What happened to credit growth?

Unless there is a reversal of the secular decline in credit growth, a full-blown economic recovery might not be on the cards

The one niggle in the otherwise unexpectedly happy story of demonetisation and its economic impact is the sharp decline in credit growth. The last data point for the year shows loan growth at a paltry 5.1 per cent, apparently a 60-year low. Credit should prima facie be an important correlate of both nominal and real growth and thus these numbers don’t quite square up with the story of an economy that seemed to have, somewhat miraculously, remained immune to notebandi.

But, first things first! Credit growth numbers since February 2016 were pulled down by the issue of UDAY bonds that, in effect, rejigged the balance sheets of commercial banks. As loans to power discoms were converted to statebacked bonds, banks saw a decline in their outstanding credit and a corresponding rise in investments. If we factor in the impact of the roughly ~2.3 lakh crore of this issuance, it accounts for a dip of about two-and-a-half percentage points on average in credit growth since early 2016. If we use this correction for the March data, the figure prints at over 7 per cent instead of 5.1 per cent.

That said, 7 per cent is a pretty dismal number and marks a precipitous fall from an average of around 11 per cent (adjusting for the UDAY factor again) in the months before demonetisation. In fact, the currency crunch slammed the brakes at a time when loan growth had shown some sign of improvement. Commodity prices had stabilised at the end of 2015 and started recovering since then (commodity prices determine inventory value and hence the demand for working capital); capacity utilisation that tends to affect credit offtake with a lag had shown signs of improvement since 2015 and the Reserve Bank of India’s (RBI’s) rate cuts (one and three quarter percentage points since January 2015) had begun to push loan demand up albeit moderately.

Going by the commentary provided by analysts and banks themselves, the hit on credit demand was concentrated in the SME (small and medium-sized enterprises) sector. Companies repaid a significant fraction of their loans in old currency notes and did not take fresh loans. A major public sector bank pointed out in its post-results conference that about 10 per of their loans were repaid in hard cash in this period. Thus, credit market behaviour seems to support the claim that the impact of the note-crunch on the MSME (micro, small and medium enterprises) sector was under-estimated in the overall gross domestic product numbers.

This leaves us with a question: Why hasn’t credit growth picked up now that the worst of demonetisation is over and the system has been remonetised to a considerable degree? For one thing, any analysis of the relationship between credit growth and the factors influencing it shows a web of leads and lags. It is thus possible that credit demand will pick up in a while from now.

The other factor that could be responsible in pushing credit demand down is the aggressive “destocking” or the whittling down of inventories in anticipation of the goods and services tax (GST). This behaviour is typical when there is a tax-regime change. To start with, the uncertainty regarding the rates that would apply to different goods is reason enough for firms to lighten inventory. Besides, according to the GST rules, while there are provisions to claim input tax credit on stocks, there are conditions that need to be fulfilled, such as stocks should have been purchased by the dealer not earlier than six months of implementation of the GST, and this could encourage the drawdown of old inventory.

The good news is that both demonetisation and the GST blues are temporary. As they dissipate, credit growth is likely to pick up. In fact, once the GST is implemented, there could be a phase of aggressive restocking. Besides, the UDAY bond effect will get filtered out in 2017-18, as both the current figure and the base become UDAY inclusive. That would bump up the growth rates significantly.

So far so good. However, the bigger question that needs to be answered is that of the secular decline in credit growth for the past seven years. In December 2010, the peak of the current growth cycle, the growth rate was 24 per cent. That dropped to an average of around 9 per cent in the second quarter of 2016-17 before demonetisation pulled it down further. One needn’t go back so far. Between the JulySeptember quarter of 2014 and the corresponding quarter of 2016, loan growth dropped by close to 7 percentage points. If we net out the UDAY effect, the dip is about 4.8 percentage points.

This needs to be explained before we bet on a fullblown credit recovery. A simple model constructed by HDFC Bank shows the play of demand and supply factors. Two things need to be pointed out right at the outset. The fall in lending rates that accompanied the RBI’s policy rate cut had a relatively small impact and, if you trust our model, pushed credit growth up by only seven-tenth of a percentage point. Disintermediation, the issue of corporate bonds and papers instead of borrowing from banks, made an even smaller impact on credit growth.

Factors such as low-capacity utilisation and sluggish sales growth have played a major role in stifling credit demand. Our analysis shows capacity utilisation rates are perhaps the most critical demand component. Fluctuations in commodity prices also have a major role to play since they impact inventory values for a large number of industries (from cars to paints) and hence working capital needs.

However, left to demand factors alone, credit disbursal would have been higher. Credit growth has also been impacted on by problems on the supply side — the weight of non-performing loans and the associated from capital inadequacy. Again our model shows that of the 7 percentage points decline, 3 percentage points can be attributed to demand factors and a little over 2 percentage points to these supply problems.

The bottom line is that we are likely to see a pop in credit growth as the short-run problems of demonetisation and the GST dissipate but, unless there is a reversal of the secular decline, a full-blown recovery might not be on the cards.