A V Rajwade: Monetary policy, credit & banks' capital
| In the previous week, this newspaper hosted a round table of chief executives of some of the largest banks in the country to discuss whether the system will be able to provide the credit needs of a fast-growing economy. The second part of the discussion was about the monetary policy statement of the RBI Governor on the previous day. There are obvious links between the two, particularly as the Governor has expressed concern about the extent of credit growth, even though it is acknowledged that the banking aggregates in the country are well below those in many Asian economies, as a percentage of GDP. |
| But first, the scale of the problem. As Tamal Bandopadhyay said in his introductory remarks in Business Standard, the announced investment plans of the larger hundred companies come to about Rs 600,000 crore over the next three years and Rs 950,000 crore over the next five years. These figures do not include infrastructure investments and, presumably, the increased working capital needed to finance the expanded output. As for infrastructure, investments of the order of $320 bn or, say, Rs 14 lakh crore are needed by this sector over the next five years: perhaps half of this may need to come from the private sector. (The resources for public investment would also need to be provided indirectly by the banking system, which is by far the largest buyer of government bonds.) To this would need to be added the investment of the second-tier companies, the normal increase in working capital, consumer and housing finance, etc. The task does look daunting. |
| Overall, the credit market may need to finance credit growth of the order of perhaps Rs 20 lakh crore over the next five years; to put the figure in perspective, the outstanding bank credit is of the order of Rs 15 lakh crore. Besides, there are outstanding corporate bonds estimated at about Rs 3 lakh crore. In other words, the size of the credit market would need to double in the next five years in today's rupees: given the inflation rate, the actual numbers in nominal rupees would be even higher. The issue needs to be looked at from several perspectives: resources, capital and monetary policy. |
| Arguably, foreign currency resources, both equity and loans, will help meet part of the needs. However, at the macro level, foreign savings can supplement domestic savings only to the extent of the deficit on the current account. Since our comfort level on current account deficits does not exceed, say, 2-3 per cent of GDP, the contribution of foreign currency resources would remain limited to this number. |
| As for rupee resources, the surplus liquidity available with the banking system in the form of excess SLR investments is fast coming down. From a level in excess of 40 per cent, it is now very close to 30 per cent. There is not much cushion there. Therefore, deposit growth over the period would need to be of the order of Rs 25 lakh crore, which is more than the level of deposits the system has built up since it was born! There are large segments of unbanked people in the country: but initially at least, they would constitute demand for resources rather than be suppliers, even if cost-effective ways of taking banking services to them are innovated. |
| The second issue is capital adequacy. While Basle II has been postponed by a year, banks may need to double their capital over the next five years""in other words, the system would need extra capital of the order of Rs 2 lakh crore. Since a very large proportion (75 per cent) of the industry is under government ownership, and as the government faces constraints in bringing down the percentage of its shareholdings, how will the need for additional capital be met? Or would the public sector banking industry be forced to curtail its growth? "Innovative" instruments are only a very partial solution. |
| The third issue is of monetary policy and financial sector reforms. If my numbers are roughly correct, an annual credit growth rate of 25-30 per cent is needed if GDP growth is to be maintained. The authorities may also need to cut reserve requirements: the objective should be to reach monetary aggregate levels, as a percentage of nominal GDP, comparable to other countries in Asia, over the next five years. As the basic theory of banking suggests, credit growth itself would lead to deposit growth and bring resources. Secondly, as the central banks' central bank acknowledged in its last annual report, inflation has come down worldwide despite widely different monetary policies""thanks to globalisation. So, policy-makers can afford to take some chances on faster monetary growth. |
| Meanwhile, as the banking regulator, the central bank needs to address several issues: |
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| The monetary authorities have expressed concern at the growth of consumer finance and home loans: even the finance minister seems to have emphasised in his meeting with public sector bank chairmen the need to "rebalance" their credit portfolios, with more emphasis on production/infrastructure finance. One wonders whether the caution about home loans is warranted, at least at this stage. For one thing, home loans as a percentage of the total credit market are still low compared to the rest of the world. Secondly, the household sector remains a very substantial positive contributor to the financial sector: in 2005-06, for example, the change in financial assets of the household sector was Rs 589,000 crore, as against an increase in financial liabilities of less than a third (Rs 183,000 crore). Again, under Basle I, the capital ratio for mortgage loans (i.e. housing finance) is half that for commercial credit, reflecting both the relative safety of the segment as also the huge spread of risks it commands. |
| The Governor's call for greater transparency in housing finance is well taken. As I have argued in this paper earlier, two concrete steps would help: floating rates linked to the 6-month T-bill yield and a swap contract also based on it, in the absence of a better benchmark. avrajwade@gmail.com |