UPSC Economics Banking System NCERT Extracts - Money and Credit

Money as a Medium of Exchange

• Have we ever wondered why transactions are made in money? The reason is simple.
• A person holding money can easily exchange it for any commodity or service that he or she might 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 others 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. Since money acts as an intermediate in ^ the exchange process, it is called a medium of exchange.

Modern forms of Money

• 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
• Modem forms of money include currency - paper notes and coins. Unlike the things that were used as money earlier, modem currency is not made of precious metal such as gold, silver and copper. And unlike grain and cattle, they are neither of everyday use.
• The modem 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).
• 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 modem economy.
• We 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 modem forms of money - currency and deposits - are closely linked to the working of the modem banking system.

Loan Activities of Banks

• Banks keep only a small proportion of their deposits as cash with themselves. For example, banks in India these days hold about 15 per cent of their deposits as cash.
• 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 use the major portion of the deposits to extend loans. There is a huge demand for loans for various economic activities.
• Banks make use of the 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 need of these funds (the borrowers).
• Banks charge a higher interest rate 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.

Two 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.
• In rural areas, the main demand for credit is for crop production. Crop production involves considerable costs on seeds, fertilisers, pesticides, water, electricity, repair of equipment, etc.
• There is a minimum stretch of three to four months between the time when the farmers buy these inputs and when they sell the crop.
• Farmers usually take crop loans at the beginning of the season and repay the loan after harvest. Repayment of the loan is crucially dependent on the income from farming.
• In some cases the failure of the crop made loan repayment impossible. They had to sell part of the land to repay the loan. Credit, instead of helping them improve their earnings, left them worse off.
• This is an example of what is commonly called debt-trap. Credit in this case pushes the borrower into a situation from which recovery is very painful.
• 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.
• 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.

Terms of Credit

• Every loan agreement specifies an interest rate which the borrower must pay to the lender along with the repayment of the principal. In addition, lenders may demand collateral (security) against loans.
• Collateral is an asset that the borrower owns (such as land, building, vehicle, live stocks, deposits with banks) 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 asset or collateral to obtain payment.
• Property such as land titles, deposits with banks, livestock are some common examples of collateral used for borrowing.
• 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.

Loans 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. 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.

Formal Sector Credit in India

• People obtain loans from various 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.
• 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.
• Higher cost of borrowing means a larger part of the earnings of the borrowers is used to repay the loan. Hence, borrowers have less income left for themselves.
• In certain cases, the high interest rate for borrowing can mean that the amount to be repaid is greater than the income of the borrower.
• This could lead to increasing debt and debt trap. Also, people who might wish to start an enterprise by borrowing may not do so because of the high cost of borrowing.
• For these reasons, 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.
• Formal and informal credit: Who gets what?
• We 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.
• 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.
• The formal sector still meets only about half of the total credit needs of the rural people. The remaining credit needs are met from informal sources.
• 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.
• Secondly, 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.

Self-help Groups for the Poor

• In the previous section we have seen that poor households are still dependent on informal sources of credit. Why is it so? 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. Bank loans require proper documents and collateral. 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 self-reliant, the regular meetings of the group provide a platform to discuss and act on a variety of social issues such as health, nutrition, domestic violence, etc.

Grameen 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 October, 2014 has over 8.63 million members in about 81,390 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.
• "If credit can be made available to the poor people on terms and conditions that are appropriate and reasonable these millions of small people with their millions of small pursuits can add up to create the biggest development wonder." (Professor Muhammad Yunus, the founder of Grameen Bank, and recipient of 2006 Nobel Prize for Peace).