When India's finance minister Palaniappan Chidambaram stands up to present his government's annual budget on Feb. 28, the biggest quandary he will face is: "What can I say in the next two hours that will boost both the demand for credit and its supply?"
- The right answer to that question has three parts: To recapitalise state-run lenders to the extent the government's meagre resources permit; to hand out new banking licences; and to remove the obstacles that prevent global banks from including India in the list of countries where they would like to deploy more of their shareholders' money.
- Why should Chidambaram be so desperate for more bank capital? The reasons are connected to both demand for credit and its supply. Right now in India, both sides of the equation are equally dire.
- Demand for credit is low because an economy that had become accustomed to growing more than 8 percent a year before the global financial crisis is now expanding only 5 percent annually. Companies that loaded up on debt when India was being hailed as the world's second-fastest-growing economy are now deleveraging to clean up their balance sheets.
- While it's convenient to blame the Reserve Bank of India's aggressive monetary tightening for the slowdown in credit demand, a recent analysis by the International Monetary Fund shows that higher real interest rates only account for about a quarter of the investment slowdown. Besides, the spurt in inflation that prompted the central bank to raise interest rates 13 times between March 2010 and October 2011 was occasioned by the government's pathological refusal to do anything about the expansion of its own spending, which is estimated to have more than doubled in six years.
- The supply side of the credit equation is problematic because a bank-dominated financial system in which state-controlled lenders account for 74 percent of total assets has all sorts of bad incentives to stretch out corporate deleveraging. Loans that have gone sour aren't written off but are "restructured" to give borrowers easier terms. And although the monetary authority wants banks to set aside more of their future income to offset potential losses, the current rate of provision is just 2.75 percent of the value of the restructured loans.
- In a typical business-cycle slowdown, the strategy works out. Most debtors see a recovery after a short blip and start servicing loans again. Demand for new credit picks up, and