A Cooperative Bank, a Weaver, and a State Borrowing Programme
The Karur District Cooperative Bank receives ₹2 crore of fresh deposits from handloom exporters in a single month. Its board meets with two items on the agenda. First, the cash reserve ratio is 10 per cent, and the manager has kept the entire reserve idle while refusing a ₹40 lakh working capital loan to a weaver's society; the manager says the bank "has no funds to spare". Second, the state government has announced a market borrowing to build a bridge and a new secretariat block, and the bank's treasury officer wants to park the new deposits in state government securities, which qualify for the statutory liquidity ratio and carry an assured return. Attached to the agenda is the state's budget summary for the year: revenue receipts ₹1,20,000 crore, revenue expenditure ₹1,35,000 crore, capital expenditure ₹25,000 crore, recoveries of loans ₹2,000 crore and interest payments ₹18,000 crore. The board must decide both on the weaver's loan and on its view of the state's borrowing.
1. Compute the total deposits and total credit the banking system can create from the ₹2 crore at a 10 per cent cash reserve ratio, and explain the process step by step.
Read the worked answer
Multiplier. Credit multiplier = 1 ÷ CRR = 1 ÷ 0.10 = 10
Totals
- Total deposits created = ₹2 crore × 10 = ₹20 crore
- Reserves held = 10% of ₹20 crore = ₹2 crore
- Total credit created = deposits − reserves = 20 − 2 = ₹18 crore
The process (round by round)
- Primary deposit ₹2 crore; bank keeps ₹20 lakh (10%) and lends ₹1.80 crore.
- The borrower pays a supplier, who deposits ₹1.80 crore; the bank keeps ₹18 lakh and lends ₹1.62 crore.
- Next round: deposit ₹1.62 crore, reserve ₹16.2 lakh, loan ₹1.458 crore, and so on.
Total deposits = 2 + 1.8 + 1.62 + … = 2 × 1/(1 − 0.9) = ₹20 crore, a geometric series.
Assumptions that must be stated. No currency drain (the public re-deposits every rupee), no excess reserves, no other leakages, and every borrower spends the loan within the banking system. In this bank the assumption fails: the manager is holding cash above the requirement, so actual credit creation will be below ₹18 crore. Excess reserves are a leakage exactly like currency held by the public, and they shrink the multiplier.
2. Compute the revenue deficit, fiscal deficit and primary deficit from the budget summary, and comment on whether the state's borrowing is financially sound.
Read the worked answer
Working
- Total expenditure = revenue expenditure ₹1,35,000 crore + capital expenditure ₹25,000 crore = ₹1,60,000 crore
- Total receipts excluding borrowings = revenue receipts ₹1,20,000 crore + recoveries of loans ₹2,000 crore = ₹1,22,000 crore
| Deficit | Formula | Value (₹ crore) |
|---|---|---|
| Revenue deficit | Revenue expenditure − revenue receipts | 1,35,000 − 1,20,000 = 15,000 |
| Fiscal deficit | Total expenditure − total receipts excluding borrowings | 1,60,000 − 1,22,000 = 38,000 |
| Primary deficit | Fiscal deficit − interest payments | 38,000 − 18,000 = 20,000 |
The fiscal deficit of ₹38,000 crore is the amount the state must borrow.
Is the borrowing sound?
- Golden-rule test. Borrowing is defensible when it finances capital expenditure that yields a return sufficient to service the debt. Capital expenditure here is ₹25,000 crore, but borrowing is ₹38,000 crore - about ₹13,000 crore of borrowing finances consumption, not assets. Indeed the revenue deficit of ₹15,000 crore on its own implies that at least that much borrowing goes into current spending.
- Primary deficit. Even after removing interest, receipts fall short by ₹20,000 crore, so the debt will keep compounding rather than stabilising.
- Interest burden. Interest payments are 18,000 ÷ 1,20,000 = 15 per cent of revenue receipts, which crowds out salaries, maintenance and development spending.
Verdict. The bridge is financeable by borrowing; the secretariat block and the revenue deficit are not, on a strict golden-rule reading. A sounder package would match borrowing to the capital component and raise revenue receipts or cut current expenditure to close the ₹15,000 crore revenue gap.
3. Explain how the bank's refusal to lend and its preference for state securities can be described as crowding out, and evaluate whether the refusal is justified.
Read the worked answer
The crowding-out mechanism. When the government borrows ₹38,000 crore, it competes for the same pool of savings that would otherwise finance private borrowers. Government securities are SLR-eligible, carry a sovereign guarantee and need no monitoring; a ₹40 lakh loan to a weaver's society carries default risk, appraisal cost and follow-up cost. Faced with a safe alternative, the bank either demands a higher rate from the weaver or rations credit outright. Here the weaver is refused even though the bank has just received ₹2 crore of new deposits - the classic symptom of crowding out, where private investment falls because public borrowing has absorbed the funds.
Evaluating the refusal
- The stated reason is false. "No funds to spare" is not true: the bank has deposits and a theoretical lending capacity of ₹18 crore. Holding excess reserves is a choice, not a constraint - and it is a choice that itself contracts money supply by reducing the multiplier.
- The financial logic is defensible. A cooperative bank must protect liquidity and solvency; long-gestation lending out of volatile exporter deposits is genuinely risky, and the treasury officer's preference for SLR securities is prudent portfolio management.
- The economic cost is real. A working-capital-starved handloom society sheds employment in a labour-intensive export cluster, while the funds go to a bridge with a long gestation and a secretariat building that produces no marketed output. The opportunity cost is the weaver's output forgone.
A reasoned decision. Split the funds: lend a monitored, repayable portion to the weaver's society against a workable schedule and hold the balance in securities; and report the refusal to the lead bank so that priority-sector targets and the reasons for shortfall are on record. The board should also note that if the state raises its borrowing further, the spread in favour of government paper will widen and the weaver's access to credit will worsen.