Cheap auto, consumer goods loans: How will Chidu finance PSBs?

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 on October 7, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why RBI killed the debt fund

RBI-Logo_8Vivek Kaul 
The Reserve Bank of India(RBI) is doing everything that it can do to stop the rupee from falling against the dollar. Yesterday it announced further measures on that front.
Each bank will now be allowed to borrow only upto 0.5% of its deposits from the RBI at the repo rate. Repo rate is the interest rate at which RBI lends to banks in the short term and it currently stands at 7.25%.
Sometime back the RBI had put an overall limit of Rs 75,000 crore, on the amount of money that banks could borrow from it, at the repo rate. This facility of banks borrowing from the RBI at the repo rate is referred to as the liquidity adjustment facility.
The limit of Rs 75,000 crore worked out to around 1% of total deposits of all banks. Now the borrowing limit has been set at an individual bank level. And each bank cannot borrow more than 0.5% of its deposits from the RBI at the repo rate. This move by the RBI is expected bring down the total quantum of funds available to all banks to Rs 37,000 crore, reports The Economic Times.
In another move the RBI tweaked the amount of money that banks need to maintain as a cash reserve ratio(CRR) on a daily basis. Banks currently need to maintain a CRR of 4% i.e. for every Rs 100 of deposits that the banks have, Rs 4 needs to set aside with the RBI.
Currently the banks need to maintain an average CRR of 4% over a reporting fortnight. On a daily basis this number may vary and can even dip under 4% on some days. So the banks need not maintain a CRR of Rs 4 with the RBI for every Rs 100 of deposits they have, on every day.
They are allowed to maintain a CRR of as low as Rs 2.80 (i.e. 70% of 4%) for every Rs 100 of deposits they have. Of course, this means that on other days, the banks will have to maintain a higher CRR, so as to average 4% over the reporting fortnight.
This gives the banks some amount of flexibility. Money put aside to maintain the CRR does not earn any interest. Hence, if on any given day if the bank is short of funds, it can always run down its CRR instead of borrowing money.
But the RBI has now taken away that flexibility. Effective from July 27, 2013, banks will be required to maintain a minimum daily CRR balance of 99 per cent of the requirement. This means that on any given day the banks need to maintain a CRR of Rs 3.96 (99% of 4%) for every Rs 100 of deposits they have. This number could have earlier fallen to Rs 2.80 for every Rs 100 of deposits. The Economic Times reports that this move is expected to suck out Rs 90,000 crore from the financial system.
With so much money being sucked out of the financial system the idea is to make rupee scarce and hence help increase its value against the dollar. As I write this the rupee is worth 59.24 to a dollar. It had closed at 59.76 to a dollar yesterday. So RBI’s moves have had some impact in the short term, or the chances are that the rupee might have crossed 60 to a dollar again today.
But there are side effects to this as well. Banks can now borrow only a limited amount of money from the RBI under the liquidity adjustment facility at the repo rate of 7.25%. If they have to borrow money beyond that they need to borrow it at the marginal standing facility rate which is at 10.25%. This is three hundred basis points(one basis point is equal to one hundredth of a percentage) higher than the repo rate at 10.25%. Given that, the banks can borrow only a limited amount of money from the RBI at the repo rate. Hence, the marginal standing facility rate has effectively become the repo rate.
As Pratip Chaudhuri, chairman of State Bank of India told Business Standard “Effectively, the repo rate becomes the marginal standing facility rate, and we have to adjust to this new rate regime. The steps show the central bank wants to stabilise the rupee.”
All this suggests an environment of “tight liquidity” in the Indian financial system. What this also means is that instead of borrowing from the RBI at a significantly higher 10.25%, the banks may sell out on the government bonds they have invested in, whenever they need hard cash.
When many banks and financial institutions sell bonds at the same time, bond prices fall. When bond prices fall, the return or yield, for those who bought the bonds at lower prices, goes up. This is because the amount of interest that is paid on these bonds by the government continues to be the same.
And that is precisely what happened today. The return on the 10 year Indian government bond has risen by a whopping 33 basis points to 8.5%. Returns on other bonds have also jumped.
Debt mutual funds which invest in various kinds of bonds have been severely impacted by the recent moves of the RBI. Since bond prices have fallen, debt mutual funds which invest in these bonds have faced significant losses.
In fact, the data for the kind of losses that debt mutual funds will face today, will only become available by late evening. But their performance has been disastrous over the last one month. And things should be no different today.
Many debt funds have lost as much as 5% over the last one month. And these are funds which give investors a return of 8-10% over a period of one year. So RBI has effectively killed the debt fund investors in India.
But then there was nothing else that it could really do. The RBI has been trying to manage one side of the rupee dollar equation. It has been trying to make rupee scarce by sucking it out of the financial system.
The other thing that it could possibly do is to sell dollars and buy rupees. This will lead to there being enough dollars in the market and thus the rupee will not lose value against the dollar. The trouble is that the RBI has only so many dollars and it cannot create them out of thin air (which it can do with rupees). As the following graph tells us very clearly, India does not have enough foreign exchange reserves in comparison to its imports.
The ratio of foreign exchange reserves divided by imports is a little over six. What this means is that India’s total foreign exchange reserves as of now are good enough to pay for imports of around a little over six months. This is a precarious situation to be in and was only last seen in the 1990s, as is clear from the graph.
The government may be clamping down on gold imports but there are other imports it really doesn’t have much control on. “The commodity intensity of imports is high,” write analysts of Nomura Financial Advisory and Securities in a report titled India: Turbulent Times Ahead. This is because India imports a lot of coal, oil, gas, fertilizer and edible oil. And there is no way that the government can clamp down on the import of these commodities, which are an everyday necessity. Given this, India will continue to need a lot of dollars to import these commodities.
Hence, RBI is not in a situation to sell dollars to control the value of the rupee. So, it has had to resort to taking steps that make the rupee scarce in the financial system.
The trouble is that this has severe negative repercussions on other fronts. Debt fund investors are now reeling under heavy losses. Also, the return on the 10 year bonds has gone up. This means that other borrowers will have to pay higher interest on their loans. Lending to the government is deemed to be the safest form of lending. Given this, returns on other loans need to be higher than the return on lending to the government, to compensate for the greater amount of risk. And this means higher interest rates.
The finance minister P Chidambaram has been calling for lower interest rates to revive economic growth. But he is not going to get them any time soon. The mess is getting messier.
The article originally appeared on on July 24, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)