Worry About Small Industries, Not About the Banks

Bharat Jhunjhunwala

The Government is worried about the poor financial condition of the Public-Sector Banks. They are beset with inefficiencies and corruption. But the basic problem is that the role of banking in the economy is shrinking. There has been a slowdown in bank credit. An analysis of Reserve Bank of India data shows that bank credit growth in the previous year 2015 was 10.6 per cent. It has grown at a mere 5.1 percent in 2016, which is slowest in the last 19 years.

The first reason seems to lie in the growth of the services sector. The Gross Value Added by the manufacturing sector increased by 32 percent between 2012 and 2017. The Gross Value Added by the services sector increased by 51 percent in the same period. This shows that the engine of growth has now become the services sector. The requirement of capital investments is relatively less in this sector. A software development company needs to invest only in an office and computers. One engineer sitting in front of a computer worth Rs 50,000 can produce software worth many lakh rupees. The requirement of credit is only for working capital such as discounting of bills. A manufacturing company has to invest in a large factory building and machines, in addition to the working capital. There is less demand for bank credit because growth is coming from services sector which does not require huge capital investments.

The second reason for the decline in bank credit is the emergence of a strong bond market. Companies are issuing bonds directly to retail investors to raise the capital for investments. They mortgage their property with the Registrar of Companies. Then they issue bonds to retail investors against this mortgaged property. The investors feel secure because their money is backed by this property. Essentially the same process is adopted by the banks. The company mortgages its property with the bank. The bank accepts deposits from retail investors and gives that money to the borrowers. However, the banks take a cut of 4 to 5 percent for providing this service. They accept deposits at an interest rate of 7 percent, and lend to the borrowers at an interest rate of 12 percent. They make a profit in the middle. The bond market eliminates the banker as the middleman. The company pays, say, 11 percent and the investor gets 11 percent. It is better both for the borrower and the investor to undertake the transfer of money directly through a bond. Big companies, therefore, prefer to raise the money in the bond market. A report by Livemint says that the share of bank credit in the total flow of financial resources to the commercial sector has dipped to 22% this year from 45% four years ago. The share of the bond market has risen in the same period to 33% from 22% a year ago.

The third reason is that many businessmen have round tripped their incomes and used their own money to meet the capital requirements instead of borrowing from the banks. Say, a businessman has black money of Rs 10 crores. He sends it abroad by Hawala and then brings it back as foreign investment in his own company. He returns the loan taken from the bank. He saves on the interest payments to the bank.

I think the decline in bank credit is fundamentally positive for the country. Our natural resources such as water and iron are limited. Manufacturing is hard on the environment with huge problems of air and water pollution. We are short of energy as well. Manufacturing is increasingly being done with the help of automatic machines hence there is very little, if any, net creation of jobs. Old factories are employing lesser persons by installing automatic machines. The jobs created in new factories are barely able to make up for the reduction of employment in older factories. The global demand for physical products like cars and clothing is also getting saturated.

The services sector is suited to our resource endowments. It requires more use of mind, the invigoration of which is the strong point of our culture. It requires less use of minerals and energy. Therefore, we are being pushed by circumstances in the right direction despite ourselves wanting to move in the wrong direction of manufacturing.

We are exporting services such as software and processing of insurance claims, and using the money to import goods, especially from China. This means that there will be more requirement of bank credit in China and also more environment degradation. We should not worry about this because it is fundamentally good for the environment and for the incomes of our country.

The situation of small industries is quite different. They are not able to raise loans through the bond market because of their small size.  They continue to be dependent upon the banks. This area is still catered to by the banks. But the policies of the Government have been negative for the small industries. The Government is trying to attract large Multinational companies that produce with automatic machines. These companies kill the market of the small businesses. Demonetization and now GST has made their live very complicated. Thus, the small industries are under stress. A report by India Infoline News Service says that loans to large industries decreased by 4.4%, and to small industries declined by 7.4% this year. The small industries create most employment in the country. This includes small service providers like beauty parlors and hotels as well small manufacturing units. Most employment is presently generated in these small units. The decline of credit to this sector therefore should send the alarm bells ringing.

The way forward for the Government requires three steps. One, we should focus on the development of newly emerging services sectors such as health tourism and space travels. Two, we should give substantial protection to our medium and small service providers and industries both from domestic large industries and imported goods made by foreign large industries. Three there is a need to prepare for a much more difficult future for our banks. Their market is shrinking and they will come under increased pressure. The Government must privatize the Public-Sector Banks as soon as possible, before they incur higher losses and become unsalable just as the shopkeeper sells the medicines before the expiry date.

Author was formerly Professor of Economics at IIM Bengaluru

Aug 7, 2017

Bharat Jhunjhunwala

Your Comment if any