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.
Tuesday, November 25, 2008
Sunday, November 23, 2008
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.
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.
Monday, November 17, 2008
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.
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.
Tuesday, November 4, 2008
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.
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