Defunct ideas argued anew

Defunct ideas argued anew

Banks, like all commercial organizations, search for profits. Repeating this truism may surprise many, but it bears reiteration for this basic truth is in the danger of being lost sight of once again.

In an interview with Mint on Monday, former Reserve Bank of India (RBI) governor Y.V. Reddy argued for selective credit controls and credit allocation. He expressed concern at “productive" sectors being deprived of resources. In this context, he mentioned large-scale lending by banks to fund acquisitions, pay telecom licence fees, real estate and infrastructure. He also raised the issue of asset bubbles.

These concerns, however well-placed they may sound, hark back to a different era in the Indian economy and are unsuitable today, given its very different evolution.

Take the case of credit controls and allocation of credit. This has been tried before. At one point, nationalized banks devoted a huge chunk of their resources towards agriculture. But along with credit controls and allocations came political interference. Large amounts of money lent to farmers and other parts of the agriculture sector could not be recovered because the government simply wrote off the loans. Similar attempts at channelling money to “important" industries often backfired because politically motivated lending led to borrowers not repaying their loans.

Credit rationing and its obverse, credit allocation, as determined by a government, or for that matter, a central bank, only lead to inefficiency of the kind that was once witnessed in centrally controlled economies. Those pathologies are too well known to be repeated here. A call for credit rationing only leads to that abandoned road.

If banks and their borrowers are investing money in what are termed “speculative" investments, say housing and real estate, the problem lies with the lack of investment options. Here it is appropriate to mention the absence of a deep and liquid bond market in India. The presence of such a market could have easily addressed many of the concerns flagged by Reddy. It is pertinent to note here that RBI did not do enough during the Reddy years to create a deep bond market.

It is futile to look for theories of “final causes", but as illustrated by economist George Cooper in his book The Origin of Financial Crises, the absence of adequate investment opportunities leads investors to pour money into existing financial assets, leading to bubbles. The answer to the problem is not to restrict credit flow, something that will only create more distortions in the financial system, but to create more investment channels.

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