Waiting for the central bank: Mint 7th january 2010

Food inflation is complicating RBI’s stance. Perhaps it’s time to restructure the use of monetary policyCan this apply to India’s inflation conundrum today? On the one hand, the government has argued that inflation is cost-push driven, resulting from supply shortages—hence, by increasing interest rates or stifling liquidity we cannot generate more rice and pulses to bring down prices. Monetary policy should, therefore, continue to be supportive. On the other hand, Reserve Bank of India’s (RBI) spokespersons have at times spoken of policy options to control inflation. So which one is it?It is true that monetary policy cannot bring in supplies, but it is also debatable whether increasing rates today will affect investment. This is because if opportunities are there, businesses will invest, notwithstanding higher interest rates —just as steel producers do not stop investment merely because the price of electricity or ore increases. But, for the sake of argument, let us assume that higher rates can spoil the party while the economy is looking to grow now by 7.75% this year. What should be the approach of monetary policy then? Illustration: Jayachandran / Mint First, on the one hand, shortages in supplies will automatically exacerbate the demand-supply imbalance at the macro level and lead to excess demand forces, even if demand per se remains unchanged (the same number of people vying for fewer goods). On the other hand, if we believe in the 7.75% growth story, there will be latent inflation, since demand-pull pressures will build up. There is, then, a need to pull the trigger. Either way, there is a case for monetary action to check inflation. Perhaps RBI knows that already: Its response to inflation in mid-2008 was to increase rates and reserves, even when inflation was predominantly on the supply side.Second, theoretically, monetary policy should be forward-looking. Policy actions take timeto work for both growth and inflation. Therefore, if we are expecting inflation to rise in the future—even if it is not engendered by excess demand —monetary action is required to pre-empt it. That makes a strong case for RBI intervention. Reducing liquidity through a hike in the cash reserve ratio (CRR)—the reserves banks set aside—is a way out. But such quantitative measures are less preferable in a market economy with thousands of separate actors who may react differently, and should be the last resort. We can draw an analogy from foreign trade: Tariffs cause fewer distortions than a quota and are, hence, superior. Therefore, an interest rate hike, which can specifically target banks’ ability to lend based on market forces (higher rates lower the demand for credit) is preferable. Changing the cost of credit is better than lowering the quantum of funds through CRR.The debate over the use of monetary measures raises the question of whether or not monetary policy itself is being abused. Economics’ Rational Expectations School advocates a simple approach, where the authority announces the targets and sticks to it during the year. Given the availability of perfect information to all market participants, the University of Chicago’s Robert Lucas and New York University’s Thomas Sarjent argued that government policy would not really be effective. As a corollary, the only way in which policy would work would be in case the government systematically fooled the public by changing policy measures by going in for “fine-tuning” later. Therefore, if we started off with, say, a CRR of 5%, everyone would adjust to it. But, now, by altering CRR or the repo rate unexpectedly, we would contrive to make our policy work by “fooling” the public. RBI may just have done this in the recent past: In the first half of 2008-09, it countered inflation by aggressive action, which stifled the growth process. Subsequently, in the second half, it did an about-turn to revive the economy. From the point of view of expectations, it would have been better off not doing anything.This is relevant because RBI’s policies have an impact on the market—and one is not sure if RBI works independently or is influenced by the Prime Minister, the finance ministry, the Planning Commission or the Prime Minister’s economic advisory council. Every statement made by any of these authorities swings the market because there are expectations that RBI will follow suit. Further, RBI’s governor and the deputy governors have their own say, often prompting speculation or expectations, which then tend to be self-fulfilling. News of a rate hike can move the bond or call money market substantially as there is, on average, Rs50,000 crore of trading guided by these expectations.The question is whether or not this array of authorities should be providing signals and whether we are to take them seriously? Ideally, if we believe in the Rational Expectations School, RBI should not be having so many policy statements. But the concept of fine-tuning has led it to four policy announcements a year. Moreover, some governors have made it a habit to make announcements between policy statements, thus making the exercise potentially destabilizing.One solution to reduce uncertainty is to set “intervention thresholds” during the year. RBI can set triggers such as point-to-point inflation crossing 6% or non-food inflation crossing 4% as potential intervention points. Theoretically, we need two instruments for two objectives: A Keynesian approach to fiscal policy will address growth, while the monetarist position will tackle inflation. By letting this known, we also pay obeisance to the Rational Expectations School, thus making the policy combine, to borrow a metaphor from the ice cream parlour, three-in-one economics.

Good for banks, but the system? January 6, 2010 Financial Express

The McKinsey-EY Report on consolidation of public sector banks is timely because this is the time when RBI should have been opening up the sector to foreign participation. With more foreign banks entering the country and capital account convertibility around the corner (though everything has been delayed by the financial crisis), there is evidently a need to seriously debate the issue of consolidation among banks. Is consolidation an answer to future competition? The answer is a shoulder shrug, even though consolidation would help banks become more competitive. Consolidation helps organisations attain scale. A bigger balance sheet makes it easier for a bank to raise capital against the background of Basel II requirements. Further, such alliances bring about synergies for an organisation, especially across geographies and businesses. A bank focused on wholesale banking and another on retail can merge to create a monolith that provides complete banking solutions. A bank with a strong branch network and another with technology can merge to emerge stronger. Similarly, a bank based in the North can work with one with base in the South. All this helps in diversifying risk, which makes consolidation a viable proposition. So far, in India, mergers involving public sector banks have been restricted to rescuing failed banks. In the case of private banks there were different reasons such as survival (universal banking), weakness of a partner or plain loss of interest by the promoter. When it comes to public sector banks, the issue is more ticklish. To begin with, the ownership is with the government for all the entities. The management is professional with its appointment following the same procedures. The culture and quality of staff of these banks would also tend to be the same, since the recruitment process is standardised. In terms of profitability and other financial indicators there would be significant differences, which can make consolidation a worthwhile proposition. However, one needs to examine the rationale for creating these many public sector banks. All these banks tend to be stronger in various regions while there are some, like SBI, that have an all-India presence. Under these circumstances, the objective was to reach out to a larger cross-section of society and make banking more inclusive. The same could have been done by just having SBI stretch out, but multiple organisations made sense from an administrative point of view. While consolidation would be a sound idea today in a world where size matters, we would have to unwind these structures. The two areas of concern would be the branches and workforce. With the growth in banking, there has been a tendency for banks to open branches in common centres, which makes them redundant when one goes in for consolidation. The other is workforce. While some have been nimble-footed like Corporation Bank, others could have legacy issues that have to be ironed out. Are we in a position to close down these branches and downsize? The answers to these questions must be juxtaposed with other fundamental questions behind the consolidation debate. Have our banks exhausted the route to organic growth? They are well-capitalised today and have scope to go into non-fund based activities like the private banks. Therefore, there may not prima facie be major advantages in such like-minded banks merging. The second is, are we prepared for concentration in this sector? New private banks have already merged and there are probably three major ones that will continue to dominate the scene in future. Consolidation on the rationale of size would germinate the process of concentration. Third, how real is this threat of competition? Foreign banks operate under unequal regulatory conditions in terms of, say, priority sector lending, but have limitations when opening branches. The performance of public sector banks is almost on par with that of foreign banks. Therefore, prima facie there may be little justification to think that they have a major competitor to tackle. Globally, our banks are still too small, with only SBI making a mark with a domestic share of around 30%. Hence by having a merger that accounts for 7-8% of the system, little can be achieved even in terms of making a global mark. Therefore, before deciding on a roadmap for bank consolidation, we need to be sure of our objectives. As long as they are state-owned, capital should not be a problem unless we are ideologically inclined towards privatisation. Size building is good for leveraging synergies and diversifying risks, but the costs of technology, physical infrastructure and workforce redundancy have to be balanced. There is hence a necessity to have a serious discussion on the issue.

Don't ignore External Commercial Borrowings Business Standard: 26th December 2009

While RBI is right to worry about the share of outstanding ECBs in our reserves, firms need these to finance investment — some prudent limits need to be set.
The Reserve Bank of India (RBI) is seriously concerned about the increased dependence on external commercial borrowings (ECBs) by Indian corporate houses. The worry is palpable when companies flock to the global markets shopping for loans when interest rates are down. Hence RBI has been stipulating the maximum amount that can be borrowed, the all-in cost ceiling (as done recently), end use etc.There are essentially two issues relating to ECBs. The first is that this component will increase the external debt of the country and has to be matched by growth in the forex reserves to maintain solvency in the long run as all such debts have to be repaid. The other is that there is a currency risk involved as depreciation in the rupee will, for example, lead to a higher burden for the borrower when it comes to repayment. Hence, ECBs per se are less preferred to, say, foreign direct investment (FDI), which has the status of permanent parking in the country.The question is whether or not RBI’s concerns are justified at a time when the economy is growing and gradually getting integrated globally and there is progressively a greater requirement of funds to finance our growth story. To address these issues, the various sources of funding for long-term investment are analysed. The main sources of long-term finance today are banks, financial institutions like Sidbi, LIC, GIC etc; capital market in the domestic sphere; and FDI, ECBs and foreign assistance in the external field. As can be observed in the table, financial institutions were the dominant source along with capital markets at the beginning of the century. But, the importance of these institutions declined with the concept of universal banking catching on. Banks today have taken over this role but do face limitations in providing term funds on account of asset-liability considerations as they normally pick up deposits for up to three years and have to provide loans for tenures of over 10 years. Capital markets have provided support to around 25-30 per cent of the requirements, but this component would depend a lot on the state of the equity markets and the appetite for bonds.Now, in the last three years, there has been a tendency for dependence on foreign sources of funds to increase through both the debt and equity routes, and they now account for a little over 20 per cent of the total requirement. In particular, ECBs have become quite dominant in this period.The ECB market has distinct advantages over domestic borrowing. At present, the one-year Libor is just above 1 per cent. Assuming that based on country risk rating, a triple-A rated company can manage to procure a loan at, say, around 5-7 per cent. After considering the currency risk, it would still work out to be cheaper than a domestic loan where the PLR is 11.5 per cent. Therefore, it makes sense to borrow from these markets. Further, the rupee appears to be getting stronger over time, which means that fewer rupees are needed to repay the loans. Unless the rupee falls by around 5 per cent or so, the cost of ECBs would near the domestic PLR. The ideological issue that comes in RBI’s way is that too much dependence on foreign debt could place the country in a vulnerable spot. The external account debt-equity ratio has averaged 1.08 in the last five years and, ideally, it should be less than 1. Further, with inflation rates varying between India and the developed world, real interest rate becomes critical in interest rate formulation. The nominal rates thus would tend to be higher than those in the euro markets and hence, would be more attractive for all potential borrowers to access these markets (to the extent that they have the financial strength) after taking into account the exchange rate risk. Indian banks can lower the rates to only a limited extent by reducing their spreads as the cost of deposits is high partly due to inflation. Therefore, there is a pressing necessity to exercise control over this inflow of funds.ECBs as a proportion of total external debt have been increasing from around 20 per cent in 2005 to 27 per cent in 2009, making it a very important component of debt. RBI’s concern would be the value of outstanding ECBs to our forex reserves. This ratio was over 50 per cent in 2000 but has come down, more on account of increasing reserves, and is now at around 25 per cent.While RBI has a strong case in its favour as it has to maintain the solvency of the external economy, the question is for how long can this be the policy? There is paucity of funds to finance long-term investment; and the external route affords an option to players. When we do go in for capital account convertibility, such distinctions will become less dense and the force of competition will crate demand in different markets. Borrowers should have a choice of the source of finance. RBI should internally set parameters for intervention such as debt-equity ratio, debt to reserves and absolute level of reserves, which can be used for policy changes. This would be a more pragmatic way of addressing an issue which can be both an opportunity and threat simultaneously.