Chapter 3 Money And Credit

This chapter explores the crucial roles of money and credit in economic life. It delves into how money facilitates exchange, the nature of modern currency and bank deposits, how banks manage funds through lending, the varying conditions under which credit is extended, and the significance of formal versus informal sources of credit, particularly for the poor. The chapter aims to highlight the importance of affordable and accessible credit for development and discusses initiatives like Self-Help Groups (SHGs) and the Grameen Bank.

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Money As A Medium Of Exchange

Money is central to everyday transactions, from buying goods and services to promising future payments. The primary reason transactions are made using money is its convenience: a person holding money can easily exchange it for any commodity or service they desire.

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Double Coincidence Of Wants

Before the use of money, transactions were often conducted through barter, where goods were directly exchanged for other goods. A key difficulty in a barter system is the need for a double coincidence of wants. This means that what a person desires to sell must be exactly what the other person wishes to buy. For example, a shoe manufacturer wanting wheat would have to find a wheat farmer who not only wants to sell wheat but also specifically wants to buy shoes in exchange. This matching of needs can be very difficult and inefficient.

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Money As An Intermediate

Money overcomes the need for double coincidence of wants. It acts as a crucial intermediate step in the exchange process. The shoe manufacturer can sell shoes for money and then use that money to buy wheat or any other commodity from the market. Money's function as an intermediate facilitator makes exchange much easier and more efficient compared to barter. Because money acts as a go-between in transactions, it is called a medium of exchange.

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Modern Forms Of Money

Throughout history, various objects have served as money. Before coins, items like grains and cattle were used in India. Later, metallic coins made of gold, silver, and copper became common.

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Currency

Modern forms of money primarily consist of currency – paper notes and coins. Unlike historical forms like precious metals, grains, or cattle, modern currency typically has no intrinsic use or value of its own. Despite this, it is widely accepted as a medium of exchange because it is authorised by the government of the country.

In India, the Reserve Bank of India (RBI) issues currency notes on behalf of the central government, and no other entity is legally permitted to do so. Indian law designates the rupee as a legal medium of payment that cannot be refused for settling transactions within the country. This legal backing makes the rupee widely accepted for exchange.

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Deposits With Banks

Besides physical currency, people also hold money as deposits with banks. People generally don't need all their money in cash for daily needs. Extra cash, such as monthly salaries received by workers, is often deposited in bank accounts. Banks accept these deposits and pay interest on them, ensuring the money is safe and earns returns.

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Demand Deposits

Money deposited in bank accounts is called demand deposits because depositors can withdraw their money on demand, as and when they require it. This flexibility makes demand deposits similar to currency in terms of accessibility and usability.

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Cheque Payments

Demand deposits offer another convenient facility: payments can be made using cheques instead of cash. A cheque is a written instruction to the bank from a person with an account, directing the bank to pay a specific amount to the person in whose name the cheque is issued. This allows for the transfer of money between bank accounts without involving physical cash.

Since demand deposits, accessible via cheques, are widely accepted as a means of payment alongside currency, they are considered an essential part of money in the modern economy. The banking system plays a critical role by facilitating demand deposits and cheque payments, closely linking modern money forms to the functioning of banks.

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Loan Activities Of Banks

Banks play a crucial role in the economy by managing the money deposited by the public. They don't keep all deposits as cash.

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Banks Keep A Small Proportion As Cash

Banks in India typically hold only a small percentage (around 15%) of their total deposits as cash. This cash serves as a reserve to meet the daily needs of depositors who might come to withdraw money. Since not all depositors withdraw money simultaneously on any given day, this small proportion is usually sufficient to manage withdrawals.

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Banks Use Deposits To Extend Loans

The major portion of the deposits accepted from the public is used by banks to extend loans to borrowers. There is a significant demand for loans for various economic activities, from starting businesses to buying homes.

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Interest Rate Difference (Source Of Income)

Banks act as intermediaries, facilitating the flow of funds from those with surplus money (depositors) to those who need funds (borrowers). Banks charge a higher interest rate on the loans they provide than the interest rate they offer on deposits. The difference between the interest earned from borrowers and the interest paid to depositors is the primary source of income for banks.

Two Different Credit Situations

Credit, or a loan, is an agreement where a lender provides a borrower with money, goods, or services with the promise of future repayment. Credit is prevalent in daily activities and can have vastly different outcomes depending on the situation. Let's look at two examples:

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Festival Season (Salim's Example)

Salim, a shoe manufacturer, receives a large order for shoes requiring him to hire more workers and purchase raw materials. To cover these working capital needs, he obtains credit: he gets leather now, promising to pay later, and receives an advance payment from the trader for part of the order. By completing the order on time, Salim makes a profit and repays the loan.

In this scenario, credit plays a vital and positive role. It helps Salim meet production expenses, complete his order, and increase his earnings, leaving him better off.

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Swapna’s Problem (Swapna's Example)

Swapna, a small farmer, takes a loan from a moneylender for cultivation expenses, expecting to repay it after harvest. However, her crop fails due to pests, despite using expensive pesticides. Unable to repay the loan, her debt grows. The next year, she takes a fresh loan for a normal crop, but her earnings are still insufficient to cover the accumulated debt. She gets caught in a debt trap, ultimately having to sell a portion of her land to repay the debt.

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Credit Outcomes (Positive And Negative)

These two examples show that credit can have vastly different impacts. In Salim's case, it leads to increased earnings and economic improvement. In Swapna's case, due to unforeseen circumstances (crop failure), it pushes her into a debt trap, making her significantly worse off. The outcome of credit depends heavily on the risks involved in the borrower's situation and whether there is support available in case of losses or failures.

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Debt-trap

A debt trap occurs when borrowing, instead of helping a person improve their earnings, pushes them into a situation where they are unable to repay the loan. This often leads to increasing debt and may force the borrower to sell assets or take on more painful measures to clear the debt. This illustrates how credit can be detrimental if the borrower cannot generate sufficient income to repay it, especially when faced with high risks or lack of support.

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Terms Of Credit

Every loan agreement includes specific conditions and requirements that govern the lending arrangement. These are collectively known as the terms of credit.

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Interest Rate

The loan agreement specifies an interest rate that the borrower must pay to the lender. This payment is in addition to the repayment of the principal amount borrowed.

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Collateral

Lenders often require collateral (or security) against loans. Collateral is an asset owned by the borrower (such as land, a building, a vehicle, livestock, or bank deposits) that is used as a guarantee to the lender until the loan is repaid. If the borrower defaults on the loan, the lender has the right to sell the collateral asset to recover the payment. Common examples include land titles and bank deposits.

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Documentation

Formal lending arrangements, particularly with institutions like banks, typically require borrowers to submit various documents. This documentation helps the lender assess the borrower's ability to repay and formalises the loan agreement. For example, proof of employment and salary records might be required for a house loan.

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Mode Of Repayment

The loan agreement also specifies the mode of repayment, outlining how the loan will be repaid (e.g., in lump sum, in regular monthly or annual installments) and the schedule for repayments.

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Varying Terms

The terms of credit (interest rate, collateral, documentation, repayment mode) are not standard; they vary substantially depending on the specific loan arrangement and the nature of both the lender and the borrower. Different types of lenders (e.g., banks, moneylenders, employers) offer credit on different terms.

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A House Loan (Example)

Answer:

This example illustrates the typical terms involved in a formal credit arrangement like a bank loan for a house: a specified interest rate, collateral (the house property papers), documentation requirements, and a structured repayment schedule (monthly installments).

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Variety Of Credit Arrangements

Credit is obtained from diverse sources, with different individuals and communities accessing loans under varying terms. Let's explore examples from a village setting.

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Example Of A Village (Sonpur)

In Sonpur, a small irrigated village, different residents have different credit arrangements based on their economic status and relationships:

• Shyamal (small farmer): Borrows from a village moneylender (previously) at 60% annual interest, and now from an agricultural trader at 36% annual interest. The trader provides inputs on credit and requires Shyamal to sell his crop to him, often at a lower price after harvest, benefiting the trader. Risk: High interest, potentially unfair crop price.
• Arun (medium farmer): Receives a bank loan at a much lower interest rate (8.5% per annum). He plans to repay after harvest, store the rest of the crop in cold storage, and get a fresh loan against the receipt. This is a formal credit arrangement with favourable terms.
• Rama (agricultural labourer): Works seasonally and needs credit for daily expenses and unexpected needs (illness, functions). She relies on her landowner-employer for loans at a high interest rate (60% per annum). She repays by working, often needing a new loan before the old one is repaid, leading to increasing debt and dependence. Risk: High interest, dependency on employer, debt trap potential.

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Sources Of Credit In Sonpur

The examples from Sonpur show varied sources of credit:

• Moneylender
• Agricultural trader
• Bank
• Landowner-employer
• Cooperative society (Krishak Cooperative)

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Comparison Of Terms

Comparing the terms of credit for the different individuals in Sonpur reveals clear disparities:

• Shyamal faces high interest rates (36-60%) and potentially unfair market practices from the trader.
• Arun benefits from a low interest bank loan (8.5%), flexibility in repayment, and access to further credit against storage receipts.
• Rama faces extremely high interest rates (60%) and dependency on her employer, leading to a cycle of debt.

Access to cheap credit is clearly not available to everyone in Sonpur. Those with assets (like Arun with land who qualifies for a bank loan) can access cheaper, formal credit, while small farmers and landless labourers often have to rely on expensive informal sources.

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Loans From Cooperatives

Cooperative societies, like the Krishak Cooperative in Sonpur's vicinity, represent another important source of cheap credit in rural areas. Cooperatives are associations where members pool resources and collaborate in specific areas. Krishak Cooperative accepts deposits from its 2300 farmer members, uses these as collateral to get large loans from banks, and then provides loans to its members at reasonable rates for various needs (farming inputs, cultivation, trade, fisheries, housing, assets). This model helps members access affordable credit.

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Formal Sector Credit In India

Loan sources can be broadly categorised as formal and informal. Formal sources include banks and cooperatives. Informal lenders include moneylenders, traders, employers, relatives, and friends. In rural India, credit comes from both sectors, but historically, informal sources have been dominant.

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Formal Vs Informal Sources

Graph 1 shows that in 2019, commercial banks (51%) and cooperative banks/societies (10%) were significant formal sources in rural India. However, informal sources like moneylenders (23%) and relatives/friends (7%) still provided a substantial portion of credit.

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Supervision By Rbi (Formal Sector)

The Reserve Bank of India (RBI) supervises the functioning of formal credit sources like banks. The RBI monitors banks' cash balance maintenance and ensures they extend loans not just to profitable businesses but also to small borrowers, farmers, and small industries. Banks must periodically report their lending activities (amount, recipient, interest rate) to the RBI. This supervision ensures the formal credit system operates smoothly and serves broader development goals.

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Informal Lender Activities

Informal lenders, on the other hand, are not supervised by any organisation like the RBI. They are free to set their own interest rates and terms, and there is no external body to prevent them from using unfair or coercive means to recover loans.

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Higher Cost Of Informal Loans

A major difference is the cost of borrowing. Compared to formal lenders, informal lenders typically charge much higher interest rates on loans. This makes the cost of informal credit significantly higher for borrowers.

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Consequences Of High Cost

The high cost of borrowing from informal sources has severe consequences for borrowers. A large portion of their earnings is used to repay the loan, leaving them with less disposable income (as seen with Shyamal). In extreme cases, the repayment amount can exceed the borrower's income, leading to increasing debt and trapping them in a debt cycle (like Rama). High borrowing costs also discourage people from starting new businesses or enterprises.

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Importance Of Banks And Cooperatives

To address these issues, it is crucial for banks and cooperative societies to increase their lending activities, especially in rural areas. Increased formal lending would reduce dependence on expensive informal credit, making it cheaper for people to borrow for various needs like farming, business, or setting up small industries. Affordable credit can significantly contribute to higher incomes and overall development.

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Cheap And Affordable Credit

Cheap and affordable credit is considered crucial for a country's development. It enables individuals to invest in productive activities, increase their earnings, and escape debt traps, contributing to economic growth and poverty reduction.

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Formal And Informal Credit: Who Gets What?

Despite the benefits of formal credit and the drawbacks of informal credit, the distribution of credit from these sources is often unequal, particularly impacting poorer households.

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Distribution In Urban Areas (Poor Vs Rich)

Graph 2 shows the percentage of loans from formal and informal sources for different categories of urban households based on wealth. Poor households obtain a large majority (84%) of their loans from informal sources, paying high interest.

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Distribution In Rural Areas (Similar Pattern)

Comparing this to rich urban households, only a small percentage (17%) of their loans come from informal sources, while the vast majority (83%) are from formal sources. This means rich households benefit from cheaper formal credit. A similar pattern of unequal access to formal credit is observed among households in rural areas as well.

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Need To Expand Formal Sector Loans

The fact that the formal sector currently meets only about half of the total rural credit needs, with the rest met by informal sources, suggests a need to expand formal lending. Increasing the availability of formal credit would help reduce the dependence on more expensive informal sources.

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Need For Equitable Distribution

Beyond increasing the total amount of formal credit, it is equally important to ensure that these loans are distributed more equally across the population. At present, richer households disproportionately benefit from formal credit, while the poor remain largely reliant on informal sources. Greater equity in the distribution of formal credit is essential so that poor households can also access cheaper loans and benefit from them for development.

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Self-Help Groups For The Poor

Recognising the persistent reliance of poor households on informal credit sources, particularly due to difficulties in accessing banks, newer approaches have been developed to provide affordable loans to the poor. Banks often require documentation and collateral, which many poor individuals lack.

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Why Poor Rely On Informal Sources

Poor households often depend on informal lenders because banks may not be present in their areas, and accessing bank loans is challenging due to requirements like documentation and collateral. Informal lenders, knowing the borrowers personally, might lend without collateral and can be approached even with outstanding loans, but they charge very high interest rates and may use unfair practices.

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Problem Of Lack Of Collateral

The inability to provide collateral is a significant barrier preventing poor people from obtaining loans from banks.

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Idea Of SHGs

A newer approach involves organising rural poor, especially women, into small Self-Help Groups (SHGs). The core idea is for members to pool their savings.

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How SHGs Function (Savings And Internal Loans)

A typical SHG comprises 15-20 members from the same neighbourhood who meet and save regularly (varying amounts based on ability). Members can take small loans from the group's pooled savings to meet their immediate needs. These loans also carry interest, but at a rate lower than that charged by moneylenders.

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Bank Loans Through SHGs

After regularly saving for a year or two, an SHG becomes eligible to avail loans from a bank. The loan is sanctioned in the group's name.

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Purposes Of SHG Loans

Loans from the bank sanctioned through the SHG are meant to create self-employment opportunities for members. These small loans can be used for various productive purposes:

• Releasing land that has been mortgaged.
• Meeting working capital needs (buying seeds, fertilizers, raw materials like bamboo, cloth).
• Purchasing housing materials.
• Acquiring assets like sewing machines, handlooms, cattle.

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Decision Making And Repayment Responsibility

Crucially, the SHG members make most decisions about savings and loans, including the purpose, amount, interest, and repayment schedule for internal loans. The group collectively is responsible for the repayment of the bank loan. Non-repayment by any member is seriously followed up by the other members. This collective responsibility makes banks willing to lend to SHGs, even without traditional collateral from individual members.

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Benefits Of SHGs

SHGs help poor borrowers overcome the lack of collateral, enabling them to access timely loans at reasonable interest rates for diverse needs. Beyond financial benefits, SHGs serve as platforms for organising rural poor and empower women by helping them become financially independent. Regular group meetings also provide opportunities to discuss and address social issues like health, nutrition, and domestic violence.

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Grameen Bank Of Bangladesh (Example)

The Grameen Bank of Bangladesh is a successful model of providing affordable credit to the poor. Founded by Professor Muhammad Yunus, it started as a small project and has grown significantly, providing microcredit primarily to women in poor households across Bangladesh. Its success demonstrates that poor women are reliable borrowers and can use small loans for successful income-generating activities.

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Summing Up

This chapter explored the interplay between money, the banking system, and credit in the modern economy.

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Money, Banking, And Credit

Modern money, consisting of currency and demand deposits, is intricately linked to the banking system. Banks facilitate the flow of funds from depositors to borrowers, managing deposits and extending loans.

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Impact And Sources Of Credit

Credit is essential for economic activities. As seen through examples, credit can have positive outcomes, boosting earnings and facilitating development, but it also carries risks and can lead to debt traps. Credit is available from various sources, broadly classified as formal and informal.

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Formal Vs Informal Credit

Formal sources (banks, cooperatives) are supervised (by RBI in India) and offer loans at reasonable terms. Informal sources (moneylenders, traders, etc.) are unregulated, often charge very high interest rates, and can exploit borrowers. The cost of informal credit is significantly higher and can hinder development.

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Need For Expanded And Equitable Formal Credit

In India, informal sources still meet a substantial portion of credit needs, especially for the poor. To reduce dependence on expensive informal credit, total formal sector credit must increase. Crucially, formal credit needs to be distributed more equitably, with a larger share going to poor households who currently rely on informal sources. Expanding and ensuring equitable access to formal, cheap credit is vital for broad-based development.