New Delhi: The Economic Advisory Council to the Prime Minister (EAC-PM) has said that India's priority sector lending (PSL) framework has played a key role in addressing credit market failures and promoting financial inclusion, but cautioned that indiscriminate expansion of directed credit may not necessarily translate into higher economic growth.
In its working paper titled "Economic impact analysis of Priority Sector Lending", the EAC-PM noted that the policy has been operational in India "for almost five decades" and mandates banks to direct "at least 40% of their overall credit towards the priority sector."
The report said the priority sector framework was designed to address systemic equity gaps by ensuring credit flow to small and marginal farmers, micro enterprises and weaker sections.
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According to the paper, earlier studies have shown that directed lending policies helped reduce rural poverty and improve investment and firm performance. "Priority sector advances (PSAs) have been correlated with a decline in rural poverty and an increase in firm and agricultural investment and firm performance," it said.\
At the same time, the EAC-PM warned that such lending policies also carry risks. "Diversion of credit to potentially inefficient sectors can harm total factor productivity," the report said, adding that directed lending policies may also impact "bank profitability due to the associated risk of asset default and high asset management costs."
The paper analysed district-level quarterly RBI data between 2020 and 2025 to assess the impact of priority sector advances on output growth. Using night time luminosity as a proxy for economic activity, the report found that an increase in PSA growth rate does not significantly impact a district's output over a two-year horizon.
It further observed considerable variation across districts. "The bottom 10 percentile of districts (in terms of outstanding PSAs) had the lowest elasticity as compared to other district tiers," the report stated.
The EAC-PM said that forcing additional credit allocation to poorer districts through a top-down mandate may not be efficient. "Increasing the allocation of PSAs to these districts using a top-down bank mandate will be inefficient in terms of growth," it noted. Instead, "targeted interventions that holistically tackle binding development constraints (including access to finance) are likely to give better outcomes."
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The report also examined the functioning of Priority Sector Lending Certificates (PSLCs), introduced by the Reserve Bank of India in 2016. These certificates allow banks to trade priority sector obligations without transferring the underlying credit risk.
According to the study, "PSLCs help mitigate bank profitability risks from PSAs by allowing banks to trade the fulfilment of priority sector obligations at a market determined rate without trading the underlying asset or risk."
The analysis found that PSLCs enabled banks to lend according to their operational strengths without altering the regional distribution of PSAs or output growth.
