Have you ever wondered how central banks keep the economy stable and prevent inflation from spiralling out of control? One important tool they use is credit control. But what exactly is credit control, and why is it so important?
Credit control can be concisely defined as the methodology used by financial authorities as the central bank, to regulate the supply of credit in an economy. By adjusting the credit available, those authorities can exert their influence over different macroeconomic variables: inflation, interest rates, and the overall growth in the economy.
Let’s break down what credit control is, credit control techniques, and how they impact you and the economy.
What is Credit Control?
Credit control generally refers to the process of controlling the amount of money and credit in circulation. Credit control of central banks regulates this lending and borrowing in an economy that is neither too low nor too high. This would aid in price stability, controlling inflation, and sustaining economic growth.
Why is Credit Control Important?
Without proper credit control, an economy will be exposed to unnecessary fluctuations. If credit is plentiful and easy to acquire, people and businesses may indulge in borrowing, consequently leading to inflation. On the other hand, if credit is scarce, that means economic growth would face a hindrance.
Thus, the central banks use various credit control techniques to influence the money flow and ensure stability.
Credit Control Techniques
There are several credit control techniques that central banks use to regulate the economy. Each technique works differently, but they all aim to influence borrowing and spending.
Quantitative Credit Control
Quantitative methods are focused on the overall volume of credit in the economy. These techniques impact the total supply of money without targeting any specific sector.
- Open Market Operations (OMO) - Open Market Operations, one of the most commonly used methods of credit control, refers to the buying or selling of government securities in the open market. If the central bank buys securities, it increases the money supply in the economy, inducing banks to lend and consumers to spend. The central bank, on the contrary, would sell government securities to drain money from the economy and discourage excessive borrowing.
- Changing Interest Rates - By changing interest rates, central banks can modify the cost of money on borrowing. High interest rates on loans will be costly for borrowers and hence, it can reduce borrowing and spending, which will control the economy from inflation. On the other hand, low rates will make borrowing cheaper and encourage spending and investment.
- Reserve Requirements - Further, reserve requirements can be altered to affect commercial banks. For example, if the reserve ratio is increased by the central bank, banks will have less money to lend, thereby shrinking credit inflow. Of course, decreasing the reserve ratio will result in more money being available for lending.
Qualitative Credit Control
Qualitative credit control refers to those techniques that are concerned with the nature of credit extended and not with the amount. This includes the regulation of credit availability through various restrictions on certain sectors or types of loans. Thus, it seeks to prevent excessive borrowing in those areas of the economy so that credit is directed towards the areas that are needed most.
Qualitative Measures of Credit Control
There are several qualitative measures of credit control, such as:
- Credit Rationing: This involves setting limits on the amount or type of loans banks can offer for various purposes.
- Regulation of Consumer Credit: Placing terms and conditions on loans for consumer goods to avoid over-indebtedness among individuals.
- Moral Suasion: This is a method through which central banks would usually influence their commercial banks through persuasion rather than through any direct intervention. Or this might be a sort of advocacy for banks to lend more responsibly or avoid risky lending in the concerned areas.
Selective Credit Control
Selective credit control is one of the most efficient methods of credit control. This method allows central banks to restrict credit to specific sectors or industries, thereby preventing them from overborrowing in unproductive sectors of the economy. For example, a central bank might limit credit during periods of inflation for the housing sector or discourage loans in non-productive sectors.
Selective credit control provides evidence for implementing finer-tuning of economic policies. It would ensure that credit flows into specific sectors while avoiding overheating.
For instance, the central bank may say banks should extend more loans to those industries that are related to economic growth, like agriculture or infrastructure, but may equally discourage lending to the non-essential sectors, such as luxury goods.
Final Thoughts,
Credit control is an important tool employed by central banks and financial institutions within an economy to balance their activities. By applying a mix of all the major methods of credit control, including both quantitative and qualitative credit control, it can be useful for policymakers to guide economic development, inflation, and stabilize the financial system. This could be achieved through Open Market Operations and selective credit control, these techniques help maintain the delicate balance between supply and demand for credit in the economy.
Remember, while qualitative credit control and selective credit control may sound complex, they’re just part of the broader effort to create a healthier, more sustainable economy for everyone.
