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Banks face a growth dilemma

Cash-strapped public sector banks may be unnecessarily waiting for deposits to grow to start lending

Subhomoy Bhattacharjee 

Instead of declining deposits, is it shrinking credit that has pushed deposit creation southward in the Indian economy? The answer could determine how deep the central government may have to dig into its pocket to bail out state-run banks. Data from the past ten years for the Indian economy show this may indeed be the case. Any increase in deposits has been preceded by a growth in credit. It happened during the boom of FY07 and FYO8, and again when the economy lost momentum in FY13 and FY14. So, is there a possibility that deposits would continue to be anaemic till credit turns around? Since credit growth also depends on GDP and interest rates, it would take a long time for banks, if they decide to wait for expansion of their current and savings account deposits, to be able to lend aggressively. Deep Narayan Mukherjee, visiting professor at IIM Calcutta, has done an interesting work on this subject. Trawling data from the Reserve Bank of India from 2002 onwards, Mukherjee’s work starts off by showing that bank deposits and credit are strongly correlated. While bank economists hold that it is deposits that fuel the growth in credit, this may not be accurate, Mukherjee shows. When banks lend to enterprises, big or small, those enterprises in turn do two things. They create current deposits with banks and use the rest to invest in plants and workers. This creates a virtuous spiral in the economy, that expands deposits. Since banks can in principle borrow to begin their first round of credit creation, they need not wait for deposits at all, goes the argument. It is an argument developed by Joseph Schumpeter, one of the iconic economists of 20th century. In History of Economic Analysis, Schumpeter wrote: “It proves extraordinarily difficult for economists to recognise that bank loan and bank investment create deposit.” A new approach While bankers recognise the truth of this argument, their mindset has changed since 2008. Since then banking regulators worldwide have insisted that banks finance an increasing part of their credit from their retail deposits, instead of depending on borrowing from other sources. As a result, bankers prefer to err on the side of caution. Before 2008, when banks found the rate of growth of deposits to be sluggish, they borrowed money from the market as a percentage of their share capital. For state-owned Indian banks that option has meant depending on ever larger capital support from the government to support their borrowing. The data on the Indian economy show the traditional understanding from the Schumpeter line of argument could hold true. In financial year 2006-07, credit and deposits both declined as then RBI governor YV Reddy raised interest rates harshly to curb speculative investments particularly in the real estate sector.

From next year, however, the rate of growth of credit from the banking system began to rise post the Lehman crisis, with the government slashing interest rates under the next RBI governor, D Subbarao. It kept rising till the end of financial year 2011. In the same period, the pace of growth of deposits with the banking system slackened off. Between April 2008 and 2009, it fell instead of growing as the chart shows. It began to rise after April 2009, but trailed the growth of credit by a long margin, Mukherjee’s study shows. The asymmetry between the growth of credit and that of deposit does not end there. As the effect of the stimulus administered by the finance ministry and the RBI tapered off by 2012, credit growth in the economy fell. All this while the growth in deposits continued unabated. So while a higher deposit does eventually lead to higher credit formation, its role as a trigger to create a higher round of lending is not evident. An independent analysis done by Saugata Bhattacharya, senior vice-president and chief economist at Axis Bank, also shows that rate of growth of credit has been more prone to swings than deposits. Which brings up the chicken and egg problem. Is the banking system unnecessarily waiting for a positive turn in the growth of deposits to widen its credit net? Former National Institute of Public Finance and Policy professor Indira Rajaraman says there is no flaw in the argument. Yet “banks don’t have much room for cutting lending rates aggressively unless liquidity is eased a lot more.” According to her, the evidence of the tightness in the liquidity available to banks is the call rates “still hugging the repo”. But she adds that the indicator from the time series should not be the only yardstick to estimate the current trend of low growth in credit. “A high stressed assets ratio of 11.5 per cent (end-March) places a risk premium on lending rates.” Deposit growth appears to have been more stable over a longer term, says Bhattacharya. “The gap which opened up in credit & deposit growth from FY03 to FY09…I can’t make up my mind whether volatility has increased.” Salary growth and deposits Mukherjee’s analysis makes another interesting point: there is little correlation between bank deposits, the currency made available with the public and the credit made available by banks. Over the last ten years, there is little evidence to show that when government makes more money available with the public, it leads to a rise in credit for industry. In his period of measurement, the correlation between the two has sometimes been as low as 0.70 and has averaged less than 0.90 ( closeness to 1 implies strong correlation). So, while the extra spending from the Seventh Pay Commission will lead to rise in spending, it is not given that the money will makes its way into the bank ledgers as deposits and, in turn, fuel credit growth. R Gopalan, former secretary in the department of economic affairs in the finance ministry, agrees with the argument. “In financial year 2007–08, credit offtake went down. Expansionary policy post 2008 helped in credit expansion in subsequent years, with fresh capacity getting created,” he says. Banks have not been able to translate the higher deposits into higher lending, he adds.

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First Published: Tue, August 02 2016. 21:15 IST
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