Chapter 3: Money and Credit
Money as a Medium of Exchange
The use of money spans a very large part of our everyday life. A person holding money can easily exchange it for any commodity or service that he or she wants — this is why money is called a medium of exchange: it acts as an intermediate in the exchange process.
Barter and the double coincidence of wants: in a barter system, goods are directly exchanged without the use of money. This requires a double coincidence of wants — what a person desires to sell is exactly what the other wishes to buy. For example, a shoe manufacturer who wants wheat must find a wheat-growing farmer who also wants shoes. This is the essential feature of barter and its main difficulty. Money eliminates this problem — the shoemaker can sell shoes for money and then buy wheat from anyone.
Modern Forms of Money
Before modern money, Indians used grains and cattle, then metallic coins of gold, silver and copper. Modern forms of money include:
- Currency — paper notes and coins. Unlike grain or cattle, modern currency is not made of precious metal and has no use of its own. It is accepted because it is authorised by the government: in India, the Reserve Bank of India (RBI) issues currency notes on behalf of the central government. By law, no other individual or organisation is allowed to issue currency, and no one can legally refuse the rupee as a medium of payment in India — the rupee is legal tender.
- Deposits with banks (demand deposits) — people deposit extra cash in bank accounts; banks accept the deposits and pay interest. Since the deposits can be withdrawn on demand, they are called demand deposits.
- Cheques — a cheque is a paper instructing the bank to pay a specific amount from the person's account to the person in whose name the cheque has been issued. Payment happens by transfer between accounts without any cash. The facility of cheques against demand deposits makes it possible to settle payments directly — hence demand deposits share the essential features of money and are counted as money in a modern economy. Banks make this possible.
Loan Activities of Banks
Banks keep only a small proportion of their deposits as cash with themselves — in India about 15 per cent of deposits is kept as cash to pay depositors who may come to withdraw on any given day. Since only some depositors withdraw on a day, the bank uses the major portion of deposits to extend loans. There is a huge demand for loans for various economic activities.
How banks earn: banks charge a higher interest rate on loans than what they offer on deposits. The difference between the interest charged from borrowers and the interest paid to depositors is the main source of income of banks. Banks thus mediate between depositors (who have surplus funds) and borrowers (who need funds).
Two Different Credit Situations
Credit (loan) refers to an agreement in which the lender supplies the borrower with money, goods or services in return for the promise of future payment. Whether credit is useful or harmful depends on the situation:
| Situation 1 — Salim (festival season) | Situation 2 — Swapna (crop failure) | |
|---|---|---|
| Who | A shoe manufacturer who receives a large order | A small farmer who grows groundnut on her 3 acres |
| Loan taken for | Working capital — advance payments from traders and a loan from the leather supplier to meet production expenses | Crop cultivation expenses — loan from the village moneylender, hoping to repay from harvest |
| Outcome | He delivers the order in time, makes a good profit, and repays the loan — credit increases his earnings | Pests destroy the crop; she cannot repay, the debt grows; next year she borrows again, harvest is only moderate — she must sell part of her land to repay |
| Lesson | Credit plays a vital and positive role | Credit pushes the borrower into a debt-trap — she is much worse off than before |
In rural areas, where farming involves high risks (main demand for credit is for crop production), failure of the crop can make loan repayment impossible. Hence whether credit is useful depends on the risks involved and whether there is support in case of loss.
Terms of Credit
Every loan agreement specifies the terms of credit, which comprise:
- Interest rate — the borrower must repay the principal along with interest.
- Collateral — an asset the borrower owns (land, building, vehicle, livestock, bank deposits) and uses as a guarantee to the lender until the loan is repaid. If the borrower fails to repay, the lender has the right to sell the collateral to obtain payment.
- Documentation — papers/evidence of employment, income, ownership etc. required by the lender.
- Mode of repayment — how the loan will be paid back (instalments, lump sum, etc.).
The terms of credit vary substantially from one credit arrangement to another, depending on the nature of the lender and the borrower — e.g. a landowner charging a farm labourer 5 per cent per month versus a bank charging a rich urban household 12 per cent per year for a house loan.
Formal and Informal Sources of Credit
| Basis | Formal Sector Loans | Informal Sector Loans |
|---|---|---|
| Sources | Banks and cooperatives | Moneylenders, traders, employers, relatives and friends |
| Supervision | The Reserve Bank of India supervises their functioning — banks must report how much they lend, to whom and at what rates; RBI ensures banks maintain minimum cash balance and give loans not just to profit-making businesses but also to small cultivators, small-scale industries and small borrowers | No organisation supervises them — lenders can charge any rate of interest and use unfair means to get their money back |
| Interest rate | Lower | Much higher — a large part of the borrower's earnings goes into interest repayment; higher cost of borrowing can even mean less income for the borrower and a debt-trap |
| Collateral / documentation | Usually required | Often lent without collateral, but on very harsh terms |
| Who mainly gets these loans | Richer households — formal credit is not available to all, and formal sources meet only about half of the total credit need of rural people | Poor households depend heavily on informal sources (85% of loans taken by poor urban households are from informal sources) |
Why should formal credit expand? (i) informal lenders charge very high interest and bring little income to borrowers; (ii) cheap and affordable credit is crucial for the country's development; (iii) banks and cooperatives should lend more, and to a wider range of people — everyone, especially the poor, should get formal loans at reasonable rates. It is also necessary that formal credit is distributed more equally so that the poor benefit.
Self-Help Groups (SHGs) for the Poor
Poor households still depend on informal sources because banks are not present everywhere in rural India, and getting a bank loan requires proper documents and collateral, which the poor usually lack. Self-Help Groups are a newer way to organise rural poor, particularly women:
- A typical SHG has 15-20 members, usually belonging to one neighbourhood, who meet and save regularly — savings vary from Rs 25 to Rs 100 or more per member.
- Members can take small loans from the group itself to meet their needs; the group charges interest, but this is less than what the moneylender charges.
- After a year or two, if the group is regular in savings, it becomes eligible for a loan from the bank — the loan is sanctioned in the name of the group, to create self-employment opportunities (releasing mortgaged land, seeds, fertilisers, sewing machines, handlooms, cattle, raw materials, etc.).
- Important decisions on loans (purpose, amount, interest, repayment) are taken by the group members themselves; the group is responsible for repayment. Non-repayment by any one member is followed up seriously by the others — because of this collective responsibility, banks lend to the poor women even without collateral.
- SHGs are the building blocks of the organisation of the rural poor — besides finance, they give women a platform to discuss and act on social issues (health, nutrition, domestic violence).
Grameen Bank of Bangladesh: started in the 1970s as a small project, it now serves millions of poor borrowers, almost all of them women from the poorest sections, and is a success story in reaching the poor with credit at reasonable rates. Its founder, Professor Muhammad Yunus, received the Nobel Peace Prize in 2006 (jointly with Grameen Bank).