RBI can always calibrate the liquidity in the banking system by desisting from sterilising inflows.

The other impact of robust credit growth will be on bank bottom lines. With a bottoming out of interest rates, banks no longer have access to windfall profits from the sale of securities. A few months ago, the outlook on bank profits seemed to be clouded, since bank credit had yet to pick up.

That is no longer the case, and banks can go back to generating profits from their lending business. Now that the windfall capital gains have helped banks clean up their balance sheets, the profits from increased credit offtake will flow directly to the bottom line, without the earlier need to make large provisions.