A 'Catch-22' situation for Indian Economy

I wrote an article a few months back about divergence of lending and deposit rates in the scheduled commercial banks in India and the situation where lending rate softening will increase the domestic consumption and keeping the spread intact will attract foreign capital.

This article is a logical extension to the previous article because the excessive foreign capital led to inflation in domestic market and 3 weeks back, Government of India modified the external commercial borrowing (ECB) policy to modulate capital inflows.

The government had been under pressure to stem the appreciation of rupee against the dollar; and capital inflows have had a decisive role in the rupee appreciation. The new policy is probably aimed at curbing the capital inflows. While many analysts, economists and bankers have expressed their opinion against or in favor of this move, we should also understand why external commercial borrowing by the Indian corporate has increased over the years.

One argument in favor of increased borrowing can be related to India growth story. Indian economy has stabilized over the last decade and is the second fastest growing economy in the world; and hence it is lucrative to invest in India. But this argument did not answer the question of increased external borrowing.

On analyzing the overall deposit and credit (as a percentage of GDP) of scheduled commercial banks in India, we can see that the difference between total deposits and total credit is about 20% of GDP over the last 10 years.

Scheduled Commercial Bank Credit and Deposit as % of GDP

(Source – RBI)

This is in stark contrast to most of the developed and developing countries of the world where the difference between total deposits and total credits is much smaller and even negative in case of China. This implies that total credit disbursement is greater than the total deposits.

Total credit as a % of total deposits

(Source – McKinsey India Financial Reforms Report)

The above chart clearly demonstrates that the total credit as a percentage of total deposits is low in India. One can argue that in developed countries like UK and UK, a greater amount of lending is done for commercial purposes as compared to priority sectors and banks prefer commercial lending owing to higher lending rates. In India, a greater amount is given to the priority sectors where lending rates should be lower and thus Indian banks do not lend as much as they can.

But the argument given above is flawed owing to following reasons – firstly the differential between India and countries like China, US and UK is very large. Secondly, countries like Brazil have a better credit to deposit ratio and the regulations are similar to that of India.

We can conclude that there is something more fundamental due to which external commercial borrowing has increased. If we check the average deposit and lending rates of scheduled commercial banks in India then we can see that the over the last 10 years, spread of commercial banks (including State Bank of India) deposit rates and lending rates has increased approximately by 175 basis points.

The spread was 225 basis points in 1997-98 which increased to 525 basis points in 2002-03 and 2003-04 to 400 basis points in 2006-07.

Source-RBI

Notable point is that deposit rates are for more than 5 yr deposits which offer higher rates. In India, a large amount of deposits are short term deposits (less than 5 yr) and this divergence is even more for short term deposits. If the lending rates are reduced then liquidity in market will increase leading to higher inflation and if the spread is kept high than more foreign capital inflow will take place.

Inflation is one of the most important factors in judging the performance of a government in India. Inflation rose to above 7.5% in April 2007 and RBI took various measures to bring it to nearly 4%. Recently RBI increased the Cash Reserve Ratio (CRR) to 7% to curb the liquidity in the economy. So it seems highly unlikely that RBI will allow the softening of effective lending rates in the economy. Moreover, most of the banks have reduced the average deposit rates over the last month and the spread has increased further making the commercial borrowing more costly.

Given the fact that commercial loans in India (as a % of deposits) is among the lowest in the world, Indian regulatory authorities now find themselves in a 'Catch 22' situation where lending rate softening will increase the domestic consumption thus increasing inflationary pressure and keeping the spread intact will attract foreign capital. It will be interesting to see how RBI will formulate its policy in future to fulfill two contradictory goals of keeping the inflation in check and controlling external commercial borrowing.