Financial Daily from THE HINDU group of publications
Thursday, Jan 08, 2004
Advances against shares Dividing the multiplier effect
It is a classic case of Selective Credit Control (SCC), which is the regulation of the channels or directions of flow of bank credit. It has both positive and negative connotations. The stipulation of targets for advances to the so-called "priority sectors" is an example of the former. The restriction on advances against shares is illustrative of the latter.
"So-called" because, strictly speaking, one should take a look at the economy's input-output matrix and find out which sectors make the maximum contribution to the growth of Gross Domestic Product not only directly but also indirectly.
This was not done when the concept of priority sector was first mooted. It was a purely political decision arising out of the internal power struggles in the Congress(I).
Though the SCC is defined internationally as given above, in the Indian context the RBI has evolved and used its own definition. Thus, advances against "sensitive commodities" alone, regulated under Section 21 of the Banking Regulation Act are considered part of the SCC.
The sensitive commodities are those that have a high weightage in the price indices. They are foodgrains, cotton (kapas, yarn and textiles), jute and hessian, edible oilseeds/oils/vanaspati, sugar and gur.
In the wake of deregulation and liberalisation, the SCC is practically dead with one exception advances to sugar mills against the stocks of levy sugar. Normally, the brunt of the control regime in the past was against traders on the ground that they tend to speculate in the market and can, thus, misuse bank credit for the purpose.
In fact, the SCC was not used by the RBI from its inception in 1935 till May 17, 1956. Its origin can be traced to the spurt in the price of rice in early 1956 despite a good crop and the press reports that traders were borrowing money from banks with a view to building stocks. Though the stipulated increase in margin was withdrawn it had to be re-imposed soon owing to another price rise.
According to the History of RBI (Vol II), in 1957, the then Prime Minister, Jawaharlal Nehru, expressed his anguish to the then Governor, H. V. R. Iengar, about banks allegedly flouting instructions to make large advances to millers and encouraging the hoarding of rice.
An investigation was conducted in the West Godavari district of Andhra Pradesh. The State accounted for about one-third of total bank advances in the country against rice/paddy. It was found that about Rs 1 crore had been issued in that district to rice millers/traders against the pledge or hypothecation of the commodity.
This may sound a small sum due to the astronomical figures of bank credit, money supply, and so on prevailing now. But in those days an advance of Rs 1 crore in a district represented a large volume of paddy/rice in the stocks of traders in a small area.
The SCC instruments were refined from time to time and, by the 1970s, they were minimum margin, had a ceiling on credit and with minimum rate of interest. The minimum margins were either hiked or reduced depending on whether less or more credit was desired to be given, keeping in view the demand and supply position of the relative commodity.
The level of credit restriction ensured that too much was not made available even if the margin was provided by the borrower. In general, it was fixed at the peak of the outstanding credit to the borrowing party in the previous three years.
The minimum rate was generally above the general minimum lending rate for all advances. Three misconceptions need to be cleared. One is the view that the SCC is intended to curb a rise in prices. It is not so. The trends in prices depend upon the demand and supply factors. There are other policy measures designed to deal with the problem of inflation.
Further, the SCC does not seek to eliminate speculation as such. The traders have access to several sources of funds, and can speculate even if bank credit is not available. All that the SCC tries to achieve is to ensure that bank credit is not used for speculative purposes.
Third, one uninformed criticism in the past has been that once imposed the SCC remained even if there was occasion for relaxation. Right from the beginning, the SCC was reviewed periodically in the Banking Division of the then Research Department of the RBI as part of the exercises for the formulation of monetary and credit policies.
Either new restrictions were added or old ones removed. Anyone who cares to see the Annual Report or the Report on Currency and Finance of the past can easily find this out. Thus, to give one example, control on advances against textiles was removed in the 1970s once the supply situation improved and was never re-imposed.
Advances against any commodity can have a multiplier effect as in the case of credit/deposit multiplier. Take the instance of a wheat trader taking a loan by pledging his stocks. If the margin prescribed by the bank is 10 per cent he can take Rs 90 as credit by pledging/hypothecating stocks worth Rs 100.
With the Rs 90 borrowed he can go to the market and buy stocks for that amount. He can again pledge those stocks and raise another loan of Rs 81 providing a margin of 10 per cent.
This process can go on to such an extent that theoretically the borrower can get a total credit of as much as Rs 1,000 in the end! Impossible? No, this process was, in fact, observed in the West Godavari study.
The latest raising of minimum margin from 40 per cent to 50 per cent on advances against shares means that the potential value of the multiplier is reduced from 2.5 to 2. One good aspect of the measure is that, unlike in the past instances, the rise in margin is prospective and does not extend to existing advances.
This should help in avoiding any distress to the borrowers with a consequent unfavourable impact on the market. The RBI should adopt the international definition of the SCC. In the US, it has been used generally to curb stock market advances during periods of speculative boom. And once when the Federal Reserve wanted to ban them altogether, instead of saying so, it prescribed the minimum margin at 100 per cent.
(The author is a former Officer-in-Charge, Department of Economic Analysis and Policy, RBI.)
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