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Bank lending has been growing at double-digit rates in 2022-23. In September, non-food credit growth crossed 15% year-on-year for the first time since 2018. This is good news, because bank credit is often a leading indicator of growth. Companies use bank loans to finance working capital as well as new investments. Households borrow to fund housing, education, consumer durables, vehicles and other personal expenses. Non-banking finance companies (NBFCs) borrow from banks to on-lend to customers. Thus, a sustained rise in bank credit usually signals an economic recovery.

Since 2000, India has experienced three periods when real economic growth exceeded 7% for a continuous stretch. Each phase was preceded, and sometimes accompanied, by a lending surge. This is because bank credit continues to play a significant part in financing economic activity, notwithstanding the rise of alternatives such as non-banking companies and overseas loans. Bank finance constituted 47.5% of the total flow of resources to the commercial sector in 2021-22.

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Credit impulse, a more nuanced metric, has also picked up after a long negative stint during the pandemic. Measured as the change in flow of bank credit as a percent of GDP, credit impulse is better able to predict recoveries from a slowdown. For example, in the early stages of a recovery, the credit growth rate may be low, but if new credit rises at an increasing rate, it can provide an “impulse" to investment demand. Credit impulse has been positive for four quarters now, raising hopes of a revival in investment.

Credit impulse
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Credit impulse

Industrial credit

Two developments threaten this optimism. First, credit to the industry. True, an uptick has been seen this year, but that could be because of several factors that may not really convert into investments. In reality, sluggish growth over the past decade means the share of industry in total bank credit has declined sharply from 45.7% in March 2013 to 25.7% in August 2022.

This year’s growth can be explained by high fuel and raw material costs, which may have led to additional funding needs. Some bank loans may have replaced costlier overseas debt. Interest rate hikes probably made it cheaper to borrow from banks than from bond markets. (Minimum cost of funds-based lending rates are relatively cheaper than rates based on external benchmarks.) All of this suggests that the pickup in industrial credit may be a response to current conditions, rather than a sign of higher investment spending.

Deposits lag

The second threat is deposit growth. Banks rely primarily on deposits from the public to fund their lending. Since April, while credit growth has surged, deposits have grown at a steady 9-10% rate. This lag has created a funding gap. Banks will have to mobilize more deposits or raise funds from other sources to ease this resource constraint.

Recently, several banks announced higher deposit rates to attract more savings. However, given the large deposit shortfall, banks will probably have to raise additional funds via other instruments such as certificates of deposits (CDs) or bonds. Unfortunately, even though Indian households like to keep the bulk of their savings in bank deposits, they may not be able to fill the deposit-credit gap. That’s because household savings are under pressure from inflation, while their consumption is growing on the back of pent-up pandemic demand. If banks are unable to secure more resources, they will face constraints to credit growth.

Larger risks

By far, the greatest concern for banks is the worsening economic scenario, which risks both investment and consumption growth. The International Monetary Fund predicts a contraction in one-third of the world economy by next year, and stalling growth in the US, Europe and China. A global slowdown of this scale will hurt India’s exports and outward-oriented service sectors. In domestic manufacturing, capacity utilization remains well below the 80% level that usually calls for new investment.

The current high-inflation high-interest-rate environment does not favour bank credit. Households eschew loans when prices are high or rates are going up. Corporates may also turn cautious as the festive rush slows. In other words, rising bank credit, while welcome, does not guarantee a genuine demand recovery. That would require a rise in real income, which in turn would spur a sustained rise in savings, consumption and investment.

Deepa Vasudevan is an independent writer in economics and finance.

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