Risky Business, Easy Times, Credit Boom, Preposterous Rate Cut
Risky Business
When market interest rates stay below their natural rate for an extended period, it causes economic participants to adopt risky and unhealthy financial habits. Such habits cause risk to accumulate in the financial system. The financial system becomes more fragile consequently, and thus, is more prone to external shocks and disruptions. A fragile and distorted financial system leads to capital misallocation – capital flows out of the productive to the unproductive.
The high growth in unsecured retail loans by NBFCs over the past seven years seems to be the outcome of such a risky and unhealthy habit. The unsecured retail loans of NBFCs grew annually at 32 per cent during FY2017-24. Consequently, the share of unsecured retail loans in NBFC’s total loans rose to 14 per cent from 5 per cent in March 2016, according to a report on NBFCs by Assocham and ICRA (Source: Times of India).
Retail unsecured loans are riskier than retail secured loans. Retail-secured loans are backed by vehicles, homes, gold, or other assets. In case of default, lenders could confiscate the assets backing the loans and later resell them to recover their dues. However, as retail unsecured loans are not asset-backed and are primarily availed for consumption purposes, in case of default, lenders look at the prospect of losing money.
If the unsecured credit is such a risky business, why are lenders pursuing it?
Recently, the RBI governor speaking at an event, had warned financial institutions to avoid “the mindless pursuit of the bottom line.” The governor might be suggesting excessive risky behaviours like the one we just discussed.
The increased tendency among people to borrow for consumption through the ‘unsecured credit route’ offers lenders the opportunity for high credit growth. Moreover, unsecured credit always carries high interest rates due to its inherent riskiness. If things are going well, which means borrowers are making timely interest payments, lenders achieve both high growth and profit through retail unsecured lending.
These are easy times, which happen when interest rates are kept below their natural level. High credit growth is a symptom of easy times. Lenders adopt more liberal (less prudent) lending practices in such times. But easy times don’t last forever. When it comes to an end, the liberal lending practices are brought to reckoning.
The RBI governor in the speech also warned that “some profit-driven business models may contain hidden vulnerabilities” and emphasized that “profitability should not come at the expense of managing these risks.” The spike in the share of unsecured retail loans on NBFC loan books could easily be construed as the result of the liberal lending practices originating from such ‘profit-driven business models.’
These practices aim for small (near-term) profits without considering the larger (long-term) consequences. The lenders who adopt such practices, knowingly or unknowingly, are embracing more-than-warranted risk for the sake of short-term profit now, and then pushing those risks into the future. These lenders by pushing present risk into the future live under the illusion that risk has been properly dealt with.
The truth is that risks are getting accumulated in the future. One day the lenders’ ability to push present risks into the future ceases. That would be the day of reckoning. It would have disastrous consequences on the financial and economic system.
But the lenders whose imprudent lending practices had led to the crisis won’t be the ones facing those consequences. Rather they would be saved and protected by government and regulators because of their systemic importance. It would be the general populace (the masses or the common man), being non-systemic, who would have to suffer the punitive consequences.
Easy Times
‘These are easy times’ is a disputable statement, considering that RBI had raised policy interest rates from 4.00 per cent to 6.50 per cent during 2022-2023; and ‘rate cuts’ is the current consensus among economists about RBI’s next move.
The RBI rate hikes of 2022-2023 read alongside the current economists’ consensus suggest that ‘these should be hard times’, which means market interest rates are likely above the natural rate of interest, and thus, must be brought down towards the natural level.
A market interest rate that aligns closely with the natural rate of interest is desirable because long-term sustainable economic growth is possible only under such conditions. However, the economy is an expansive, complex, and adaptive system, and deciphering the natural rate of interest appropriate for it is implausible. In other words, the natural rate of interest is ambiguous, elusive, and most likely, indiscernible.
But when the market interest rates deviate from the natural rate, it leaves clues in the form of excesses (or scarcity). Such excesses (or scarcity) could help us determine where the market interest rate stands to its natural rate. When market rates are too low, there are credit booms, asset price booms, high inflation, and speculative manias. When rates are too high, there is a credit crunch, deflation, and economic stagnation, among others.
I call the present times easy because, firstly, we have a credit boom and a stock market boom going on. Both RBI and SEBI on various occasions have expressed concern about excesses in both the credit and stock market. Even the Chief Justice of India had expressed concern about elevated stock prices and their rapid rise, during the euphoria that followed when Sensex touched 80,000 for the first time.
Secondly, our market interest rates should be evaluated alongside global interest rates. More than two years ago, when the policy interest rate was 4.00 per cent in India, the US policy rate was close to zero: then the rate difference was 4.00 per cent. However, when our policy rates rose to 6.50 per cent since then, the US rates have risen much faster to 5.00 per cent: the rate difference now at just 1.50 per cent is much lower than it was two years ago and is also the lowest in more than a decade.
Interest rates have declined in India, relatively, over the past two years. Read alongside the high credit growth and rapid rise in stock prices, these are most likely to be ‘easy times.’
The Credit Boom
The credit growth has been outpacing deposit growth for some time now. The financial system becomes vulnerable if the trend continues for long. RBI had flagged this concern on several occasions. High credit growth also can make the financial system vulnerable, particularly if it outpaces economic growth for too long.
In the first quarter of FY25, the credit and deposit growth were 14 per cent and 10.6 per cent respectively. India’s GDP grew 8.2 per cent in FY24. These figures show that credit growth has outpaced both economic growth and deposit growth by wide margins, and this doesn’t bode well for our financial stability.
However, although high credit growth is a threat to financial stability, it augurs well for lender’s profitability. So, lenders remained reluctant to tighten their credit tap. The imbalance could be rectified by either slowing the pace of credit growth or else increasing the pace of deposit growth.
While lenders were reluctant on the former option, they failed at the latter option. The deposit growth failed to gain pace, despite keen efforts from lenders. The trend of low deposit growth could be considered another testament that market interest rates are below their natural rates. Due to inadequate returns from bank deposits, money is flowing towards riskier alternatives – mutual funds, stock markets, and even the derivatives market – for better returns.
The rapid rise in bank lending to NBFCs is another concern flagged by RBI, alongside the rapid rise in retail unsecured loans by NBFCs. This indicates that banks are indirectly complicit in the rapid rise of NBFC’s retail unsecured loans. If there is an implosion, it is unlikely to be confined within the NBFC space; instead, there would be wider repercussions.
An implosion, now only a possibility, would cause lenders to pivot on their lending practices: they will tighten their credit standards. Even those firms following good practices and in good shape, though under normal conditions, might come under stress when credit tightens, and liquidity vanishes.
How extensive would be the repercussions of such an implosion is impalpable. The global financial crisis of 2008 had its origins in the sub-prime segment of the US mortgage market, but its grave repercussions were felt globally. The aftereffects of an implosion of the unsecured retail credit bubble in our economy are unlikely to percolate into the global financial system, but it surely will have wider repercussions within our domestic financial and economic system.
The correction of excesses in both credit and stock markets is a very likely possibility. But the repercussions would stop at that is not guaranteed. There is too much froth in the system – that’s for sure. Purging the system of the accumulated forth, though could be postponed, is essential and inevitable.
There is always someone buying a luxury apartment, or an ultra-expensive vehicle, or else, there is a wedding. Weddings, and house or vehicle purchases are normal things, but what doesn’t feel normal is when these events create headlines and gain public attention due to their extravagance.
A bubble in the credit market is just a possibility now. Even if there is one, its implosion too is just a possibility. Moreover, even if the above two possibilities materialise, whether the aftereffects of the implosion would go on until the system is cleansed of all accumulated forth is too much to comprehend.
But there is a feeling, which has been going on for some time, that things aren’t as good as they seem to be. Almost everyone is struggling… there is heightened uncertainty… but all these are wrapped under an illusion of prosperity…
But by whom?
Maybe, by the very few who wield the power…
Why would they do that?
To maintain the status quo… which serves them well… but not the many.
Or else… all these could just be the imagination… of a disgruntled one…
Only time could solve this conundrum…
Preposterous Rate Cut
There is strong pressure on RBI to cut rates, but they are resisting it well, which is commendable. The rapid rise in stock prices and high credit growth continue unfettered posing grave danger to financial stability. This is despite repeated warnings from regulators about the risk they pose.
The CPI-based inflation has been staying above RBI’s target rate for the past few months. The volatile food prices have been putting upward pressure on inflation recently. RBI governor had said last month in an interview that: it is ‘premature’ to talk about rate cuts when inflation remains above its target rate.
India’s GDP grew 8.2 per cent in FY24 – the best performance over the last seven years (excluding FY22 growth, which was on the lower base of FY21) – and the third-best performance over the past eighteen years. Most of the agencies – domestic and international – have upgraded India’s GDP growth recently.
Then why is there a chorus for a rate cut now when there is robust economic growth, high inflation, a credit boom, and a stock market boom?
Aren’t these excesses indicating that market interest rates are more likely lower than their natural rate, and thus, what is required is not a rate cut, but rather a rate hike?
Wouldn’t a rate cut now exacerbate the excesses, and make the system more fragile?
The rally for a rate cut always comes from the industry. They get together under tough conditions and lobby policymakers for support measures: interest rate cuts are one such measure. But there never had been a case where depositors got together and lobbied policymakers for higher returns on their money. That’s why the RBI governor called them ‘silent depositors’ recently.
Instead, in pursuit of higher returns, depositors move their money elsewhere. RBI governor recently pointed to a shift in customer preference from bank deposits to mutual funds, and other investments. SEBI chairperson had warned of the rising (also, dangerous) trend of savings moving towards speculation in the derivatives segment.
How could a rate cut help here, other than to exacerbate the dangerous trend of seeking higher returns from speculative activities by savers, because of inadequate returns from traditional sources?
There is a chorus for rate cuts… the RBI bats for the status quo… but why is there not a single voice for rate hikes…
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