YV Reddy is right: The govt borrowing on its own won’t work

yv reddy
In the budget speech he made on February 28, 2015, the finance minister Arun Jaitley had said: “I intend to begin this process this year by setting up a Public Debt Management Agency (PDMA) which will bring both India’s external borrowings and domestic debt under one roof.”

The government of India, like most governments spends more than it earns. The difference it makes up through borrowing. This borrowing is currently managed by the Reserve Bank of India (RBI). Jaitley now wants to take away this responsibility from the RBI and set up an independent public debt management agency.
On the face of it this sounds like a simple move-one institution was taking care of the government borrowings needs, now the government wants to takeover the responsibility. But it is not as simple as that.
Before I explain why, it is important to understand something known as the statutory liquidity ratio (SLR), which currently stands at 21.5%. What this means is that for every Rs 100 that banks raise as a deposit, Rs 21.5 needs to be invested in government bonds.
This number was at higher levels earlier and has constantly been brought down by the RBI over the years. This provision helps the government raise money at lower interest rates than it would otherwise be able to.
This is something that the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee) released in January 2014 pointed out: “Large government market borrowing has been supported by regulatory prescriptions under which most financial institutions in India, including banks, are statutorily required to invest a certain portion of their specified liabilities in government securities and/or maintain a statutory liquidity ratio (SLR).”
This statutory requirement essentially ensures that there is a constant demand for government bonds. This helps the government get away by offering a lower rate of interest on its bonds.
The SLR prescription provides a captive market for government securities and helps to artificially suppress the cost of borrowing for the Government, dampening the transmission of interest rate changes across the term structure,” the Expert Committee report points out.
Take a look at the following chart. Between 2007-2008 and 2013-2014, the government was able to borrow money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt (i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008. 

The major reason for the same is the fact that there is an inbuilt demand for government securities. The Economic Survey of 2014-2015 has some interesting data which buttresses the point that I am trying to make. The total internal liabilities of the government of India have gone up by 1.9 times between 2009-10 and 2014-2015. Nevertheless, the average cost of borrowing has gone up only from 7.5% to 8.41%.

average cost of borrowing
This financial repression of forcing banks, insurance companies as well as provident funds to buy government bonds, allows the government to raise money at low interest rates, than they would be able to do if they allowed the market to operate.
Now the government wants to take away the debt management function from the RBI and raise money independently. In this scenario the question is can the SLR continue? Dr YV Reddy, former governor of the RBI, made this point in an interview to the The Economic Times. As he said: “If the government is having an independent debt office then how can the statutory liquidity ratio of a high order continue. Once it is an independent debt office, basically, it should independently be able to raise money.”
Fair point, I guess. “So, if the government want to raise money then indirectly the regulator cannot go on supporting through a cell. So the pre-condition will be SLR has to be removed. Because it would be inappropriate to say that you are independent but I will help you do something. So, in all probability the RBI will have no choice except to reduce SLR to zero as a precondition for an independent debt office,” Reddy told The Economic Times. 
The question that crops up here is whether the government is ready to take on this risk given that it is likely to lead to higher interest rates. With banks no longer having to compulsorily buy government bonds, they may not buy government bonds all the time, like is the case currently. This will lead to a situation where the government will have to offer a higher interest rate to get the banks interested. While this sounds good on the face of it, given that if the government offers higher interest rates on its bonds, that higher interest rate will become the benchmark.
Given this, banks will have to offer higher interest rates on their fixed deposits. This means that the chances of savers getting a higher rate of interest (which is greater than the rate of inflation) also goes up.
But if banks offer a higher rate of interest on fixed deposits, they will also have to charge a higher rate of interest on their loans. And this is something that the government won’t like, given that it is currently trying to push down interest rates in the hope of getting the investment cycle and the consumption cycle going all over again. It needs to be pointed out that savers are not the ones either governments or politicians are really bothered about.
Nevertheless, the government might force the RBI to keep the SLR at its current level. But then there would be no independent public debt office. It would be a farce. As Reddy put it: “If the government is pressurising the RBI to not reduce the SLR that is inappropriate. That is not an independent debt office. And it would be inappropriate for RBI even to appear to support the government debt programme. It cannot appear to be.”
Long story short-we haven’t heard the last of this issue. There will be more to come in the time to come. Stay tuned.

The column originally appeared on The Daily Reckoning on Mar 14, 2015

SLR cut: A central banker shouldn't jump into bed with his finance minister

 ARTS RAJANVivek Kaul  

Since yesterday there has been a lot of analysis about the Raghuram Rajan led Reserve Bank of India (RBI) cutting the statutory liquidity ratio(SLR) from 23% to 22.5%. Earlier the banks had to maintain 23% of their deposits in government securities. Now they need to maintain only 22.5%, a cut of 50 basis points. One basis point amounts to one hundredth of a percentage.
This cut, the analysts have concluded will lead to bank giving out more loans. The Business Standard estimates that “the cut will free up about Rs 35,000 crore with banks which they can now lend.”
The newspaper does not explain how they arrived at that number. But an educated guess can be made. Currently, the aggregate deposits of scheduled commercial banks in India amounts to Rs 7,855,520 crore. The SLR ratio has been cut by 50 basis points or 0.5%. This amounts to around Rs 39,278 crore (0.5% of Rs Rs 7,855,520 crore) of the total deposits of banks. From this number, the ballpark number of Rs 35,000 crore seems to have been derived.
It is important to make things simple, but not simplistic. The assumption being made here is that now that banks need to invest a lesser amount in government securities, they will do so and prefer to lend more money instead.
But is that really the case? The latest numbers released by the RBI show that scheduled commercial banks had invested nearly 29.27% of their deposits in government securities. This when the SLR had stood at 23%. What does this tell us? It tells us that banks prefer to invest in government securities than lend money.
This is not a recent phenomenon. In late September 2007, when the economic scenario was significantly better than it is now, scheduled commercial banks had nearly 31% of their deposits invested in government securities. In mid May 2012, the number had stood at 30%.
Given this, even though banks are required to maintain only a certain portion of their money in government securities, they have maintained a significantly higher amount over the years. Whether this is lazy banking or the lack of good investment opportunities that only the banks can tell us.
In fact, it is interesting to see how things panned out after the RBI cut the SLR from 24% to 23% on July 31, 2012. As on July 28, 2012, the banks had invested nearly 30.6% of their deposits in government securities. Three days later, the RBI cut the SLR. A little over six months later in early February 2013, the government securities to deposit ratio stood at 30.4%. So, the banks did cut down on their exposure to government securities, but not significantly. In fact, as on July 26, 2013, nearly a year later, the government securities to deposits ratio stood at 30.8%. This was higher than the ratio before the SLR cut.
What this clearly tells us is that a cut in SLR does not necessarily mean that banks will invest less in government securities and lend that money instead.
The RBI of course understands this. If it really wanted to ensure that banks had more money to lend it would have cut the cash reserve ratio (CRR). CRR is the portion of their deposits that banks need to hold with the RBI. It currently stands at 4%.
The RBI does not pay any interest on the money that banks maintain with it to fulfil their CRR obligations. Hence, when the RBI cuts the CRR, banks have an incentive to lend the money that is freed up. The same scenario does not hold in case of an SLR cut because banks get paid interest on the money they invest in government securities.
So that brings us to the question, why did Rajan cut the SLR? My guess on this is that there was pressure on him from the Finance Ministry to show that RBI was serious about “economic growth” and do something that forced banks to lend more. And that something came in the form of an SLR cut. It was his way of telling the government, look you wanted me to do something, I did something. If banks are still not lending, what can I do about it?
In the monetary policy statement Rajan said that there were still “Upside risks” to inflation “in the form of a sub-normal/delayed monsoon on account of possible El Nino effects, geo-political tensions and their impact on fuel prices, and uncertainties surrounding the setting of administered prices.” What this tells us clearly is that Rajan is still not totally convinced that we have seen the last of the high inflation that has prevailed over the years.
What this further tells us is that Rajan continues to be his own man as he was in the past and is unlikely to be weighed in by pressure from the finance ministry. It is important to remember here what economist Stephen D. King writes in
When the Money Runs Out “A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation.”
Given this, it is important that Rajan stays as independent as he has been since taking over as the RBI governor in September 2013.

The article originally appeared on www.firstbiz.com on June 4, 2014

 (Vivek Kaul is a writer. He can be reached at [email protected])  

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 www.firstpost.com on October 7, 2013

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