In an interview to Bloomberg Asia on August 17, Nobel laureate Prof. Michael Spence observed that there is still a chance of recession in the US, despite the recent drop in unemployment rates. He felt that persistent inflation could yet force the Fed to hike interest rates further. He also expressed concern about the global repercussions of the slowdown in China and the high inflation and recession in Europe.

Against this gloomy backdrop, where does India stand? Between May and June 2022, the RBI raised policy repo rates by 90 basis points (bps) in order to control the spiralling domestic inflation. Did such a hike lead to a sharp increase in lending rates and a consequent credit crunch which could derail economic growth?

The answer to this question may help us anticipate future policy measures by the RBI.

As depicted in the Chart, policy rate increase has had a strong impact on the rates for fresh rupee loans sanctioned between May and June. The lending rates of scheduled commercial banks increased from 7.51 per cent at end-April 2022 to 7.94 per cent at end-June (that is, by 43 bps).

It shows that monetary policy transmission to cost of credit has been faster and more effective, since interest rates on retail loans are now linked to repo rates. Public sector banks have passed on 55 bps and private banks 37 bps (out of 90 bps policy rate hike) to their new borrowers.

However, the pleasant surprise is that loan disbursement has not been affected by such a dramatic rise in borrowing costs. Non-food bank credit growth between April 8 and August 12, 2022, has continued to grow steadily at a healthy cumulative rate of 4 per cent. As the Chart shows, outstanding non-food bank credit rose from ₹119.3 trillion on April 8 to ₹124 trillion on August 12.

Such a sustained increase in credit despite tightening monetary policy measures cannot be treated as an aberration. Nor can it be attributed to a low base effect. The increase in loan disbursement during the rate hike period has happened from a higher threshold of ₹119.3 trillion outstanding as on April 8,2022, than the amounts outstanding as at March-end 2020 (that is, onset of Covid-19), when outstanding gross non-food bank credit was ₹103.2 trillion. Therefore, the only inference is that demand for credit continues to be robust, despite a series of adverse shocks to lending rates.

High growth in credit

The relationship between interest rate changes and impact on credit growth during comparable periods is shown in the Table. It indicates that lending rates have seen the sharpest rise during the current rate hike period. Yet, growth in credit has also been the highest since 2015 and, more importantly, distributed across all sectors.

These results are counter-intuitive since one would expect credit growth to slow down with faster and larger pass-through of tightening monetary policy into borrowing costs. If this contradictory relationship remains tenable going forward, it will have several positive implications for the economy at large.

Firstly, the sustained and broad-based nature of credit flows clearly allays fears of an imminent recession. Secondly, the relatively higher credit growth in labour-intensive sectors like services and MSME, which also have a higher share in bank credit, will benefit employment generation.

Thirdly, increased lending to agriculture and allied activities, supported by satisfactory monsoons, signals a potential easing of supply constraints which will keep inflationary pressures under control.

Banks will see an improvement in their net interest income, since deposit rates have not risen to the same extent as lending rates, thereby enhancing their organic growth capital. Furthermore, if balanced credit demand continues across sectors, banks may also reap the advantages of diversified credit growth, making them less vulnerable to default-related losses.

However, the optimism needs to be tempered with a word of caution on relatively rapid rise in retail credit which is most sensitive to rate hikes. A high rate of growth in this segment may fuel private consumption, before supply constraints are relaxed, and create demand-side inflationary pressures.

In sum, the recent buoyancy in bank credit reflects a resilience in economic activity, in the wake of a steep rise in policy driven lending rates. The strength of the Indian economy is expected to give the RBI greater headroom to fight inflation, without being worried too much about the implications for economic growth.

Therefore, it is no surprise that the Monetary Policy Committee (MPC) chose to raise policy repo rates by a further 50 bps on August 5. The RBI Governor, Shaktikanta Das, stated in the minutes of the latest MPC meeting that “domestic growth remains resilient and gives us the space to act”. Evidence from the Indian credit markets supports his conviction.

The writers are faculty members, National Institute of Bank Management, Pune. Views are personal

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