By Atishay Jain
In macroeconomic context, credit growth implies an increase in debt or loan in an economy. This growth may be due to several reasons: fall in interest rates, increasing expectations of people, present value of returns from assets being more than asset price, etc. The macroeconomics theory given by many economists and given in most of the textbooks suggests that increase in debt leads to increase in aggregate demand (due to increase in consumption and investment expenditure), which plays an important role in economic growth. Now the question arises, if this theory always holds then why is recession occurs?
In fact, much credit growth is not essential to economic growth because it doesnt play a direct role in financing consumption or investment. Economics textbooks often describe how households save money and deposit it into banks that lend to businesses to finance capital investment. But this story is largely fictional in most parts of the world. Instead a large part of banks lending finances the purchase of existing assets, particularly the commercial and residential real estate. Such existing asset finances does not directly stimulate investment or consumption; rather it drives up the asset prices causing the lenders and borrowers to believe that more credit growth is desirable as well as safe. Recession is triggered by large decrease in prices of assets. Many economists interpret these decreases as the ends of asset-price bubbles. A bubble occurs when asset prices rise far above the present value of the expected income from the assets. Then, at some point, sentiment shifts: people begin to worry that asset prices are too high and start selling the assets, pushing prices down. Decreases in asset prices are accompanied by failures of financial institutions because of loan defaults, increase in interest rates, and other events. Thus, lending to finance existing assets has little impact on demand, output and prices during boom. It triggers crisis and results in debt overhang, deleveraging and depressed demand in post crisis period.
Let us go by fact, nominal demand in America grew by 5% annually despite credit growth of 10% or more. Despite of the increase in credit volumes and asset prices soaring, labor markets are not overheating; real earnings remain flat and inflation rates are remarkably stable in many advanced economies. This scenario reminds us of 2008 crisis when bubble of excessive private debt busted when people who undertook huge liabilities failed to pay off thus leading to havoc among financial institutions. The same pattern is going on in emerging economies, especially China, where credit growth is far outpacing nominal GDP growth and leverage is increasing. It seems that the rising credit intensity of GDP growth (amount of new credit required to generate a unit of output) is needed to ensure that economic performance remains in line with potential.
Dont get me wrong I am not against increasing credit growth but some harsh measures need to be introduced so as to ensure that the economy doesnt fall prey to recession. Policymakers should categories between types of debt. For example, they could impose higher capital requirements on real estate lending or introduce direct borrower constraints like loan to income ratio, etc. Without targeted policies aimed at limiting wrong type of debt, the world economy risks further cycles of instability and crisis. The fall in credit uptake also has some problems associated with it. This will have far reaching repercussions. For emerging markets like India, the global slowdown is compounding the problem. The RBI (Central bank of India) must realize that if India and Indian citizens curb borrowing and stop investing, the economy may end up in coma and reviving it then may become a Herculean task. The times have changed and require out of the box thinking instead of repetition of textbook measures.
This implies a serious dilemma: While rising leverage is apparently essential, it inevitably leads to crisis and recession. Keeping this point in mind, policymakers must consider whether rapid credit growth is really essential or there are some alternatives-a questions that modern economists have largely ignored.
The author is a student of commerce in Shri Ram College of Commerce,Delhi. His area of interest are finance,economics,social change and taxation. Pursuing CA as well. He can be contacted at atishayjn8@gmail.com.