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Arvind Subramanian

How can India be facing a credit crunch if credit continues to grow at a torrid 30 per cent? Yet, it is undeniable that call rates have risen sharply to double-digit levels. What is going on? And how should monetary policy respond?

First, distinguish the Indian phenomenon from what we have seen in western credit markets. In the latter, the crisis was primarily about a lack of confidence in the financial system and the evaporation of trust between agents because of uncertainty about exposure to mortgage-related assets. In short, the problem was a diminished supply of credit. Even the inability of firms to raise capital in the commercial paper market similarly reflected an unwillingness of banks and the public to supply finance to firms that were believed to be exposed to toxic assets.

The Indian variant is somewhat different. The private sector’s funding from foreign sources and from the non-bank public (through the issuance of bonds and raising equity) has dried up because of a combination of capital outflows and declining share prices. In 2007-08, for example, 40 per cent of funds available to Indian industry were raised through external commercial borrowings and new equity issues. Funding for Indian companies that have borrowed abroad has also dried up because of trouble in foreign credit markets, forcing these companies to turn to the domestic banking system for credit. Additionally, firms’ own funding has declined as profits head south.

This reduced supply of non-bank and foreign funding has led the private sector to turn to banks to make up this shortfall: that is, there has been a sharp increase in the demand for domestic bank credit. Of course, with banks lending to finance the losses of oil companies, there has been an additional squeeze, or crowding out, of credit to the private sector as a result of pre-emption of bank credit by the government.

So, the answer is yes, there is a credit crunch despite torrid credit growth because the demand for credit has gone up. Price - the call interest rate - and not quantity is the right signal.

The policy question, then, is: how can this additional credit be provided to the private sector? Or to put it in accounting terms, how can the aggregate size of the balance sheet of the banking system as a whole be increased?

Simple macroeconomic accounting suggests that additional supply of credit can come from five sources: the government, the Reserve Bank of India, firms’ own profits, the non-bank public and abroad.

If the government could reduce its deficit, more of the existing credit could be made available for the private sector. With oil prices declining, this channel should, unless the government increases its deficit for other reasons, start kicking in.

There is a dilemma for interest rate policy. Reducing interest rates can help address the current credit crunch in a number of ways.

First, by reducing the cost of banks' funding and raising their spreads, it would increase their profitability. Second, it could also help corporate profitability, which has two positive effects: by increasing the own source of funding - profits - it reduces firms’ demand for bank credit, and by improving the asset quality of banks, it frees up resources to expand credit.

Finally, lower rates helping corporate profitability could attract foreign capital into the equity market. This would again alleviate the credit crunch by increasing non-bank funding of firms and hence reducing their demand for bank credit.

This article first appeared on VoxEU.org

Arvind Subramanian is senior research professor at Johns Hopkins University