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Monday, August 07, 2006

Easing credit constraints

In an ideal world, individuals should be able to smooth consumption across time through a variety of financial devices such as debt. Given the high risk aversion of most households, there is quite a bit of welfare that can be gained by better smoothing of consumption. In India, a large number of households are "credit constrained" - they are unable to have significant debt. This is not necessarily bad - e.g. some of the problem of farmers killing themselves has surely got to do with inappropriate debt-equity ratios.

Every country goes through a transition where the overall borrowing of households goes from roughly nothing, and ends up with a significant amount of leverage. Robert Samuelson has a very nice story about how the US went from household debt of 22% of disposable income in 1946 to 126% in 2006. (I suppose he means PFCE when he says "disposable income"?) William Pesek had a nice article in 2005 on the crisis with household credit in South Korea. It's a great period for the macroeconomy, with high consumption growth, while households are adding leverage. It is a transition that comes only once in the life of a country.

A while ago, I had written about new approaches to solving credit constraints in the form of loans against securities and credit cards. All over the world, when the credit card business works, it effectively serves as small-business financing.

Loans against securities are now quite mainstream thanks to the mass of dematerialised shares that are now in existence. The NSDL data shows they have Rs.18 trillion of equity and roughly Rs.3.5 trillion of debt securities amongst their 7.7 million accounts. The CDSL data shows another Rs.2.1 trillion of demat assets.

What is new about demat securities is that they constitute top quality collateral. The collateral is frictionless for the lender, mark to market is easy, liquidation is easy. This makes it easy to give a loan against such high quality collateral. In contrast, real estate or cars are bad collateral.

One new kind of high quality collateral that is falling into place is dematerialised warehouse receipts which are claims on standardised physical commodities. These aren't quite as good as securities on the issues of valuation and liquidation, but it's another big step forward for easing credit constraints. Today's Indian Express has a story by Suresh P. Iyengar on this.

In my opinion, another frontier on easing credit constraints is obtaining a loan using the accumulated balance in your DC pension account as collateral. The size of credit required to tide over small problems like health or unemployment are small compared with the size of pension wealth that needs to be built up over life, so for most decades of the working life, it is possible to solve the consumption smoothing required owing to ill-health and unemployment by having access to loans against the DC pension account. I have talked about this a bit in my submission to PRS about the PFRDA Bill.

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