So what is currently squeezing demand? Risk-averse households and firms? Or a risk averse financial sector? Disentangling these hypotheses is crucial to identifying the right policy response.
Credit slowdown: Symptom or cause?
First, it’s important to appreciate the quantum of the credit slowdown. The flow of credit across banks and non-banks has fallen a staggering 90 per cent compared to a year ago, according to the RBI. The NBFC retrenchment is understandable, given continuing asset quality concerns, the asymmetric information that grips that sector, and market access largely drying up. Instead, the real surprise is the banking sector, which was expected to fill the gap. Exactly the opposite has occurred. Bank credit growth has almost halved from a year ago.
No wonder that such a sharp retrenchment of credit is correlated with a sharp slowdown. The question is, which is causing which? Is the credit slowdown a symptom of the slowdown? Or is it the cause?
To disentangle this, we use interest rates as an identification strategy. If demand for credit has fallen, offtake would fall, and interest rates should also fall to clear the market of loanable funds. Conversely, if banks have become more risk averse, lending standards have tightened and risk premia have gone up, this would be akin to the supply curve moving up. Credit offtake would slow but there should be upward pressure on interest rates. In both cases, credit offtake slows, but a demand shock should result in lower rates while a supply shock should push up rates.
How does this currently apply to India? India has witnessed a large policy easing cycle in 2019. If the transmission from policy to lending rates is much less than normal, banks’ reluctance to cut lending rates would be a tell-tale sign of lending conditions tightening, risk premia rising, and the supply curve moving upwards. In contrast, if the transmission is typical, that would militate against such a hypothesis. Higher-than-normal transmission would suggest a potentially acute demand shock.
2019 versus 2015
To judge transmission, however, we need a benchmark. We use the 2015 easing cycle which saw 125 bps of cuts versus 135 bps in 2019. But transmission across the cycles is almost incomparable.
Eight months into the 2019 cycle, only 33 per cent of policy rate cuts have permeated into bank lending rates for fresh loans. At this time in 2015, a full 90 per cent of policy cuts had transmitted. The differences are equally stark when looking at the outstanding stock of all loans (since these get progressively repriced). In 2015, lending rates on the stock of loans had moved down 31bps (against policy rate cuts of 75bps at this point in the cycle). In 2019, the weighted average lending rate has actually increased by 2bps despite policy cuts of 135bps! Consequently, real bank lending rates have increased very sharply over the last year which has likely choked credit off-take and economic activity.
What else could explain this? Could these stark differences be explained by other proximate factors? Quite the contrary. First, liquidity has been in a massive surplus in 2019 but was in a deficit through most of the 2015 cycle. Second, bond market transmission has been greater in 2019 with yields moving down 70-80 bps versus just 15-20 bps in 2015. Third, incremental credit-deposit ratios have been lower in 2015 compared to 2019. Every one of these factors would argue for greater transmission in 2015. Taken together, they should have resulted in materially lower lending rates than in 2015. Exactly the opposite has happened, though.
Could deposit rate differences explain this? Ostensibly. In 2015, almost 80 per cent of the policy cuts had permeated into deposit rates by this time. In 2019, it has been a miserly 12 per cent! Why haven’t deposit rates fallen more? Two hypotheses. First, the 2019 easing started with the largest gulf between small savings and deposit rates (110 bps) in more than a decade. In 2015, the gaps was negligible. Perhaps banks are wary of cutting deposit rates for fear of losing market share to small savings? Second, are deposit rates subject to “nominal illusion”? While real deposit rates remain healthy, nominal deposit rates are the lowest in 12 years. Perhaps banks worry that if nominal rates are cut, they would lose out to other asset classes?
But sticky deposit rates are only part of the story. If demand was so weak, banks could have reduced spreads to grow volumes and clear the market. The fact that they didn’t is revealed evidence of growing risk aversion.
All told, a dramatic drop in credit offtake has accompanied the growth slowdown. The NBFC retrenchment is understandable, given asset quality issues still plaguing their balance sheets and consequent rationing out of credit markets. Bank diffidence is the surprise. The sheer lack of transmission suggests an increasingly risk-averse banking system sharply tightening lending standards. This has meant real lending rates have increased very sharply, hurting credit and activity. Unsurprisingly, firms that can access global markets are rushing to do so, with external commercial borrowing (ECB) doubling in 2019 versus 2018 — further evidence of a domestic supply constraint. External borrowing, of course, both puts upward pressure on the exchange rate and, if unhedged, creates financial stability concerns.
The clear policy implication is tackling the financial sector is a prerequisite to a recovery. This includes one, hastening resolution of stressed assets; two, urgently changing the incentives of PSU banks (P J Nayak Committee); three, ensuring small savings rates actually move with market benchmarks; four, resolving the asymmetric information failure in the NBFC space; and five, plugging the capital/equity gap in systemically important NBFCs.
This is not to say slowing demand plays no role. Risk-aversion amongst banks also reflects stress in key sectors of the economy (real estate, power, telecom) and the consequent bank diffidence creates a vicious interplay of demand and supply forces. De-risking key sectors is therefore imperative in breaking the logjam.
It’s tempting to contemplate out-of-the-box solutions like “QE” or “Operation Twist” to bring down bond yields in the hope of better monetary transmission. But it’s clear the constraint lies elsewhere. Before thinking out of the box therefore, we must attend to the plumbing within the box.
The author is chief India economist at J.P. Morgan. Views are personal