As interest rates rise, the question that economists are being asked is: How will companies manage?
This question gets asked repetitively because the dark memories of 1997 have been singed in our minds. The Reserve Bank of India (RBI) had hiked interest rates sharply in 1996 and 1997 to cool an overheated economy. Critics of the central bank say it overdid the dose, and the economy had to suffer a painful slowdown.
There is little doubt that rising interest rates could hurt company balance sheets and hence the books of banks that have lent to these companies. But, unlike in the past, that is not all. We also need to look at the effects of higher interest rates on household balance sheets. For the first time ever, the risks to the retail-lending portfolios of Indian banks could be a significant macroeconomic worry. In other words, the inability of people like you and me to service our housing and auto loans could send ripples of uncertainty out into the rest of the economy.
In a speech he gave in Mumbai on 13 February, RBI deputy governor Rakesh Mohan did sound some initial warnings. “The growth of bank credit has favoured retail lending, particularly housing, real estate, trade transport and professional services, and non-banking financial companies—sectors which were not hitherto priced into the credit market. While banks’ exposure to these sectors is still relatively small, given the low base, the high rates of growth have raised worries about the quality of these assets and potential non-performance,” he said.
The retail credit boom that we have seen over the past few years has fuelled a huge change in middle-class attitudes. How many people do you know who have not borrowed in recent years to buy a house, a car or some newfangled gizmo? Not too many, right?
There are undoubtedly many specimens of financial virtue in the great Indian middle class, the debt-free angels who are our financial alter egos. But face it—the rest of us have been on a borrowing binge. Not that this binge has been completely unwarranted. Low interest rates and income growth are good enough reasons to borrow. A lot of us could not have bought houses, for example, if mortgage finance had not been so easily available.
But high interest rates will eventually bite, and it is increasingly possible that some of us who borrowed to buy houses at the peak of the real-estate boom or shares when the market was kissing the stratosphere will be in trouble. The banks that have lent to these people in a hurry will also suffer. It is very likely that retail-loan delinquencies will rise in the coming quarters. This is what Rakesh Mohan also said in his 13 February speech: “Default rates in regard to credit card receivables and personal loans have been rising.”
How big is the potential problem? Morgan Stanley economist Chetan Ahaya has said in a recent research note that the amount of money lent out by Indian banks has increased from $250 billion September 2003 (when the current credit boom began) to $440 billion today. That’s an extra $190 billion of bank credit in three- and-a-half years. Let’s assume that around a quarter of this has been lent out to people like you and me—around $95 billion, or 10% of GDP.
Consumer credit as a proportion of GDP is nearly three times higher in many other Asian countries. But it is growing—and as it does, so, the nature of financial risk in the economy is irrevocably changing.
The problem is that while we have a pretty good idea of the nature of corporate balance sheets and the amount of financial leverage in them, there is very little understanding on the nature of household risk in India. There is no high-quality data, for example, on how household debts have increased in relation to income over these past few years.
Some central banks in Europe do keep tabs on household finances. The IMF World Economic Outlook published in September 2006 tells us what Riksbank, Sweden’s central bank, does. “It uses a detailed annual survey that covers household income, debt and wealth. For the analysis, households are divided into five categories based on their level of disposable income,” says IMF.
There’s more. The Swedish Riksbank then carries out various “stress tests” to understand what can happen to households in case interest rates and unemployment go up. In other words, it tries to assess how well indebted households can manage economic shocks.
This is precisely the sort of data Indian economists and policymakers will need on their desks in the years ahead, if they are to adequately understand what damage higher interest rates, a drop in asset prices or an economic slowdown could have on indebted households—and the extent to which their woes can spread into the rest of the economy.
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