Macroeconomics of directed credit reforms in India

Abstract

This paper develops a theoretical framework to evaluate directed credit reforms in India. It formulates a post-Keynesian/structuralist macro model that incorporates key features of the Indian banking system. The model divides the economy into a demand constrained industrial sector and a credit constrained agricultural sector. The model shows that directed credit reforms tighten agricultural credit and output, erode real wages by increasing the agricultural price and reduce industrial demand. Inflation also picks up on account of real wage resistance. This paper, therefore, has a close affinity with existing accounts that warn against the stagflationary consequences of financial liberalisation.

Keywords:

• financial liberalisation
• directed credit
• India
• macro model
• post Keynesian
• structuralist
• credit rationing
• endogenous money
• stagflation

JEL Classifications:

• E12
• E51
• O11
• O16

Acknowledgements

I am thankful to Professor J. Mohan Rao and two anonymous referees for valuable comments on earlier drafts. I have also benefited from my discussions with Professor R. Ramakumar and Dr. Pallavi Chavan on the subject of rural credit in India. Needless to say, I am solely responsible for remaining errors.

Notes

1. Observed levels of rural credit could be influenced by the demand for such credit. Binswanger and Khandker (1995) argue that the number of bank branches in a district, being policy driven, would be exogenous of farmer demand. The component of total credit supply predicted by this exogenous indicator is then used as an explanatory variable in output, fertiliser use and investment regressions. Binswanger and Khandker (1995) also find that agricultural output responds more or less positively to rural credit depending on which institution purveys rural credit. Credit flow from agricultural co-operatives has a greater explanatory power in output regressions than credit flow from commercial banks. As the authors explain, this is because agricultural co-operatives exclusively concern themselves with the financing of agricultural operations whereas commercial banks also provide finance for non-farm activities.

2. Lack of irrigation facilities can also constrain the adoption of HYV technology but Sarap (1990) found that even in irrigated villages in his study area, most cultivators did not get sufficient credit to adopt HYV technology at recommended levels.

3. This appears similar to the balance sheet channel of monetary policy transmission suggested by New-Keynesians (Bernanke and Gertler 1995). However, the role of collateral and credit in explaining macroeconomic fluctuations has long been central to post-Keynesian research programmes. In this regard, the work of Kalecki (1937) and Minsky (1995) deserves a special mention.

4. Non-performing assets are those on which either interest or principal is due for 90 days or more.

5. For a review of the arguments of the Narasimham Committee see, among others, Dandekar (1993) and Kohli (1997).

6. The view that deposit creation requires nothing more than a book entry operation by banks has an impressive pedigree. It was emphasised by Keynes in the Treatise on Money, where he pointed out two ways of deposit creation: one passive, in which notes or cheques are deposited with the bank, and another active, when ‘additional deposits are exchanged for the lOUs of borrowers’ (Studart 1995, 38). On this, also see Lavoie (1984), Rochon (1999) and Graziani (2002).

7. This rather brief exposition does considerable injustice to the richness of endogenous money theory. Besides the articles mentioned in the previous endnote, see Kaldor (1985) and Rochon (2006). Some post-Keynesians, called ‘structuralists’ believe that central banks needn’t passively accommodate all demand for reserves and that the rate of interest may increase with loan demand. Fontana (2004) contains a detailed examination of ‘structuralist’ and ‘horizontalist’ views of endogenous money. With its assumption of fixed interest rates, irrespective of the level of loan demand, this paper leans towards the ‘horizontalist’ conception of endogenous money.

8. Let us assume that the industrial sector is one large complex and its purchase of intermediate inputs from other sectors stands at one-fifth of the value of its output and, therefore, one-fourth of its Gross Value Added (or GDP). If wage earnings constitute half of industrial GDP, total production costs (including wages and intermediate inputs from other sectors) would stand at three quarters of industrial GDP. If it takes three months to process intermediate inputs into final goods and generate revenues from sales, industry’s total financing requirement in a year would stand at 18.75% of its GDP. If unutilised balances in cash credit and overdraft account stand at 15% of industrial GDP, industry can meet 80% of its financing requirement without requiring any increment in credit limit.

9. It is possible that banks always accommodate the entire credit demand of agricultural borrowers through their demand loan window. But this would raise the question of why they repeatedly go through the trouble of scrutinising the loan applications of agricultural borrowers instead of offering them a generous running credit line facility.

10. Our specification that agricultural output is credit constrained is somewhat different from the standard formulation adopted by structuralist and Kaldorian dual economy models that make agricultural output a function of capital stock (Dutt 1992; Rao 1993). This formulation is based on our reading of existing literature on credit constraints in agriculture and banking practices in India. We understand that our denial of any capital stock constraint on agricultural sector is not completely realistic. But then, no model, including those that deny any credit constraint and peg agriculture’s output to its capital stock, can claim to be completely realistic. Our model, like others, seeks to capture a slice of reality it considers pertinent. However, we realise that land is an indispensable fixed asset in agriculture. We may realistically assume that the amount of land is fixed and more agricultural output is produced through a more intensive application of the industrial input.

11. Agricultural sector in India is marked by a diversity of property relations. Besides capitalist production, peasant production on both owned and rented land is quite common. It is difficult to capture such institutional diversity in simple models.

12. Although, it is likely that small scale agricultural capitalists (as well as the other important beneficiaries of priority sector credit, namely capitalists in the small industrial sector) have consumption propensities that are much higher than those of large scale industrial capitalists.

13. Although a rural wage that is a constant fraction of the urban wage would do as well.

14. There is an inverse relationship between food prices and industrial demand, as has been emphasised both in the debates on Indian industrial development (Mitra 1977) and in structuralist dual economy models (Taylor 1987; Rao 1993).

15. It is assumed that agriculture transfers its entire savings to industry. The introduction of agricultural investment would imply increasing capital stock in agriculture but that should not affect the course of agricultural output which, by assumption, is credit constrained. However, when introduced as a function of its profits/savings, investment in agricultural sector may influence the positive correlation between agricultural and industrial output suggested by our model. As it stands, the model suggests that a reduction in agricultural credit and output would reduce industrial output by shrinking both consumption and input demand for the industrial good. Once agricultural investment is introduced, we will need to account for an additional possibility. Suppose agricultural price increases to more than make up for the decline in agricultural output so that agricultural profits increase. If agricultural investment responds strongly to profits, we can visualise a situation in which overall industrial demand increases despite a fall in both input and consumption demand. However, a strong investment response to profits in the agricultural sector is unlikely when existing agricultural capacity remains underutilised due to shortage of production credit. Thus, we expect the prediction of our model to hold even in the presence of (profit driven) agricultural investment.

16. Re-write equation (8) as:

where stands for interest paid by industrial capitalists. On re-arranging terms:

Since the bracket term on the right-hand side is equal to savings of industrial capitalists, we get the result stated in the text.

17. This demarcation motivates our formulation of the agricultural credit target of banks, defined in terms of production credit granted to industry, in the subsequent analysis. It is also in agreement with India’s financial landscape. Traditionally, in India, banks have been responsible for financing production and state-owned term lending institutions for funding industry. True, banks were important recipients of household savings which they transferred to industry by procuring the securities of term lending institutions. But this would not have affected their agricultural credit target, which is defined in terms of credit granted and not securities purchased. In more recent years, due to diversification of household savings, other financial institutions (insurance, pension funds, etc.) have assumed an important role in funding the private corporate sector. However, the most prominent role in funding the corporate sector deficit is now played by rest of the world (through foreign portfolio flows, external loans, etc.), which, incidentally, on account of RBI’s purchase of foreign assets, is not a major net lender to the country as a whole. According to flow-of-funds data for India, other financial institutions and rest of the world covered from 70 to 85% of the investment-savings gap of the corporate sector between 2009 and 2011.

18. Banks minimise the following function: .

19. Our specification of wealth growth is not precise. Within the terms of our model, the wealth of agricultural capitalists would include two different things. First, wealth would include the market price of land that should equal the capitalised value of agricultural profits (also see note 10). Secondly, the wealth of agricultural capitalists would include financial assets accumulated through savings and, plausibly, going by our understanding of India’s rural economy, held in cash or near-cash forms. Our specification of wealth growth relates only to the growth of financial assets and disregards the capital gain effect of rising agricultural profits. However, this is only a simplification whose removal, while making our model more complicated, should not affect its results qualitatively since a variation in agricultural profits would influence land prices in the same direction as savings of agricultural capitalists.

20. We have assumed that all adjustments to or away from equilibrium take place along the AA curve. However, if the economy were allowed to lie off the AA curve, the relevant phase diagram would show that dynamics around E in Figure 5 are cyclical. This is an interesting feature of our model. However, a full examination of out-of-equilibrium dynamics, which we have separately carried out, was not included because we did not wish to be sidetracked from the objective of analysing equilibrium effects of financial reforms.

21. A full examination of out- of- equilibrium dynamics would reveal that E in Figure 6 is a saddle point. Dynamics around E′ are cyclical; it is a spiral sink.

22. This discussion is reminiscent of Rao’s (1993) suggestion that agricultural capitalists in India, especially in regions that are already well-endowed with irrigation facilities, would lose as expansion of agricultural infrastructure to new areas reduces their profit margin.

23. The Indian government has recently decided to periodically adjust the wage of its rural workers (hired under the National Rural Employment Guarantee Scheme) according to changes in cost of living. Wage indexing by government in rural areas has improved rural workers’ bargaining power vis-a-vis private employers.

24. We follow Taylor’s (1987, 1425) diagnosis that ‘a shift in terms of trade toward agriculture is a signal that inflation is soon to follow in most corners of the Third World.’

25. The dynamics of u_a remain unaltered because inflation will be added to credit growth equation but subtracted from agricultural output growth equation.

26. On the adverse supply effect of stabilisation and adjustment, see Bhaduri (1992) and Rakshit (1994).

27. Rao (1993) has provided another important reason for cumulative interaction between demand and supply constraints in the context of the Indian economy. In Rao’s model, greater public investment crowds in private investment in agriculture and, thus, enlarges the agricultural output. The combined effect of these changes is to increase industrial demand and output and tax revenues of the government. But, because the government is fiscally constrained, higher tax revenues stimulate public investment, which results in further relaxation of the agricultural supply constraint.