Potential dangers of rapid credit growth
Rapid credit growth lures economies with the promise of prosperity only to lead them into crises.
Each financial boom is framed as a story of financial innovation and good times. But each new story is just whipped-up frenzy, it is, in economist Robert Shiller’s words, “irrational exuberance”.
As the economists Carmen Reinhart and Kenneth Rogoff explained in their celebrated history of financial folly, governments and market participants dismiss previous crises that followed credit booms by invoking the mantra “this time is different”
The current celebration of India’s credit growth deflects attention from the deep-rooted jobs’ and human capital deficit; and it extends the hype into dangerous territory.
The truth is that when lending expands, the financial sector looks in good health as new loans pay off old ones.
But the house of cards collapses when lending slows and options for more loans to repay earlier obligations get shut.
The IMF knows this history well: heavily indebted households and businesses sharply reduce spending to repay their debt, causing an economic crunch
This distressing script is set to repeat for India especially because of the feverish expansion of households lending at between 25% and 30% a year.
As financial intermediaries have pushed their loans, many lower- and middle-income households have viewed the funds as easy cash to make ends meet or to buy homes, gadgets and cars, pay for education, and indulge in ‘lifestyle’ spending, including vacations and elective medical procedures
A household debt boom is a quintessentially “bad” boom.
It does not add to productive capacity but, instead, bids up domestic prices, making the country less competitive
As economists Atif Mian and Amir Sufi report: the higher the household debt burden, the steeper the crash that follows.
Add to the bad credit boom a stock market rising unmoored from weak corporate investment and anaemic consumer spending, an overvalued exchange rate, and a tendency for Indian authorities to talk up dodgy data, and India presents a textbook example of the key elements that signal a looming financial crisis.
The financial crisis will cause not just economic pain but will also degrade the economy’s long-term well-being.
Indian household debt, at 40% of GDP, is low by international standards, but household debt-service-to-income ratio, at 12%, is among the highest in the world because of high interest rates and predominantly short duration loans.
Past financial crises caused by similar credit booms
The Indian household debt-service ratio is alarmingly similar to that in the United States and Spain just before their 2008 financial crises, when high household debt-service burdens precipitated major economic downturns.
Challenges
The source of the impending crisis lies in a paradox: despite buoyant credit growth, household consumption is increasing at an excruciatingly slow pace.
Households are struggling; their savings rates have declined and they are boosting meagre consumption by borrowing money.
Soon, it will no longer be possible to repay old loans with new ones and consumption could even contract.
The crisis will come initially through such macroeconomic contraction; defaults on loans will follow.
The initial defaults will topple more dominoes, a consequence of the interconnected nature of banks, NBFCs, and fintechs.
Cascading defaults will induce more economic contraction and financial sector distress.
History makes clear that rapid credit growth and an overvalued exchange rate are a lethal combination.
As the risks of a financial crisis grow, an acute job shortage persists, reflected most poignantly in a catastrophic regression of the workforce back to agriculture
After all, the weak and vulnerable will bear the burden of the crisis, as the dire employment situation becomes worse — and stark inequalities become starker.
Way forward
Preventing the crisis requires surgically downsizing the financial services industry to better match lending capacity and productive borrowing needs, and weakening the rupee to help expand exports and cushion the downturn when it comes.
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