Thursday, October 05, 2006

Is credit growth a concern?

What risks does credit growth pose and how should policy makers respond?

Credit growth is at 30% for the past two years and promises to do so in the current year as well. The RBI has favoured the growth to slow down to 20%.

Credit can grow rapidly for three reasons: financial deepening, normal cyclical upturns and excessive cyclical movements. Only the last qualifies as a ‘credit boom’ and is destabilizing in nature.

Credit growth poses a problem when asset prices get magnified. For instance, when stock prices zoom, firms’ net worth rises sharply and banks may be tempted to lend more to these companies. When asset prices collapse, banks find themselves in trouble.

The World Economic Outlook (of IMF) states: a credit expansion is a boom when it exceeds the standard deviation of a country’s credit fluctuations around trend by a factor of 1.75. The other warning signs are: a surge in capital inflows, a consumption or investment boom, a sharp rise in stock prices, a worsening of corporate leverage and an increase in banks’ external borrowings.

In taking a view on whether credit growth, we need to take a look into the composition of credit – corporate vs retail, domestic vs foreign currency, sensitive vs non-sensitive – in judging whether there is an unsustainable boom. We must also look out for imbalances in the macro-economy. When we do so, the current surge in credit does not appear to warrant concern.