MacroScan - Bank Credit: A Reassertion of Priorities?

Democracy yields many dividends. Important among them is the pressure on governments, however neo-liberal in inclination, to pay heed to sentiments that can determine political legitimacy and make a difference to electoral outcomes. Over the last year, it has been obvious that the economic decision-makers within the UPA government have a strong preference for neo-liberal policies. Yet, they have had to accept, even if with much reticence and hesitation, that markets are often prone to fail, necessitating intervention by the state. Among the few areas where such good sense appears to now prevail is the direction of credit to priority sectors.

A draft Technical Paper prepared by an internal working group of the Reserve Bank of India (RBI) has recommended correcting the dilution of priority sector credit provision. The constitution of the working group was triggered by a December 2004 decision to revitalise priority sector credit, which was followed by a reference in the Annual Policy Statement of the Reserve Bank of India to a view that enlargement of areas eligible for priority sector lending had resulted in a loss of focus and that ''credit growth in housing, venture capital and infrastructure has been strong while it has been sluggish in agriculture and small industries.'' The working group's mandate therefore was to revisit the need for priority sector lending and assess the demand for course correction in the implementation of the programme.

Since the mid-1960s, credit has been seen as an important instrument of development policy in India. The agrarian crisis of 1964-66, the industrial deceleration and overall economic stagnation that followed and the political instabilities these generated, brought home the point that crucial institutional constraints to growth had not been addressed during the early planning years. This had not only resulted in a development impasse, but necessitated attention to the deep inequities that characterised whatever development that had occurred.

Though this realisation did not trigger any fundamental institutional reform, such as the redistribution of land, it ensured the adoption of at least some much-needed policy initiatives, among which was a programme of priority sector lending. It was clear by then that India's then predominantly privately owned banking system was not geared to or interested in delivering credit to a range of sectors outside of large industry. Influenced by the fact that credit was an important component of the Green Revolution ''package'' aimed at stimulating agricultural growth, and confronted by the sectoral and unit-wise concentration of credit delivery, a decision was taken in 1967-68 to consciously direct credit to priority sectors such as agriculture, small-scale industry and exports.

After 1969, when 14 major commercial banks were nationalised, the government went much further in this direction. In the event, the priority sector was defined to include Agriculture, Small Scale Industry, Small Road and Water Transport Operators, Retail Trade, Small Business, Professional and Self Employed Persons, State sponsored schemes for Scheduled Castes/Scheduled Tribes, Education, Housing and Consumption.

However, among these sectors the emphasis was to be on agriculture, small industry and small business. At present, the programme requires that priority sector advances should constitute 40 per cent of net bank credit (NBC) of domestic banks. The sub-target for the agricultural sector stands at 18 per cent of total advances. Further, 60 per cent of advances to the small scale sector are expected to be directed to the tiny sector. And, 10 per cent of net bank credit has to be directed towards weaker sections. (The requirement set for foreign banks was lower—at 32 per cent—and the sectoral composition too was more lenient.)

However, over the last decade, financial liberalisation has been diluting the directed credit programme, partly by redefining the priority sector or providing alternatives such as Rural Infrastructure Development Fund (RIDF) bonds as a substitute for priority sector lending. Moreover, special targets for the principal priority areas have been missed. Thus, during the period 2001-04, the total outstanding credit to the agricultural sector extended even by public sector banks was within the range of 15-16 per cent of NBC as against the target of 18.0 per. Though in respect of private sector banks, the ratio of agricultural credit to NBC increased from 7.1 per cent to 11.8 per cent, it still was below target.

Further with banks allowed to lend to seed and input supplying companies or invest in RIDF bonds, the share of direct finance to agriculture in total agricultural credit declined from 88.2 per cent in 1995 to 71.3 percent in 2004. The share of credit for distribution of fertilizers and other inputs which was at 2.2 per cent in 1995 increased to 4.2 per cent in 2004 and the share of other types of indirect finance from 4.8 per cent to 21.0 per cent. Further, credit to the SSI sector as a percentage of NBC declined from 13.8 per cent to 8.2 per cent. Much of this credit went to larger SSI units, as suggested by the fact that the number of SSI accounts availing of banking finance declined from 29.6 lakh to 18.1 lakh.

The most disconcerting trend was the sharp rise in the role of the ''other priority sector'' in total priority sector lending. This sector includes: loans up to Rs. 15 lakh in rural/ semi-urban areas, urban and metropolitan areas for construction of houses by individuals; investment by banks in mortgage backed securities, provided they satisfy conditions such as their being pooled assets in respect of direct housing loans that are eligible for priority sector lending or are securitised loans originated by the housing finance companies/banks; and loans to software units with credit limit up to Rs. 1 crore. Not surprisingly, the ratio of ''other priority sector'' lending to net bank credit rose from 7.4 per cent in 1995 to 17.4 per cent in 2005.

All this occurred even though the priority sector was by no means principally responsible for non performing assets (NPAs) in the banking system. NPAs under the priority sector accounted for 47.5 per cent of total NPAs in 2004. Even though, this was slightly higher than the share of the sector in total advances (44 per cent) it was by no means disturbingly disproportionate, given the presumption that these were ''weaker'' sectors eligible for cross-subsidisation.

In the circumstances, the RBI's decision to correct course, especially given signs of agrarian distress and rising SSI mortality, seems natural. Yet, for the RBI, the constitution of the working group and its decision to recommend persisting with and strengthening the priority sector lending programme is indeed a major step forward. Financial liberalisation, which the central bank spearheads in tandem with the Ministry of Finance, seeks to refashion India's financial structure in directions that require the dismantling of priority sector lending. In 1991, the early days of unthinking ''reform'', the Narasimham Committee on the Financial System had argued that, though directed credit programmes had extended the reach of the banking system to cover sectors that had earlier been neglected, the use of the banking system to support priority sectors and weaker sections was fundamentally misplaced. That objective the Committee felt should the remit of the fiscal rather than the credit system. It, therefore, recommended that directed credit programmes should be phased out. At most, 10 per cent of aggregate credit, as opposed to the prevailing norm of 40 per cent, could be directed, and targeted at a priority sector redefined to include only small and marginal farmers, the tiny sector of industry, small business and transport operators, village and cottage industries, rural artisans and other weaker sections.

Given the evidence that some of these were the sectors which received the lowest share of priority lending even during the heydays of directed lending, such targeting was a prescription for dismantling the system. That was understandable within the Narasimham framework, which saw directed credit as unjustified. But ground realities prevented the implementation of the Narasimham recommendations. And changed economic and political conditions have now forced the RBI to revisit the implementation of the programme.

In fact, the working group starts by once again posing the question as to whether such credit is needed at all. Thankfully, its answer is yes. But given the predilections of the central bank, the justification provided for that answer is weak and even contrary. There are two levels at which the justification can rest. The first is on grounds of equity alone. All sectors must get a fair share of credit, however 'fair' be defined. It is clearly on this ground that the working group advances its case for persisting with directed credit. To quote the working group's draft report: ''Even after 36 years of priority sector lending prescriptions, it is observed that certain important sectors in the economy continue to suffer from inadequate credit flow…. As such, the need for having priority sector prescriptions continues to exist.''

While equity is indeed a valid objective in itself, the second and more important reason why priority sectors are delineated and supported with directed credit (sometimes even at lower interest rates) is that credit concentration is inimical to balanced development, which in the medium term keeps overall growth below its potential. It could either result in inadequate supplies in sectors crucial to development, that hold back the expansion of the more ''dynamic'' ones; it could limit the expansion of incomes and the market and therefore of production.

For example, because of differentials in profitability, the allocation of investment may not be in keeping with that required to ensure a certain profile of the pattern of production, needed to raise the rate of saving and investment as emphasised in India by the Mahalanobis model. An obvious way in which this happens is through inadequate investments in the infrastructural sector characterised most often by lumpy investments, long gestation lags, higher risk and lower profit. Given the ''external benefits'' associated with such industries, inadequate investments in infrastructure would obviously constrain the rate of growth. Overall, the private-profit driven allocation of credit for investment could aggravate the inherent tendency in markets to direct credit to non-priority and import-intensive but more profitable sectors, to concentrate investment funds in the hands of a few large players and direct savings to already well-developed centres of economic activity.

Finally, even in developing countries which choose a mercantilist strategy of growth based on the rapid acquisition of larger shares of segments of the world market for manufactures, the government must ensure an adequate flow of cheap credit to chosen firms. This needs to be done so that they can make investments in frontline technologies and internationally competitive scales of production and would have the wherewithal to survive during the long period when they build goodwill in the market.

It is for these reasons that directed credit programmes were and continue to be adopted by late industrialising countries. This seems to be recognised by the draft report, inasmuch as it surveys the experience with directed credit of a select sample of countries such as China, Japan and South Korea. However, the emphasis of the survey is not the importance of directed credit in the development of these countries, but on the problems confronted in implementing directed credit programmes. The ''findings'' of the survey are discouraging: risks of default on priority lending are high; targeting results in diversion of funds to non-priority purposes; differential interest rates increase the cost of credit for non-preferred borrowers and distort (rather than correct distorted) incentive structures; and, once introduced, priority lending is difficult to dispense with. Given this litany of problems with directed credit, the working group's case for continuing with priority sector lending appears to be a contradiction. At best it appears to be the better of two evils: iniquitous lending and distorting interventionism in credit markets.

Fortunately, this has not prevented the working group from recommending that the priority sector lending programme should not just continue at the current level, but be restructured. It calls for focus on direct and not indirect lending to agriculture, for rendering mediated lending to the small scale sector or lending for creation of industrial estates is ineligible for priority status, and for substantially reducing the width of ''other'' priority sectors by excluding areas like housing and consumption loans and loans to SHGs/NGOs, the food and agro-based processing sector and the software industry.

The recommendation to remove advances to SHGs/NGOs and microfinance institutions from the priority category is particularly significant. The enforced retreat of the banks from rural credit provision under financial liberalisation has been accompanied by an emphasis on microcredit. But experience has shown that high transaction costs make such credit extremely expensive and inadequate to finance productive activity. But now, the pressure to use the credit mechanism as an instrument of the state is obviously strong enough for the working group to recognise that microfinance is no substitute for lending by the formal banking sector. Hopefully, these conclusions and recommendations, and not the working groups views on the experience with directed credit worldwide, would be the basis for future policy.
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