Tracing Patterns in Industrial Growth: Business Standard: 29th December 2008

The primary factors driving industrial growth are investment and foreign trade growth, not growth in capital issues, foreign investment or the Sensex, says Madan Sabnavis
The negative growth in industry in the month of October has caused umbrage as this is the first time in over a decade that we have actually witnessed a decline in industrial growth. Add to this the decline in exports and the picture is quite disheartening. Several reasons have been offered for the lower rates of growth in industry. Some of them are lower consumption levels, investment, government expenditure, trade and so on. On the other hand, policy measures have been invoked to redress the same.
The purpose here is to take an impassioned view of the relationships between industrial growth and certain variables for which we have a priori reason to believe that there could be a relationship between the two. Therefore, we can look at, say, the growth in consumption, which theoretically would be related with industrial growth as it provides critical demand to stimulate growth. The coefficient of correlation between the two could be looked at for the last 18 years to ascertain whether or not the two are related. This way one can see whether there is prima facie a relationship between high industrial growth and these variables. The coefficient of correlation, it must be remembered, only says whether there is directional relationship and does not talk of causation. Hence, while we all know that high industrial growth causes GDP growth, the number per se only says that in the last 18 years, the thought that high industrial growth was associated with high GDP growth was good.
Tables 1 and 2 give the correlation coefficients between industrial growth rate and other variables where the relationship was significant and not-so-significant. For a set of 18 observations (ie, after reforms set in), a significant coefficient would be above 0.44.
Table 1 shows that the top 5 variables that have a strong correlation with industrial growth are growth in imports, exports, GDP, level of FII and growth in bank credit. While imports and exports are definitely linked with industry as imports are used for industrial production while exports prospects feed back into demand stimulus for industry, the same cannot be said about FII investments. For both FII and FDI levels, it may be said that higher industrial growth affects these levels in terms of foreign flows into the country either in the secondary market or as investment. The same holds for the Sensex and capital issues, where the level would be related with industrial performance. Growth in the services sector can be linked inexorably with that in manufacturing as organised services such as finance, transport, communication and trade would need positive impulses from the industrial growth front. Further, while higher growth in credit is another pre-requisite for industrial growth, inflation is not.
Table 2 however is more revealing as it goes at times against the grain of common perception. Let us go back to the rudimentary text book where output is the sum of C(onsumption), I(nvestment), G(overnment), E(xports) and I(mports). This holds for any sector. The table shows that consumption growth does not have a strong relationship with industrial growth — which means that we need more of the other factors to help in growth. Government expenditure also does not impact industry in the same year — this means that all the fiscal stimulus packages would really take time to work out as the impact is indirect. Trade however is significant.
Therefore, the primary factors are really investment and foreign trade growth. Further, the growth in capital issues, foreign investment and the Sensex are not associated with industrial growth. This means that the rate of change in these variables is not correlated with the industrial growth rate.
Given this picture, how can we relate the present circumstances with the industrial scenario? On the supply side, we have witnessed growth in bank credit rising and imports, which means that industrial growth has taken place up to October. Sentiments are low as gauged by FII, FDI and capital market indicators. There is a shoulder shrug as far as investment is concerned as we do not have clear indications — bank credit partly reflects growth but lower capital issues could negate this performance. The government stimulus package does not appear to have the strength to change things, nor would private consumption. As exports growth is not too impressive, the demand stimulus would not be there. The imports route will work provided the demand is there, as imports only talk of the supply side. The low growth of the energy sector shows that there are roadblocks ahead.
All this points towards difficulties in the times to come and conjectures of this sector’s growth should logically be conservative in general.

The best blunder award goes to: Financial Express: 23rd December 2008

The year 2008 has been a major blow in reputation for investment bankers, analysts, economists, rating agencies and regulators. The fact that no one can predict a crisis is known, but the fact that people were so consistently wrong was appalling. Consider these ten blunders.
The first institutional blunder was the approach to financial sector bailouts. Bear Stearns started it all in 2007 and the crisis resurfaced when the housing twins Freddie Mac and Fannie Mae raised an eyebrow. Subsequently, we witnessed Lehman Brothers sink even as Merrill Lynch escaped by the skin of the teeth, while AIG brought back the ‘milk of human kindness’ in Mr Paulson. The government evidently was unsure of whether or not moral hazard had to be eradicated or whether there was a larger duty to the public or the failed institution.
The second blunder, in regulation. While investment banks and hedge funds do not have a regulator, banks do. Basel-II takes pride in bringing about discipline across banks and the Fed has made it difficult to skip the rope. Then how come Citibank landed in trouble.
The third, a panic response from the Fed which has once again lowered interest rates to 0.25% at a time when the economy is on the verge of a recession. Now, Mr Greenspan has been named the culprit for the present problem by pursuing a policy of liberal interest rates. It looks like that Mr Bernanke may be starting another bubble—though we are not sure which one this will be.
The ECB and BoE would take the fourth place as being central banks without an independent mind, as they have lowered their indicative rates too, but only after the Fed took the lead. But wasn’t the Euro supposed to actually challenge the dollar and take the lead?
The RBI in India fared no better. Higher inflation prompted interest rates and the cash reserve ratio to be increased. This was at a time when inflation was caused by lower supplies and high oil prices.
Sixth, the government of India has introduced a fiscal stimulus package of Rs 30,000 crore. But no one believes that it will work. Besides, even if it does, it would take time as government expenditure will take time to be approved and tendered (this is very important here) and it would be mid-2009 before we see any action.
The seventh blunder is the behaviour of the Opec. After much dithering it has decided to lower its output by a little over 4 million barrels a day to stabilise prices. They would like a price of $75 per barrel, which seems distant today.
But, the puzzle really is that the prices are down today because of a slowdown, and by cutting output to ostensibly raise prices, it would actually lead to slide in prices as demand falls further. Quite clearly, it is unsure of what has to be done.
The eighth puzzle has been the fall out of the series of bailouts. So far the bailouts have been for distressed financial institutions. But, we had the big three auto companies in the US actually approach the government for a bail out, and why not? After all these people actually bring about production and the auto along with the reality sectors are the leaders in growth. So where should the government stop when it comes to bailouts?
The ninth institutional shock was domestic and the usual suspect, ICICI Bank featured again as deposit holders made a bee line for the ATMs to withdraw money because of a rumour that there was a run on the bank. The dynamism that propelled the bank to stardom with their strong presence in the derivative segment this time and agri loans earlier became a liability, as the RBI went out of the way to reassure everybody that all was well.
And lastly, a blow to the economy was dealt by the terror attacks on the Taj and Oberoi as this was an attack on the commercial capital. Debates centred on whether or not these attacks would affect the Indian economy—with the general conclusion being that the city and business was resilient (whatever that means).

Purchasing Power: DNA: 17th December 2008

The ultimate hallmark of successful globalisation in economics is when all nations are placed in a similar corner on account of a single factor. In the growth phase, there is a disparate performance across countries.
The developed nations always fare better which provokes critics to say that the gains of globalisation are always unequal. However, when there is a downturn, everyone suffers. Globalisation becomes a kind of a leveller. This is the case with all economies today with every country trying to cope with the pains of the financial crisis which has spread like a contagion.
The policy response across the globe has been cohesive — slashing of interest rates. The basic idea is that when demand is sluggish, the only way out is to provide a stimulus through lower interest rates which enable industry and individuals to borrow more, which will push up demand and hence growth. This is the classic monetary policy approach to a downturn.
Two issues arise here. The first is whether or not individuals will spend more money because loans are cheaper. Mortgage rates have been lowered by banks for loans of up to Rs20 lakh. The decision to take a loan will actually depend on the condition of the borrower. Is the borrower today really in a state to take a loan?
This is important because a dwelling purchased with a loan has to be serviced for a period of, say, 10 to 20 years. The present state in the private sector is grim with job loss threats and cuts in salaries looming large. The last thing on one’s mind will be to take on more debt for a protracted time period. The public sector may be better off with the Pay Commission hikes, but as most arrears will not be paid immediately, there would be some hesitation on their side too. Hence, at the individual level, expenditures may be deferred.
If we look at companies now, will they borrow more? Investment decisions are based on consumption expectations and existence of spare capacity. While evidence suggests that capacity utilisation may have crossed 80 per cent in the capital goods segment, the same is not evident for consumer goods. There is spare capacity which has been affected by the downswing in demand due to lower purchasing power. The better kharif harvest has not been translated into higher spending. Thus, today we have a situation where interest rates have been lowered and liquidity is adequate. Yet, while growth in bank credit is steady, there is no pressure on funds. Clearly, industrial demand has to pick up to fill this lacuna.
While the government is aware of the possible lags involved in monetary policy measures working out, it has simultaneously drafted policy on the demand side, which is quite different from what governments worldwide have done. It has embarked on an expansionary policy in the Keynesian genre — when economies slow down, governments should spend more as this generates investment, more jobs and higher consumption. The measures announced were in the direction of higher spending on the Plan account and more funds for rural sectors. This was topped by an across-the-board reduction by 4 per cent in excise duties.
The India Infrastructure Finance Company will raise Rs10,000 crore to boost the infrastructure sector. The total package of over Rs30,000 crore is to set the tone for growth from the point of view of consumption.
The government has actually taken that stance that it is no longer worried about the fiscal deficit. One may recollect that the government had arrived at a fiscal deficit level of 2.5 per cent of GDP for 2008-09. This had not taken account of loan write-offs and the Pay Commission burden. Now with the excise duty cut and higher Plan expenditure resulting in an additional cost of Rs30,000 crore and the higher food subsidy of Rs20,000 crore, the original target will be exceeded by 40 per cent, leading to 5 per cent fiscal deficit. But, under such circumstances, it can be justified as being necessary.
So, will these measures work? The answer is a big yes as lower interest rates and higher spending are just the antidotes for recessionary conditions. However, the time-impact is not going to be instantaneous.
Demand for consumer goods will not increase until buyers are more upbeat about their jobs. The auto and white goods sectors have to wait for a while. Real estate prices have to move southwards for the spending spiral to begin. Monetary policy will work with a lag as, at present, there is surplus liquidity which when absorbed as investment would involve gestation lags of at least three months. Tax refunds could have been considered but once again there is the risk of such refunds taking time and being stacked as savings. This simply means that we need to be patient and settle for lower growth this year (RBI has already indicated so). But, tomorrow may be brighter than today — that is the immediate hope.

How about a Global Bankruptcy Fund? Business Line 17th December 2008

A Global Bankruptcy Fund can be set up to rescue failed institutions by either taking on the bad assets or liabilities or providing a loan.
Contrary to the adage that a dead man tells no tales, every financial crisis provides lessons to be learnt. However, each one is different and the lessons appear to have more anecdotal value.
Two thoughts emerge from the analysis of the current global financial crisis. We need to first have better regulation and, second, create a system that can take care of these damages. Also, crises are bound to be engendered as innovation gains in prec edence; and while the Schumpeterian theory of creative destruction cannot be eschewed, the damages can be mitigated if these twin goals are pursued. At the same time, if risks are not taken, the financial world would be stagnant and will offer few choices. Need for a global regulator
The BIS has shown the way of how all banking systems in the world can come to terms with a single code of rectitude. The same needs to be replicated in the rest of the financial world, where prudential norms need to be established for hedge funds, investment banks, derivatives (securitisation) markets and other non-bank financial intermediaries. This would really mean regulators for all financial segments will ensure there are norms set for each and every financial player in any country. While this by itself cannot prevent a crisis, the magnitude of impact can be lessened. Therefore, just like how we have the RBI, the FMC, the SEBI, the NHB etc in India, there needs to be a regulator for every line of business. This will lead to greater transparency.Transparency in operations
But, given that crises are all-spreading, there is need for a global regulator too, which could be a single entity to oversee financial developments. Like the BIS, the regulator could actually set the rules in terms of leverage, capital adequacy, investment norms, and so on for financial markets that could be pursued in different countries. A simple example being no financial institution can take an exposure of more than ‘X’ per cent of its assets or income on any off-balance-sheet account. Or, all inter-financial sector lending should be ‘purpose-’ and ‘rating-’based; just like how a bank knows how the funds lent to a borrower are going to be deployed, the same should be known when Bank ‘X’ lends to, say, Lehman. The objective is to have a trail of all financial flows and transparency in operations so that all the intermediaries are aware of the quantum of risk being undertaken — with this level being monitored, though not necessarily fixed by the regulator or super-regulator.
The second thought arising from the series of financial crises is that we should think of creating a new organisation or fund, called, say, the Global Bankruptcy Fund (GBF), to tackle all these disturbances. Just like how central banks play the role of lender of last resort, there should be a global lender of last resort. The function of such a fund would be to rescue failed institutions by either taking on the bad assets or liabilities or providing a loan. To make this work, the following structure can be followed.Suggested structure
Analogous to the IMF, which was set up to help countries get out of balance of payments disequilibrium, the GBF would have the responsibility of bailing out institutions from a sticky state. The institutions would necessarily have to take membership of the fund and pay a subscription as well as an annual charge. These charges could be linked directly to the size of the institution or the risky assets carried on its books — both balance sheet and off-balance sheet items.
To ensure that there is fair play, the financial results would have to be audited by a panel (similar to the US GAAP followed by the banks). The fees collected would be invested by the GBF to earn revenue that would be used to maintain the organisation. The initial seed capital could be provided by various participating country governments. These funds would be used when required to aid the members in times of distress.
The creation of this fund would help alleviate the pain caused when there is a crisis, though the crisis cannot be averted. However, members would be better off, because the fact that they are members of the GBF will by itself ensure that they can borrow or deal in the markets on better terms as the comfort factor would be higher. Further, the rating agencies could always use this as a consideration when rating any financial entity.
Can the IMF be restructured to facilitate this operation? By taking on this role, the organisation can be made more relevant.

A Gentle Push: Financial Express: 10th December 2008

John Maynard Keynes had advocated fiscal stimulus as a way out of a recession. While his theory has been contested, a number of countries have used it to revive their economies. Almost everybody becomes a Keynesian when the chips are down. The logic is infallible. If growth is down because people are not spending, let them do so through policy action.
There is, however, an unexplained conundrum: where has all the money gone? We know that the stock markets are down, which means that people are not investing here and are in a sell-off mood. Mutual funds are trying their best to stop redemption as investors are asking for their money back. Investments in debt instruments have fallen and above all, the rise in bank deposits has been tardy. Sales of automobiles are down and will remain so as the jobs scene looks grim in the country. No amount of cheap lending can revive this market for the time being. Further, while the RBI has tried its best to make people borrow more for housing, it will not help as the industry is on a sticky wicket with new owners on the decline. If people are not saving and are also not spending, then where is the money?
While we appear to be fairly sanguine about growth of 7% this year, the government evidently would like to see a number closer to 8%. Now, how can we view this stimulus package of over Rs 30,000 crore? The excise cuts need to get reflected in lower prices for the consumer. Only then will they work in terms of improving spending. Also their impact would be more at the margin for consumer durable goods, as the demand is inelastic for non-durable goods. While interest rate subvention would improve the profitability of the exporting companies, the impact on exports per se may be limited. They are more likely to be influenced by the depreciating rupee.
IIFCL is to raise bonds for refinancing bank lending to infrastructure, which is a good measure, but would take time before an impact. Refinancing such loans releases capital for banks to lend more on infrastructure or industry. This slew of measures will work with a lag, and the positive influence is more likely in the next fiscal.
The basic problem is that thanks to the financial crisis and the backlash in corporate India, spending has come down with staff downsizing. This is a critical consumer class which will not be in a position to spend more at this point of time. The spending class is more likely to be government staff, when the Pay Commission terms are fully implemented. The only immediate impact would be on the fiscal deficit, where the ratio to GDP could inch towards the 5% mark if all the Budget and extraordinary Budget and off-Budget items are considered.
The second part of the booster being provided by the government is through the monetary policy. The problem one month back was with liquidity and the RBI eased the same by lowering the CRR. Through the repurchase of MSS bonds, liquidity was injected even as it left the system due to the FII withdrawal. But, interest rates have remained high as banks at the micro level had to garner deposits at higher rates. The signal now is to lower rates, which banks can do provided their cost of deposits comes down. The critical part will be to ensure that lower rates do not dissuade savers when deposits are not growing and people are not spending.
The entire package of the government is positive as it is biased towards growth. With inflation moving downwards mainly due to cooling of oil prices and better harvests coupled with a global recession, it is possible for monetary authorities across the globe to lower rates. The only question to be asked is as to when the effects would be seen. Monetary policy is typically slower when it tackles inflation and faster on growth, especially when funds are used for investment. Fiscal policy is more direct but expenditure works faster than tax cuts, which have their own time schedules to work themselves out. Hence, the best answer is a shoulder shrug.

Compromising on provisioning norms : Business Line: 24th November 2008

The RBI’s lowering of the general provisioning requirements for standard assets could be used as a precedent for further easing of norms for sub-standard assets at a later date.
Business cycles are now accepted as being a part of the economic way of life and the prevalence of capitalism only ensures that this process is continuous. While the amplitude of these cycles has come down, they have become more common than before. Joseph Schumpeter had written extensively on the process of creative destruction wherein capitalism ensures that when there are crises, the good are separated from the not-so-good and the system carries on as before, albeit afte r some painful adjustments are made.
Contemporary economic history shows that all such crises are engendered by the monetary authority which then goes through the equally painful process of readjusting the interest rates to counter the crisis; and just as things look good, it is time for the next round.Pumping in liquidity
Central banks across the world are busy trying to increase the flow of liquidity by providing finance to banks as well as lowering interest rates. The lowering of rates by the Federal Reserve once again to 1 per cent (with an effective rate of 0.25 per cent now) brings in the feeling of déjÀ vu as this was also the situation when the derivative-cum-housing bubble evolved.
The RBI has also followed the same path and the extensions that have been invoked should start some fresh debate. The RBI had assiduously increased interest rates from May onwards to counter inflation and has now gone backwards to provide liquidity to address growth. While such fine monetary tuning is debatable, it is still acceptable as the monetary authority has to take a stance one way or the other. But the announcements made relating to provisioning requirements are serious.Lower provisioning
The RBI has reduced the general provisioning requirements on standard assets for residential housing loans as well as personal loans to 0.40 per cent from 1 per cent and 2 per cent respectively. The same has been done on banks’ exposures to sectors such as unrated claims on corporates and loans secured by real estate to 100 per cent from 150 per cent. The issue raised is whether this practice should be encouraged or not?
Banks have had the temptation to lend more to these sectors which is why such relief would be beneficial for banks in such trying times. Lower provisioning actually helps to improve the bottom line. In fact, it could be enticing for banks to lend more to the unrated companies today where they could charge a higher rate at a time when their spreads are under pressure, without the encumbrance of higher provisioning.
Let us look at the ostensible reasons for doing so. Banks do claim that their profit margins would be affected quite obtrusively by the interest rate movements since their lending rates have come down probably due to some pressure being put by the government while the deposit rates cannot move down as they do not have funds and are hence providing higher rates on long term deposits of over a year.
Further, there is a distinct possibility of banks booking losses on their asset portfolio due to their exposures to the CDO and CDS segments as well as the possibility of defaults on mortgage service payments. In this scenario, the RBI evidently is trying to provide support by easing the provisioning norms.Not a right approach
The situation is analogous to one where the pass mark is reduced in an examination to allow more students to pass! Ideally, this should not be a suggested approach because while support can be provided through the interest rate and CRR routes, tampering with prudential norms would not be advisable.
As the RBI has worked quite hard in bringing in prudential norms into the banking system, whereby banks became more conscious of the quality of their assets as well as capital, more in line with Basle I and Basle II requirements, the present move once again raises the issue of a new moral hazard at the institutional level.
Will the banks consider indiscriminate lending with the hope of the RBI providing relief in the form of easier provisioning requirements in the future?
The broader issue really is whether or not the RBI should be concerned about profitability of banks, especially where there is a conflict with prudence. The function of the RBI is to monitor liquidity and ensure that the rate structure is in consonance with the overall macroeconomic targets that have been set forth in terms of inflation and growth.
Banks would need to work their way through these broad parameters that are set. While today the rates have been lowered for standard assets, and hence prima facie looks fairly innocuous, the precedent could be used for further easing of norms for sub-standard assets at a later date. A matter of prudence
It must be realised that the idea of having such norms at a nominal rate for standard assets is a matter of prudence where the provisions actually cumulate to provide for a buffer when assets deteriorate in quality at a later date. The exposures to the mortgage or personal loan segment or even the derivative segment for that matter would actually show as possible pressure points at a later date, for which the present provisioning provides the requisite cushion.
This really goes back to the basic question about how far should the monetary authority go in protecting the banking system?
Ensuring that the deposit holders are not affected looks a convincing stance, though gearing policies towards protecting the profit lines of banks does not work, even at the academic level.

Why not do nothing? Financial Express: 24th November 2008

Inflation, which was a major worry in the last six months, has now eased considerably and there are signs that it will gravitate towards the 6% mark by March end. This is mostly on account of the easing of oil prices that has tempered the price rise. Also, the global decline in metal prices has eased the prices of manufactured products while food prices have been brought down due to the stabilisation of supplies. In this situation, what should be the approach taken by the government?
Today, there is a liquidity problem in the country. During the current financial year the difference between incremental deposits and credit and investment is around Rs 25,000 crore. Credit has been growing, though the allocation could be in favour of agriculture (priority sector) and retail segment. But, the fact that there is a shortage means that the price of credit, which is market-determined, should increase. RBI is trying its best to maintain liquidity through CRR reduction and repurchases in the MSS window, so that government borrowings do not become intrusive. We need to ask ourselves whether RBI should be concerned with the direction of rates when weighed against market conditions.
The Rational Expectations School which was popular in the eighties was an attack on the Keynesian idea that monetary policy could only affect inflation, and not stimulate growth. The logic was that if the monetary authority announced its targets and stuck to them, the market would automatically take decisions based on these guidelines and this would result in an optimum equilibrium. As a corollary, Lucas, Sarjent and Wallace (who are proponents of the School) said that the authority could be effective only if it systematically ‘fooled the public’. This would mean that the policy announced in April would be reversed subsequently and repeatedly, which would affect the growth path as market participants would constantly keep readjusting their decisions based on the policy moves. The School concluded that this was not an efficient way of going about things.
Now let us see what RBI has done. When inflation was increasing during the first part of the last financia l year, it responded with strict monetary controls, raising rates and absorbing liquidity. This sent signals of contraction, and investment and spending plans were curtailed. As it was then the slack season in which investment is typically on a low key, this may not have been disastrous. However, after the global financial crisis resurfaced in August 2008 through the CDS route after the CDO path in 2007, the response was to reverse these policies. This was done by reducing the CRR successively and then touching on the interest rates to make life easier. Today, we are seeing declining inflation but the threat of lower growth has also made its appearance. Under these changed circumstances, RBI faces a quandary. It needs to lower rates to provide succour to the market, but it has little control over the growth of deposits even as demand for credit is increasing.
The efficient way out would be to do nothing and let the markets do the talking. In fact, by lowering rates further today, RBI will be distorting the price mechanism. The banks have quite subtly thrown the onus of lowering interest rates on RBI. On their own, they are offering higher rates on long term deposits because this is the only way to garner medium term funds for deployment, given the shortage of liquidity. This is the reason why the deposit rates are still not coming down even after lending rates have been perforce reduced.
Now industry should not be complaining about higher rates, as interest cost constitutes only around 4-6% of its total cost of production. Yes, liquidity is a concern that can be redressed through CRR intervention. The retail segment lending has slowed down which in a way is good for the banks as it gives them time to introspect.
What should the government do today? The answer is that it should do nothing. The act of constantly tinkering with the interest rates, which moves against the market conditions, should provoke a wider debate.

Why have the markets tanked? Financial Express: 8th November 2008

The Indian stock market has fallen quite dramatically over the last three months and the analysts who conjured visions of the Sensex touching 25,000 earlier this year are now trying to explain the lows in the range of 7000-8000. A slower economic growth this year, could explain a part of the story, but the kernel of the meltdown lies elsewhere. Curiously, the Indian stock market has become a reflection of the actions of the FIIs, which is significant as it reflects the strengths and weakness of the market.
The strength is revealed in the fact that the Indian market has now become globalised in the true sense and is able to take into account the benefits of the same as the actions of the FIIs get reflected in our own market. However, the weakness that has to go along with such a package is that our markets become vulnerable to the changing strategies that they pursue which makes them shaky at times. Unfortunately, this isn’t always related to fundamentals.
FIIs have withdrawn a net amount of close to $16 bn in the first 10 months of 2008 which works out to approximately Rs 65,000 cr from the equity market. Their actions have had a decisive impact on the Sensex which has tended to fall sharply every time they have moved funds out in a big manner. This has happened in June, September and October when they withdrew as much as much as $ 7.8 bn from the market. In the first 5 months of the year, the Sensex ranged between 15,500 and 17,500 with a fall being witnessed sharply in March, when the FIIs had a neutral position. Subsequently, the FIIs have been on the selling spree that has accelerated the decline which got the ultimate shove in September when the CDS crisis erupted. The question that needs to be raised is why should this be significant?
The FIIs account for around 1/3rd of the total transactions (buy plus sell) that take place in the equity market. The number should not actually be driving the market as there is another 2/3rd which is being driven by the other elements. Mutual funds accounted for around 8% of the total transactions in the equity market in the first 10 months of calendar 2008, which implies that the balance actually comes from other institutional investors and the retail segment.
The FIIs as a group tend to act in the same manner as they are driven by virtually the same factors individually. They see a market to invest in when the P-E ratios are attractive. However, given that they have diversified interests in various markets as they are investing globally in equity, debt, derivatives and bonds, they take a macro view and balance out the net gains across markets. Hence, a financial crisis in the US on the derivative side implies losses for them which in turn would make them unwind their positions across the globe even in say the equity markets overseas, causing a sharp fall in the emerging markets.
Mutual funds have also had a role to play in this story even though their share is low. In fact, the fact that their share is low raises certain questions. In the first 10 months of the year, out of a total net investment of Rs 68,000 that was made by these funds, only Rs 10,500 crore went into equity while the rest was ploughed into debt. Quite clearly, the investors were wary of the equity segment as the revealed preference for this segment means that individual investing in debt funds (FMPs and money market funds became popular) did not expect the equity book to really last for longer.
The message hence is quite clear. Our markets are going to be driven by the FIIs as the rest of the market is going to take cues from their actions. Higher growth or lower inflation or a strong corporate performance will probably swing the market temporarily—maybe a few days. But over a 1-year horizon, the FIIs rather than the mutual funds would continue to show the way.

Investors ride roller-coaster across markets: Economic Times: 5th November 2008

The financial markets had gone berserk in the last two months following the financial crisis which erupted in the US with the fall of Lehman Brothers and Merrill Lynch. The Indian markets went into a spin and all segments got affected, which culminated with RBI stepping in to lower the CRR and repo rates as there was a liquidity crunch with repo subscriptions touching Rs 90,000 crore on a regular basis. The domestic stock markets felt the repercussions of the US crisis as the FIIs started selling. This, combined with the rising trade balance, caused the rupee to fall. Meanwhile, the Fed’s assurance and the US treasury’s resuscitation measures brought cheer to the US markets with the dollar strengthening, which in turn put pressure on the rupee again. The RBI intervened to supply dollars which depleted the reserves further by nearly $40 billion in these two months. The squeezing of liquidity on this score combined with news of a possible scare on a bank, led to panic that raised interest rates as liquidity dried up with mutual funds also queuing up for redemptions. Relief came in the form of RBI intervention in several quick steps which have sort of restored some order. Meanwhile, with the dollar strengthening, the price of gold and silver fell in the global market and the signs of a recession in the US led to crude oil rapidly lose ground. In this set-up, all markets exhibited some crazy levels of volatility. The call market witnessed the highest annualised volatility of 349% as the Mibor ranged between 6.07% and 20.3% during these 2 months. The continuous speculation of RBI action and a tepid response followed up by a series of CRR and repo rate cuts created this volatility in end-September and first half of October. This really means that a bank which had enough liquidity could have made a lot of money by trading this volatility. The second most volatile market was the stock market, with the Nifty exhibiting a level of 63%, as the index slid from 4504 to a low of 2524 and then recovered. The continuous FII withdrawal of $7 billion added to this slide as other players took similar steps. The third volatile market was quite unrelated to the crisis per se directly, as crude oil continued its descent from above $120 to the region of $ 60/barrel. With volatility of 52% in these 2 months, it was a very hot investment option though it would have been more of a bear market. The fourth most volatile market was the market for bullion with gold displaying a volatility level of 35% and silver with 43%. This was a direct consequence of the strengthening of the dollar as bullion is considered to be a substitute for the dollar and investors switch from one to the other easily. A stronger dollar made more sense resulting in silver showing a min-max variation of Rs 4400/kg while silver had a range of Rs 2800/10 gms. The government security market (as shown by the NSE GSec total returns index) was relatively less volatile, but thanks to the interest rate gyrations, had a volatility of 21% which is over twice of its historical average of 8-10%. Lastly, the rupee-dollar rates was relatively subdued at 13.5% mainly due to RBI intervention which ensured that the daily variations were kept under check and while the RBI reference rate did cross Rs 50/dollar, it has been kept within a range of Rs 48-50 most of the time. The revelation really is that this is probably one of the rare occasions when all sections of the financial markets have been volatile, and there were really opportunities for investors who were willing to take the risk. However, as the gyrations were in both directions, it would have been difficult to guess the direction and magnitude of change with the RBI actually controlling the strings - the fact that it has intervened in the market when least expected in both the money and forex market, means that game, set and match really goes to the monetary authority.

Which Rate to cut? Financial Express: 1st November 2008

The CRR and repo rate are two instruments used by the RBI to control growth in money supply. How does one choose between the two and which is the superior tool? This is important in the current scenario where there are phases of low and high liquidity in a scene where interest rates are still sticky.
The CRR impounds/releases cash from banks which reduces/increases their scope to lend thus controlling the money multiplier. The resources impounded earn no interest either in the form of a loan disbursed or a token rate paid by the RBI. This in a way impacts the profitability of banks as interest is being paid without any commensurate income being earned.
In case of the repo (or reverse repo) the RBI changes the interest rate at which banks deal with it. Therefore, to the extent that banks are lending or borrowing from the RBI, the rate change will affect their cost of borrowing which should logically get translated into their interest rate structure. But the efficacy of the rate hike depends on the quantity of money that the banks are borrowing. If banks expect a liquidity crunch then they would revise their basic rates, but if the liquidity situation is expected to be relatively easy, then status quo may prevail. Today a number of banks are offering high rates for 3 years, which means that either there is a mismatch in assets and liabilities or that they would like to lock into such rates for a longer term as the tenure of their assets would be lengthened.
Now, in the current situation, their relative costs could be evaluated. A CRR increase of say 50 bps would mean the impounding of Rs 20,000 crore. As banks would not be receiving any income on these funds, and would be paying an average deposit rate of say 6%, the direct loss would be Rs 1,200 crore, for the entire year. This is intractable unless the CRR is reversed, in which case the gain would be say 200 bps over the deposit rate, or Rs 400 cr. In case of the repo rate, if it is hiked by say 50 bps, then assuming that the banking industry borrows Rs 20,000 cr from the RBI on a daily basis (which never happens since there is an equal spread of borrowings and lending from the RBI throughout the year), then the loss would be Rs 100 crore. Further, banks may choose to rework their interest rates across the board and actually cover up for this higher interest rate. Therefore, they would be better off with a repo rate hike compared with the CRR hike.
The impact on the investment portfolio in terms of losses booked would be the same in both cases as yields on GSecs and bond prices fall when the mark to market valuation is done as interest rates increase.
So, which is the superior tool? CRR is superior when the idea is to curb the lending ability which was the objective when there were large forex inflows which led to monetisation. However, when liquidity is tight, and there is need to restrict growth in credit, then a repo rate is preferable.
An interesting analogy that can be drawn here is with the foreign trade sector, where tariffs are more efficient than quotas. CRR is like a quota while interest rates are like tariffs. Quotas are inefficient as they tamper with the market mechanism, but are effective if the purpose is to physically limit the quantity of funds in the market. Interest rates like tariffs only move the acceptable price schedules laterally. This may not serve the purpose of say increasing interest rates like those on deposits or loans, but then the choice is with the bank to absorb this higher cost.
Therefore, ideally the CRR must be used only when there are excess/shortage funds in the market. The repo rates must be the main tool to control monetary growth. A way out for the RBI is to fix these rates every month based on the state of liquidity. This will address the concern of liquidity changing periodically. As a rule price adjustments should be preferred to quantitative restrictions for the system to be efficient, and the latter should be tinkered with only in case of extreme liquidity situations.

Monetary Signals ahead: Financial Express: 19th October 2008

RBI's action of reducing the CRR in three tranches from 9% to 6.5% is a clear indication of a system of changing paradigms that has been in vogue throughout the year. One will recollect that the RBI started the financial year with a series of increases in the CRR from 7.5% to 9% as many as 6 times between April 26 and August 30. The reason then ostensibly was that inflation was a concern and there was pressure to control the rate of growth of price increase. At that time, critics felt that inflation was a cost-push phenomenon and that removing liquidity from the system would not really help as long as the supply constraints remained. However, it was justified on the belief that potential demand-pull forces would be controlled through these measures and would address the broader issue of inflationary expectations. In a way it did not matter, as it was the traditional slack season when the demand for funds is low.
The policy of increasing the CRR and curbing liquidity however, had certain unintended effects in terms of the negative impulses seen on industrial growth. which has come down to less than 2% in August, which is now a concern. Projections for the same are less than sanguine, between 6-7%, now following the financial crisis from the number of 8-9% expected earlier. Also, inflation per se has not really been moderated and is only gradually coming down from the level of 12%, as supply fundamentals have improved. RBI is of course carefully tracking this variable before posting a comment on whether or not the worst of inflation is behind us. It may be waiting for the declining trend to continue before passing a firm judgment.
Now, the global crisis has exacerbated the situation, forcing RBI to lower the CRR to 6.5%. The trace of urgency is palpable because the three reductions have been with effect from the same date: October 11, as the crisis has intensified. There was a deficit of Rs 90,000 crore in the system as evidenced from the borrowings through repos in the market, which could not be covered by the 50 bps or the 150 bps reductions to begin with, which prompted the third round cut of 100 bps. The overall attempt to increase liquidity through reimbursements of farm waivers, opening the window for mutual funds, etc, are all targeted at making life morecomfortable. There are now hopes based on the u-turn of RBI that the repo rate will also be reduced going ahead.
Now, there are two issues, which come to the forefront. The first is that we have tacitly accepted that growth will now be more important than inflation and that the monetary policy in particular will be geared in this direction. This in turn makes the overall approach to policy fairly fickle, as the three reductions were in a span of just a little over a week. This phased reduction has now sort of matched the deficit that has come up in the system. The fact that we are now going to focus on growth means that inflation is not a worry. But, what if inflation starts rising again? This will become a delicate issue because by lowering rates at this time to spur growth, higher demand, especially from investment, could lead to the problem of lags and leads, which can be painful in terms of higher inflation in the interim period. What would be the approach then? We may have to restart increasing the CRR and repo rates again.
The second issue is that theoretically we need to be more sure of the use of the monetary policy. The Rational Expectations Theory propounded by Lucas and Sergeant would advocate strict targeting of money supply and rates by the monetary authority and silence there onwards. The markets are smart enough and efficient to take the cue and make the required adjustments. However, this year, probably on account of certain compulsions, the CRR was increased when inflation was high. And now that we are used to a high inflation number, the rates are being lowered to spur growth. The market gets confused signals about the monetary stance, which paradoxically provides scope for the monetary policy to be effective.
This kind of excessive fine tuning, though theoretically sound, does send mixed signals and a statement from RBI regarding its focus would actually guide the markets, as the present measures may only provide solace of affirmative action being taken. We have already lost out on growth by raising the rates and run the risk of having the double-digit inflation rate follow us till March. Industrial growth could get sliced down by 2% points, as banks have decided not to reduce rates as yet. Maybe they are waiting for the repo rate cut now. We are now banking on the kharif harvest and falling oil prices; as also the declining metal prices, following lower demand on account of the global slowdown, to provide comfort on the inflation numbers. However, we may still have to fall back on the supply factors for relief in inflation, as the present relaxation in CRR has the potential to stoke demand side factors. The rest of the year is surely going to be a challenging one.

How Safe are our Banks: October 25th 2008: DNA

The only way to ensure secure banking is to have strong prudential practices in place
The US government’s decision to take stake in the private institutions following the financial crisis has been interpreted as a move towards nationalisation. This, it has been said, is a clear vindication of the view that capitalism in the current form delivers greed under the veil of efficiency. India, fortunately has not been affected because we were conservative, and probably wiser, on hindsight. Is this feeling of security really justified or is it misplaced?
The recent scare that was caused by possible problems with ICICI Bank got the FM and the RBI to jointly vouch for the strength of the bank. This should make us stop and think. Are we really secure in a flattened world? And, in case things really went wrong what could be the consequences?
To the question as to how safe are our banks, there’s no clear answer. Nobody ever expected that the high growth in mortgages in the USA which were dressed up as securitised assets was actually an explosive waiting to be detonated. The fall of Bear Stearns and other investment banks was a result of something which went wrong which no one expected would go wrong, which is the case with all financial crises.
The RBI was prompt to get the banks to reveal their exposures to Lehman, but Lehman is just the tip of the proverbial iceberg. The fact that banks do take on large exposures in non-fund based activities is worrisome. When a bank lends money directly for a project, the risk is known. When it provides support to a derivative instrument or lends to another institution which has exposures to such instruments, then it loses that many degrees of freedom. In a quest to earn more non-fund-based ‘other income’ banks actually built up contingent liabilities which run into multiples of their own balance sheets, which is a concern.
However, there are other ticklish issues which have surfaced in the name of competition wherein banks have been chasing the customer to credit cards and mortgages. This was the route taken by several private banks to garner a greater share of the retail pie, as wholesale credit was not growing fast. Banks pitched for retail loans which looked good because they were small tickets and all could not default at the same time — but this did happen in the US which germinated the present financial crisis in the form of the sub-prime crisis.
Credit cards can be explosive as even today they are being provided indiscriminately to customers over the phone or outside the airport without any due diligence. These cards have spread quite swiftly increasing consumer spending and one is not sure about the defaults.
The message is that there are booms and busts for every phase of economic activity. It has been seen in manufacturing, in construction and there is no reason for it not to happen in the banking sector. That the RBI has been conservative has helped, but the regulator must monitor banks closely.
From the point of view of the deposit holder, the natural question raised is as to what would happen in case a bank went down under? If the bank was small, then the RBI could take care of it easily with a merger that took care of the depositors’ interest. But what could be done if a bank with a balance sheet size of Rs400,000 cr goes down? Deposit holders today are insured for Rs 100,000 and quite clearly, this needs to be enhanced. But here again the problem is that if say Rs250,000 cr of deposits have to be paid by the insurance company, where will the money come from? Secondly, a large bank cannot be merged with another one given the size involved — a failed large private bank might make another go down under the burden of the losses.
Given that there is no easy solution, the question of government participation in banks becomes relevant again. Public sector banks provide more confidence to deposit holders. Less than a decade ago Dena Bank, Allahabad Bank, United Bank and UCO Bank were in deep trouble — but no one withdrew their money because they are owned by the government.
However, a rumour regarding the stability of ICICI Bank started a run on the ATMs. It may make sense for the regulator to have a nominee on the boards of private banks (this may lead to several groans) so that someone responsible knows what is happening.
Commercial banking is a mundane business and as one is dealing with public money, the deployment of such funds must be judicious. Capitalism espouses creative destruction of institutions, but when the subject is banking it cannot be permitted. The only solution is to have strong prudential practices in place, and hope that things do not get out of control.

Eye See Eye See Eye: Financial Express: 21st October 2008

Traditionally, all banks tend to have imposing building structures because they have to give the impression of stability and reassurance to all their customers. Deposit holders in particular need to be told that their money is in safe hands. The most awe-inspiring building is the one built by ICICI Bank in Bandra Kurla Complex which is symbolic of size, dynamism and innovation.
The malicious campaign against ICICI Bank perhaps had roots in the bank’s success; a case of sour grapes. ICICI’s global forays were aggressive and accolades were won when the conquests were made. But this was turned into a fear factor by those talking about risks. The best thing is, of course, to always look at the numbers.
Quite coincidentally, RBI recently brought out data on banks. ICICI has witnessed a growth of 260% in its deposits and credit in the last four years. With a credit-deposit ratio of 92% (SBI peaked at 78% in FY08), it clearly shows the calibre of a leader. However, its cost of funds has increased from 3.02% in FY05 to 6.4% in FY08. Contrast this with SBI which has seen an increase from 4.9% to 5.64% during the same period. Quite clearly, the deposit garnering act has been at a higher cost.
On the earnings side, the adjusted return on advances (after adjusting for cost of funds) has fallen almost continuously from 6.94% in FY04 to 4.08% in FY07 before rising to 4.33% in FY08. Higher cost of funds (deposit) combined with lower returns does raise questions. One often quoted instance of aggressiveness is in the cards business where the Bank has one of the largest number of card holders—however, these cards are distributed quite freely outside Food Bazaar outlets or any other department store. This could be a source of concern as delinquencies can be high here if proper due diligence is not done. Again in contrast, the SBI’s return on advances actually rose from 1.88% in FY04 to 3.70% in FY08.
These numbers would not otherwise have been too significant but for the fact that the NPA ratio has also been on the rise. In fact, the Bank had prudently brought down this level post becoming a universal bank in 2003, from 2.21% to 0.72% in FY06. However, it has risen in the last 2 years to 1.55%. In contrast, the NPAs of SBI had come down from 3.48% in FY04 to 1.56% in FY07 before rising to 1.78% in FY08. ICICI Bank is well capitalised which is comforting as the ratio has risen to 13.97%, one of the highest in the industry. However, the fact that it has been raising capital in the past means that with this kind of financials, it may be difficult to do so more frequently. Its capital (equity plus reserves) has gone up from Rs 8,360 cr to Rs 46,820 cr during this period, while SBI was able to add only Rs 28,802 cr essentially through profit plough-back.
The other question raised about ICICI, and about banks in general, is their participation in financial ‘innovation’. Indian private banks and some public sector banks do have positions in off-balance sheet items that come under the heading of contingent liabilities. These business lines offer fee income without any accompanying deployment of resources and are therefore attractive. In case of ICICI Bank, the ratio of contingent liabilities to total assets was 2.87, while it was 4.45 for HDFC Bank and 2.36 for AXIS Bank. The same was 1.12 for SBI and 0.47 for Bank of Baroda. Everyone is taking a closer look at these business lines that provide a lot of ‘other income’ to banks and come under the scanner only under these unusual circumstances.
But the key question is: was there any reason for the layman, or deposit holder, to have got worried? The answer is obviously no because ICICI is very well capitalised and solid in terms of its functioning and losses if any can easily be absorbed. The fact that profits earned are over Rs 4,000 cr and that it has paid a dividend rate of over 100% this year are firm pointers of good performance and safety.

Back to the beginning: Hindustan Times, 15th October 2008

It is said that irony seldom escapes the characters in a drama. This is especially so when it is the financial stage where we all have our ‘entries and exits’. The way the financial crisis has unfurled, quite a few shibboleths of capitalism have been left shattered. The wiser ones describe the working of ‘capitalist greed’ as the ‘privatisation of profits and socialisation of losses’ — something that would rake up a turf war between Adam Smith and Karl Marx.
A significant aspect of the crisis is that we are all wiser after the event. Financial engineering threw up a lot of jargon — CDOs, CDS, securitisation, ABS, MBS etc. We never really figured out how they worked but all of us clapped when the off-balance sheet business multiplied to some $600 trillion, or 11 times the world output. The boom and bust of this business cycle is much like the now popular words of Nelly Furtado — why must all good things come to an end.
There are a few things that stand out from this crisis. One is that this is the first time in the last few decades that all the countries of the world have united for a non-political cause. So have the central banks — including China’s — to reduce interest rates across the board to assure the players that the government cares. The world now shares a common voice with two tones: one, rubbishing capitalism and two, doing everything to keep the world economy going while some countries like Iceland and Pakistan are slipping towards bankruptcy.
Both small and big institutions can fail without being noticed. But if the malaise is so deep that the entire edifice crumbles on failure, then one can be moderately sure of a rescue. If the US financial market goes under, so would the European, Japanese and other markets. The US maintained a stiff upper lip when Lehman Brothers crashed, which was out of place because when AIG went down a few days later, the parachute was opened.
Now everybody is suspicious of everybody else. Even lower interest rates have not encouraged banks to lend to one another, as no one is quite sure of the skeletons that may exist in another’s closet. In 2007, after Bear Sterns, it seemed that the worst was over. But along came the Freddie Mac and Fannie Mae sagas, followed by Lehman, Merrill and the rest. It will take time for this suspicion to die.
While India has been tom-tomming the fact that it was insulated from the crisis due to sound policies and practices, the recent scare related to a private bank has shown that no one is totally protected. The regulator assured us that overall bank exposures to Lehman were minimal. But then, Lehman is only the tip of the iceberg and the air of uncertainty now pervades the entire system as various other institutions around the world continue to crumble. How exposed are we to them?
With Goldman Sachs and Morgan Stanley now looking towards becoming regular commercial banks, the financial system appears to have come a full circle. Therefore, from being the hub of action and innovation, banking will go back to its ledgers and tellers.
Progressively, governments across the world will now be taking a stake in commercial banks. This is being done with a dual purpose. The first is to assure the public that their money is safe; the second is to keep a watch on the operations of the banks. This works well for the banks for, after the mess that has been created by them, the government can now be a part of the cleaning-up operations.
The move towards nationalisation and government support makes one nostalgic for the 70s-80s. And to think that those like Moodys, Standard & Poor, IMF and the World Bank have all been clamouring for more privatisation.

Wall Street Lessons: DNA 18th September 2008

When a credit market gets overheated, governments and regulators must step in
Bear Sterns, Fannie Mae and Freddie Mac (and Northern Rock somewhere along the way), Lehman Brothers, Merrill Lynch and AIG are all big-sounding financial names which a year back inspired awe in the layman.
Today they are symbolic of what has gone wrong in an area where it seemed nothing could go wrong and whose impact stretches across the world. It involves not just the highly paid managers and other back-office employees, but also central banks and governments where everyone is involved and has to create new ideologies or break old ones to keep the system alive.
Lehman Brothers and Merrill Lynch have run large losses to the extent that one has filed for bankruptcy while the other has managed to find a buyer. This is a result of the fallout of the sub-prime crisis which claimed Bear Sterns and Northern Rock last year and hit the twins earlier this year. The story leading to this crisis was straightforward. While interest rates were lowered by the US Federal Reserve over the years, people borrowed like mad. Home loans were provided without due diligence and came to be called NINJA loans (no income no jobs no assets).
There was a property boom which sent prices upwards and cheap loans provided the enticements. These loans were bundled and securitised — a process where these loans are converted into securities (asset-backed securities) and resold in the market. This is where these investment banks stepped in.
These CDOs (collateralised debt obligations) fetched higher rates and the investment banks borrowed funds to invest in them. Once the rates started moving up, problems began. Home owners started defaulting. Simultaneously higher interest rates drove down the property prices and as indebted home owners left their keys back and disappeared, the collateral value had fallen. This meant that the housing finance companies took a hit as did those who dealt with the securities in the CDO market backed by these houses.
The crisis has now entered a dangerous phase. If Lehman's assets are avoided in the process of liquidation, there will be a chain reaction and similar assets on other firms' books will have to be marked down. One take-away from this Lehman episode is that the industry is harsh and is not willing to rescue the sick, even when the consequences of inaction are potentially dire.
The other concern is the impact on the credit-default swap market where Lehman holds contracts with a notional value of almost $800 billion.
The story obviously is more intricate but the gist was that such over-leveraged purchases of assets provided a double whammy on both sides leading to a collapse. Usually when there is a collapse of such a magnitude, a bail-out is expected. Northern Rock had it when Bank of England intervened and Freddie Mac, Fannie Mae and Bear Stearns had the US government intervening.
Governments either directly provide relief or get the monetary authorities to lower rates. This has in a way set a precedent of moral hazard as the so-called wrong-doers are bailed out.
The debate now is whether or not such bail-outs are desirable? Going by economist Joseph Schumpeter's theory, financial failures are necessary to separate the good from the bad and they start the process of creative destruction. If we destroy our own institution, then it may not matter. However, if your own destruction rocks the entire global system, then someone will help out. Therefore, if one has to destroy, make the destruction big! This line of thought is not sustainable.
Hank Paulson could be lauded for letting Lehman file for bankruptcy but the issue of AIG is ticklish, which has an exposure of around $ 450 billion. Goldman Sachs and JP Morgan were approached for a fresh fund infusion of $ 120 billion, but there was no interest.
The Fed has finally announced an $ 85 billion loan for its revival, which thus blows hot and cold over the approach to financial moral hazard. Spurning Lehman, it has in a fortnight bailed out huge mortgage companies and an insurer. The puzzle is, why not Lehman?
What are the lessons to be learnt? The first is that no institution is too big to fail. The second is that failures should not ideally be bailed out as they set precedents of moral hazard. Third, the securitisation market is still an unknown quantity.
Fourth, when assets are fraught with risk, over-leveraging in a booming market is not a prudent policy. Lastly, regulators and governments need to be more observant when there is a boom, rather than reactive when the crisis descends. This way the intensity of the crisis can be moderated and the pain lowered.

Tackling the banking camel: Financial Express: 16th September 2008

Dr Subbarao takes over as governor of RBI at an interesting stage, when he has to cast the dice in favour of either growth or inflation. Also, banking is on the threshold of some new challenges that have to be taken head-on. The now familiar acronym of CAMEL in banking parlance takes on the following form: capital, asset quality, monetary policy, emerging banking scenario and lending.
Subbarao was once the secretary of the PM's Economic Advisory Council, a group that put our growth at 7.7% for the year. He now heads an institution that has been more optimistic at 8% in its target. On the face of things, this should not matter because a 0.3% growth in GDP is just around Rs 10,000 crore. But, psychologically the number of 7.7% looks satisfactory while 8% seems impressive.
The other reason why this difference matters is that the overall monetary stance will depend on whether we pitch for 7.7 or 8%. If we are speaking of 8%, the governor has to think hard before increasing the pressure on the brakes and may have to consider a loosening of the strings. But, if 7.7% is acceptable, then he will be satisfied with the current state of affairs.
The fact that he was in the PM’s advisory council also means an ostensible shift from a government official who looks at the politics of Economics to an Economist at the Central Bank who should ideally give greater weight to Economics. With an election in the vicinity, this will mean a focus on tackling inflation. The fact that the prices of commodities are softening and that past monetary measures should start delivering from October means that there is comfort to be had.
All governors have gotten typecast for certain actions. Dr Reddy had favoured a CRR intervention while Dr Jalan had the knack of coming in when no one expected RBI action. It will take some time before the media and the market start typecasting this governor.
The banking sector will need to be prepared as per Basel II. One of the biggest challenges is capital for further expansion. Fund requirements will be especially enormous because our 8% growth model is dominated by infrastructure, industrial and construction sectors. Presently, the banking system is compliant on this score, with a large number of banks having capital adequacy ratios of over 10%. In 2009 we will see the banking sector open up to greater foreign participation, which will mean more competition. Skeptics are saying we should not hurry on this front. Privatisation of public sector banks also needs to be tackled with a new perspective. How do public sector banks start disinvesting their equity? Should they be sold to the public or other banks, and do the latter include foreign and private banks? Will private sector banks survive in this competitive set up?
Against the background of the sub-prime crisis, the RBI also has to take a deeper look at asset quality. A US-like situation is not really visible in the Indian context, but home loans have been growing even as interest rates on them have risen from 8% to 12-14%. The RBI will need to be alert.
The elections will also demand a balancing act between loan waivers and inclusive lending. Inclusive lending tends to be associated with higher NPAs, which have also been part of the waiver story. While the burden of waivers is being borne by the government, there is a new moral hazard, which incentivises defaults. The banks would have to take the stick and this also has to be addressed by the RBI.
So, Subbarao has very interesting challenges ahead of him, and the fact that he has been part of the government will amplify his political compulsions. On the other hand, being one of the better economists, he will be aware of these pitfalls and their solutions. This story should unfold in the next year or so.

A Time to Choose: DNA: 8th September 2008

The new RBI governor has to decide between aiding growth and controlling inflation
With a new governor taking over the Reserve Bank of India (RBI), it is a good time to evaluate the prospects for the Indian economy. Four factors must be kept in mind. The first is that there are signs of industry slowing down and inflation is still high.
The second is that we are not alone in this conundrum, as slower growth and inflation are an all-pervasive phenomena and central banks everywhere in the world are trying to resolve these twin problems. The third is that there are some indications of world prices, especially of oil, cooling down.
Lastly, the change of guard at the RBI is germane to this issue because future policy will be guided by a new wave of thinking on Mint Street.
At this moment, the prospects for growth look bleaker than they were last year. The question in one’s mind is whether we will be over 8 per cent this year or fall somewhere below. The majority consensus is that 8 per cent will be difficult. The RBI had also scaled down the number from 8-8.5 per cent in April to 8 per cent in July.
The PM’s Economic Advisory Council (the new RBI governor was a part of this council) had brought it down to 7.7 per cent while others are pitching for 7.5 per cent with a bit of luck. The numbers matter not just for the psychological reasons, as 8 per cent sounds good while anything lower gives the impression that we have lost out somewhere.
The important thing is that even 0.1 per cent difference means that real income of around Rs3,100 crore is lost (our GDP in real terms is Rs31,00,000 cr), and hence the difference between the RBI and the PMO’s projections could mean close to Rs10,000 crore in income.
Broadly speaking, the economic performance will be driven by the kharif harvest and RBI action. The agri outcome will determine the amount of money that will be spent by the people. People in rural India are dependent on the harvest and a good one means that they can spend easily on other industrial goods. Therefore, the months of October-November are critical.
City folk, too, plan their expenses, especially on white goods and automobiles, at this time. In fact, housing projects invariably take off during Dussehra and keys are handed over for new flats at the time of Diwali. It is not surprising that this is the time when companies as well as retailers offer the highest discounts.
These discounts rise during times of an economic slowdown and hence this year we could expect more of such competitive sales for refrigerators, TV sets, washing machines, and the like. The season ends when the New Year comes, which is spending time again for all people as those who missed the bus earlier catch up with their purchases.
This is where the RBI can make a difference, as interest rates will guide spending patterns. The new RBI governor will have to toss the coin for either favouring growth or paying attention to inflation. Higher interest rates could put a spoke in the wheel as consumption decisions are postponed for a while, especially in the mortgage sphere.
At the same time, inflation today is more or else accepted as a double digit phenomenon. No one really expects inflation to come down to 5 per cent this year. In fact, curiously, the comparable numbers for the CPI (consumer price index) inflation are in the region of 7.5-8.5 per cent and hence project a more tolerable picture today. But to expect that inflation will come down to a single digit would be a bit too optimistic.
With all of us getting reconciled to a double digit inflation rate, it may be prudent for the RBI governor to persevere with the growth objective and aim for above 8 per cent growth rate which will mean a more liberal approach to interest rates. The new governor was part of the 7.7 per cent estimate and is now a part of the 8 per cent estimate for GDP.
Even while trying to reconcile the two numbers, he would have to take a judicious call on interest rates. Inflation, as mentioned earlier, is unlikely to come down drastically, and the global conditions probably signal that the worst may be over as of now.
If the RBI is happy with a 7.7 per cent number, then it could continue tightening the monetary side, but if it pitches for higher growth, then rates may have to be reduced to spur demand from both consumption and investment. For this, they also run the risk of spurring inflation, though frankly, once the rate is over 10 per cent, 12 or 13 may not really matter. But with a general election looming in the background, inflation management may be more important. After all, the common man does not understand growth or GDP for that matter. But he knows what inflation is, and that matters the most.

Currency Futures: Questions for the RBI: 6th September 2008: Business Line

The RBI, as the holder of the country’s foreign exchange reserves, has an interest in participating in the currency market, both as the monetary regulator and as a player hedging its own currency risk. Thus, its every announcement will have a significant impact on the market, says MADAN SABNAVIS.
The introduction of currency futures is probably the first of the last set of steps towards in the country’s tryst with capital account convertibility. The exchange rate, which was considered sacrosanct by the RBI in the days of forex shortages and was earlier fixed against a basket of currencies, is now on the threshold of being fully market-determined.
As the forward market is very active today, there is a lot of discussion on how this segment and the futures markets will be integrated. This is more on the commercial side. However, at the ideological level, the question posed is how the RBI’s role will be redefined in this area.
Let us look at the theoretical view on currency futures. Participants would trade in rupee-dollar rates and, hence, determine the futures price. The participants would be both those with exposure to foreign exchange risk, such as exporters or importers, and those who are pure speculators. The rate is decided by the market, and transactions are settled in rupees and not dollars. To this extent there is no pressure on dollar reserves.
The market values the dollar rate based on two benchmarks: the current spot rate and the current forward rate. However, there is no reason to assume that the futures rate will be higher than the spot and equivalent to the forward rates. The future rate is theoretically defined as the spot price plus cost of carry. If the cost of carry is positive, then the futures will be higher than the spot price. However, today, the spot rate is not quite market-determined as the RBI has a role to play here. The RBI ensures that the spot rate does not depreciate or appreciate too drastically, and uses forex reserves to do so. To do this, the RBI buys or sells dollars in the market.
Now the futures market can upset calculations. If, for example, the market believes there will be large capital inflows, meaning that FDI and FII flows will keep increasing by, say, $20 billion in the next three months; the futures rate should logically start appreciating. The forward rate may not capture it as it based more on the spot plus cost of carry concept. At the same time the spot would also get affected by the futures price. If players in the spot market know that the rupee will appreciate, then buyers would defer their purchase while sellers would sell immediately, thus lowering (appreciating) the spot rate. Spot-Futures Correlation
Now, it is not really clear in the derivative markets whether the spot market drives the futures market, or the other way round. But when futures indicate an appreciation, it would tend to feed into the spot market too.
Further, it has been observed that there is no strong correlation between foreign exchange reserves and currency movements. Hence, the spot rates may not really reflect the fundamentals at all times.
Nothing wrong, really, with this line of thought, except that, when it comes to the exchange rate, we have so far not let it move entirely based on market fundamentals. This is so as it affects all other foreign exchange transactions, especially the exporters. In fact, the RBI has played a critical role in ensuring that the interests of the exporters and importers are taken care of along the way.
For example, last year, when foreign investments flooded the country, the rupee was to appreciate rapidly. However, the RBI intervened and held on to the rupee, thus causing an implicit depreciation. Had the futures market existed at that time, the market would have sent similar signals well in advance and the RBI intervention would have given rise to the conundrum of two directions being provided to this rate.Market-determined
The question is whether or not the RBI is prepared for such an eventuality. Going by the experiences of the commodity futures market, where the price of a commodity such as wheat is fixed by the government, an interesting issue is raised.
When the futures market delivered a higher price in 2006, based on the fundamentals, there was an ideological issue raised when farmers preferred to sell to the market rather than the government.
The exchange rate admittedly is not a fixed price, like the MSP, but there has been little firmness in allowing the rate to be fully market-determined.
Therefore, when the price of any commodity is controlled by any entity, a free futures market could run into contradictions at the ideological level.
On the other side, the settlement price would be based on the RBI reference price, in which case the RBI would still control the movements in the futures market.
This rate is, in effect, largely determined by the RBI, in which case the futures market will still be guided by the RBI and there are theoretical limits to which the price could fluctuate.
Again, borrowing from the experiences of the commodity market, where there is no unique spot price, which is therefore polled by the exchanges, the settlement takes place at this price. The spot price is a polled one and is, hence, relatively free from bias, while the reference rate could, as stated earlier, be influenced by the RBI indirectly when it buys or sells foreign exchange in the market.Monetary management
Another puzzle could be in terms of monetary management. Just suppose the futures market becomes the unique force that decides the exchange rate.
Now, let us assume the rupee is appreciating at a rapid rate. From a spot rate of Rs 43.5, the futures indicate a rate of Rs 41.5. Assume that Rs 41.5 is not acceptable for the RBI and it goes in for buying up dollars, thus increasing money supply.
This process will be accelerated when the rupee keeps on appreciating and the RBI may perforce be compelled to follow a tight monetary policy as the market will always have the futures rate in its periscope. Therefore, monetary management will become that much tighter.
A final thought on this market is whether or not the RBI could be a player in the market. The RBI is the holder of the reserves for the country and, hence, owns the largest quantity of foreign exchange. Should it hedge on this platform?
It has, hence, an interest in participation, both in terms of being the regulator of the monetary sector as well as a player hedging its own currency reserves risk.
Even if the RBI does not take direct part in the market, every announcement made would have a significant impact on the market. Can we escape this one?

The Right Start Matters: Business Standard: 28th August 2008

Industry's first quarter growth is closely linked to the full year's growth - in which case, write off this year.
With higher interest rates putting pressure on both the demand and supply sides, there is a lot of concern about whether industrial growth will pick up. On the demand side, fewer goods are demanded that depend on credit such as automobiles, consumer durable goods, and housing. This in turn affects the output of these industries, causing them to cut back on investment which slows down overall growth. On the supply side, higher interest rates make borrowing expensive and companies defer investment plans. Holding costs of inventory increase and affect the bottom lines of companies.
The most recent number for industrial growth has been put at 5.2 per cent for the first quarter of the year. What is one to make of it? Relative to last year, this number is quite low as it was 10.3 per cent last year. The high base year effect is a plausible explanation, though there is still considerable scepticism about this. Does this mean that growth will be low by the end of the year? At a theoretical level, the period up to August or so is considered to be the slack season because typically one would not be spending too much on consumption goods during this period. Normally, people spend more during the festival season that starts from August onwards. We have Raksha Bandhan, Janmashthami, Ganesh Chathurthi (in the west), Dassera, Diwali, Christmas, and New Year that are associated with festival spending. This happens all across the country where people invest in a variety of things, right from clothing for the family to dwellings. The idea being that purchasing is associated with an auspicious occasion.
As we move to rural areas, the harvest factor also plays a role. Typically the kharif harvest begins in October or so and goes on through till December. It begins again in the months of April and goes on till May when the rabi harvest begins. Therefore, spending again increases from the Baisakhi-Holi time, albeit at a slower rate since festival season is over. Against this background, the argument goes, one should not be startled at a lower industrial growth rate in the first quarter of the year as this is how it should be.
This was the school of thought for a long time when the RBI also called its credit policy the slack season policy from April to October and the subsequent period was called the busy season. In fact, in the past, there was a tendency for the RBI to try and complete 60-70 per cent of the government’s borrowing programme in the first half of the year when there was less demand from the commercial sector. However, in the last decade or so, the RBI has given up differentiating between the two seasons as the tendency for spending has evened out through the year. Therefore, demand for credit today is considered to be an element that needs to be monitored throughout the year and hence deserves attention. It is not surprising that the RBI has resorted to monetary action at any time of the year unlike in the past when the second half mattered more.
In fact, it is often said that the quickest way to gauge economic confidence levels in the country is to count the number of “sales” that are going on around in the country. Usually, as stated earlier, these discount sales are meant for the festival season where dealers compete to garner a greater share of the consumers’ wallet. However, this year, the competitive discount season has begun earlier for all the consumer goods segments. This holds for automobiles and housing projects too where the spectre of higher interest rates in the future is being used to attract customers to get into deals immediately. Independence Day has now become a landmark day for potential customers!
In this context it would be useful to see how annual growth in industrial output has behaved relative to the growth in the first quarter. More importantly, is it possible to conjecture the extent of overall growth based on the information of first quarter?
As can be seen from the table, there is very strong correlation between the growth rate witnessed in the first quarter of a year and the growth for the entire year (around 85 per cent). Low growth in the first quarter invariably translates into a low growth for the entire year, while a high growth rate may not necessarily do so. Hence, looking at a growth rate of 5.2 per cent in the first quarter, based on past experience, it may be conjectured that industrial growth for the entire year would be at best between 6.5 per cent and 7 per cent.
Coincidentally, the projections of the Economic Advisory Committee of the PMO (EAC) had scaled down GDP growth projection for the year to 7.7 per cent and that of industry to 7.5 per cent. This could be attributed to both the high interest rate regime as well as the high base year effect where industrial growth has been greater than 8 per cent for four successive years while peaking at 11.5 per cent in FY07.
In which case, we need to revisit the calculations for GDP growth this year, where the monsoon will be critical as agriculture will play a decisive role in determining the final figure. With a 7 per cent growth rate and a 20 per cent share in GDP, industry will contribute a maximum of 1.4 per cent to GDP growth, while agriculture with a share of 17 per cent will need to clock 4 per cent to add another 0.7 per cent. We would still be need services to grow by 9 per cent to end up with a final number of 7.8 per cent. Can this be done?

After the Godzilla Effect: Financial Express: 26th August 2008

Banking was a rather somnolent business until 1992 when bankers simply waited for the customers to walk up to them, because the latter didn’t really have many choices. Then the force of competition ushered in by the implementation of the Narasimham Committee Report changed this landscape substantially. The entry of new private banks and the spread of foreign banks added momentum to these changes. But the strategies that initially took innovative routes have ironically returned to a pre-reforms mode typified by conservatism. Consider the following u-turns:
New private banks have usually been innovative trendsetters. They were the first ones to introduce technologies like ATMs and phone banking and Internet banking, which were swiftly accepted by their customers. Till a short time ago, there was immense competition among these banks to grab ATM leadership. First, ICICI Bank claimed this spot, but SBI soon let it be known that it was the one with the highest number of ATMs in the country. But now the RBI is encouraging banks to share their ATMs to save on equipment costs, and the numbers game has become non-existent.
Secondly, in the initial post-reforms phase, banks were keen to attract customers by giving out bundled products such as cards, loans etc. The idea was to reach out to as many customers as possible and garner market share. The move was towards mass banking. Today, however, banks want only high-end customers and have changed tracks.
On the lending side, banks initially went in for big-ticket customers as the Godzilla effect took shape. Corporates were segregated into large and small categories, with the focus being on the larger ones that were expected to help maintain better quality portfolios. While the private banks took the lead here, the public sector banks also followed the same route to keep in the race. Today banks have switched over to the SME route on the grounds that this is category with the larger potential, and also has a healthy track record.
There was also a time when banks were rushing into the retail segment. The idea was that housing loans were safe bets with low default rates. Besides, as houses were hypothecated to banks, there was reason to believe that these loans could not go bad. Banks hence lent extensively to this sector and set up special divisions for the same. Low interest rates and longer tenures were the attractionsHowever, with interest rates climbing of late and the shadows of the sub-prime crisis hanging over us, banks are fast withdrawing from this segment. They are increasing rates to better protect their bottom lines, and trying to ensure better repayments by focussing on high-end customers.
Earlier, banks were offering variable lending schemes where borrowers had the choice of fixed and flexible interest rates. This was at a time when the flexible schemes made sense because rates were poised southwards. With interest rates going up lately, these options are hardly exercised anymore, and we are seeing only fixed rates in both the deposits and loans segments.
Also, in the post-reform period, the basic mantra for expansion has been one of taking over smaller banks in order to reap economies of scale: one got branches, customers, business and skilled staff through such mergers. Today the sector is wary of mergers, especially since there is now the possibility of foreign banks actually taking over Indian banks after 2009, when this sector is opened up.
These u-turns mean that the current landscape is characterised by well-diversified conventional portfolios and stable rates rather than variable rates. On the deposits side, customers are returning to the branches even though other modes have been remarkably well accepted. While mass banking is still the preferred choice today, class banking is increasingly being prioritised. In short, the overall approach to strategy appears to have come full circle, or almost.

Cracks in the Communist Citadel: 12th August 2008

The Chinese citadel appears to have finally developed some cracks. China is now a country that is looked at with a growing degree of suspicion. Curiously, the reasons are both political and economic, with the most recent trigger for dissatisfaction being Tibet. In fact, even the Olympics preparations were marred by tales of distress caused to the local population by the government to placate its own ego. Add to this the sympathies with rogue regimes in Sudan, Myanmar and North Korea, the scales get tipped even further.
With China’s progress now coming under the lens, there are some interesting facts which have been brought to the forefront. First, while Chinese economic numbers have always been suspicious, the theory now doing the rounds is that GDP growth numbers are overstated. This is so because they are collected from the provinces which have a tendency to over-report to be on the right side of the government. Further, growth in industrial production or services does not match with the overall growth numbers of the economy. The relevant question is, where is growth coming from?
Second, inflation numbers that have been quoted at low levels are being attributed to repression in areas of health, transport, education as they are state governed, which tends to understate the true picture. Food prices, too, are partly controlled and hence the country is buffered against the present inflation which has swept almost all nations.
Third, China is supposed to have started a new kind of colonialism wherein it consumes the bulk of natural resources available in the world. China accounts for half of the pork consumed, a third of steel produced, nearly 80% of the copper used, a quarter of aluminium consumed and half of total cereals produced in the world. Its consumption of imported soybean and crude oil has increased by 35 times since 1999. This was what colonialism was all about: in the 19th century it was through conquests, while it is legitimately done through the channel of foreign trade today.
The quality of the growth story does not look good as it involves the running of sweatshops where labour is virtually bonded to produce cheap goods while being kept at a subsistence level. Hence, the manner in which price competitiveness has been achieved would not be politically correct in a free society. Fifth, the quality of goods produced is not always world-class as has been seen in case... of electronics or even toys, where it was found that Chinese toys contain toxic substances. Sixth, China is one of the largest polluters in the world as its quest for industrial growth has led to the degradation of the air as well as water. Curiously, the power consumed in the steel industry is higher than what goes into households, and this has resulted in such degradation.
There are also other economic distortions that have resulted from the process of rapid growth, which will impact its own functioning, notwithstanding controls being exercised by the state. The first is, unbalanced growth in favour of industry which has lowered the quantity of arable land. Land was forcibly used for industrialisation as a result of which there is less space available for cultivation and greater demand for imports. At the same time, China has put restrictions at times on exports, thus tilting the global price scales. The demand for farm products, energy and minerals has pushed up global prices at a time when the world is struggling with a financial crisis and central banks are grappling with their monetary policies. Add to this the policy of not appreciating the currency and artificially pushing down the interest rates—-China has in fact encouraged indiscriminate lending by state-run banks, which have officially reported non-performing loans in the region of 5-10%, though analysts suspect it could be over 20%.
What then is one to make of the whole story? China remains a leader despite the political dogma which still is a hard nut to crack. Considering that future growth will still be driven from this side of the world, there is a need for introspection by the government about cleaning up the mess which is being created along the way as it is bound to rebound perversely at some point of time.

Pains and Gains of Credit policy: Financial Express: 4th August 2008

This was one of the rare occasions when everybody got it wrong. Most economists and treasurers expected no change in the policy, while some of the more aggressive ones pitched for a repo rate hike. But, the RBI, which has developed a knack of surprising markets, which is what the Rational Expectations School would have supported, did the unexpected i.e. raising both the repo rate and the CRR. The markets, naturally were taken aback.
Taking any policy decision on the 29th was going to be a tough decision considering that the RBI had to really toss for either inflation or growth. Growth appears to be a downward path and inflation well entrenched at a double-digit mark. As neither lower growth nor high inflation are acceptable, especially since the next general elections will hopefully be held against the backdrop of these two numbers, the rational belief was that RBI would do nothing to hurt growth, while inflation would be guided by past policy decisions as well as improvement in real sector supplies.
By opting to increase the CRR and repo rate, RBI has made it clear that it is antagonistic towards inflation. Further, by talking of a rate of 7% towards the end of the year, it does hope that these measures work.
There are two parts to this story, which is the case with all monetary policies. One needs to closely look at both inflation and growth.
Inflation today is a cost-side driven phenomenon and therefore cannot be directly affected by monetary policy. If there are shortfalls in foodgrains production or oilseeds output, no amount of monetary tightening will help. Money supply growth is increasing but the growth in credit is more due to the higher lending to the oil companies rather than an industrial revival. In fact, as discussed later, industrial growth has slowed down. Such lending will carry on nonetheless as it has to be done.
There can be two explanations behind raising interest rates to control inflation. The first is that inflation has now reached a stage where there are negative real interest rates. With inflation ruling at 12% a deposit holder with an interest rate of 10% is actually still in the negative territory by 2%. But, by raising the interest rates by 50 bps we are only narrowing the gap and not eliminating the same. In fact, if this is going to be a policy decision, then there are hard times signalled for the future. The second reason could be that RBI would like to stifle inflationary expectations such that overall spending through borrowing is curbed, which will moderate the build-up of demand-pull forces. The thought process here is that inflation as such is not as dangerous as inflationary expectations. If all expect inflation to go up, and then inflation will move up - a self-fulfilling prophecy. By raising rates now, people will automatically spend less, thus either reducing demand or deferring the same, both of which will lead to lower inflation. This is the approach the European Central Bank has also taken when increasing its benchmark rate a while ago.
However, what is interesting here is that since March 31, 2008, RBI has increased the CRR by 125 bps and the repo rate by 75 bps (before this policy). But, inflation has not really come down and remains in the double-digit level. While it is not clear as to the exact time taken for these measures to bear fruition, it is felt that the period would vary between 2-4 months. Therefore, if these rate hikes have to work, they should be doing so now.
The second part of the story is growth, and industrial advance has been tardy during the first two months of the year, and the symptoms are not too encouraging. There are no real signs of large investment taking place. Overall corporate performance appears to have slowed down this year and the increasing interest rate regime is part of this story. By raising rates further, there is a possibility of the slowdown becoming more acute.
High interest rates affect the industry on both the demand and supply sides. On the supply side higher rates increases costs for companies, which may prompt them to defer investment plans, especially if growth is already sluggish.
On the demand side, interest rates affect consumer behaviour. Two major boosters for industrial growth on the demand side come from mortgage finance and auto cum consumer durable loans. When people borrow smaller quantities of money when rates go up, then the demand for housing comes down. This has a backward linkage effect on the cement, steel, machinery and electrical equipment sectors. Lower demand for consumer durable goods and automobiles will again affect the auto and ancillary sectors, durables segment, steel, glass, machinery and electrical equipment industries thus calling... for a review in expansion plans.
RBI has hence, definitely opted for the inflation path and has put the growth objective on the sidelines. But, the perplexing part of the policy has been the move to increase the CRR. Banks presently are facing a shortage of funds and are making use of the LAF facility to the tune of around Rs 30,000 crore. By raising this rate, RBI will be forcing banks to borrow more from the RBI through the repo window where there will be paying a higher price. It is hence a double whammy for the banks that have fewer resources to lend as RBI is impounding resources on which no interest is being paid. Further, they have to borrow the same funds from RBI at a higher rate now through the repo window.
What are the likely effects of these moves? The first is that the banks' profitability will be affected as their cost of funds goes up and they have to book losses on their investment portfolios. The industry will invest less now, which will impact overall GDP growth. Inflation may be tempered, but that will mainly be due to better supply conditions and only partly due to the monetary squeeze. Individuals however, can be happy that they are less worse-off than that before as their real interest loss narrows down. But no real gainers, only losers.