Top 5 Methods of Credit Control of an Economy

Read this article to learn about the five important methods of credit control of an economy.

1. Bank Rate:

Bank rate is the rate prescribed by the central bank. It is the minimum rate at which the central bank will discount first class bills of exchange or will advance loans against approved securities.

Sometimes, it is called the discount rate. There is a direct and organic type of relationship between bank rate and other money-market interest rates, so that changes in the bank rate are followed by changes in the interest rates of commercial banks for short-term money and bank loans and advances.

The market rate as distinguished from the bank rate, is also a rate of discount but one at which the lending institutions in the country other than the central bank discount the bills. The rate of interest, on the other hand, is the rate which the lending institutions or banks pay to their depositors.

It is an important instrument of credit control. If the central bank wants credit expansion, it will lower the bank rate making credit cheaper, followed by commercial banks, who lower their interest rates. The central bank will raise the bank rate to discourage credit creation under inflationary conditions. A rise in the bank rate will raise the cost of borrowing making it dearer, discouraging businessmen, entrepreneurs, speculators and traders borrow more, and reducing the volume of bank credit.

The production of investment goods and other business or construction activities, which primarily depend upon borrowed funds, will be slowed down and unemployment will ensure. Dealers who keep stocks of goods with borrowed money will reduce their stock as the cost of borrowing has gone up and there is an expectation of falling prices.

They will reduce orders to producers of goods, resulting in the curtailment of productive activities and accentuating unemployment, which, in turn, lead to a fall in prices and money incomes. The opposite happens when the bank rate is lowered, business activity will expand and employment will rise as the cost of borrowing goes down.

Similarly, a rise in the bank rate will set right an adverse balance of trade. An adverse balance causes an export of gold. As the bank rate is raised, all other money rates, including that on deposits go up in the money market. Foreigners, who now obtain a higher rate on their investments, will not withdraw any money. Foreigners, who have funds to invest for short periods will send them to that country. Thus, there will be movement of capital into the country on account of better returns and stoppage of money going out of that country.

The demand for domestic currency will rise, raising its value and making the exchange rates more favourable. Moreover, borrowed funds having become costly, less would be spent on the purchase of imported goods, leading to a decline in the volume of imports. The balance of trade will, thus, become favourable as a result of a rise in the bank rate.

It should, however, be clear, that for successful working of the bank rate mechanism the money market must be an integral whole, that is, there must be a direct and organic type of relationship between the bank rate and the other market interest rates, so that whenever there is a change in the bank rate other money market rates of interest also undergo change.

Again, the economic structure of the country has got to be elastic, so that changes in money and credit conditions are promptly reflected in the changes in other variables like costs, wages, prices, production and employment. Different views have been expressed by different writers concerning the degree of responsiveness of other money market rates of interest to the bank rate. Two distinct views have been expressed by Hawtrey and Keynes regarding the operation of the rate of interest and its influence on investment and economic activity.

According to Hawtrey these are influenced by changes in the short-term rate of interest, while Keynes expressed the opinion that these are mainly influenced by changes in the long-term rate of interest. Hawtrey holds that movements in the short-term rates of interest affect income, output and employment through their influence on the stock holders activities like traders or dealers who keep stocks of goods with borrowed money. Should the short-term rate of interest go up, they will reduce the stocks because the cost of holding has increased.

This view of Hawtrey has been criticised because it gives undue importance to the activities of stock-holders and to the rate of interest as the cost of holding such stocks—whereas it is only one factor in the total cost. Keynes considers the effect of long-term rates of interest on investment.

According to him, variations in bank rate affect economic activities through their impact on long-term rates of interest. Keynes believed that investment in fixed capital depends on the MEC in relation to the long-term rate of interest. Given the MEC, a rise or fall in the long-term rate of interest rates will condition the responses of investors concerning investment in fixed capital.

The Radcliffe Committee Report points out that the movement in bank interest rate could have two types of effects:

(i) The incentive effect,

(ii) The general liquidity effect.

The incentive effect refers to changes in the rate of interest, that is, cost of money influencing the cost of holding stocks of goods—whether commodities or capital goods. With the rise in the rate of interest the stock-holder or the investor would like to cut back on account of the increased cost of holding the stocks or taking up the venture. This is interest incentive effect which pays attention to the cost of money in holding goods, etc.

But Radcliffe Committee observes that the cost of money is relatively small in comparison with other costs of production that it has little or no effect on holders or investors to change their plans. Because the capital investment is often decided by the costs and the availability of material or labour and not by the rate of interest.

The general liquidity effect on the other hand pertains to the behaviour of lenders rather than borrowers. It refers to the liquidity position of the near money asset-holders due to changes in the value of such financial assets. As a result of the effect of changes in the rates of interest on the prices of such assets; the behaviour of lenders undergoes a change, which in turn, may influence the credit availability in the money market.

Thus, when the interest rates go up, the lenders find that the value of their financial assets has dropped, and they are less ready to lend more cash to borrowers. The report says that from the evidence it seems that the general liquidity effect of the rate of interest has a little more weight than the interest incentive effect bank rate as an instrument of credit control.

It is, no doubt, true that the importance of bank rate as a means to control credit has declined in recent years, even then, it is considered as an indispensable tool of credit control and has regained its importance after 1945. It has been fairly successful in controlling inflation, but has proved a failure in arresting a deflationary trend.

2. Open Market Operations:

Prof. Halm remarks, “In view of the short-comings rediscount policy the development of open market operations—the purchase and sale of government securities and other credit instruments in the open market—as an additional and to some extent alternative instrument of central bank policy is a logical step.” In other words, whenever the central bank wants to regulate the amount of money in circulation, it resorts to open market operations, the sale and purchase of securities by the central bank.

If the central bank wishes to reduce the volume of credit, it sells securities to the public, for which it receives payment either in cash from the public (in which case the quantity of money with the public to that extent is reduced) or it may receive payments by cheques drawn on the commercial banks, in which case the cash held by these banks with the central bank is reduced, and to that extent, commercial banks are compelled to reduce the volume credit.

On the other hand, if the central bank wants to increase credit, it buys approved securities from the market either by paying cash direct to the public or cheques (which people deposit in their bank accounts) and to that extent the central bank is able to create additional money.

Open market operations, thus, become an important instrument of credit control and produce their effects by altering the cash reserves of commercial banks. Thus, open market operations are the most important day-do-day tools in the hands of central bank. They are extremely flexible both in amount and timing. They affect banking operation with least disturbance. They are useful contra cyclical device and are admirably suited to off-setting undesired changes in bank reserves— that are unplanned.

Limitation:

There are many limitations to the working of open market operations as a method of credit control or credit expansion, as the assumptions on which it depends may not always hold true. For example, whenever commercial banks find themselves with additional cash they will expand credit and, whenever they find their cash reserves reduced, they will contract credit.

Actually, this may not happen. Credit expansion or contraction is more a matter of business psychology and mood of entrepreneurs. If there is a general wave of optimism and expectations of high profits, businessmen will borrow and bankers will lend even though the latter have very low reserves or they may even replenish their cash by discounting some of their eligible bills at the central bank. Further, it has been observed that during depression, even though the banks have high cash reserves, they do not expand credit on account of business pessimism.

Moreover, this method cannot be very effectively used in underdeveloped countries like India and Pakistan as all the conditions, necessary for its success do not exist here. Thus, the degree to which the open market operations can succeed in controlling the credit depends on the stage of development of the capital and money market in the economy and the extent to which central bank is willing to enter into the sale and purchase operations. In spite of its limitations, it has become the chief instrument of credit control in countries like UK and USA, where the money markets are well developed.

3. Bank Rate versus Open Market Operations:

It is necessary to understand that open market operations are by no means intended to do away with the bank-rate policy, it is rather a useful and indispensable complement of the latter. It is obvious that the use of bank rate and open market operations cannot be separated from each other, as each by itself may not be as effective as is desirable. The two methods should be so used as not to counterbalance each other. They have to be coordinated so as to achieve effective results of monetary control.

For example, if the open market policy is not followed by suitable changes in the bank rate, it may prove ineffective. Suppose central bank sells securities in order to control credit but has not raised the bank rate or the rate of discount. Member banks will then replenish their reserves by rediscounting the securities with the central bank because the bank rate is low, rendering the policy of credit control unsuccessful. Had the bank rate been also raised, rediscounting would not have been possible and credit control would have been more effective.

Open market operations are now-a-days used to prepare the market for possible changes in the bank rate. Before the bank rate is increased, securities are sold in the market to prepare the ground before hand to make bank rate more effective.

Prof. Halm remarks, “From the standpoint of their strategic value to the central bank, open market operations possess a degree of superiority over rediscount policy because of the fact that the initiative in the hands of the monetary authority in the case of the former, whereas bank rate policy is passive in the sense that its effectiveness depend on the responses of commercial banks and their customers to changes in bank rates.” Thus, we find that open market operations become superior to bank rate, because they directly increase or decrease the money supply and show quicker and more definite results than the bank rate changes. Moreover, open market operations are less harmful than bank rate changes insofar as they avoid the difficulties of international flows of capital which take place due to changes in the bank rate.

4. Bank Rate and Open Market Operations in Developing Economies:

Bank rate is not very effective in unorganized money markets like India, Pakistan and Bangladesh; where the indigenous, unorganized sector of the money market lies beyond the scope of the control of the central bank. Despite, the bank rate in such developing economies assumes significant role because it is the rate at which the public can obtain accommodation from the central bank, at which commercial banks obtain accommodation from the central bank and has a great psychological value as an instrument of credit control.

Similarly, the efficiency of open market operations is highly doubtful in such economies because the basic conditions for its success like the existence of broad and effective security market, maintenance of fixed cash-reserve ratio are not fulfilled.

The volume of these securities is so small that they can hardly influence the working and credit policies of commercial banks. However, RBI (Reserve Bank of India) admitted, that these operations are not solely designed to suit the role of a full-fledged instrument of credit control but these operations in such economies can be taken to neutralize seasonal movements in the economy. In India, for example, these operations have been resorted to help the government in its borrowing operations and for maintaining orderly conditions in the government securities market, than for influencing the availability of cost of credit.

5. Changes in Reserve Requirements:

Another more effective and direct method of credit control is to effect changes in the legal reserve requirements of the commercial banks. In all countries, every commercial bank is required by law or custom to keep a certain amount of cash reserve with the central bank, usually a certain percentage of its time and demand deposits to ensure liquidity and solvency of individual commercial banks.

Changes in reserve requirements affect the amount of excess reserve which commercial banks must hold with the central bank and hence the amount available for lending or investing. When the central bank wants to control credit, it will absorb the excess reserves by raising the reserve requirements, say from 5 to 10 per cent. This will mean that commercial banks will have to get additional 5 per cent cash by reducing their loans and advances. This method of variations or changes in reserve requirements is better than open market operations because changes in reserve ratios can directly influence the liquidity position of the banks.

They are, therefore, more effective means than open market operations. Moreover, their operations or working does not require a well built organized money market with short and long-term securities as the open market operations would require—these operations of open market affect credit creation only of commercial banks dealing in government securities ; whereas, the variable reserve ratios affect the credit creation capacity of all banks. But this method of credit control has some limitations.

In a period of inflationary boom there is no reason why commercial banks need bother about the reserve ratio, as under such circumstances the banks elect to work with a small amount of cash on account of optimism. Again, if there is a large net inflow of gold, due to say, a constant export surplus, it would increase the reserves of commercial banks, counteracting the effects of higher requirements. Moreover, frequent changes in reserve ratios will be disturbing to commercial banks complicating their customary ways of doing business.

Altering reserve requirements is, therefore, not a normal everyday instrument of credit control. Dr. De Kock remarks, “While it (reserve ratio) is a very prompt and effective method of bringing about the desired changes in the available supply of bank cash, it has some technical and psychological limitations which prescribe that it should be used with moderation and discretion and only under obviously abnormal conditions.”

According to H.G. Johnson, “The disturbing effects of changes in reserve requirements have led most economists to believe that they should be used very sparingly, if at all, especially to control credit expansion,” Haines also expressed the opinion that the power to alter legal reserves is a blunt weapon and may prove dangerous if used indiscriminately. Milton Friedman also asserted that variable reserve requirements are a technically defective instrument for controlling the stock of money and may even be eliminated.

Despite these limitations, it may be said that the authority to change reserve requirements within a limited range has been useful on occasions and is likely to prove useful in future also. To quote Prof. Sayers, “It is a weapon which should always be placed in the hands of a central bank. Given such power, the central bank can perform useful functions that commercial banks cannot be expected to perform.