Aspects of India's Economy Nos. 36 & 37: The Real State of India's Economy

In the economic theory currently touted by the imperialist institutions worldwide, if financial markets are freed of excessive Government interference, finance will flow to the economic activities which are most competitive and therefore the most profitable; the differences in interest rates for different borrowers will reflect the risk of default (that is, they are higher for those who are more likely to default); and financial markets will be able to make the correct choices because they function rationally and have perfect information. All sectors of the economy would be connected by an integrated financial market. Indeed, according to this theory freeing of finance from Government direction is crucial to making the entire economy more competitive (industries that are uncompetitive would close down, competitive ones would get cheap finance and grow; crops in which India is uncompetitive globally would be unable to get cheap loans, and farmers would stop growing them in order to specialise in crops in which India enjoys `comparative advantage' worldwide).

Various of these claims have been shown to be false. For example, it has been shown that different participants in the financial markets enjoy different levels of information; that such markets tend to work irrationally in their pursuit of high profits; that they have an inbuilt tendency to break down; and that the crises generated in these markets can impinge on and even dislocate the real, productive sector of the economy, rather than increase 'efficiency'.

In India, moreover, there is not a single, integrated financial market. So, even in theory, finance cannot seek out and promote the most 'efficient' sectors of economic activity. Whereas the large firms and better-off individuals have access to finance from banks and financial institutions, the bulk of India's productive sector — comprising agriculture and small-scale industry — is shut out of bank finance, and cannot raise money directly from financial markets like large industry (shares, bonds, etc). Agriculture and small-scale industry have to depend on the `informal financial sector'. In the informal sector there are a number of operators — chit funds, moneylenders, traders, landlords — all charging much higher rates of interest than the banks; the terms vary widely not only from region to region but depending on the nature of the relation between the lender and the customer. The rates of interest and other terms can be so steep as even to strangle productive activity; a 60 per cent annual rate is not unusual, and even higher rates are frequently found. In many cases there is no question of competition among different lenders bringing down the rate of interest: the borrowers are desperate for capital, and the lenders are scarce (if there is more than one, they may have agreements among them) and are usually in a dominating social position vis-a-vis the borrowers.

To whatever slight extent bank finance reaches such borrowers, they would get some small relief from the usurers, and even the interest rates they pay to usurers may be moderated. In such a situation, to advocate the `freeing' of bank finance from Government direction is to reinforce the wall between the formal and the informal sectors and to condemn the capital-starved producers to backwardness.

In 1990, the World Bank presented a confidential report, India: Financial Sector Report: Consolidation of the Financial System, which was dittoed almost in full by the report of the Committee on the Financial System (June 1991), headed by M. Narasimham. The Bank and the Narasimham Committee report charted a course eliminating any measure of Government direction of finance to productive activities starved of capital, to social welfare needs, and to backward regions. Instead the financial sector would be free to concentrate on high-profit (and high-risk) activities such as speculation and consumer lending, and to ready itself for takeover by foreign capital.

Although, for fear of the social consequences, the Government was unable to implement these measures in full, it moved steadily in that direction. One consequence of this direction was a series of massive bank frauds and scandals starring Harshad Mehta, Ketan Parekh, MS Shoes, C.R. Bhansali and others. Another was the massive shift of bank finance away from productive activities such as agriculture and small scale industry.

In 2002-03 the operating profits of the scheduled commercial banks (SCBs) witnessed their highest growth. Net profits of the banks increased by nearly 50 per cent in 2002-03, on top of a rise of 81 per cent in the previous year. This achievement of the banks was applauded by the business press. How was it achieved? Did it indicate a pick-up in the productive economy? No. The banks earned higher profits from interest on Government debt instruments, and trading in such instruments; from bigger margins on loans; and from housing loans to middle and upper class househeholds.

The 'normal' activity of banks is to borrow from individuals and lend to businesses; the 'spread' between the rate at which they borrow and the rate at which they lend is meant to constitute the main source of their income. However, in the recent period, the character of the banks has changed. Large corporate sector firms have not wanted to borrow, since they were already burdened with excess capacity and low demand (indeed, they were not even willing to invest their own surplus cash in productive activity). On the other hand, the overall thrust of policy and practice since 1991 has conveyed to the banks that they need not bother with the difficult, low-profit job of lending to agriculture and small-scale industries, which requires manpower, branches in the rural areas, and commitment. So banks have instead placed their funds in Government debt, earning risk-free interest and using little manpower. Secondly, as the price of these Government debt instruments has risen recently, the banks have also been making profits trading in these instruments — which is a speculative profit, not much different from trading on the share market.

In 2002-03, the interest/discount earned on advances or bills, which is the core income of banks, fell below 40 per cent of their total income. This was barely above the level of interest income on banks' investments (mainly Government debt), which accounted for 36 per cent of their total income in that year. "The issue has, therefore, arisen", admits the RBI, as to whether investments are "the major source of bank income."¹⁵

Secondly, the rise in profits from the sale of investments was very steep. Such trading profits in 2002-03 accounted for about 7.7 per cent of the total income of banks and about 33 per cent of their operating profits. The banks are functioning less and less as banks, and more and more like any private speculator.

Table 5: Scheduled Commercial Banks' "Other Income"
(ie income other than interest income) and Operating Profit (Rs. billion)

	2000-01	2001-02	2002-03
Other Income	169.85	240.74	316.56
Operating Profit	197.57	298.37	406.82
-- RBI, Trend and Progress of Banking in India, 2002-03.

The second reason for the sharp growth in bank profits was the growth of the banks' `spread' -- the interest they earned minus the interest they paid out. As the Government reduced interest rates, the banks reduced the interest rates they paid to depositors, but they did not correspondingly reduce the interest they charged on loans to many borrowers, especially the borrowers who had no other ways of raising money. As a result the banks' spread grew from Rs 36,950 crore (Rs 369.5 billion) in 2000-01 to Rs 39,441 crore (Rs 394.41 billion) in 2001-02 to Rs 47,111 crore (Rs 471.11 billion) in 2002-03. However, the banks did reduce the rates on loans to large borrowers (as we saw earlier, the corporate sector reduced its interest expenditure sharply). Thus, in effect, the banks used the drop in interest rates to help transfer income, away from small depositors and small borrowers, to the corporate sector and their own pockets. The soaring profits of the banks bring a twinkle into the eyes of foreign investors, who are waiting for the privatisations that will follow the coming elections.

The third trend to be noted in the banks' performance is the shift in their loan portfolio, from lending for production to lending for consumption of the better-off classes. In 2001-02 and 2002-03, this was strikingly seen in the case of housing loans, which are availed of by the middle and upper classes. Disbursements in 2002-03 were 294 per cent higher than the target, and more than double those of the earlier year.

The flow of credit (that is, the increase in outstanding credit, or disbursement minus repayments) for housing loans in 2001-02 was Rs 6,203 crore (Rs 62 billion); in 2002-03, it rose to Rs 12,308 crore (Rs 123.08 billion). Strikingly, this was larger than the flow of credit from scheduled commercial banks to all of agriculture, which was just Rs 10,848 crore (Rs 108.48 billion) in 2002-03. The contrast is even more striking in March-August 2003, when the flow to housing is more than double that to agriculture.

In 2003-04, housing loans reportedly have been overshadowed by rapidly-growing consumer loans for the purchase of cars and other such items. By contrast lending to industry reportedly has not picked up as late as January 2004. It is also worth noting here that development banks such as IDBI, IFCI, IRBI and (now IIBI), whose task it was to lend to industry for projects, are in terminal decline. ICICI has merged with its own banking arm, and has become a bank, plugging consumer loans rather than industrial finance.

Table 8: Flow of Credit to Agriculture from Scheduled Commercial Banks

Starving agriculture of credit
During the 1990s, implementing as far as possible the World Bank line, the Government has given the clear signal to the banks that they can ignore the targets for lending to the 'priority sector', especially agriculture, small-scale industries, and weaker sections. Moreover, the Government has repeatedly relaxed the relevant definitions so that loans to the distributors of agricultural inputs, State Electricity Boards' work in the rural areas, and other 'indirect finance',¹⁶ can be considered to be part of agricultural lending. As a result, lending to agriculture fell as a percentage of bank credit from 15.9 per cent to 9.8 per cent between June 1990 and March 2003; within this, direct credit to agriculture fell even more sharply from 13.8 per cent of bank credit to 7.2 per cent by March 2001.

One visible sign of the drain of investible resources from the rural areas is the ratio between the credit extended by banks in the rural areas and the deposits they receive in these areas. This ratio has fallen from 61.2 per cent in March 1990 to 41.8 per cent in March 2002.

Moreover, the better-off sections have grabbed a larger share of what credit is available. The RBI Report on Currency and Finance 2001-02 notes that in 1990s banks' disbursement of direct finance to small and marginal farmers slowed down, so that the latter's share of credit is falling. Another indicator of the same trend is that during the 1990s the number of borrowal accounts of farmers with less than 2.5 acres fell by 25 per cent, and those with 2.5 to 5 acres fell 15 per cent. By contrast, the number of borrowal accounts of farmers with over 5 acres remained the same.¹⁷

Earlier, banks used to account for most of the medium and long term loans (while cooperatives accounted for more of the short-term loans). However, during the 1990s, banks too have shifted more and more to short-term loans, reflecting their lack of commitment to agricultural lending. The RBI notes that "The shift in the composition of the agricultural loans in favour of short-term advances is a matter of some concern, as it is likely to further accentuate the declining private sector capital formation (ie, investment) in agriculture."

The shifting focus of finance is also reflected in the changing distribution of Scheduled Commercial Banks' offices. Between 1991 and 2003 the number of rural bank branches fell by 2,771; whereas metropolitan branches grew by 3,812.¹⁸

Small scale industry too starved of finance
Small-scale industries, which account for 40 per cent of value added in manufacturing, too have been starved of credit. In the National Sample Survey (2000-01) shortage of capital was most frequently named by small-scale industrialists as the principal problem faced by them. These sections too are driven to take loans at usurious rates. During the liberalisation' era, small-scale industries' share of bank credit has plunged by 6.6 percentage points — a fall even steeper than that of agriculture.

Thus, given the dualism in the credit market — formal sector credit for the large firms and, in the rural areas, for landlords and agricultural traders; usurious loans for peasants and small firms — the repeated reductions in interest rates hardly stimulate investment. The sectors that need cheap credit to expand productive activities get none, while those which are in a position to flourish on market manipulation and speculative activities can merely take advantage of interest rate reductions to boost their profits.

16. The overwhelming bulk of 'indirect finance to agriculture' is actually the Rural Infrastructure Development Fund, which is not lent to peasants at all, but to state governments. (back)


Nos. 36 & 37, March 2004