Spreading Credit in the Economy

If you are credit worthy to the extent of 50% of your spend every month, you may not be using the full credit limit, whereas there could be ten times the number of people around who could be in need of that credit. You are not utilizing the credit for different reasons, some of them could be entirely cultural or related to your beliefs or values or even related to risk aversion. When you have a large savings amassed in your account you have far less reason to aim for credit.

The need of borrowing should go down with higher savings, but those who need to borrow do not start from a credit worthy position, on the contrary. Creditors and debtors therefore need a balancing act and risks to pass through, where the banks and the financial system must play the role. By punishing savers, sometimes, we end up throwing the baby with the bath-water.

Such are the travails of large corporations as well. They have so much cash on their balance sheet and not enough projects to invest in, their credit worthiness is less utilized in the economy, whereas large cohorts of businesses in need of cash have far too little credit worthiness to access funds at rates that would be meaningful for them to invest and make ends meet.

This puzzle in the economy appears in many forms, you see this most prominently in changes in corporate credit spreads, sometimes they expand and sometimes they contract, which gives a measure of the direction in which the economy is acting in concert.

But there are other market participants like the hedge funds who take advantage, hedge funds often take highly levered positions in corporate bonds; they can afford to do this only when they can  hedge the interest rate risk by shorting treasuries. As a consequence, their portfolios become extremely sensitive to changes in credit spreads rather than changes in bond yields.

To explain this phenomena let us look at a situation that the treasury yields are at 6% whereas the corporate bond yields are at 8% giving a 2% spread. If the hedge fund takes a levered position on corporate bonds, the only way to hedge that risk would be to short treasury bonds where it would gain from lower treasury yields.

One of the reasons why cohorts in the financial industry demand a lower central bank rate is precisely this.

But let me go back to my original submission, the case for spreading the credit in the economy, where the risk of doling out higher credit to those who need them has to be taken by the rest of the economy who are holders of unutilized credit.

If this puzzle is not solved, no matter how low we try to push the interest rates, thinking that it would benefit the economy, we would be actually pushing a thread, while precious little would happen in terms of economic activities.

If a piece of credit is not passed on to the goods maker, service provider, farm participant or for that matter anyone in the informal sector, there will be no furthering of economic activity. Large amassed savings would pass on as money creators or wealth creators for sure, but would not translate into additional income for the marginally living person.

But we have an issue at hand that high levered positions in some corporate sectors have a cascade effect in our banking system. Further risks cannot be taken in the bank balance sheet, which therefore needs the shadow banking system to take over or the equity markets. This transition also has its own pace of adjustments, some of these adjustments could be very unpredictable.

The marginally placed farmer or the serviceman in the informal sector is on the demand side of the arc, they can hardly be ignored, in fact they should be at the center of the agenda.

Waivers make short term stories look appealing, they bring in shocks for the fiscal side which has wide ramifications for the rest of the economy.

To put some numbers to this problem, let us go back to the budget announcements this February, the total agricultural loan targeted for 2017-18 is Rs.10 Lakh Crore, which if disbursed entirely over the 65% marginal farmer (of the 50% in the population) would mean a per capita loan of Rs.21000 per year, which is just 20% of the per capita income of the country.

This shows the level of farm credit, which is in dire need of expansion, whereas much of the credit in the rest of the economy goes a begging, showing little signs of expansion.

Lot of talk around GDP needs to be diverted to this important topic of spreading credit and credit worthiness.