Home / Opinion / What drives private banks’ interest in rural areas?

The coincidence of the drive for “financial inclusion" and rural India’s brisk growth offer interesting insights into the finance-growth nexus. The rapid increase of rural incomes and consumption with a shift in expenditure patterns has altered the business perceptions of private banks about this segment of the economy. Rural businesses do not seem so risky any more. Their untapped potential is a growth driver for many private banks; HDFC Bank Ltd, for instance, aims to grow its business share from rural areas to 50% in the next five years. Differences in rural-urban demand patterns are now exploited to balance cyclical pressures by some private banks. Banks are eager to finance consumer, personal and business loans in this sphere, not just mobilize deposits as was earlier the case. While all public and private banks were advised to incorporate “financial inclusion" plans from 2010, a growth-spurred momentum to this process is unmistakably visible.

This visible demand-supply interplay revives the question whether financial development spurs growth or vice-versa, a long-unsettled subject. In the early 20th century, Joseph Schumpeter argued that financial intermediaries were essential for technological progress and economic development; to mobilize savings, finance projects as well as monitoring and transaction purposes. Subsequent economists like Goldsmith and McKinnon empirically documented the close ties between financial development and growth. Other studies followed, mostly presenting cross-country evidence consistent with Schumpeter’s view that financial systems can promote economic growth. Indeed, many financial development measures are strongly associated with real per capita GDP growth, the rate of accumulation of physical capital and the efficiency with which it is employed, while the predetermined component of financial development is also robustly correlated with these variables.

The idea that financial development promotes growth has been very influential. Many developing countries have pursued supply-led financial development policies through setting up banks and other financial institutions. India itself followed a vigorous one starting with bank nationalization in 1969, pushing bank branches in a targeted manner. Rural bank branches expanded fourfold in the decade from 1973, doubling thereafter in the next 30 years; in June, 2012, 37% of overall bank branches were in rural areas. There’s little specific evidence for growth-enhancing effects of bank-branch expansion. But some studies do show priority sector credit policies—this share in total bank credit doubled from 1969 to 31.3% by March 2012—mitigated information asymmetries for small firms, relaxing financial constraints. Lower poverty levels are also found to coexist with more financially developed parts of the country.

After a gap, the supply-side thrust to financial development is back, now described as financial inclusion. As part of the thrust to draw in marginalized small firms and households, new private banks are also expected to be licensed soon. This time round, a happy concurrence of demand and supply factors should ensure a self-propelling momentum to financial development.

Renu Kohli is a New Delhi-based macroeconomist.

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