Stop Forcing Banks to Lend to India’s “Priority Sectors”

By Anit Mukherjee — 

Woman threshing wheat in Bakchur, India. Source: AdamCohn’s flickr photostream, used under a creative commons license.

Status: Not StartedSince the 1970s, Reserve Bank of India (RBI) has stipulated that 40 percent of credit allocation for domestic and 32 percent for foreign commercial banks should be targeted towards agriculture, micro, small, and medium enterprises (MSME) and advances to weaker sections. Other sectors such as education, housing, social infrastructure, and renewable energy are also included in priority sector lending (PSL) but without any targets.

Low Difficulty: Only RBI guidelines neededThe reform will require a change in RBI guidelines and consent from the Ministry of Finance. Political opposition is likely from vested interests both in agriculture and small and medium enterprises sector who will have to pay higher market rates for their borrowing. This can be mitigated through a transparent policy framework and re-capitalization of specialized sectoral lending institutions and instruments.

This is the tenth installment in a new series of articles on the India Reforms Scorecard: 2019-2024 by the staff and experts at the Wadhwani Chair in U.S.-India Policy Studies. The series seeks to provide analysis on why reforms marked as “Incomplete” or “In Progress” have not been completed, and the impact such reforms can have on specific sectors or the economy at large.

India has continued with a policy of directed credit through the PSL instrument for nearly half a century following bank nationalization in the early 1970s. While there may have been some justification at that time given the priorities of centralized planning and the government’s control over productive sectors of the economy, India’s current needs and priorities are very different. With the looming of a slowdown in the economy stemming largely from the inability to resolve the issue of non-performing assets of the banking sector, reform of priority sector lending norms has become more urgent than ever before.

Directed credit requirements imposed on commercial banks – both Indian and foreign – should be stopped. In its place, the government and the RBI should increase the flow of liquidity to ‘priority’ sectors such as agriculture, MSMEs, and housing through the National Bank for Agricultural and Rural Development, Small Industries Development Bank of India, and National Housing Bank. Moreover, the National Infrastructure Investment Fund can be further leveraged to build rural infrastructure as one of its key mandates. This move will result in more efficient credit allocation by commercial banks and address the capital needs of emerging sectors of the economy.

Moreover, credit needs for anti-poverty programs, sustainable livelihoods, and climate finance can be better served by creating a development finance institution (DFI) with a specific mandate that would provide a mix of grants and loans to underserved sectors and geographies. Especially since RBI’s composition of PSL credit  shows heavy emphasis on MSMEs, while falling short of stated weaker-section goals. With appropriate risk allocation in its portfolio, this new DFI can cater to the demand for credit in emerging sectors particularly related to the digital economy, microfinance, and microinsurance. The new institution can use blended financial instruments to raise a corpus from government, commercial banks, and venture capital institutions, as well as a pool for corporate social responsibility funds. It can then specify minimum sectoral disbursement targets and choose projects based on independent risk assessment and intended development outcomes.

Source: Comparison of growth in two PSL areas in India, agriculture and MSME, to India’s annual GDP growth. 2018-2019 agriculture and gross domestic product (GDP) are estimated. Data for agriculture growth from Government of India, Ministry of Agriculture and Farmers Welfare. Data for MSME growth from Government of India Ministry of Micro, Small and Medium Enterprises. Data for GDP growth from World Bank. Compiled by author and Wadhwani Chair staff.

If the government and the RBI stop forcing banks to adhere to priority sector lending norms, it will support the pressing objective of increased credit to emerging and productive sectors, reduce systemic risk, and enable the commercial banking system to function according to market signals to allocate liquidity more efficiently, enhancing India’s growth prospects in the short, medium, and long run.

Dr. Anit Mukherjee is an Adjunct Fellow (non-resident) with the Wadhwani Chair in U.S.-India Policy Studies at CSIS and a policy fellow with the Center for Global Development. Follow him on twitter @Anitnath.

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