Money and Credit — Notes

In barter, goods are exchanged directly for goods. It works only when there is a double coincidence of wants: each party wants what the other has to offer. Because this rarely happens, barter is slow and difficult.

Money solves the problem. Everyone accepts it, so a person can sell to anyone for money and buy from anyone with it. Money acts as an intermediate in exchange, so it is called a medium of exchange.

Over time money has taken many forms: grain, cattle and shells; coins of gold, silver and copper; paper notes; and today bank deposits used through cheques, cards and digital payments.

Currency: paper notes and coins. In India the Reserve Bank of India issues currency notes on behalf of the central government; coins are issued by the Government of India. Currency is accepted because it is authorised by the government: the rupee is legal tender, and no individual in India can legally refuse payment in rupees.

Demand deposits: money kept in bank accounts that can be withdrawn on demand. Banks pay some interest on them. They can be used for payments without cash:

• a cheque is an instruction to the bank to pay a specific amount from the account to the person named;
• debit cards, net banking and UPI move deposits from one account to another; UPI payments are instant and used even for small purchases.

Because deposits can be withdrawn on demand and are widely accepted in payment, they share the essential features of money. The RBI is also piloting a digital rupee (e₹), a digital form of currency.

On any day only a small share of depositors withdraw money, so banks keep a small part of deposits as cash (as the RBI requires) and use most of the rest to give loans.

Banks charge borrowers a higher rate of interest than they pay depositors. The difference is their main source of income. In this way banks act as a link between savers and borrowers, putting idle savings to productive use.

Credit (loan) is an agreement in which a lender supplies money, goods or services to a borrower in return for a promise of future payment.

• Credit that helps: a producer borrows for raw materials or tools, production and sales rise, the loan is repaid from higher earnings, and the borrower is better off.
• Credit that hurts: income fails (crop failure, illness, lost orders), the borrower cannot repay, takes new loans or sells land, cattle or gold, and ends worse off: a debt trap.

Whether credit helps depends on the risk in the activity and the terms of the loan, and on whether there is support when income fails.

The terms of credit are the conditions of a loan:

1. Interest rate: the extra paid on top of the principal.
2. Collateral: an asset the borrower owns and pledges as a guarantee (land, a building, a vehicle, livestock, gold, bank deposits). If the loan is not repaid, the lender may sell it.
3. Documentation: papers such as identity proof, land records and income records.
4. Mode of repayment: instalments or a lump sum, and when.

Terms vary widely between lenders. To compare costs, convert interest rates to the same basis: 2% a month is 24% a year.

Formal sources: banks and cooperatives. Informal sources: moneylenders, traders, employers, relatives and friends.

Role of the RBI: it supervises formal lenders. It checks that banks keep a minimum cash balance; it sees that banks lend not only to profit-making businesses and traders but also to small cultivators, small-scale industries and small borrowers; and banks must report periodically how much they lend, to whom and at what rate.

Informal lenders are not supervised by anyone. They can charge very high interest and sometimes use unfair means to recover loans. High-cost credit takes a large share of the borrower's income, can cause debt traps, and discourages people from starting enterprises.

The gap: better-off households get most of their loans from formal sources, while the poor depend largely on informal ones, because they lack collateral and documents and banks may be far away. Cheap, affordable credit is crucial for development, so formal credit must expand, especially in rural areas, and reach the poor. Steps include Jan Dhan accounts, banking correspondents, Kisan Credit Cards, SHG–bank linkage and RBI rules for digital lending.

A self-help group (SHG) has typically 15–20 members, usually poor women from one locality, who pool their savings regularly. The group lends small amounts to members at reasonable interest. After a year or two of regular saving, the group becomes eligible for a bank loan in its name, used to create self-employment: livestock, tailoring, small shops, processing units.

• Members take most decisions on savings and loans: purpose, amount, interest, repayment.
• The group is responsible for repayment, so no collateral is needed; members follow up anyone who does not repay.
• SHGs free members from moneylenders, give them their own income, and build confidence; meetings are a platform for health, nutrition and violence.

The idea of lending to the poor through groups was made famous by the Grameen Bank of Bangladesh, founded by Muhammad Yunus (Nobel Peace Prize 2006). In India, about 10 crore rural women are SHG members under the national rural livelihoods mission.