IT IS often felt that credit policy in a developing economy should be selective. Monetary management should not merely aim at a general restraint or spur to economic activity; it should also try to influence different economic activities in different ways. A number of devices have accordingly been adopted in recent years, particularly in Latin America, to provide specific encouragement or discouragement to certain types of investment and expenditure.¹

Some General Considerations

Selective credit controls are intended to encourage or discourage specific types of investment and expenditure by influencing the lending policy of banks and similar credit institutions.² In evaluating the usefulness of these controls and of the different techniques for selectiveness, it is necessary first to define the basic objectives to be fulfilled.

A policy of selective credit control may be adopted, for example, as an adjunct to a well-balanced development program. The basic problems in an underdeveloped country are to achieve a high level of savings and investment and to ensure that the funds available for investment are directed to socially desirable channels. It is often contended that there is an institutional bias in underdeveloped countries in favor of investment in construction and trade to the detriment of more productive alternatives available in industry and agriculture. The traditional regard for short-term “self-liquidating” loans on the part of the banks encourages purely commercial activities as distinguished from production; and in the absence of adequate facilities for medium-term or long-term credit, some of the existing opportunities for increasing production are wasted. Selective credit controls may also be necessary to protect the interests of certain ill-organized sectors of the economy, whose credit needs are not satisfied by existing institutions. Attempts to develop an economy are often accompanied by egalitarian measures, such as the division of large estates among small peasant proprietors, and such measures often create new ill-organized areas with special credit needs. Another justification for selective credit control as a long-term policy arises from the urge to diversify the economic structure.

These considerations are undoubtedly significant in many underdeveloped countries. Nonetheless, selective credit controls have only a limited role to play in the process of well-balanced development. Their ultimate objective is to ensure that bank credit is used in accordance with a certain order of priorities. If these priorities do not correspond to the lending policy of the banks but are in conformity with the investment preferences of borrowers, it is enough to control the banks; and this is a comparatively easy task. But if selective credit controls are intended to modify the investment decisions of borrowers, as well as to alter the lending policy of banks, it becomes necessary to check on the actual use made of bank credit. More often than not, the bias in favor of “undesirable” investment or expenditure is on the part of borrowers as well as lenders; and this situation requires something more than selective credit controls.

A distinction should also be made between attempts to encourage a better use of existing investment opportunities and efforts to create new investment opportunities by suitable assistance. If production of certain types is to be encouraged in the interests of diversification or for other reasons, some assistance or protection may be necessary in the short run. But preferential credit arrangements can be only the first step in such a policy. Unless attempts are made simultaneously to remove the other bottlenecks in production and to divert demand, if necessary, to the desired lines of production, selective credit controls will lead only to bad debts and hidden subsidies. As a device for forcing the pace of development in certain lines, selective credit controls should not be allowed to divert attention from more basic solutions or difficulties.

Apart from this, only some of the investment in a community is financed by bank credit. A large part of the investment which is self-financed or financed through the capital market or through private borrowing would be left untouched by efforts to modify the pattern of bank credit. What is more, the possibility of substitution between bank borrowing and other finance would reduce the significance of any selective controls over banks. It is arguable that these considerations are not so important in underdeveloped countries, where capital markets are generally nonexistent and where much reliance is placed on credit institutions for most short-term as well as long-term credit needs. It is also true that, in a developing economy, the total volume of credit is likely to expand in the course of time, and that monetary authorities have better chances of success in channeling an expansion of credit along the desired lines than in changing the distribution of a given amount of credit. Nevertheless, a large part of the investment activity going on at any time must remain outside the purview of selective credit controls.

Selective credit control may be adopted less as a long-term objective than in response to some short-term difficulties, e.g., during a period of active inflation. It is now generally recognized that inflation creates balance of payments difficulties and encourages too much unproductive investment in inventories, luxury construction, etc. The introduction of selective credit controls in many Latin American countries in recent years has been motivated largely by the desire to minimize these adverse consequences of inflation. The reasons for adopting a policy of selective credit control during a period of active inflation, however, need careful consideration.

It may be hoped, for example, that selective credit controls would enable a country to achieve a supposedly higher rate of savings and investment through inflation without any serious misdirection of resources or without serious balance of payments difficulties. The need for exercising a general restraint on credit would be obviated insofar as all “undesirable” credit is eliminated by selective controls over credit for construction, imports, inventories, etc.

It is not necessary to discuss here the general case for or against inflation as a means of financing development. Nor is it necessary to show why any attempt to prescribe the purposes for which bank credit could be used is bound to be futile as long as credit for ostensibly desirable purposes is available without any restraint. But even if the assumption is made that selective credit controls are effective in curtailing certain types of investment or expenditure, it does not follow that the resources so released will be automatically transferred to more productive uses. The reason for excessive investment in inventories and real estate during inflation may well be that such investment constitutes, in the short run, the major practicable channel for private enterprise. Even if other opportunities for additional investment are available, a period of inflation with the inevitable social tension and uncertainty may not provide the right atmosphere for such productive investment. If this is the case, selective credit controls will only reduce the general level of expenditure and as such the pace of inflation. But if this result is acceptable, it could be achieved more easily by straightforward or general credit controls. It is difficult to see how selective credit controls can offer any justification for pursuing a deliberately inflationary policy.

Alternatively, selective credit controls may be adopted to prevent inflation from getting out of hand. Even if it is not possible to avoid a certain degree of inflationary pressure, as a result of budgetary difficulties, for example, it may be desirable to prevent a secondary expansion of bank credit. This can be done by general credit controls. But if the inflation is very mild and if the expansion in credit is likely to be concentrated in certain areas, such as credit for imports, it may be sufficient to control credit conditions on a selective basis. In short, selective credit controls may serve as a useful substitute for general credit controls in a very mild inflation.

Another circumstance in which selective credit controls can be particularly useful is during the process of stabilization. After a period of prolonged inflation, the only way to restore confidence in the currency may be to bring the expansion of credit to a halt. If the measures taken to achieve this are very restrictive, some genuine needs for credit may not be met and there may be adverse repercussions on production. On the other hand, if some increase in credit is permitted, it may still be necessary to ensure that the credit is used for the right purposes. Selective exceptions to the highly restrictive general credit controls may be quite effective in these circumstances.

To sum up: in considering the usefulness of selective credit controls, certain distinctions must be kept in mind. Are they used as long-term devices or as short-term expedients? If they are used as an adjunct to the long-term process of development, is the intention to influence the lending policy of banks, or to alter the investment preferences of borrowers, or to create new investment opportunities? In the short run, are they employed as exceptions to a tight money regime, or as a means of exercising a general restraint on credit, or as a way of obviating the need for any restraint on the over-all supply of credit?

Techniques of Selective Credit Control

An active use of credit policy rests on the assumption that the general level of effective demand, and consequently the general level of prices and production, can be influenced by modifying the availability and cost of credit. In attempting to encourage or discourage specific types of activity, selective credit controls assume further that the pattern of investment and production can be influenced by differentiating between the cost and availability of credit to different sectors.

Apart from exhortations and moral suasion, selectiveness can be introduced in credit policy in two ways. The allocation of bank credit may be influenced directly by stipulating the loans that can be made, the amounts, the rates of interest, the duration, the type that is not desirable, the amount of collateral, etc. Alternatively, if the central bank actively assists or controls the banking system, such assistance or controls may be exercised selectively, so as to influence indirectly the behavior of the banks. For example, rediscount rates or rediscount ceilings may be different for different types of loans; where reserve requirements are imposed, some selective exceptions may be made. In short, the cost and availability of bank credit to different sectors can be differentiated by direct regulation or by indirect inducements to the banking system in terms of the cost and availability of liquid funds. By and large, the direct type of selective control entails a greater administrative burden for monetary authorities.

Selective Credit Control as a Long-Term Objective

If the credit needs of the community are not met adequately by existing institutions, the government can set up new or specialized credit institutions. Almost all Latin American countries in recent years have set up such institutions to meet the special needs of agriculture or of new industries. Whatever the defects in the actual operation of these institutions, the basic idea in setting them up is undoubtedly sound.

In the extreme case, governments can impose their own pattern on loans by centralizing much of the credit activity in official or semiofficial agencies. Such a result can be achieved in part if governmental credit agencies appropriate for themselves the entire growth potential in credit. If reserve requirements and credit ceilings make it virtually impossible for private banks to expand credit, there is, so to speak, a nationalization of banking at the margin. Many of the smaller Latin American countries have already moved to a position where the desire for selectiveness has led to an increasing concentration of credit facilities in official entities. However, if private banks are to be assigned a significant role in the economy, it becomes necessary to influence their decisions.

The traditional fears of private banks concerning medium-term or long-term loans of a productive character may be allayed by appropriate government guarantees or rediscount facilities. A more fruitful approach may be to explore the possibility of joint loans by the commercial banks and the state-managed development finance institutes.³ Thus a five-year loan for the purchase of industrial machinery may be made jointly, with the provision that the bank’s share will be paid back in the first year or two and can be transferred to the development institute. If the commercial banks do not have the technical staff to appraise the soundness of new schemes, the cooperation of a government agency will help to create the necessary confidence. And the banks’ knowledge of particular customers and of their other activities will facilitate a better supervision of the loan.

If it is not possible to induce banks to make productive loans on an adequate scale, some measure of compulsion may be used. For example, ceilings may be established for certain types of loans so as to encourage diversion of funds into desired channels. Such a policy, however, is hardly desirable as a long-term objective. With the general growth of the economy, the ceilings have to be revised from time to time; and insofar as all banks do not grow at the same rate, any approach through absolute ceilings may create some injustice. Apart from this, any categorization of bank loans is bound to be arbitrary, to some extent. A loan for commercial purposes, for example, cannot be distinguished easily from a loan to industry for raw material requirements. The monetary authorities would have a burdensome administrative task of deciding whether particular loans conform to the classification laid down by law.

Alternatively, commercial banks may be required to distribute their assets in a certain manner. For example, it may be obligatory for banks to hold at least 10 per cent of their assets in government securities. The government can use the proceeds of such loans for financing official credit institutes. But clearly, such a measure reduces rather than modifies the role of the banks. Stipulations may be made about other aspects of a bank’s portfolio, requiring, for example, that loans to agriculture and industry shall not fall below a certain proportion. Here again, the problem arises of establishing uniform standards for the classification of loans; and the consequent interference and supervision by monetary authorities may not be desirable as a permanent or long-term feature.

Another technique which offers a compromise between compulsion and encouragement involves higher reserve requirements with specific exemptions. Assume that the banks keep all their cash as deposits with the central bank, and that a ratio of cash to deposits of 10 per cent is regarded as safe or necessary by the banks to meet their normal requirements. The banks, however, may be required to hold, say, 20 per cent of their deposits as reserves, with the provision that at least half of the required reserves must be kept as deposits with the central bank and the remainder held in the form of certain preferred assets or securities. This technique has been adopted in Mexico.

The reason why this arrangement induces banks to change the composition of their loans in favor of the preferred category is easy to see. Other things being equal, the volume of their loans would be increased if their lending were concentrated on the preferred type of asset that constitutes a part of the required reserves.

The technique under consideration has the great advantage of administrative simplicity. The basic reserve requirements, although high, need not be so high as to prevent banks from expanding their activity as their deposits grow; and there is no compulsion on the part of the banks to increase their loans in any set proportion. Consequently, the central bank is not required to scrutinize all the loan operations of banks. It merely has to ensure that the loans which it accepts as part of required reserves actually conform to the prescribed type.

On the other hand, the selective impact of higher reserve requirements with specific exemptions may not be as great as appears at first sight. When banks make loans, they need additional cash for two reasons. Part of the loan may be taken out in cash by the borrower; and the part which remains as an increment to deposits kept at that bank or other banks requires more cash as a normal backing or in view of legal requirements. In underdeveloped countries, where the ratio of currency to money supply is very high, the first drain on cash reserves is by far the more important, unless legal reserve requirements are very stringent. This tends to reduce the discriminatory significance of any provisions concerning reserve requirements.

It is also arguable that, even if the banks are able to increase their loans more by concentrating on preferred types, they may not do so. It will be a matter of indifference to the bank whether it lends four units for one purpose or five units for another purpose, if it can charge a higher rate of interest for the first category of loan. However, such a discriminatory interest rate policy can be discouraged if the central bank prescribes maximum rates of interest for nonpreferred categories of loan. Apart from this, if the banks prefer to continue lending for less desirable purposes, their total loans will in any case be smaller, inasmuch as required reserves will be higher on the average. This will enable official credit agencies to increase their encouragement to the desired lines.

Selectiveness may be introduced through reserve requirements in a number of ways. If required reserves are related to deposits, some preferred assets may simply be deducted before calculating required reserves. Alternatively, required reserves may be related to bank assets rather than to deposits, and different requirements may be set for different assets.⁴ It is not necessary, however, to comment on all these variations.

On the whole, if selective credit controls are intended to correct a long-term bias in the lending policy of banks, techniques adequate for the purpose can be devised.

Selective Credit Control as a Short-Term Expedient

Some of the techniques discussed above can be useful as purely short-term expedients. It is obvious, for example, that if a tight rein is kept on credit expansion by rigid credit ceilings or stringent reserve requirements, the special needs of some sectors can be satisfied by selective exemptions. Whenever quantitative limits are placed on the total credit that a bank can give to any one customer (e.g., in Paraguay) or to all its customers, it is generally provided that these limits may be exceeded in specific cases, with the prior approval of the central bank. Such a selective approach can be effective when it is combined with highly restrictive general credit controls. There is no reason why the banks should want to flout the wishes of the central bank, and there will be better supervision of the end-use of credit when the few selective exemptions are scrutinized individually.

The situation is quite different, however, when selective techniques are adopted in an inflationary situation, without any attempt to control the general expansion in credit. This can be shown easily by an examination of some of the expedients used for the purpose.

In most countries, the monetary authorities rely primarily on recommendations to the banks for avoiding credits for certain purposes. But such exhortations are not likely to be very effective even when they are sanctified in the form of a semilegal decree. The banks have no incentive to comply with such requests; and even if some of them are imbued with a sense of social discipline, compliance places them at a disadvantage in relation to less scrupulous banks. The environment in many underdeveloped countries is hardly such as to sustain any concerted self-restraint on the part of the banks. Even if the banks respect the wishes of the monetary authorities, they are not able to control the end-use of their credit to any great extent. As long as inflation continues and the banks are in a liquid position, they will lend rather freely for ostensible purposes that are not frowned upon; and they will not be able to prevent the use of loans for purposes different from those intended by them. In the absence of other sanctions, selection by exhortation is likely to produce complacency rather than results.

The central bank may attempt to influence the banks indirectly by a selective rediscount policy. It may refuse to rediscount certain types of credit, or it may charge higher rates of interest for certain rediscounts. The limitations of such a policy are also obvious, however. Banks can rediscount eligible paper in order to extend credit in undesirable fields. During a period of inflation, the banks need not rely much on central bank rediscounting for expanding credit if the central bank is already providing reserves, for example, by financing budget deficits. And even if the banks are influenced by discriminatory rediscount facilities, they are in no better position to control the end-use of their credit.

One measure frequently adopted and which seeks to influence bank lending indirectly, viz., prior deposit requirements for imports, is of special interest. Underdeveloped countries are particularly susceptible to balance of payments difficulties under inflationary conditions, the excess demand tending mainly to increase imports. In addition, the constant expectation of devaluation leads to excessive stockpiling of imports. In order to curtail the demand for imports (or to ease the pressure on exchange controls), special credit requirements are often imposed in relation to imports. One that is frequently imposed requires an importer to deposit with the central bank at the time of applying for an import license—i.e., in advance of the purchase of foreign exchange—a part of the local currency equivalent of his imports. An import license is generally required at the time of placing an order abroad, even before the goods are shipped, whereas the payment to the supplier and the purchase of foreign exchange for the purpose can in some cases be deferred until the goods are shipped or even received. The prior deposit requirement, therefore, creates an artificial need for credit on the part of the importer. The importer may be able to borrow the sum required from a bank; but insofar as the deposit is transferred to the central bank, there will be an equal decline in the reserves of the banking system.

It is evident that prior deposit requirements of this kind for importers will have some anti-inflationary effect. If an artificial need for credit is created, and if bank reserves are reduced to the full extent of any increase in bank credit to meet this need, the liquidity of the banks is reduced effectively. Such an indirect way of curtailing the ability of the banks to expand credit has the great advantage of administrative simplicity.

It is not clear, however, that the restrictive effect will be felt primarily in the demand for imports. As far as the importers are concerned, the only unfavorable development is the increased need for borrowing in relation to a certain amount of imports. But the additional interest cost of such borrowing is likely to be only a minor deterrent in a period of inflation. The banks certainly have an incentive to avoid loans for financing prior deposit requirements for imports. Such loans tie up their reserves more than other loans. However, the banks are not in a position to decide the extent to which their loans are used for one purpose rather than another. As long as part of their loans (or current deposits) are used for meeting prior deposit requirements for imports, the banks will suffer the same immobilization of reserves. It seems, therefore, that such deposit requirements are more useful as generally restrictive measures than as devices for curtailing imports.

The effects of prior deposit requirements for imports as a generally restrictive device are of a once-for-all character, however. The restrictive effect comes into operation when the requirements are introduced and whenever there is a subsequent increase in imports. If the banks have sufficient excess reserves or if such reserves are being created continuously, even the once-for-all effect will not be of much significance.

The prior deposit requirement for imports cannot be employed in the absence of a system of import licensing. In such cases, banks may be required to keep an advance deposit with the central bank against letters of credit covering imports; and the deposit requirement may differ according to the type of import covered by the letters of credit. In principle, this device is similar to differential reserve requirements against different types of bank assets. If an importer cannot substitute for a letter of credit other means of payment, such as direct cash payments, the requirement of a prior deposit may prove effective in curtailing the demand for undesirable imports. The banks may, as was argued earlier, prefer to acquire assets other than letters of credit for importers; and even if they do not alter their lending policy because of inertia or irrationality, or because they are able to charge differential rates of interest, some general restraint on credit will be exercised.

It is arguable that, on the whole, it would be better if the banks did not modify their lending policy in response to prior deposit requirements for imports, for the prior deposit requirements would then at least have an immediate general anti-inflationary effect. If instead the banks should avoid credit for imports so as to make larger loans for other purposes, the inflationary pressures would be increased, and it would become even more difficult to avoid balance of payments difficulties at a later stage. In short, it may be advisable to treat prior deposit requirements for imports as a useful means of curbing inflationary pressures in general rather than as a device for curbing the demand for imports in particular. If this view is correct, their desirability would depend on a comparison with the probable effects of straightforward reserve requirements.

Another approach to selectiveness during an inflation, which deserves some attention, is margin requirements for certain types of collateral. Banks generally require some collateral against their loans, which in underdeveloped countries often consists of inventories, real estate, land, gold, or foreign exchange—i.e., precisely the type of asset whose accumulation needs to be discouraged. The monetary authorities may require that loans secured against certain types of collateral shall not exceed a certain proportion (say, 80 per cent) of the value of such collateral. In the extreme case, some types of asset, such as gold, may be declared ineligible as collateral.

Such a provision poses an obvious problem of enforcement. The valuation of real estate or land must remain arbitrary to some extent, and any overvaluation would tend to nullify the effect of margin requirements. Again, such requirements are not selective enough. If inventories in general are excessive, some inventories are nonetheless essential. For small merchants and producers without other assets, inventories may be the only collateral available (or acceptable to the banks), and they would have a legitimate grievance if inventories were ruled out as collateral. In theory, this difficulty can be overcome by selective exemptions for small borrowers. But this may defeat the purpose as far as large borrowers are concerned. The banks would be less reluctant to increase their unsecured loans to big borrowers, especially when they know that their loans against inventories or real estate are oversecured. In order to be effective, margin requirements for collateral require that the banks should not increase the proportion of unsecured loans beyond a point, and that the substitution between different types of collateral by borrowers can be made only to a limited extent.

Even when margin requirements for certain types of collateral are an effective deterrent to credit expansion, the question still remains whether their usefulness lies primarily in their generally restrictive effect or in the selective character of the restraint exercised by them. Insofar as the amount of credit tends to be related to the amount of collateral, margin requirements of this kind act essentially like reserve requirements. By reducing the base for bank borrowing, so to speak, they act as a general deterrent to the expansion of bank credit. Faced with the prospect of smaller accommodation from banks, borrowers would curtail their expenditure. But it does not follow that the reduction in expenditure would fall entirely or primarily on inventories or luxury construction. It is arguable that investment in inventories or luxury construction would become relatively less attractive insofar as their usefulness as collateral is diminished. But apart from this consideration, margin requirements would achieve little more than straightforward credit restraints, such as credit ceilings and reserve requirements, which are easier to administer.

These comments on margin requirements are made, having in mind particularly the possibility of excessive “new” investment in certain lines. During an inflation, bank credit is used also to create a speculative boom in the market for existing assets, such as land, houses, etc.—with these assets themselves serving as collateral for the credit. That high margin requirements may serve a useful purpose in curbing such speculation has been shown by the experience of the United States in connection with securities.

Summary

All these considerations show that any attempt to generalize about the effectiveness or desirability of selective credit controls is bound to be misleading. They are adopted for a variety of reasons and under different sets of circumstances. They may be adopted during a period of active inflation in the hope of minimizing the distortions introduced by inflation into the pattern of investment. Alternatively, if a tight money policy is pursued to bring inflation to a halt, it may be felt desirable to protect certain forms of investment from the generally restrictive trend. These cases should be distinguished from selective credit controls applied in an environment of monetary stability in response to certain long-term objectives or structural needs.

If selective credit controls are applied in the hope that there can be inflation, and the supposedly higher level of investment resulting therefrom, without any misdirection of resources, they are likely to prove disappointing. On the other hand, they can be quite useful as temporary correctives during a determined effort at stabilization or as long-term devices to aid the process of well-balanced development. The techniques for introducing selectiveness on a long-term basis would, of course, differ from those suitable as short-term expedients.

In some cases, selective credit controls may be adopted as an economical way of influencing the general level of demand rather than as a means of influencing certain types of demand. If fluctuations in effective demand are concentrated in certain sensitive areas, and if these areas are particularly susceptible to changes in credit conditions, a decisive influence on aggregate demand may be exercised by controlling credit conditions in a few strategic fields only. This is in part the rationale of the control of durable consumer goods and housing credit in the United States. It is arguable that some of the techniques adopted recently in Latin America for influencing particular types of demand are, in fact, more useful for exercising a general restraint on credit. In judging the usefulness of selective credit controls, this aspect of the problem should also be borne in mind.