Money and Credit

"In many of the transactions, gooods are being bought and sold with the use of money. Credit is a crucial element in economic life. We need to find new ways and this is one of the social challenges that developing countries face."

1.0Introduction

The history of money and how various forms were used at different times is an interesting story. Modern forms of money are linked to the banking system. The present situation in India, where newer forms of money are slowly spreading with computerisation of the banking system, offers many opportunities. Credit is a crucial element in economic life and it is, therefore, important to first understand this in a conceptual manner. There are many innovative interventions, such as that of Grameen Bank, of which students may be made familiar with but it is important to realise that we don't have answers to all questions.

2.0Money as a Medium of Exchange

The use of money spans a very large part of our everyday life. In many transactions, goods are being bought and sold with the use of money. In some of these transactions, services are being exchanged with money. For some, there might not be any actual transfer of money taking place now but a promise to pay money later.

A person holding money can easily exchange it for any commodity or service that he or she might want. Thus, everyone prefers to receive payments in money and then exchange the money for things that they want. Take the case of a shoe manufacturer. He wants to sell shoes in the market and buy wheat. The shoe manufacturer will first exchange shoes that he has produced for money, and then exchange the money for wheat. Imagine how much more difficult it would be if the shoe manufacturer had to directly exchange shoes for wheat without the use of money.

He would have to look for a wheat growing farmer who not only wants to sell wheat but also wants to buy the shoes in exchange. That is, both parties have to agree to sell and buy each other's commodities. This is known as double coincidence of wants. What a person desires to sell is exactly what the other wishes to buy. In a barter system where goods are directly exchanged without the use of money, double coincidence of wants is an essential feature.

In contrast, in an economy where money is in use, money by providing the crucial intermediate step eliminates the need for double coincidence of wants. It is no longer necessary for the shoe manufacturer to look for a farmer who will buy his shoes and at the same time sell him wheat. All he has to do is find a buyer for his shoes. Once he has exchanged his shoes for money, he can purchase wheat or any other commodity in the market. Since money acts as an intermediate in the exchange process, it is called a medium of exchange.

3.0Modern forms of money

We have seen that money is something that can act as a medium of exchange in transactions. Before the introduction of coins, a variety of objects was used as money. For example, since the very early ages, Indians used grains and cattle as money. Thereafter came the use of metallic coins - gold, silver, copper coins - a phase which continued well into the last century.

Currency

• Modern forms of money include currency - paper notes and coins.
• Unlike the things that were used as money earlier, modern currency is not made of precious metal such as gold, silver, copper. And unlike grain and cattle, they are neither of everyday use. The modern currency is without any use of its own.
• It is accepted as a medium of exchange because the currency is authorised by the government of the country.
• In India, the Reserve Bank of India issues currency notes on behalf of the central government.
• As per Indian law, no other individual or organisation is allowed to issue currency.
• Moreover, the law legalises the use of rupee as a medium of payment that cannot be refused in settling transactions in India.
• No individual in India can legally refuse a payment made in rupees. Hence, the rupee is widely accepted as a medium of exchange.

Deposits with Banks

The other form in which people hold money is as deposits with banks. At a point of time, people need only some currency for their day-to-day needs. For instance, workers who receive their salaries at the end of each month have extra cash at the beginning of the month. They deposit it with the banks by opening a bank account in their name.

Banks accept the deposits and also pay an amount as interest on the deposits. In this way people's money is safe with the banks and it earns an amount as interest. People also have the provision to withdraw the money as and when they require. Since the deposits in the bank accounts can be withdrawn on demand, these deposits are called demand deposits. Demand deposits offer another interesting facility. It is this facility which lends it the essential characteristics of money (that of a medium of exchange).

Cheque

For payment through cheque, the payer who has an account with the bank, makes out a cheque for a specific amount. 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.

Thus, we see that demand deposits share the essential features of money. The facility of cheques against demand deposits makes it possible to directly settle payments without the use of cash. Since demand deposits are accepted widely as a means of payment, along with currency, they constitute money in the modern economy.

You must remember the role that the banks play here. But for the banks, there would be no demand deposits and no payments by cheques against these deposits. The modern forms of money - currency and deposits - are closely linked to the working of the modern banking system.

4.0Loan activities of banks

• Banks keep only a small proportion of their deposits as cash with themselves. (About 15% for their deposits).
• This is kept as provision to pay the depositors who might come to withdraw money from the bank on any given day. Since, on any particular day, only some of its many depositors come to withdraw cash, the bank is able to manage with this cash.
• Banks make use of deposits to meet the loan requirements of the people.
  
• In this way, Banks mediate between those who have surplus funds (the depositors) and those who are in needs of funds (the borrowers).
• Bank charge a higher rate of interest on loans than what they offer on deposits. The difference between what is charged from borrowers and what is paid to depositors is their main source of income.

5.0Two different credit situations

A large number of transactions in our day-to-day activities involve credit in some form or the other. 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. Let us see how credit works through the following two examples.

(a) Festival seasons

In this case, Salim obtains credit to meet the working capital needs of production. The credit helps him to meet the ongoing expenses of production, complete production on time, and thereby increase his earnings. Credit therefore plays a vital and positive role in this situation.

(b) Swapna's problem

Credit in this case pushes the borrower into a situation from which recovery is very painful. She has to sell a part of the land to pay off the debt.

In one situation credit helps to increase earnings and therefore the person is better off than before. In another situation, because of the crop failure, credit pushes the person into a debt trap. To repay her loan she has to sell a portion of her land. She is clearly much worse off than before. Whether credit would be useful or not, therefore, depends on the risks in the situation and whether there is some support, in case of loss.

6.0Terms of Credit

• Interest Rate: Every loan agreement specifies an interest rate which the borrower must pay to the bank along with the repayment of the principal amount.
• Collateral Security: It is an asset that the borrower owns (such as lands, building, vehicles, livestocks, deposits with bank) and uses this as a guarantee to a lender until the loan is repaid. If the borrower fails to repay the loan, the lender has the right to sell the collateral to obtain payment. Property such as land titles, deposits with banks, livestock are some common examples of collateral used for borrowing.
• Documentation requirement
• Mode of repayment Interest rate, collateral and documentation requirement, and the mode of repayment together comprise what is called the terms of credit. The terms of credit vary substantially from one credit arrangement to another. They may vary depending on the nature of the lender and the borrower. The next section will provide examples of the varying terms of credit in different credit arrangements.

7.0Loan from Cooperatives

• Besides banks, the other major source of cheap credit in rural areas are the cooperative societies (or cooperatives).
• Members of a cooperative pool their resources for cooperation in certain areas. There are several types of cooperatives possible such as farmers cooperatives, weavers' cooperatives, industrial workers cooperatives, etc.
• Krishak Cooperative functions in a village not very far away from Sonpur. It has 2300 farmers as members. It accepts deposits from its members. With these deposits as collateral, the Cooperative has obtained a large loan from the bank, these funds are used to provide loans to members. Once these loans are repaid, another round of lending can take place. Krishak Cooperative provides loans for the purchase of agricultural implements, loans for cultivation and agricultural trade, fishery loans, loans for construction of houses and for a variety of other expenses.

8.0Sources of Credit in India

Formal lender sources

The various types of loans can be conveniently grouped as formal sector loans and informal sector loans. Among the former are loans from banks and cooperatives. The informal lenders include moneylenders, traders, employers, relatives and friends, etc. In Graph 1 you can see the various sources of credit to rural households in India.

9.0RBI - Lender of the last resort

The Reserve Bank of India supervises the functioning of formal sources of loans. For instance, we have seen that the banks maintain a minimum cash balance out of the deposits they receive. The RBI monitors the banks in actually maintaining cash balance. Similarly, the RBI sees that the banks give loans not just to profit-making businesses and traders but also to small cultivators, small scale industries, to small borrowers etc. Periodically, banks have to submit information to the RBI on how much they are lending, to whom, at what interest rate, etc.

There is no organisation which supervises the credit activities of lenders in the informal sector. They can lend at whatever interest rate they choose. There is no one to stop them from using unfair means to get their money back.

Compared to the formal lenders, most of the informal lenders charge a much higher interest on loans. Thus, the cost to the borrower of informal loans is much higher.

10.0The role of formal sector in the country's development

• Banks and cooperative societies need to lend more. This would lead to higher incomes and many people could then borrow cheaply for a variety of needs. They could grow crops, do business, set up small-scale industries etc. They could set up new industries or trade in goods.

Cheap and affordable credit is crucial for the country's development.

• Most loans from informal lenders carry a very high interest rate and do little to increase the income of the borrowers. Thus, it is necessary that banks and cooperatives increase their lending particularly in the rural areas, so that the dependence on informal sources of credit reduces.
• While formal sector loans need to expand, it is also necessary that everyone receives these loans. At present, it is the richer households who receive formal credit whereas the poor have to depend on the informal sources. It is important that the formal credit is distributed more equally so that the poor can benefit from the cheaper loans.

Unequal distribution of formal sector loans

Even after more than 74 years of independence most of rural and poor people still depends on non-formal resources for their loan requirements $85\%$ of the loan taken by poor households in the urban areas are from informal sources. The poor households have to pay a heavy price for borrowing.

Graph 2: Of a all the loans taken by urban households, what percentage was formal and that percentage was informal?

Graph 2 shows the importance of formal and informal sources of credit for people in urban areas. The people are divided into four groups, from poor to rich, as shown in the figure. You can see that 85 per cent of the loans taken by poor households in the urban areas are from informal sources. Compare this with the rich urban households. What do you find? Only 10 per cent of their loans are from informal sources, while 90 per cent are from formal sources. A similar pattern is also found in rural areas. The rich households are availing cheap credit from formal lenders whereas the poor households have to pay a large amount for borrowing.

Informal lender resources:

Difference between formal and informal credit

11.0Self Help Groups (SHG) for the poor

Banks are not present everywhere in rural India. Even when they are present, getting a loan from a bank is much more difficult than taking a loan from informal sources. Absence of collateral is one of the major reasons which prevents the poor from getting bank loans. Informal lenders such as moneylenders, on the other hand, know the borrowers personally and hence are often willing to give a loan without collateral. The borrowers can, if necessary, approach the moneylenders even without repaying their earlier loans. However, the moneylenders charge very high rates of interest, keep no records of the transactions and harass the poor borrowers. In recent years, people have tried out some newer ways of providing loans to the poor. The idea is to organise rural poor, in particular women, into small Self-Help Groups (SHGs) and pool (collect) their savings. A typical SHG has $15-20$ members, usually belonging to one neighbourhood, who meet and save regularly. Saving per member varies from Rs 25 to Rs 100 or more, depending on the ability of the people to save. Members can take small loans from the group itself to meet their needs. The group charges interest on these loans but this is still less than what the moneylender charges. After a year or two, if the group is regular in savings, it becomes eligible for availing loan from the bank. Loan is sanctioned in the name of the group and is meant to create self-employment opportunities for the members. For instance, small loans are provided to the members for releasing mortgaged land, for meeting working capital needs (e.g. buying seeds, fertilisers, raw materials like bamboo and cloth), for housing materials, for acquiring assets like sewing machine, handlooms, cattle, etc. Most of the important decisions regarding the savings and loan activities are taken by the group members. The group decides as regards the loans to be granted - the purpose, amount, interest to be charged, repayment schedule etc. Also, it is the group which is responsible for the repayment of the loan. Any case of non-repayment of loan by any one member is followed up seriously by other members in the group. Because of this feature, banks are willing to lend to the poor women when organised in SHGs, even though they have no collateral as such. Thus, the SHGs help borrowers overcome the problem of lack of collateral. They can get timely loans for a variety of purposes and at a reasonable interest rate. Moreover, SHGs are the building blocks of organisation of the rural poor. Not only does it help women to become financially selfreliant, but the regular meetings of the group also provide a platform to discuss and act on a variety of social issues such as health, nutrition, domestic violence, etc.

12.0Grameen Bank of Bangladesh

Grameen Bank of Bangladesh is one of the biggest success stories in reaching the poor to meet their credit needs at reasonable rates. Started in the 1970s as a small project, Grameen Bank in 2018 has over 9 million members in about 81,600 villages spread across Bangladesh. Almost all of the borrowers are women and belong to poorest sections of the society. These borrowers have proved that not only are poor women reliable borrowers, but that they can start and run a variety of small income-generating activities successfully. In 2006, Professor Mohammad Yunus and the Grameen Bank were jointly awarded the Noble Peace Prize for their book.

13.0Summing Up

In this chapter we have looked at the modern forms of money and how they are linked with the banking system. On one side are the depositors who keep their money in the banks and on the other side are the borrowers who take loans from these banks. Economic activities require loans or credit. Credit, as we saw can have a positive impact, or in certain situations make the borrower worse off.

Credit is available from a variety of sources. These can be either formal sources or informal sources. Terms of credit vary substantially between formal and informal lenders. At present, it is the richer households who receive credit from formal sources whereas the poor have to depend on the informal sources. It is essential that the total formal sector credit increases so that the dependence on the more expensive informal credit becomes less. Also, the poor should get a much greater share of formal loans from banks, cooperative societies etc. Both these steps are important for development.

14.0Glossary

• Transactions - A transaction is a completed agreement between a buyer and a seller to exchange goods, services, or financial assets in return for money.
• Withdrawal - Withdrawal refers to taking money out of a bank account in the form of cash.
• Lender - A lender is an individual, a group (public or private), or a financial institution that makes funds available to a person or business with the expectation that the funds will be repaid.
• Borrower - A borrower is a person or business that receives money from a lender with the agreement to pay it back within a specified period of time.
• Principal - The principal amount refers to the original sum of money borrowed from the lender to purchase a property. It represents the actual loan amount that the borrower needs to repay over the loan tenure.
• Interest rate - The interest rate is the amount a lender charges a borrower and is a percentage of the principal-the amount loaned.
• Debt trap - A Debt trap is a situation where you're forced to take new loans in order to repay your existing debt obligations.

15.0MIND MAP