The cost of credit isn’t everything: Cheap loans need productive uses

Occasionally, the central bank needs to look away from the road behind and become a bit more circumspect about the path ahead. In April, the Reserve Bank of India (RBI) officially pivoted from its policy stance of inflation control to growth support, given a flattening rise in the cost of living.

Also read: A consumption-driven economy can’t do without rapid income growth

Its monetary policy committee, led by Governor Sanjay Malhotra, has boldly cut benchmark rates of interest by a full percentage point and eased liquidity to generate credit demand in India Inc and induce banks to offer cheaper loans, with both expected to stimulate economic growth.

This drive, however, appears to have overlooked an unmarked bump in the highway: stagnant consumption demand, which dampens the capacity utilization of industry and thus its need for credit.

Excess money in the banking system amid torpid credit demand has compelled RBI to suck out liquidity every week; for example, it absorbed almost ₹14.2 trillion in the seven days from 3 July to 10 July.

Here is another indirect indicator: the category of ‘Other Deposits’ in RBI’s list of liabilities—which among other things also includes RBI’s reverse repo operations—is up 43% in the 12 months ended 11 July.

Weak demand for credit and the need of lenders to earn off the plentiful liquidity available may have bred desperation. Many non-bank lenders have sought out retail borrowers again, satisfying their latent demand for unsecured loans that are extended primarily to meet quotidian consumption needs.

If history is any guide, a bulge in this loan category presents a risk because such borrowers typically have multiple loans and any stress event can trigger a cascade of defaults.

There are several other unintended consequences that can arise from excess liquidity. An abundance of it may push banks to go slow on soliciting deposits from savers. In turn, this could drive even more savings towards high-risk-high-return assets, which could well be via speculative platforms in equity markets.

Also read: Indian consumer habits: Second guess them at your own risk

The economy might then witness a replay of the near crisis two-three years ago when there was a spike in unsecured retail lending for consumption and also high speculation in equity derivatives.

Former RBI governor Shaktikanta Das had addressed the emergent impasse by tightening prudential norms, but Governor Malhotra relaxed these rules soon after he assumed office.

Another consequence of surplus systemic liquidity, which works through the system with imprecise leads and lags, could be inflation.

If credit demand from businesses for productive purposes is weak, the money pumped out tends to fuel demand for goods and services that producers are not always able to meet at that point, leading to a rise in inflationary expectations.

To be fair, Governor Malhotra conceded during the last monetary policy meeting that a pick-up in credit demand will ultimately depend on macro-economic factors; RBI’s rate cuts and liquidity infusion are a necessary but not sufficient condition.

Also read: Mint Primer: Why consumer demand needs a quick revival

In the light of risks arising from the current cocktail of listless credit demand and profuse liquidity, the June policy meeting’s dissent note advocating “cautious progress in policy easing" has more resonance now than ever before.