State-run banks’ recap plan faces rough weather: Economic Times 4th May 2016

The cleaning up of the balance sheets of public sector banks (PSBs) and the subsequent support being provided by the government does raise several conundrums.

In FY14 and FY15, net profits of the 21 PSBs, including SBI, were around Rs 35,000 crore, down fromRs 49,000 crore in FY13.
Typically, these banks had an average dividend payout ratio of 20% in these three years, which meant transfer ofRs 27,000-28,000 crore to the reserves, which is reckoned for the purpose of capital. The government would have providedRs 25,000 crore of capital in FY16 and will be putting the same amount in FY17, too.
For the first nine months of FY16, the net profits of these banks have declined from Rs 26,500 crore in FY15 to around Rs 4,100 crore. One is not sure of what will happen in the fourth quarter. Assuming status quo, this will mean that around Rs 4,000 crore could pass on to the reserves or capital and not Rs 27,000 crore. Hence, the infusion of Rs 25,000 crore through the Budget would have just about sustained the lending activities by negating this shortfall.
There are two implications here: First, the banks will have to strive hard to protect their balance sheets. Second, the capital infusion becomes ‘maintenance capital’ for sustenance, which cannot bring about accelerated growth.

Hence, for FY17, it would be necessary for net profit to increase to the same extent as in FY14 or FY15, else the fresh infusion will not provide a ‘delta’ to the system’s lending capacity.
A second consequence of low net profit is the impact on government revenue. The government, on an average, holds 66%, or 2/3, of the shares of all these banks put together. In FY15, around Rs 4,600 crore would have accrued to the government on a profit of Rs 36,000 crore and a dividend payout of Rs 6,800 crore.
In FY16, even if the Rs 14,100 crore of profit earned in the first nine months does not turn negative, it is unlikely that there would be any significant dividend paid, which will also put pressure on the revenue. The same will hold true next year as well.
Third, the issue of divestment in PSBs has been on the discussion table for long. While everyone has been speaking of divestment up to 51%, where there is no difference of opinion, no decision has been taken as yet. This is surprising because such divestment gets in money for recapitalisation of banks and goes beyond the Rs 70,000 crore infusion through the budget in the next three years.
A back-of-the-envelope calculation shows that if the government had actually brought down its share to 51% in all these banks, it would have gotten Rs 75,000 crore as of March; if it made the divestment last year, ie, March 2015, the receipts would have been Rs 95,000 crore. Hence, if done in FY16, there would have been a loss. Are we sure that this trend will not continue if done next year, considering that these banks are unlikely to recover any time soon and it would be a gradual process?
A sale in FY17, when the prices could be much lower, would mean a presumptive loss if it is less than say the level of March 2015. The PSB resuscitation scheme has spoken of three sources of financing of capital — through capital infusion by the government through the budget route, ploughing back of profit by banks and sale of equity. All three are going to face rough weather going ahead.
Budgetary support is committed, but if the other two do not fructify, then such infusion will at best help banks to maintain their lending but not augment scale.
Profits will be under pressure as long as the problem of non-performing assets is not fully addressed and while several banks have assured that Q4-FY16 would be the last of the cleaning up phases, one cannot be too sure.
Divesting equity would entail two problems: The timing will be critical and valuations will be contingent on how the other two processes progress – capital infusion by the government and quality of assets. These are necessary conditions for better valuation.
Second, the government presently appears to be unsure of how to go about the disinvestment process after the strong resistance to the full disinvestment of IDBI Bank. Addressing these is not easy, but has to be done as there is no alternative.

Inside Unreal Estate book review: Realty check: May 1 2016

INSIDE UNREAL Estate is a very timely book, written on a subject that has always been an enigma, as we all have our own pre-conceived notions of the sector without commensurate...


Inside Unreal Estate
Sushil Kumar Sayal
Penguin
Pp 212
R499
INSIDE UNREAL Estate is a very timely book, written on a subject that has always been an enigma, as we all have our own pre-conceived notions of the sector without commensurate knowledge of the ‘why’ of these underlying beliefs. Author Sushil Kumar Sayal writes from experience, having worked in the real estate sector, and presents a balanced picture in this book.
Sayal has made the book partly autobiographical, as he takes the reader through his experiences in different organisations. In India, real estate, gold and stocks are the three most fascinating investment options, with each one having its own share of scepticism, as the full story is rarely known. By taking us through the labyrinth of the real estate sector, Sayal lays before us the machinations that characterise its operations, making some very interesting revelations.
First, while real estate is definitely the most valuable asset for anyone, it has several pitfalls that buyers realise once they are into a transaction. Hence, there are precautions to be taken, as this sector does not operate in a transparent manner. For instance, bureaucrats play a major role in fostering corruption by delaying clearances. Further, as most sales are based on cash, the same malaise trickles into the sale of housing property, which portrays the builders in a poor light.
Second, related to the first, is the issue of black money. We have to pay partly in cash because the builder has done the same to acquire the land, which includes some bit of transitivity in reasoning, as everyone in the chain is indulging in such acts. Hence, when we hear of scams, the plot thickens and we can see the links between various parties that invariably involve government and bureaucracy.
The writer also explains how the infamous Campa Cola housing case was one where the developers, municipal authorities and bureaucrats were all involved. But ultimately, with the courts intervening, the buyers had to take the rap, as the demolitions proceeded and no punitive action was taken against any officials.
Third, the pricing issues are well elucidated here. The author explains the present situation where there is excess supply of flats that cannot be sold. In 2014, unsold stocks in Mumbai would have taken seven years to exhaust. The same for Delhi or Chennai would be around four years. Surprisingly, when supply overshoots demand, prices do not come down to the same extent that they had increased to when the projects were conceived.
The genesis of this mismatch can be traced to the financial crisis, even though we were not affected directly. In this period, as funds moved out of the stock market, money flowed to real estate, which caused major appreciation in property prices. But when interest rates were increased and salary income stagnated, demand fell. While cases of default were few, demand slack led to the build-up of a large inventory, which, in turn, led to higher cost financing that affected the solvency of the real estate companies.
The existence of this excess supply has other implications, as it has hit the industry quite hard and led to bank defaults or rollover of loans from banks to NBFCs to keep the account in order where higher rates are paid.
Four, Sayal warns us of the pitfalls when buying a house. The fine print is important and one should be careful of the size of the unit, as builders do deceive with different concepts like carpet area, built-up area, etc.
Fifth concerns the issue of delays, which is a common complaint, as customers face delays in procuring possession of their units. Delays are endemic and cannot be helped, as it takes time to get permissions and clearances from the state authorities even after paying bribes.
Interestingly, this is the starting point for malfeasance. Often, the builder buys at a high cost, and then collects money from the buyers. This way, they are able to match their purchase with sale to the customer. The problem comes on the buyer’s side, with the delays hurting them, as they have borrowed funds. When the builders are unable to match their purchase costs, they tend to flout rules and go for higher-than-permitted construction limits. Or they sell basement parking to offices or create space for shops in violation of rules, as was the case with the infamous Uphaar tragedy in New Delhi.
Sixth, all is not dark here and the author is positive about two aspects. The first is that when corporates are involved, business is more structured and clean. Here, he presents his own experiences in GE Shipping, where the company never compromised on bribes. The same holds for Godrej properties or Tata Housing. This has changed the perception of buyers who are now veering towards these names.
The second is that on the regulatory front, the real estate Bill, which has now been passed, will provide enough safeguards to the buyer. Also, the concept of REITs provides enough clean funding opportunities for companies, and the combination could help to make this business less murky.
His advice is to look at the background of the builder, the contract content in detail and check if the construction is smart. His preference is for corporate real estate projects, as they would tend to be more transparent. But in this opaque business, one still has to be doubly careful.

The perils of negative interest rates: April 26 2016

Low interest rates and relentless infusion of liquidity has been a path chosen by several countries to revive their economies.

Low rates in the West—which have been forced downwards to encourage borrowing in the face of limited demand—have raised some apprehensions in the minds of analysts. In such conditions, funds may flow to riskier ventures; this can create challenges when rates move up or currencies depreciate.

Low interest rates and relentless infusion of liquidity has been a path chosen by several countries to revive their economies. These measures, however, have had limited impact in terms of bringing about a major turnaround. Japan continues to be in a recession for over two decades, while the US may be just about struggling to stay above the line. The euro region is still down, with little signs of an imminent recovery, even as Mario Draghi has promised to do everything possible—meaning thereby provide more liquidity. This has also inspired several central banks to look at lowering interest rates to revive demand. Are there any warnings to take away from such measures?
Negative interest rates have pervaded countries which account for almost 25% of world GDP, and if close-to-zero rates are added, it would touch 56%. Hence any repercussion has the potential to impact the world economy quite decisively, given the quantum of output that potentially becomes vulnerable.
Low interest rates can definitely not be the precondition for growth, as no one borrows unless there is use for the same. But it can create a bubble, as was the case with the mortgage system in the US when cheap loans pushed up demand. In this economic euphoria, lending institutions were not thorough with due diligence as they repackaged and sold the same loans to unsuspecting investors. The consequences were severe when the system crashed. Not surprisingly, the Federal Reserve had played the role twice—the first time when it lowered rates to make borrowing reckless and subsequently increased rates thus unleashing a backlash. This is probably one of the first risks associated with cheap money, as it does create a wave, which, if unchecked, can potentially trigger other problems at a later date.
In fact, the surplus liquidity generated through quantitative easing has found less use in the countries of origin and has flowed to the emerging economies, thus boosting stock markets. A reversal of such policies starting with the tapering and conclusion of the QE programme followed by a rate hike has created turmoil in the recipient countries as well as currency markets.
The second issue is that low interest rates or negative rates lead to greater holding of cash. Households and corporates would prefer to hold cash once interest rates turn negative, thus increasing the demand for money. This creates challenges in countries which are vulnerable to the creation of a grey economy, as such usage cannot be tracked.
Third, low interest rates make it worthwhile to look at other investments. While financial savings definitely gets affected, there is a bigger risk of migration of investments to physical instruments such as gold. This can create an upsurge in the bullion market, and one reason for the recent revival in gold price has been higher demand on account of absence of other investible avenues.
Property could be an alternative, but the shadow of the financial crisis will lurk quite closely. Currently, we are giving a lot of incentives to housing, and this is probably the only segment which is doing well in terms of credit growth. While a crash is not expected as financial engineering has made limited inroads through securitisation, the fall in evaluation standards cannot be ruled out.
Fourth, low interest rates also affect bank profitability, as there could be a tendency for spreads to be pressurised when rates come to low levels. They would be less willing to lend under these circumstances, as lower lending rates may not be matched by lower deposit rates because the latter would dissuade households from providing the funds. This problem is already visible in case of American and European banks where lowering of rates has impacted their profit and loss accounts. In case of India too, we may have just about reached a situation where deposit rates cannot be lowered further, but the marginal costing method for reckoning base rate could pressurise banks, provided all lending rates come down commensurately.
Fifth, a major problem is for corporates once the cycle turns around. Normally, large sums are borrowed when interest rates are low and employed in riskier ventures. In India, for instance, we have seen companies go out and acquire other companies to expand their operations. However, once things turn around and interest rates move up—which has to happen once the cycle changes—the corporate debt levels would increase putting not just their own profitability under strain as their debt servicing ability comes down, but also the financial system becomes vulnerable to the buildup of NPAs. A large part of the problem in India concerning NPAs has been also due to this phenomenon. While business plans going awry is the major cause for such slippages, the turning point is almost always when interest rates are increased.
Sixth, low interest rates can affect businesses like pensions and insurance where these players do implicitly assure certain returns. As most of their investments are in fixed income instruments, any fall in rates affects their ability to service their customers. In addition, households become reluctant to invest in these instruments and could prefer to move to the riskier stock markets or property; this will choke the supply of funds which are used often for servicing the existing customers. Hence, the entire business chain gets affected when interest rates become negative or extremely low.
Seventh, chaotic situations arise when emerging economies borrow from developed countries in large quantities due to the interest rate differential. This has already been witnessed where developing countries’ indebtedness has increased. As rates are fixed with LIBOR, any increase in policy rates is first seen in repricing of all such loans, putting pressure on companies and hence the countries. The problem emerges once currencies depreciate, which has been witnessed in the recent past, thus creating debt challenges for countries and the world economy.
Given these possibilities, it is necessary to move cautiously with interest rates in the downward direction. Low rates in the West have raised some apprehension in the minds of analysts. This is more so because rates have been forced downwards to encourage borrowing in the face of limited demand. In such conditions, funds may flow to riskier ventures, which, in turn, can create future challenges when rates move up or currencies depreciate.

Rate cut gains are not guaranteed : Business Line April 19 2016

Despite efforts to improve transmission, there can be no getting away from tepid deposit and credit growth

The monetary scene in 2015-16 has been far from satisfactory. There is some euphoria over the rate cuts invoked by the Reserve Bank of India and the new method of calculating the base rate based on the marginal cost of funds; it is believed that this will improve the transmission mechanism. However, overall conditions do not look very encouraging.

The RBI has lowered the repo rate by 75 bps in FY16. Deposit rates have been lowered with alacrity and have fallen by about 110 bps, which is higher than the change in the repo rate. The lending rate, as indicated by the base rate, is down by around 60 bps which is less than the decline in the repo rate, which has, in turn, fostered the debate over the transmission mechanism.

Lag effect

However, this lag is inescapable. If banks follow suit when the RBI lowers rates, only incremental deposits get priced at the new rate while in the case of lending almost all loans have to go at the new rate. Therefore, this lag, in effect, can be explained and it is not really right to focus too much on transmission.

Other interest rates have shown a mixed picture. The 10-year G sec rate was down by 20 bps but this was more on account of tight liquidity conditions brought about largely by the sluggish growth in deposits, even though growth in credit was weak. It looked almost that the central bank was pushing interest rates down against the market forces. The forward premium on the dollar, however, was more responsive with a decline of 120 bps on the six-month contract.

The major impact of rates is on credit and deposits, and this relation needs some analysis in terms of how they have reacted to lower interest rates. The demand for credit is the main issue. Growth in credit has been quite sluggish for the second successive year. RBI data for the last year reveals an increase of 11.3 per cent as against 9 per cent. However, this is misleading as in March 2015 (one fortnight after the last reporting fortnight), there was an upsurge in the growth in credit on account of the borrowing for the spectrum purchase which, combined with the year-end phenomenon, resulted in an increase of nearly ₹3 lakh crore.

This gets counted as credit in FY16 as the financial year for the banking sector officially ended on March 20 which was the last reporting fortnight. If the same adjustment is made, then growth this year over April would be just 6.5 per cent with the comparable number for last year being 7.7 per cent. Therefore, growth in credit has been lower than that in FY15 if looked at in this manner.

Further, it appears there has been limited demand for credit which can be attributed to the slow pace of growth in industry in particular with industrial growth for the first 11 months of the year amounting to just 2.6 per cent. For the same period, RBI data for sectoral distribution of credit reveals that manufacturing and services were under-performers. Growth in credit to manufacturing was 3.3 per cent as against 3.5 per cent last year, while that to services was 5.9 per cent versus 3 per cent.

Sluggish credit growth

Growth has been brought about more by retail credit which increased by 17.9 per cent (14.2 per cent) and agriculture 11.8 per cent (13.3 per cent). Therefore, quite clearly, the demand side of the story has been ignored even as there is a clamour, which goes overboard at times, for lowering of interest rates. Nobody borrows just because funds are cheaper and with RBI data on capacity utilisation for Q3-FY16 still being in the 70-72 per cent range, there is less incentive to invest more.

The higher growth in retail credit may be attributed to the relatively better responsiveness of the banks to interest rates in this area as the delinquency levels are lower. This brings to the fore the issue of willingness to lend on the supply side.

While lower demand for credit has been working towards lower growth, banks too have been withdrawing from lending especially for long-term purposes given the build-up of NPAs. This has been compounded by the challenge of capital availability for some of the public sector banks. Any which way, there are considerations on the supply side too.

A worry is the composition of credit in industry. In FY16, the highest growth rates were witnessed in steel 9.2 per cent (2.9 per cent), mining 9 per cent (1.5 per cent) and infrastructure 7.6 per cent (9 per cent). This is a concern because these three sectors have been identified by the RBI as those which are prone to becoming NPAs along with textiles and aviation. While banks have managed to lower their exposure to textiles, the other three remain vulnerable to delinquency.

Tepid deposit growth

The other aspect of banking on the liabilities side are deposits, which have been impacted sharply after several years. The growth in deposits has slowed down to 9.9 per cent from 10.7 per cent last year. The deposit growth rate has been moving down which is a result of both higher consumption due to high food inflation as well as lower financials savings with deposit rates going down. With an average rate of 7.25 per cent being offered on deposits with tenure of more than one year, this avenue is extremely unattractive and compares unfavourably with small savings as well as fixed maturity plans of mutual funds which offer higher rates with the possibility of lower tax rates under certain conditions.

Hence, the basic signals emanating from developments in the banking field besides the NPA overhang and capital issues for PSBs are far from encouraging. With both credit and deposits slowing down for the second successive year, the growth story of the Indian economy, which appears to be better than that of most countries, looks less luminous. This is because both of them are representative of two crucial aspects of the economy, that is, investment and savings, which finally will also get reflected in the current account deficit once the former picks up.

Banking on peer-to-peer lending Financial Express 18th April 2016

It is not uncommon for us to lend money to our domestic help. And normally, there is a low risk of default associated as we know the person concerned and there is no interest payment involved. Transpose this scenario to one involving a money-lender, an informal, unregistered source of finance. Here, loans are given against a security and are taken with a high interest cost. The lending is normally to someone known and if there is a default, the security, which is usually gold, can be sold off.
If these two situations are combined and formalised on a trading platform, we have a peer-to-peer (P2P) lending model, a form of crowd-funding even. An individual seeking a loan fills in details on a platform, which is processed within seconds after ‘due diligence’ is done and the request is matched with people with surplus funds keen to lend at an interest rate that is linked with the credit score. An internet platform, thus, brings both potential borrowers and lenders together with no intermediary. Hence, the bank or financial institution is kept out and costs are lowered. It is analogous to going to the capital market and issuing a bond. But when the requirement is very low which does not tally with, say, even the SME platform, then this P2P model makes a lot of sense.
RBI is set to bring out guidelines on this mode of finance. At present, deposit-holders feel short-changed getting low interest rates, and would look for better avenues. Borrowers complain about high base rates and premium above this benchmark. If one is not a top-rated company and, say, a venture capitalist, the cost would keep increasing. These two parties would like to deal with one another and keep the banker out. This way, the saver gets a higher interest rate and the borrower a lower cost. This is truly a win-win situation.
There are two uncertainties in this mode. The first relates to the evaluation of the potential borrower. Banks normally have the expertise required and further diversify risk by lending to several entities. In the case of P2P lending, the platform provides a credit score and basic details of the potential borrower which can be used to take a decision. Just like a bank, the lender can lend to several borrowers and thus diversify risk.
The second relates to default. In case of a bank, the defaults are absorbed on the balance sheet and the deposit-holder is protected. In a P2P model, there is no cover as a default would mean loss of money. But the duty of the platform is to ensure that payments are made, and hence there is some cover provided to the lender. For this, a safety fund is created from where there can be draws in case of a default.
The P2P model looks alluring, especially for the small saver and borrower. In today’s context, where the focus is on small enterprise with various programmes on start-ups, this mode of finance makes a lot of sense. The trick is to have credit scores which are presently not available for the common-man; this has to be arranged by the P2P company/platform. How this differs from a bank transaction is that the saver can actually choose which borrowers would be a part of the individual’s lending portfolio.
P2P platforms are just about a decade old, but have proliferated in the US and the UK with fairly large volumes. Names like Zopa and Prosper are ofttold success stories. The default rates have been low and the models have worked well. PwC has estimated a size of $150 billion for this industry by 2025.
What must be done before embarking on this venture? First, the P2P player or platform has to be registered. This is so because besides being a platform supplier, the company has to also provide the credit scores and take the responsibility of filtering the borrowers. The challenge is that if left unchecked, everyone will flock to this market as there is limited recourse for savers. A rating of these P2P companies will be in order.
Second, we need to develop scores for each person that is borrowing in the market. This will mean going to the micro-level. An individual may not have a default but have limited ability to service the loan. How would such a person be scored? Information on income provided may not be accurate. Therefore, there needs to be an agency which collects and stores such information that can be verified.
Third, the potential savers have to be registered with the platform with KYC norms just like deposit-holders of a bank. This becomes important because in the current situation where black money and overseas accounts have surfaced, there could be a lot of such money coming into the lending space. Further, if loans that are disbursed have the option for conversion into equity (especially if the borrower is a start-up), then ownership becomes dodgy if such funds flow in.
Fourth, a question that needs asking pertains to interest rates. While this would be outside the banking field, the case of MFIs is relevant. In this case, the borrowers never minded paying 30%, but the adverse consequences made us sit up and regulate the structure. What should be the ideal rate here? If a borrower is paying say 15% today, he would be happy with 12-13%, while the saver will jump at this number considering that the banks are giving only 7-8%. If such activity proliferates, then it can skew the financial system; and banks at the margin will have a problem, especially where small customers are concerned.
Fifth, if these loans are to make sense, then they should be made tradeable. This will provide an exit route for the sell side of the loan. Hence, a trading platform should ideally develop simultaneously so that this option is provided to the customer.
Last, it needs to be cleared whether there is a need for a cap on the amount that can be borrowed, given mid-size units could also access this market even as banks may like to step in as suppliers of funds.
P2P lending has opened the doors for a new dimension in the financial system. We only need to ensure that we have the structures and regulation in place given the potential for this business.

Misbehaving book review: Irrational economics: Financial Express April 3, 2016

Misbehaving
Richard H Thaler
Allen Lane
Pp415
Rs 999
MISBEHAVING IS quite an interesting autobiography of Richard H Thaler, who has established his credentials in the field of behavioural economics. In fact, it has become fairly popular for economists to gravitate towards the behavioural aspect of the subject and move away from the conventional assumption of ‘rationality’ in the textbook.
Human beings behave in a seemingly irrational manner, which helps others get them do what they want. Thaler starts with a rudimentary example of how students argued when they scored 72 out of 100, but were happy with a score of 96 out of 137, which shows that we are not always rational. Similarly, we are eager to contribute to the medical expenses of a six-year-old girl with brown hair, but will not bother about contributing to the foundation of a cancer hospital. We prefer an identified life to a statistical one.
Here are some of the seemingly irrational things explained in the book: when we have free tickets, we might feel convinced to go for the show even in a snowstorm just to realise the value of the tickets. Or we might not buy something expensive for ourselves, but if the spouse buys it from the same household budget, we are thrilled. Hence, our behaviour generally seems to be quite warped. Therefore, the title of Misbehaving.
Thaler also introduces the concept of ‘sunk costs’, which means we should ignore and not brood over an expense once incurred. This holds for club membership, which when paid for and rarely used is not a concern, as it is a sunk cost.
Quite interestingly, Thaler points out that the concept of behavioural economics had its genesis in the works of Adam Smith. In his book, The Theory of Moral Sentiments, Smith spoke of the struggle between our passions and what he called the ‘impartial spectator’. This is why we treasure the present more than the future and can be allured quite easily by market spaces. This is a blow to the concept of rationality, which is expounded in almost all economic theories. It was also implicit in the theories of John Keynes when he spoke of the concept of marginal propensity to consume, Franco Modigliani’s concept of lifecycle hypothesis and Milton Friedman’s permanent income hypothesis.
The most fascinating part of the book is where the author talks about the efficient markets hypothesis, which assumes that the market price is the right price if it takes in all the information that the market has to offer. The two assumptions made—‘prices are rational’ and ‘we cannot beat the market’—are tackled well. Thaler argues that if this were so then no one should be logically gaining, as the intrinsic value of the stock is imbibed in the price. This holds for mutual funds too, when the market price differs from the net asset value.
Thaler also goes beyond economics and gets into areas like education. How do we improve student performance? One way is to reward inputs rather than output. So the homework done by students should be rewarded more than, say, their exam results. Another way is to provide bonuses to teachers based on some performance indicators. Automatically, there is an incentive to do well.
Misbehaving holds in all fields where human beings are involved, as we all tend to behave in a way different from what textbooks describe. Being in the realm of behavioural economics, this book will be exciting for students, as the names of Daniel Kahneman, Robert Shiller and Jean Tirole will resonate often—the author has colluded or collided with their views on several occasions. This is definitely a book worth keeping on the shelf.

The ball is back in RBI’s court: Financial Express March 31, 2016

It seems almost a certainty that RBI will lower rates on April 5, the first policy review for the new fiscal. The reason is quite straight forward.


It seems almost a certainty that RBI will lower rates on April 5, the first policy review for the new fiscal. The reason is quite straight forward. The government had asked RBI in form of ‘advice’, to lower rates after the Budget where the net borrowing programme projected was lower than that of last year. Also RBI had mentioned in February policy that it would be looking closely at the impact of the budget, especially the borrowing programme before taking a call on interest rates and the government has addressed this issue adequately.
Second, inflation is within RBI’s range of 6% in January 2016 and 5% in FY17. The number of 5.2% which is down from 5.7% in January can be interpreted either ways with a tilt to decrease rates to spur the economy. Third, the central bank has been arguing that there was a dichotomy in interest rates on small savings and bank deposits which made monetary policy transmission weak. This too has been addressed by the government recently and hence a window has opened once again to further the case for a rate cut.
Fourth, the corporate sector has been asking for rates to be brought down as investment decisions have been deferred on this score. Fifth, the market wants rates to come down, which has become more of a habit now. In fact, to drive home the point, the market is talking of 50 bps cut, hoping that at least 25 bps will materialise. Therefore, there is strong case for conjectures to point in this direction.
At present, the debate is on the quantum of rate cut. Anything less than 50 bps will be a disappointment as it will be considered to be ineffective. A curious development is that this year, while central government borrowing will be under check, state government’s borrowings can be the joker in the pack as the UDAY scheme could entail additional state development loans (SDL) entering the market which can cause interest rates to move up. Intuitively, more paper in the market increase supply and lowers prices which translates to higher yields. Given that they are offering higher rates, there could be a temptation as these securities can come under held-to-maturity (HTM) category. Therefore, the course taken by the securities market will be interesting this year.
Given that interest rates will be reduced, the next question is what will be the impact. The transmission issue has probably been addressed by the soon to be introduced marginal costing method. Assuming this transpires, base lending rates will come down while deposit rates would most certainly be reduced immediately. This time lag is understandable as deposits get re-priced on incremental basis while all lending gets re-priced at lower rates, which affects bank earnings.
Two issues stand out. The first is whether banks will be keen to lower rates on lending or lend more funds. At present, they operate with a spread of 3-4% which is one of the highest in the world and banks may prefer to maintain it. Further, the PSBs are inundated with NPAs ,mainly in the sectors that are looking for funding like infrastructure and manufacturing. Unlike the PSBs, the private banks have a different profile with more focus on retail and services sectors. Hence, the question raised is whether these banks will be willing to get into the riskier ventures and concomitantly, whether the PSBs will continue lending to them. Now, most certainly, the lending rates may not come down as long as the credit risk perception and premium is high. Therefore, willingness to lend will be an issue for banks. Add to this the fact that these banks are challenged for capital and there will be further hesitation in lending.
Second, the more important issue is the demand for credit, a factor which has been ignored in this argument for lower rates. While there have been phases when corporates have sought commercial paper or bonds when the transmission was tardy, in general, demand has been low from manufacturing and non-financial services. This being the case, demand can be an issue, especially during the first half of the year, considered a lean or slack season. Also, the latest RBI data shows that the capacity utilisation rates around 70% are still quite low and may not generate any urgency on part of corporates to borrow funds.
Therefore, the demand for funds may be sluggish with supply also trickling especially from the PSBs. Banks could just pitch for more government securities and add to the excess SLR.This has been the problem even in developed economies that have pursued aggressive policies of keeping interest rates close to zero for long as well as supplying large doses of liquidity. Demand for funds did not pick up given sluggish economic conditions. Under these conditions the elasticity of demand for funds would tend to be very low, which appears to be the case in India. Thus, while government has cleared several projects, they have not taken off in a big way to pressurise the financial system.
One repercussion of rate cuts however would be on savings. RBI has spoken of a real interest rate of 1.5-2%. At present, it appears that the differential between repo rate and inflation is 1.75% and if inflation remains unchanged, any reduction in repo rate will bring real rates down further. The impact on savings will be perceptible given that returns will be falling on all instruments now. A possible consequence can be movement to real estate which will be useful at macro level; or gold which can create problems. The gold bond scheme has not quite enthused households.
RBI decision on interest rates becomes more important today given these conflicting emotions. The question is whether or not RBI will move towards placating the corporate sector and markets and hence lay the ground for further cuts in future when demand for funds picks up. The answer looks to be in the affirmative. Will this lead to an increase in credit offtake? The answer, at best, is a shrug as banks may not be too willing while demand may also be subdued. The only reason for a contrary decision, i.e., to take a pause is the news of unseasonal rains harming the rabi crop. But that would only mean deferring a decision rather than taking a stance.