Indian Money and Credit

Subroto Roy

from The Sunday Statesman, August 6 2006,

One rural household may lend another rural household 10 kg or 100 kg
of grain or seed for a short time. When it does, it expects to
receive back a little more than the amount lent ~ even if that
little amount is in services or in plain goodwill among friends or
neighbours. That extra amount is “real interest”, and the percentage
of its value relative to the whole is the “real rate of interest”.
So if 10 kg of grain are lent for two weeks and 11 kg are returned,
an implicit real rate of interest of 10 per cent has been paid over
that short period. The future is always less valuable than the
present in the sense that 10 kg of grain today is worth something
more than the prospect of the same 10 kg of grain tomorrow.
But loans may be made in terms of money rather than real units of
grain, thus the change in the value of money over the period of the
loan becomes relevant. If a loan of Rs 100,000 is made by a bank to
a borrower for one year at a simple interest rate of 13 per cent per
annum, and the value of money then declines at 8 per cent over the
year, the debtor is paying real interest of just about 13 per cent-8
per cent = 5 per cent. The Yale economist Irving Fisher described
how this monetary rate of interest equals the real rate of interest
plus the rate of monetary inflation, while the great Swedish
economist Knut Wicksell predicted inflation if the monetary rate
fell below the real rate, and vice versa.

And there is another consideration too. A new cycle-rickshaw
costs about Rs 5,000. A rickshaw driver who does not own his own
machine has to pay the owner of the rickshaw a fixed rental of about
Rs15 per day. Now a government policy may want to see more cycle-
rickshaw drivers owning their own machines, and allocate bank-credit
accordingly. But some fraction of the drivers are alcoholics and
hence are bad credit-risks, while others are industrious, have
strong family lives and are good credit-risks. If a creditor is
unable to distinguish between who is an alcoholic and who is not,
credit terms will tend towards subsidising the alcoholic and taxing
the industrious. On the other hand, a creditor who knows each debtor
individually will also know their credit-risks, and price individual
loans to them accordingly.

India’s credit markets, both rural and urban, have been segmented
always into “formal” and “informal”, and remain so despite (or
perhaps because of) much government intervention in recent decades.
Banks and the RBI operate in formal financial markets, but the
informal credit market is where the real action is. For example, a
mosaic-machine used in the construction business costs Rs 15,000
brand new and gets to be rented out at the rate of Rs 150 per day.
Someone with access to formal sector bank loans at say 13 per cent
per annum, might borrow the Rs 15,000, buy a machine, rent it out,
break-even within a few months and make a whopping profit
afterwards. Everyone would thus hunger after subsidised formal
sector bank loans, and these would be rationed quickly and then come
to be allocated to people known to bank officials (like their own
friends and relatives).

Rates of return on capital, i.e. real profits, are and always
have been massively high in India, and that is what is to be
expected because capital, both machinery and finance, is relatively
scarce as a factor of production. Rates of return on labour, i.e.
real wages, are on the other hand relatively low in India thanks to
our vast population. For these reasons we have had for three
centuries foreigners coming to India to invest their capital in
enterprise and make a profit, while Indians have emigrated all over
the world from Fiji to Britain to America in search of higher wages.

Now all of this is very elementary reasoning well known to serious
monetary economists, yet it seems to have always escaped India’s
monetary and fiscal decision-makers. For example, just the other
day, the Finance Minister said in Parliament that all rural banks
had been instructed to lend farmers credit at a 7 per cent
(monetary) rate of interest, and failure to do so would lead to
punishment. By the rickshaw example (in fact many cycle-rickshaw
drivers are also marginal farmers), the FM did not wish to, and of
course cannot in practice, distinguish between good and bad credit-
risks among the recipients of such loans. If the value of money is
declining by, say, 8 per cent per annum, a 7 per cent monetary rate
is equivalent to a minus 1 per cent real rate. i.e., the FM would
have done some Humpty Dumpty economics and caused the future
prospect of holding Rs 1,000 tomorrow to be more and not less
valuable than the certainty of holding Rs 1,000 today. It is
inevitable there will be credit-rationing when credit is so
massively subsidised, so the typical borrowing farmer will get some
little fraction of his credit-needs at the official government price
of 7 per cent per annum and then have to get the bulk of his credit-
needs fulfilled in the informal market ~ at a price perhaps of 1 per
cent-5 per cent PER DAY! The FM promising in his Budget to subsidise
farm credit sounds nice on TV but may be wholly futile as a way of
stopping farmers’ suicides.

The same kind of Humpty Dumpty monetary economics has been
religiously pursued by the RBI for decades upon directions from its
owner and master, the Finance Ministry ~ which in turn has always
meekly followed the dictates of India’s unreasonable politicians of
all parties. Formal sector interest rates in India have been for
decades so artificially lowered that even if we use official figures
measuring inflation, this leads to real interest rates being lower
in capital-scarce India than in the capital-rich West! (See graphs).
Negative or near-zero real interest rates in India’s formal
financial sector coexisting with massively high profit rates in
informal credit markets point to continuous processes of low risk
profits being made by arbitrage between the two. That is why the
organised private and public sectors seem so pleased with official
credit policies ~ while every borrower in the informal credit
markets always has suicide not far from his/her mind.

Other than Dr Rangarajan who once mentioned it, we have never had
an RBI Governor who has wished to see the RBI constitutionally
independent of the Government of the day, and hence dedicated to
restoring the integrity of India’s money. Playing with the repo rate
or other short term monetary rates is fun and makes the RBI think it
is doing something as important as the US or UK central banks.
Certainly the upward trend in such short term rates over the last
few months is better than the nonsensical flip-flops previously. But
it is small potatoes compared to the really giant variables which
are all fiscal and not monetary in India. For example, Sonia Gandhi
(as advised by another naturalized Indian, Jean Drèze, disciple of
the Non-Resident Amartya Sen) insisted on a massive “Rural
Employment Guarantee”; Manmohan Singh and Pranab Mukherjee have
insisted on massive foreign weapons’ purchases and government wage
increases; Praful Patel on massive foreign aircraft purchases; Arjun
Sengupta on Scandinavian welfare benefits; Montek Ahluwalia on
nuclear reactor purchases (so South Delhi will be able at least to
run its ACs in 20 years’ time). All this adds endlessly to the stock
of government paper being held as bank-assets, while the currency
remains inconvertible (See e.g. The Statesman 30 October 2005, 6-8
January, 23 April 2006).The RSS/BJP and JNU/Left have been equally
bereft of serious thought.

Tell any suicidal farmer that the Government of India has been
borrowing larger and larger amou
nts every year just to pay interest
on previously incurred debts; it may make him realise there are
famous and powerful people who are even more unwise than himself and
amount to effective suicide-prevention therapy. But do not tell him
that they unlike himself have been playing with public money ~ or
you may have the opposite effect.


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