Over the past 50 years and more, one of the key strategies for promoting economic development has been the provision of cheap and directed loans from banks and other formal financial intermediaries.
Towards this end, the priority sectors of the economy have been identified as agriculture, small- and medium-scale industry and exports which are given preference while granting such subsidised loans.
This strategy not only has the backing of government policy, but also that of intellectuals of various hues and of course solid public support. After all, who would forsake something for nothing, or, putting it differently, wealth out of thin air. Impeccable logic, at first glance!
Over the years, or rather decades, a surfeit of schemes for directing cheap credit has been devised and implemented which include: integrated rural development programme (IRDP), prime minister's rojgar yojana (PMRY), and differential rate of interest (DRI) loans and the newest kid off the block —Mudra Loans.
The irony is that the policy of cheap and directed credit, as a viable and sustainable policy for development, has not really worked and there are clear indications of its severe limitations and counter-productive side-effects. The single-minded pursuit of this strategy has all but destroyed our banks—with all its negative consequences to the real economy which creates real jobs and provides real income.
When any commodity is priced below its cost, there would always be an artificially high demand for it—bank loans are no different. Since the supply of credit cannot be limitless, the limited amount of cheap bank loans get channelled not on the basis of their most efficient use, to the most needy, or the repayment capacity of the borrower, but based on the amount of political muscle and financial (read bribes) power the prospective borrower can bring into play for getting the loans. This is true not only for India but across all human societies.
This directly results in humongous amounts of corruption and generation of black money—politicians of all hues and standing, petty bureaucrats, bankers, borrowers—all desperately trying to get a piece of the freebie.
Since the people with political and muscle power are generally better off than the rest of us and since they now have more capital (borrowed) at their disposal, they became even better off – thereby increasing income and wealth inequalities in society.
Furthermore, due to their superior power in accessing cheap loans, they have lower incentives to repay, since they have less to fear from the legal consequences of default or the means to get away from it. Once the repayment is avoided (or is waived-off), cheap loans bestow a double bonanza: with large borrowers getting large benefits and smaller borrowers getting smaller benefits—from not having to repay their debts. Of course, non-borrowers, who are in an overwhelming majority, get no benefits. This further increases income and wealth inequalities in society, apart from simultaneously weakening the financial position of the lender.
The macabre beauty of pushing cheap and directed credit lies in the fact that initially there is an all-round feel good factor. Banks report higher business volumes and profits and bankers get the credit which, in public sector banks (PSBs) takes the form of political patronage which ensures promotions and plum postings. Borrowers are better off with more capital at their disposal, especially funds that they really need not pay back. The economy, which is flush with low-cost funds, booms with growth in incomes and employment. Politicians win elections.
But all good things must come to an end. With little improvement in productivity and innovation, such artificial growth, sooner rather than later, comes to a grinding halt. What replaces it is all-round finger-pointing.
To make up for the loss of income because of high levels of bad loans, banks are left with few options. The first and immediate one is to blame the borrowers for loans gone bad and call them cheats, wilful defaulters and worse. The fact that it takes two to tango just vanishes - no bank takes responsibility that bad lending practices is the key reason for loans going bad.
Meanwhile, to maintain profitability, banks reduce the rate of interest they offer on deposits and simultaneously increase the interest rate which good borrowers have to pay on their borrowings! Incidentally, on an average, bank deposits have been giving a negative real rate of return as underscored not so long ago by a governor of Reserve Bank of India (RBI) in one of his speeches!
The next step to keep up the show of good health is for banks to follow archaic accounting policies which permit them not to recognise the true health of their loan portfolios—effectively just keep shoving the dirt under the carpet—amply revealed when the RBI made the banks undergo the asset quality review in 2015.
With few alternatives to keeping their hard earned savings in avenues which are safe, secure, liquid and easily accessible, while offering a decent positive real rate of return, the masses take to alternatives such as chit funds and non-banking finance companies (NBFCs) and get entangled in Ponzi schemes at regular intervals.
Low returns on bank deposits adversely affect the savings potential of the economy and total savings rate is lower than what it could be and leads the country to be more dependent on foreign capital for its investment requirements. All the while, we congratulate ourselves on the amount of foreign investment flowing into our country without bothering to realise whether we could have raised the same capital at less cost by building better and more efficient domestic financial markets.
The plethora of woes does not end here. Since the fixed costs (for appraisal and monitoring) of making a loan varies little compared to the size of the loan, there is a constant tendency for avoiding smaller loans and preferring the larger of the small borrowers. This is another reason for increasing income and wealth inequalities in Indian society.
The futility of the strategy of pushing cheap credit as a development strategy is best summed up in the words of the ever-provocative Dale Adams, "A loan provided by the (formal banking) industry ... is no more an empowerment tool than is a similar loan from an evil moneylender or a relative, unless the intent of the lender somehow transforms the usefulness of the money borrowed—which it doesn’t. ... To the unwashed it conveys the impression that smearing a dab of additional debt on a poor woman will transform her into Super Woman. ... More debt does not cure malaria or HIV/AIDS. It does not provide clean drinking water or prevent flooding. It does not improve law-and-order or eliminate weeds in a borrower’s crops. It does not make crops grow in barren soil or provide secure title to land that squatters occupy. It does not provide schools or teachers for the poor."
Without focus on improving governance in our banking industry, there can be no succour. There is much value in the adage: the road to hell is paved with good intentions!
(The author worked with various banks - public, private, and foreign both in India and abroad - for nearly 30 years and is currently on a self-imposed sabbatical to try and understand as to what ails Indian banking and what, if anything, can be done to improve its functioning.)
Do we need any new kind of system?