Many things have improved in India since the reforms of 1991, but not the country’s investment rate. Investment is profitable, and corporate profits rose by over 50 per cent last year. Yet, investment refuses to take off, despite many incentives from many ministers.
So let me suggest an alternative line of attack: reduce the shareholding of the government below 51 per cent in public sector banks. Once this happens, officers in these banks will no longer be subject to vigilance (anti-corruption) inquiries when loans go bad. This single step, with all its limitation, can give a major push to investment and industrial growth. As evidence, I cite a research paper by Abhijit Bannerjee and his colleagues at MIT, (Bank Financing in India, 2003).
Banks have to lend 40 per cent of their funds to the priority sector, which includes small-scale industries. In January 1998, the definition of small-scale industries was changed from companies with plant/machinery of Rs 65 lakh to Rs 3 crore. Looking at a sample of 253 borrowers of both kinds, Bannerje finds that additional credit has a powerful effect on sales, and an even more powerful effect on profits. Additional credit of Rs 1,000 improves the profits of borrowing companies by an astounding Rs 999, net of interest.
Now, banks lend to small industries at a subsidised rate. But even if it were as high as 22 per cent, which Bannerjee takes as the real cost of capital at the time, additional credit of Rs 1,000 yielded additional profits of Rs 940.
Some people will quarrel with the calculations. Make all the adjustments you like, but the fact remains that banks are guilty of gross under-lending. Higher lending could spur additional profits, hence investment, hence jobs.
Why are banks such chronic under-lenders?
They don’t lack cash. But they prefer to put enormous sums into low-interest government bonds rather than lend at double or triple that interest rate to solvent, profitable companies. Why?
Because, says Bannerjee, the incentives for bank officers are all wrong. Banking by its very nature involves risk-taking: in competitive economies, some borrowers will go bust even as others thrive. So, defaults by a minority of borrowers are inevitable, and should not be interpreted as a corrupt transaction. Yet this is what vigilance inquiries do.
The Central Vigilance Commission contests this: it claims that honest officials have nothing to fear from impartial inquiries. But even if an official is exonerated, it can affect his image and promotions, and cause great mental stress. The vigilance approach does not judge a bank officer on his overall record of lending, setting off bad loans against successful ones. Instead, each failed loan is seen as a possible crime.
Does this discourage lending? Bannerjee finds that commercial lending by a bank after a vigilance inquiry declines by 3 to 5 per cent, and the decline continues for up to 18 months. Clearly, vigilance inquiries stunt lending.
A banker would rather give one loan of Rs 10 crore than 10 loans of Rs 1 crore each, since the latter approach (which the country needs) will increase the chance of an inquiry! Bannerjee finds the credit limit for two-thirds of borrowers is simply renewed with no change the following year, even though 73 per cent of firms have expanding sales. Bankers like to play safe by repeating last year’s figure, especially if the original credit limit was set by a predecessor.
Moreover, most bank lending rules ask bankers to link lending to the sales of a borrower, not profits. The theory is that bank lending is meant to finance inventories (stocks of materials), and the inventories themselves are the security for the loan. Yet, widespread default in India shows that inventories are a poor form of security.
The best security for a bank is the profitability of the borrower. Yet, bank lending rules tend to ignore profitability and focus on sales. Typically, bank rules suggest lending up to 20 per cent of sales, and officials are not allowed to assume sales growth of more than 15 per cent annually (thus castrating borrowers that could grow very fast with enough credit).
The solution: base lending on profitability rather than sales. Now, even solvent businessmen sometimes refuse to repay loans. So, get post-dated cheques from them in advance. If the cheques bounce, the borrowers will suffer criminal prosecution, a powerful disincentive to wilful default.
Some years ago, Yashwant Sinha introduced legislation to lower the government stake in public sector banks to 33 per cent, while retaining management control. Privatisation would be a more thorough reform. But even this half-baked reform has been opposed by the Congress, whose help is required to clear the Rajya Sabha. Dr Manmohan Singh, you must know that your party position on this matter is nonsense. Please end it.
