I. ANALYTICAL ISSUES ON THE ROLE OF CREDIT

6.7 Financial development, i.e., the existence of well-functioning financial institutions and markets, is believed to contribute to economic growth through a number of channels: (1) acquisition of information on firms; (2) intensity with which creditors exert corporate control; (3) provision of risk-reducing arrangements; (4) pooling of capital and (5) ease of making transactions (Levine, 2004). Financial institutions are better suited than individuals to identify potentially successful projects because these institutions have better information gathering and processing ability and the requisite personnel skills to monitor the efficiency and productivity of projects. By reducing the costs of acquiring and processing information, financial institutions improve resource allocation and encourage the mobilisation of savings to invest in large projects. They also facilitate the pooling and hedging of risks inherent in individual projects and industries. Well-developed financial markets augment liquidity in the economy. Adequate liquidity enhances savings in the economy by reducing liquidity risk of securities holders’ by allowing them to sell their securities easily without affecting firms’ access to the funds initially invested. By exerting effective corporate governance, financial systems can help to retain domestic savings at home. Thus, well-developed financial markets and institutions can generate growth by increasing the pool of available funds and by reducing the risk and ensuring productive uses of funds mobilised from savers. The endogenous growth literature, building on ‘learning by doing’ processes, assigns a special role to finance. Finance is seen as a crucial factor of production like knowledge and the influence of institutional arrangements in regard to finance on growth has often been forcefully emphasised. By facilitating borrowing for accumulation of skills, financial systems can promote the accumulation of human capital (Jacoby, 1994).

6.8 Several studies have attempted to examine the relationship between various alternative indices of development (such as, the ratio of consumer credit to GDP, market capitalisation to GDP and bank credit to GDP) and growth rates. Illustratively, using cross section data for 77 countries for the period 1960-1989, King and Levine (1993) found statistically and economically significant positive relationship between the measures of financial development and growth. The measures of financial development used in this study as well as most subsequent studies are, however, quite different from what the theory suggests. Benhabib and Spiegel (2000) found that financial development affects growth both through capital accumulation and productivity increases engendered by knowledge creation.

6.9 The issue of causality between finance and growth, however, remains unsettled. Financial development may promote growth simply because financial systems develop in anticipation of future economic growth. Furthermore, differences in political systems, legal traditions or institutions may be responsible for driving both financial development and economic growth. Rajan and Zingales (1998) attempt an industry-wise analysis to circumvent the issue of causality between finance and growth and find that industries that are relatively more dependent upon external finance grow relatively faster in countries that have well-developed financial systems. Fisman and Love (2003), however, argue that the external dependence measure of Rajan and Zingales (op cit.) may be capturing good global growth opportunities rather than the role of finance.

6.10 According to Favara (2003), the relationship between financial development and economic growth is, at best, weak. Moreover, the relationship is nonlinear in the sense that finance matters for growth only at intermediate levels of financial development. The effects of financial development are found to differ considerably across countries and display no obvious pattern. In contrast to Favara’s (op cit.) findings of non-linear effects, Bossone and Lee (2004) find empirical support in favour of ‘systemic scale economies’ (SSE) hypothesis, i.e., larger, deeper and more efficient systems enable banks to save on the resources needed to manage the higher risks associated with larger production. Small banks in large systems are more cost efficient than small banks in small systems. Banks in small systems are found to over-utilise financial capital and vice versa. Finally, Bassone and Lee (op cit.) also find that large banks in large systems operate at an approximately optimal capital level.

6.11 In brief, the empirical evidence suggests that there exists a positive correlation between finance and growth. There is also an emerging consensus that the causation runs from finance to growth. Differences in financial development can alter economic growth over long time horizons and, therefore, well-developed financial sector is crucial for all economies. Healthy and competitive financial markets are an extraordinarily effective tool in spreading opportunity and fighting poverty (Rajan and Zingales, 2003).

6.12 In India, the role of finance in promoting growth was recognised early on after Independence. The First Five-Year Plan (1951) observed that central banking would have to take on a direct and active role in creating the machinery needed for financing developmental activities and ensuring that the finances available flow in the directions intended. With the initiation of the reform process in the early 1990s, although there has been a paradigm shift in the credit allocation process from micro-management to a greater role for market forces in credit allocation, the Reserve Bank continues to pursue with its efforts to improve the credit delivery mechanism in the economy. For India, empirical evidence confirms the positive role of finance on growth (RBI, 2001).

Banks versus Market Based Systems

6.13 Based on the level of sophistication and the type of system, financial systems can be grouped into two categories, i.e., (a) the Anglo-American model of market-based finance where financial markets play an impor tant role and (b) the Continental/Japanese model of bank-based finance, in which savings flow to their productive uses predominantly through financial intermediaries such as banks and other financial institutions. The market-based system is relatively impersonal as the sources of funds are atomistic household savers, directly or indirectly through mutual funds, pension funds or insurance funds. The bank-based systems are more relationship-based, because the lenders are few and large. Generally, bank-based systems often tend to be stronger in countries where governments have taken a direct role in industrial development, such as Germany, in the 19^th century, and Japan and India, in the later half of the 20^th century. At the same time, a number of EMEs, especially the South Asian tigers, follow a market-based system (Mohan, 2004a).

6.14 The two-way classification of financial systems - market-based versus bank-based – is rather restrictive. The composition may not matter since the two systems may be complementary and the key issue is a well-functioning financial system (Huybens and Smith, 1999; Merton and Bodie, 1995). Furthermore, the distinction between the two has blurred in recent years with the institutionalisation of the sources of finance all over the world. The blurring has emanated from the gradual spread of universal banking, spanning the entire range of financial services across commercial banking, insurance and securities (investment as well as underwriting).

6.15 Notwithstanding the debate on market versus bank-based systems, banks remain the predominant purveyors of credit in many developing economies. Even in advanced economies, banks continue to be important, despite the growing importance of market-based systems. Therefore, bank credit is an important source of finance although the role of credit analytics in monetary policy formulation has seen ups and downs over the past five decades. Credit aggregates were a key variable in the conduct of monetary policy during the 1950s and 1960s in a large number of economies, including the advanced economies such as the US. With restrictions on interest rates, a number of industrial economies regulated credit to various sectors of the economy during this period, although the fraction of credit so directed was smaller than that in EMEs (Krueger, 2004). During the 1970s, credit aggregates gave way to monetary aggregates. With the onset of financial innovations, as money demand turned unstable, both money and credit vanished from the scene as targeting variables by the early 1990s (Borio and Lowe, 2004). In the subsequent period, interest in credit behaviour has re-emerged as it is believed that credit conditions play a key role in the monetary transmission mechanism.

6.16 The traditional interest rate channel is based on the assumption of perfect substitution between the different financial assets and neutrality of firms’ financial structure. This view – the 'money view' -holds that financial intermediaries like banks offer no special services on the asset side and capital structures do not affect any lending/borrowing activity, while on the liability side of their balance sheet the banking system creates money by issuing demand deposits. However, the assumption of perfect substitution between financial assets such as bonds and loans does not hold in the presence of information asymmetries. The ‘credit view’ or ‘lending view’, although not necessarily in conflict with the ‘money view’, stresses imperfect substitution between bank credit and securities and, at least implicitly, between internal and external finance (Bernanke and Blinder, 1988).

6.17 The credit channel of transmission reinforces the effects of the traditional interest rate channel of monetary transmission. According to the credit view, the direct effects of monetary policy on interest rates are amplified by endogenous changes in the external finance premium (EFP). EFP is the difference in cost between funds raised externally (by issuing debt or equity) and funds generated internally (from retained earnings). The size of this EFP reflects imperfections in the credit markets and varies in the same direction as the movement in interest rates. Thus, monetary tightening increases EFP while easing of monetary policy reduces EFP. Consequently, the impact of a given change in short-term policy interest rates on demand and output is magnified, thereby reinforcing the effects of variations in interest rates per se (Bernanke and Ger tler, 1995). Thus, credit conditions play an important role in the monetary transmission process.

6.18 Within the credit view, two alternative channels are stressed. The 'bank lending' channel holds that a contractionary monetary policy decreases bank reserves, which cannot be offset by the banks (say, by issuing certificates of deposit) thereby reducing bank lending, investment demand and output. The credit view also proposes a 'balance sheet' channel of monetary transmission. According to the 'balance sheet' channel, a tight monetary policy reduces net worth of the borrowers as well as lenders. The reduction in the net worth of the borrowers, for instance, reduces the collateral available with them which, in turn, increases the EFP. This inhibits investment demand in the economy and the affects may get magnified through a financial accelerator mechanism. The effect may also depend upon the size of the firms and their access to credit markets. Small firms that have relatively poor access to credit markets will be forced to curtail their production relatively more compared to large firms with better access to credit markets. The latter may be in a better position to take recourse to alternative avenues of funds such as commercial paper so as to maintain their production. In brief, relatively more credit-constrained firms will see a larger degree of output contraction in response to monetary tightening.

6.19 The origins of the credit view can be traced to Fisher (1933), who argued that the severity of the economic downtur n dur ing the Great Depression resulted from the poor performance of financial markets. The credit view is better able to explain the severity of the Great Depression (Bernanke, 1983; Bernanke and Gertler, op cit.). Monetar y forces alone were ‘quantitatively insufficient’ to explain the depth of the Depression and its persistence, and that the collapse of the financial system, reflected largely in bank failures and stock market crash wor ldwide, was an important explanatory factor. The credit channel and the financial accelerator mechanism also explain the severity of the financial crises in the Asian countries (Catao and Rodriguez, 2000). In many instances, credit booms are a precursor to future financial instability (Box VI.1).

Box VI.1

Bank Credit Booms and Financial Instability

The 1990s was a decade of low interest rates and low inflation in many countries. At the same time, the decade witnessed sharp increases in property and securities prices, partly fuelled by accommodative monetary policies. Sharp rises in asset prices are often followed by equally sharp reversals. With increased leverage, sharp reversals in asset prices bring forth a reduction of net worth and the financial accelerator mechanism can reinforce the downswing of economic activity.

The role of credit conditions in the expansion of the 1920s and the slump of the 1930s directs attention to two factors: the structure of domestic financial systems and the interplay of finance and innovation. While financial structure and regulation have featured in the comparative literature on the causes of banking crises in the 1930s (Grossman 1994), the interplay of finance and innovation in stimulating the expansion and setting the stage for the crash has been the subject of less attention. It was precisely the experience of the 1920s and 1930s that provided the backdrop for Schumpeter’s characterisation of the cyclical aspect of capitalism as 'innovation financed by credit.' The experience of the 1990s is reminiscent of the development and effects of credit conditions in the 1920s and the fact that the interaction of credit with innovation may generate business cycles.

Against this backdrop, a view has emerged that central banks should lay more stress on movements in credit. Almost 75 per cent of credit booms in EMEs have been associated with a banking crisis while 85 per cent of the booms were associated with a currency crisis (IMF, 2004). Amongst the various variables considered individually, credit booms – defined as a situation where credit/GDP ratio is four percentage points above its trend - turn out to be the best predictor of future financial imbalances and dominate other possible variables such as money, asset prices and output gaps. Over 3-5 year horizon, credit booms predict 80 per cent of banking crises, much higher than that of 47 per cent in case of asset price misalignments. If a combination of various variables is considered, then asset price misalignments taken in conjunction with sharp movements in credit aggregates turn out to be the best predictors of future instability (Table 6.1). Thus, central banks should pay particular attention to credit developments since a focus on monetary aggregates alone is an inadequate substitute (Borio and Lowe, op cit.).

Credit booms have been often preceded by strong capital flows, but are not found to have a major impact on inflation. This is partly on account of high trade openness. Domestic demand imbalances in an open economy get reflected in widening trade and current account deficits and an appreciating exchange rate. Therefore, price stability does not prevent a credit boom/bust. Notwithstanding this, the case for pre-emptive monetary tightening to stop credit booms and asset price bubbles remains a matter of debate (see Chapter VIII).

6.20 Bank credit, in particular, plays an important role in developing economies. As a matter of fact, some European countries are even now reluctant to leave credit entirely to market forces (Krueger, op cit.). A distinctive characteristic of developing economies, often justified by the need to conserve scarce