Innovation in Private Credit Products Can Boost Economic Growth
STORY INLINE POST
There is a direct correlation between the increase in private credit and economic growth. It has been proven that periods of rapid expansion in private credit over the past 50 years have played a prominent role in economic activity.
A proxy for financial development of a country or across countries is the level of private debt to GDP, as we can associate this to real GDP per capita. Having said that, it is expected that developing countries will have a lower private debt penetration compared to developed countries. It wouldn't be realistic to compare Mexico, or any Latin American country, to the US but let’s do that just so we can visualise the gap: private debt to GDP in the US is 216%, in Latin American it is at 45% and in Mexico, it is at 38%.
So why is there such a big gap, even between Mexico and Latin America, and between both of them and the US? Everyone will tell you that the main reason is the percentage of the banked population, and yes, if we compared this, the US only has 4.5% of its population unbanked while Mexico, even with recent years growth, is at 60%; but if you ask me, there are two main reasons, apart from the unbanked population: current rates and the lack of innovation in products.
So why do I feel rates have an effect? Going back to the basics of economics: price elasticity of demand, which in simple terms is a measurement of the change in consumption or quantity of a product in relation to a change in its price. We could say that credit is elastic, although how elastic it is can vary depending on the price itself. Let’s look at the demand of credit and its elasticity, without getting too technical. At a certain rate, you have X demand for credit. If rates go lower, you can boost quantity (just as we saw with housing stats in the US from the start of the pandemic until late 2021), but there is a point where even if you lower the rate further, the change will be less. On the other hand, by bringing rates higher there comes a point where you will affect demand more than the benefit of increasing rates, or even kill demand with little change.
Now, let's go back to the main idea of increasing debt availability in a country. Having available credit supply can finance an expansion in the demand or even increase the productive capacity of an economy. Mexico has seen a clear boom in credit demand over the last 10 years. If we were to look into the data provided by the World Bank, we would notice that private credit as a percentage of GDP grew from 24.5% to 38% as of 2021. I am sure that if nothing changes, this percentage will keep on growing at the same annual rate of 1% to 2%. In order to get to a higher level and to see a clear boost in the economy, there needs to be innovation in the products and its rates available to clients; both businesses and individuals are limited by high rates for credit, which limits debt issuance.
Let's look a little bit more into the business of lending. Banks usually fund their operations from several sources, including the savings and deposits of their own clients and money that is lent to clients at a certain rate. This rate is usually linked to the overnight interbank funding rate from the central bank (in the case of Mexico: Banxico). From there, they will lend at a higher rate, giving the bank margin to generate revenue, usually called interest margin.
Now, depending on the product and the risk involved in that product, the interest rate the bank will charge may differ. Lending to a corporation is different from providing a credit card to a client as the risk involved in the latter is much higher and with that comes a high rate.
For this main reason, we can’t have a solution as simple as a lower rate for all products and, as a consequence, a boost in the economy. If it was that easy, we would just go to zero rates. We still need to consider funding, as mentioned earlier, as one can’t lend at a rate below the borrowing rate, and the risk involved with each product.
What corporations can do is to start innovating with new products that have more accessible rates and to find ways to control the risk involved in that product.
At Blum, we want to challenge the banking ecosystem and be a key agent for economic growth by increasing credit demand in Mexico. We are looking at innovating with new revolving credit options and lowering the risk of our credit products by asking for collateral and as a result, being able to offer a cheaper, more attractive interest rate to our clients.
Let’s take, for example, credit cards. In the US, the average credit card interest rate is 19.07%, while Mexico averages 80.29%, having a range between 45.5% and 118.7%, according to the June 2022 Banxico report. Of course, this wide range is associated, in part, with the specific risk each institution is assuming with each product and target market, but in some cases banks tend to have excessive rates, which is the main reason (elasticity of demand) why credit expansion has been limited.
We believe we can lower the rate to between 25% and 27% and be able to manage risk and have an acceptable nonperforming loan rate of 1% to 2% below the main players in the industry. All this without sacrificing interest margin; in other words, earnings.
Although we are pioneers in innovation regarding private credit in Mexico, we believe that more will follow, and together we can boost credit penetration.