Vivek Kaul
On October 3, 2013, the finance ministry headed by P Chidambaram put out a rather nondescript press release, in which it said “The Central Government has decided in principle to enhance the amount of capital to be infused into Public Sector Banks (PSBs). It may be recalled that in the Budget for 2013-14, a sum of Rs. 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently. The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two wheelers, consumer durables etc, at lower rates n order to stimulate demand.”
In other words, the government of India will provide public sector banks more money than what it had budgeted for, so that they can lend it to borrowers to buy two wheelers and consumer durables. And this would revive consumer demand and in turn economic growth.
Now only if economics worked in such a linear sequence, even I could be the RBI governor. The first question is where is the government going to get this ‘extra’ money from? As Deputy Governor of the Reserve Bank of India K C Chakrabarty put it on Saturday “How much (will the government put in)? If the government has so much money, then no problem.”
The government of India (like most governments in the world) spends more than it earns. Hence, it runs a fiscal deficit. This deficit is financed by selling government bonds. Who buys these bonds? Banks and other financial institutions.
Latest data released by RBI shows that as on September 20, 2013, the banks had a credit deposit ratio of 78.2%. This means that for every Rs 100 that banks had borrowed as a deposit, they had lent out Rs 78.2.
The banks need to maintain a cash reserve ratio of 4% i.e. for every Rs 100 they borrow as a deposit, they need to maintain a reserve of Rs 4 with the RBI. Other than this banks need to maintain a statutory liquidity ratio of 23% i.e. Rs 23 out of every Rs 100 borrowed as a deposit, needs to be invested in government bonds.
Hence, Rs 27 (Rs 23 + Rs 4) out of every Rs 100 borrowed as a deposit goes out of the equation straight away. This means only Rs 73 out of every Rs 100 borrowed as a deposit can be given out as a loan. But as we saw a little earlier the Indian banks have lent Rs 78.2 for every Rs 100 they have borrowed as a deposit.
This means is that banks are borrowing from other sources in the market to lend money. Why would they do that ? They are doing that because they aren’t able to raise enough enough deposits. Lets look at data over the last one year (i.e. between Sep 21, 2012 and Sep 20, 2013). Deposits have grown at a pace 11.9%. Loans have grown at a much faster 15.4%. The incremental credit deposit ratio is at 101.4%. What this means is that for every Rs 100 raised as deposit, banks have given out Rs 101.4 as loans. Ideally, for every Rs 100 raised as a deposit, banks shouldn’t be lending more than Rs 73.
Hence, banks have a paucity of funds going around. In this situation, if the government chooses to hand over extra capital to public sector banks, it will have to finance this transaction by selling government bonds. Banks and other financial institutions will buy these bonds. As we saw, banks are already stretched when it comes to deposits. In order to buy these bonds, banks will have to raise extra deposits by offering a higher rate of interest. Or they will have to raise money from sources other than deposits, and that will mean paying a higher rate of interest. And when they do that how can they be expected to lend at lower interest rates?
The finance minister has been pretty vocal about the fact that the government won’t let the fiscal deficit cross the level of 4.8% of the GDP, that it had projected in the annual budget. The trouble is that in the first five months of the financial year (i.e. between April-August 2013), the fiscal deficit has already touched 74.6% of its annual target. If the government wants to provide extra capital to public sector banks then it would lead to more expenditure, making it more difficult for the government to stick to the fiscal deficit target.
Given this, the government may look to finance this transaction by cutting other expenditure. In this scenario, it is more likely to cut planned expenditure than non planned expenditure. Planned expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government. Non- plan expenditure is an outcome of planned expenditure. For example, the government constructs a highway using money categorised as a planned expenditure. But the money that goes towards the maintenance of that highway is non-planned expenditure. Interest payments, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure.
As is obvious a lot of non plan expenditure is largely regular expenditure that cannot be done away with. Hence, when expenditure needs to be cut, it is the asset creating planned expenditure which typically faces the axe and that is not good for the overall economy.
It also needs to be pointed out that currently the market for two wheeler and consumer durable loans is dominated by private players and not public sector banks. People stay away from public sector banks because of the high level of documentation required. As a senior executive of Bajaj Auto told DNA recently “Currently, NBFCs and private banks dominate the two-wheeler finance market. So, I don’t think the move will have any major impact.” Hence, just offering lower interest rates on loans is not enough to get people to borrow from public sector banks.
Further, trying to get public sector banks to lend at lower interest rates is “inconsistency in public policy approach.” As Sonal Varma of Nomura put it in a note dated October 3, 2013, “The government is prodding public sector banks to lend at a subsidised rate at a time when the RBI has just hiked the repo rate – a signal to banks to hike their lending rate. We do not see this as a sustainable strategy to kickstart consumption.” The RBI had also recently asked banks not to offer 0% EMI plans for the purchase of consumer goods. And now the government is telling the banks that we want you to lend at lower interest rates.
Also, some little bit of basic maths can show us why interest rates do not have much of an impact, when it comes to people taking loans to buy consumer goods and two wheelers. Lets us say an individual takes on a two year loan of Rs 25,000, at an interest of 17%. The EMI for this works out at around Rs 1236. For every 100 basis point (one basis point is one hundredth of a percentage) fall in interest rate, the EMI comes down by Rs 12. Yes, you read it right.
So, if the rate of interest falls to 16%, the EMI will come to around Rs 1224 from Rs 1236 earlier. At 15% it would come to Rs 1212 and so on. Hence, even if interest rates crash by 700 basis points and come down to 10%, the EMI will come down by only Rs 84 per month.
Considering this no one is going to go ahead and buy a consumer good or a two-wheeler because the EMIs fall by Rs 12, for every 100 basis points cut in interest rates. As Chakrabarty rightly put it “You cannot lure the people (to buy goods) by lowering interest rates.”
People are not buying because they do not feel confident enough of their job prospects in the days to come. As Varma puts it “The job market and income growth – the key drivers of consumption – remain lacklustre.” And that’s the main problem. Lower interest rates alone can’t just address that.
The article originally appeared on www.firstpost.com on October 7, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Credit deposit ratio
Why Chidu's new plan to revive consumer demand won't work
Vivek Kaul
The finance minister, P Chidambaram is at it again. He wants public sector banks to cut their interest rates so that people borrow and spend more, and consumer demand improves.
The trouble is that the credit deposit ratio of banks is at extremely high levels. Latest data released by the Reserve Bank of India(RBI) shows that as on September 6, 2013, for every Rs 100 that banks borrowed as deposits, they had lent out Rs 78.52.
Banks need to maintain a cash reserve ratio of Rs 4 for every Rs 100 that they borrow as a deposit. This money is deposited with the RBI. They need to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 for every Rs 100 they borrow as a deposit in government bonds.
This means that Rs 27 out of Rs 100 that is borrowed as a deposit goes out of the equation straight away. Only the remaining Rs 73 can be lent out. But banks are lending Rs 78.52 for every Rs 100 that they raise as a deposit. This means that they are borrowing from other sources in the market to lend money.
This is happening primarily because banks have been unable to raise enough money as deposits. The deposit growth in one year(between September 7, 2012 and September 6, 2013) was at 13.5%. In comparison the loan growth has been at 18.2%.
Given that loan growth has been happening at a much faster rate than deposit growth, banks cannot cut interest rates. To cut interest rates on loans, banks will have to first cut interest rates on deposits. And if they do that they will find it even more difficult to raise deposits.
But Chidambaram seems to have found a way to get around this problem. A finance ministry press release pointed out yesterday that “It may be recalled that in the Budget for 2013-14, a sum of Rs. 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently.
The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two wheelers, consumer durables etc, at lower rates in order to stimulate demand.”
There are multiple problems with this plan. Where will the government get the money for the extra capital it is planning to offer to banks? It will borrow money by selling bonds, which will be bought by banks and other financial institutions. And where will the banks get this extra money to lend to the government? By trying to raise more deposits. And how will they do that? By offering higher interest rates.
The second and the bigger problem with the argument is that the size of loans for two wheelers, consumer durables etc is too small, for a fall in interest rates to make any difference. Lets assume an individual takes a two year two wheeler loan of Rs 50,000 from SBI at 18.05% per annum. The EMI for this comes to Rs 2497.4. If the interest rate falls to 17.05% per annum, the EMI will fall by around Rs 24 to Rs 2473.3. If the interest rate falls to 16.05% per annum, the EMI will fall by around Rs 48 to Rs 2449.35.
Of course no one is going to go ahead and buy a two wheeler because his EMIs have come down by Rs 24-48. When it comes to these kind of purchases interest rates don’t really matter. What matters is how people feel about their economic future. Questions like whether they will get a raise this year or even whether they will keep their job in the time to come are more important.
Given the bleak economic scenario that prevails, Chidambaram’s plan won’t work.
The article originally appeared in the Daily News and Analysis dated October 5, 2013 with a different headline
(Vivek Kaul is the author of soon to be published Easy Money. He tweets @kaul_vivek)
RBI may cut rates, but your loan rates may not fall
Vivek Kaul
The monetary policy review of the Reserve Bank of India(RBI) is scheduled for March 19,2013 i.e. tomorrow. Every time the top brass of the RBI is supposed to meet, calls for an interest rate cut are made. In fact, there seems to be a formula that has evolved to create pressure on the RBI to cut the repo rate. The repo rate is the interest rate at which RBI lends to banks.
The formula includes the finance minister P Chidambaram giving statements in the media about there being enough room for the RBI to cut interest rates. “There is a case for the Reserve Bank of India (RBI) to cut policy rates, and the central bank should take comfort from the government’s efforts to cut the fiscal deficit,” Chidambaram told the Bloomberg television channel today.
Other than Chidambram, an economist close to the Prime Minister Manmohan Singh also gives out similar statements. “The budget has also gone a long way in containing the fiscal deficit, both in the current year and in the following year, and played its role in containing demand pressures in the system. Therefore, in some sense there is greater space for monetary policy now to act in the direction of stimulating growth,” C Rangarajan, former RBI governor, who now heads the prime minister’s economic advisory council, told The Economic Times. What Rangarajan meant in simple English was that conditions were ideal for the RBI to cut interest rates.
And then there are bankers (most those running public sector banks) perpetually egging the RBI to cut interest rates. As an NDTV storypoints out “A majority of bankers polled by NDTV expect the Reserve Bank to cut interest rates in the policy review due on Tuesday. 85 per cent bankers polled by NDTV said the central bank is likely to cut repo rates.”
Corporates always want lower interest rates and they say that clearly. As a recent Business Standard story pointed out “An interest rate cut, at a time when demand was not showing any sign of revival, would boost sentiments, especially for interest-rate sensitives like the car and real estate sectors, which had been showing negative growth, a majority of the 15 CEOs polled by Business Standard said.”
So everyone wants lower interest rates. The finance minister. The prime minister. The banks. And the corporates.
Lower interest rates will create economic growth is the simple logic. Once the RBI cuts the repo rate, the banks will also pass on the cut to their borrowers. At lower interest rates people will borrow more. They will buy more homes, cars, two wheelers, consumer durables and so on. This will help the companies which sell these things. Car sales were down by more than 25% in the month of February. Lower interest rates will improve car sales. All this borrowing and spending will revive the economic growth and the economy will grow at higher rate instead of the 4.5% it grew at between October and December, 2012.
And that’s the formula. Those who believe in the formula also like to believe that everything else is in place. The only thing that is missing is lower interest rates. And that can only come about once the RBI starts cutting interest rates.
So the question is will the RBI governor D Subbarao oblige? He may. He may not. But the real answer to the question is, it doesn’t really matter.
Repo rate at best is a signal from the RBI to banks. When it cuts the repo rate it is sending out a signal to the banks that it expects interest rates to come down in the days to come. Now it is up to the banks whether they want to take that signal or not.
When everyone talks about lower interest rates, they basically talk about lower interest rates on loans that banks give out. Now banks can give out loans at lower interest rates only when they can raise deposits at lower interest rates. Banks can raise deposits at lower interest rates when there is enough liquidity in the system i.e. people have enough money going around and they are willing to save that money as deposits with banks.
Lets look at some numbers. In the six month period between August 24, 2012 and February 22, 2013 (the latest data which is available from the RBI) banks raised deposits worth Rs 2,69,350 crore. During the same period they gave out loans worth Rs 3,94,090 crore. This means the incremental credit-deposit ratio in the last six months for banks has been 146%.
So for every Rs 100 that banks have borrowed as a deposit they have given out Rs 146 as a loan in the last six months. If we look at things over the last one year period, things are a little better. For every Rs 100 that banks have borrowed as a deposit, they have given out Rs 93 as a loan.
What this clearly tells us is that banks have not been able to raise enough deposits to fund their loans. For every Rs 100 that banks borrow, they need to maintain a statutory liquidity ratio of 23%. This means that for every Rs 100 that banks borrow at least Rs 23 has to be invested in government securities. These securities are issued by the government to finance its fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.
Other than this a cash reserve ratio of 4% also needs to be maintained. This means that for every Rs 100 that is borrowed Rs 4 needs to be maintained as a reserve with the RBI. So for every Rs 100 that is borrowed by the banks, Rs 27 (Rs 23 + Rs 4) is taken out of the equation immediately. Hence only the remaining Rs 73 (Rs 100 – Rs 27) can be lent. This means that in an ideal scenario the credit deposit ratio of a bank cannot be more than 73%. But over the last six months its been double of that at 146% i.e. banks have loaned out Rs 146 for every Rs 100 that they have raised as a deposit.
So how have banks been financing these loans? This has been done through the extra investments (greater than the required 23%) that banks have had in government securities. Banks are selling these government securities and using that money to finance loans beyond deposits.
The broader point is that banks haven’t been able to raise enough deposits to keep financing the loans they have been giving out. And in that scenario you can’t expect them to cut interest rates on their deposits. If they can’t cut interest rates on their deposits, how will they cut interest rates on their loans?
The other point that both Chidambaram and Rangarajan harped on was the government’s effort to cut/control the fiscal deficit. The fiscal deficit for the current financial year (i.e. the period between April 1, 2012 and March 31,2013) had been targeted at Rs 5,13,590 crore. The final number is expected to come at Rs 5,20,925 crore. So where is the cut/control that Chidambaram and Rangarajan seem to be talking about? Yes, the situation could have been much worse. But simply because the situation did not turn out to be much worse doesn’t mean that it has improved.
The fiscal deficit target for the next financial year (i.e. the period between April 1, 2013 and March 31, 2014) is at Rs 5,42,499 crore. Again, this is higher than the number last year.
When the government borrows more it “crowds out” and leaves a lower amount of savings for the banks and other financial institutions to borrow from. This leads to higher interest rates on deposits.
What does not help the situation is the fact that household savings in India have been falling over the last few years. In the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010) the household savings stood at 25.2% of the GDP. In the year 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) the household savings had fallen to 22.3% of the GDP. Even within household savings, the amount of money coming into financial savings has also been falling. As the Economic Survey that came out before the budget pointed out “Within households, the share of financial savings vis-à-vis physical savings has been declining in recent years. Financial savings take the form of bank deposits, life insurance funds, pension and provident funds, shares and debentures, etc. Financial savings accounted for around 55 per cent of total household savings during the 1990s. Their share declined to 47 per cent in the 2000-10 decade and it was 36 per cent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis-à-vis 2010-11.”
While the household savings number for the current year is not available, the broader trend in savings has been downward. In this scenario interest rates on fixed deposits cannot go down. And given that interest rate on loans cannot go down either.
Of course bankers understand this but they still make calls for the RBI cutting interest rates. In case of public sector bankers the only explanation is that they are trying to toe the government line of wanting lower interest rates.
So whatever the RBI does tomorrow, it doesn’t really matter. If it cuts the repo rate, then public sector banks will be forced to announce token cuts in their interest rates as well. Like on January 29,2013, the RBI cut its repo rate by 0.25% to 7.75%. The State Bank of India, the nation’s largest bank, followed it up with a base rate cut of 0.05% to 9.7% the very next day. Base rate is the minimum interest rate that the bank is allowed to charge its customers.
A 0.05% cut in interest rate would have probably been somebody’s idea of a joke. The irony is that the joke might be about to be repeated in a few day’s time.
The article originally appeared on www.firstpost.com on March 18,2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)