The Fd Fissure

The Indian investor is facing almost the same predicament as the Indian voter. Both are disillusioned with recent experiences and distrustful of the alternatives placed before them by those who compete for their confidence.

Having lost billions of rupees in stocks, property, gold, equity-based mutual funds and plantation schemes during 1997, investors are increasingly turning to debt instruments. Debt-based mutual fund schemes received an encouraging response last year despite an unfavourable investment climate. Now, fixed deposits (Fds) and bonds may be next in line.

Two recent developments have reinforced this trend. These are the Reserve Banks new restrictions on non-banking finance companies (NBFCs) and an increase in interest rates.

 

When the rupee retreated rapidly against the US dollar in the wake of the Asian currency crisis, the Reserve Bank moved into the battlefield with heavy artillery. It increased the bank rate by two percentage points increased the cash reserve ratio by 50 basis points and cut back the refinance facility for banks and exporters to prevent arbitrage between the domestic money market and forex market.

These measures shored up the rupee impressively -- it rose from more than 40 to the dollar to nerarly 38 -- but also led to an across-the-board increase in interest rates. Commercial banks and financial institutions put up their prime lending rates by an average of 2 percentage points. Many banks began to offer higher interest rates especially on short-term deposits. Unit Trust and IDBI thought it fit to offer better returns on their monthly income scheme and bonds respectively.

Worried by the CRB fiasco and the failure of many finance companies to meet their liabilities to deposit holders, the Reserve Bank imposed severe restrictions on NBFCs deposit-raising activities. These measures were so harsh as to drive thousands of finance companies to the threshold of closure. When it was realised that the zealous prescription may actually backfire on investors, RBI relaxed some of its regulations. Companies with investment grade credit rating were allowed to raise new deposits from the public, companies that had accepted deposits in excess of the newly prescribed limits were given two more years to fall in line and even unrated companies were allowed to renew maturing deposits. Preference shares were allowed to be included in the computation of net owned funds, a measure that would enable eligible companies to raise more deposits.

Despite these relaxations, a large amount of money will move away from the NBFC deposits to other players in the debt market as investors start looking for less risky options.Where will this money flow? The claimants for fixed deposits include non-finance companies, commercial banks, financial institutions and, of course, sound and well-reputed finance companies.

Madhabi Puri Buch, senior vice-president, ICICI, says, For long, NBFCs lured depositors with high interest rates and attractive incentives. Investors either did not perceive the high risk involved in this choice or merrily ignored it, she says, adding, the recent failure of a number of finance companies to meet their obligations to deposit holders has severely jolted them out of their complacence. This does not mean that the flow of public deposits to NBFCs will dry up, but it does mean that investors will now be far more discerning and cautious.

Puri Buch gives higher marks to bond issues of financial institutions than fixed deposits of companies and commercial banks. As far as companies are concerned, she explains, the problem is that most of them operate in a single industry or a limited number of industries. On the other hand, financial institutions by the very nature of their business have a far wider spread. They are, thus, in a better position to absorb cyclical fluctuations in individual industries. If the automobile industry is down, computer hardware and software may be doing fine; if steel is in bad shape, cement may be booming. By spreading their resources across a large number of industries, financial institutions are able to offer investors much greater safety than companies.

But what about returns? It is true that companies offer higher interest rates on fixed deposits than FIs do, but they also come with a higher risk. This is not confined to the much-abused finance companies. Last year, scores of non-finance companies -- like Thapar Agro, Modern Denim, Lunar Diamonds and Western Pacques -- failed to repay deposits on maturity. H. S. Ranka, chairman of the Modern group of companies, candidly admitted in a letter to the deposit holders that if we go on repaying deposits, it will adversely affect the working of the group. Even a public sector company like Cement Corporation of India, with a turnover of Rs 450 crore, could not pay a deposit amount of just Rs 15 lakh!

The other risk could be that, legally, fixed deposits are unsecured liabilities. This means that if a company goes bust, its secured and partly secured creditors will get their dues first. Whatever, if anything, is left thereafter will be available to deposit holders.

Puri Buch points out that financial institutions bonds also offer a higher rate of return than fixed deposits with banks, while providing the same degree of safety. Bank deposits are good for short-term investment but not long-term investment. In fact, returns from bank deposits, not only in India but also in other more mature economies over a long period of time have hovered around the inflation rate, she says.

A K Dham, managing director of UTI Bank, however, points out that bank fixed deposits are more liquid than company deposits and FI bonds. Companies and FIs do not permit withdrawal for three to six months. The secondary market for company deposits does not exist and that for FI bonds is not well-developed. The major beneficiaries of the shift in investor preference to debt are mutual funds, especially those run by banks, says Dham. But banks themselves have not benefited much, owing to lower returns, as compared with outright loans.

Bank deposits, however, will continue to grow. As V Ramachandran, head, personal banking, Standard Chartered Bank said in a national daily, 1998 looks like a good year for bank deposits due to the uncertainty associated with most other investment options. The safety combined with reasonable returns would make this option worthwhile.

Opinion is divided on whether interest rates will stay high. Puri Buch of ICICI avers that there is a school of thought according to which the recent increase in the interest rates will be reversed during the lean season credit policy in April or even earlier. There is another school of thought that believes that the currency crisis in south and east Asia is likely to persist for a few more months and, therefore, the RBI will not be able to retrace its steps even if it wants to.

But Dham feels that the recent increase in interest rates will not last long. The strong measures taken by the RBI were intended to shore up the rupee against the dollar. That objective has largely been achieved, while high interest rates are discouraging investment and slowing industrial recovery. They also dent the banks profitability, he points out, since the market value of their bond portfolio depreciates. The RBI is aware of these deleterious side effects and may roll back its measures once it is satisfied that the rupee does not face a fresh onslaught from speculators in immediate future, he says.

That being so, the prudent policy for banks will be to hike interest rates on deposits of upto 180 days. It would be short-sighted to offer higher rates on deposits of longer maturity, he adds.

Mahesh Thakkar, executive director of Association of Leasing and Financial Services Companies, agrees. Short-term rates have gone up because the call money markets are tight. This trend is unlikely to last long. (Call rates have come down since he spoke to Business Standard) RBI is likely to review, if not reverse, its measures shortly. According to him, companies should go in for non-convertible debentures to raise money. As secured debt instruments, NCDs will enjoy better investor perception than fixed deposits.

For all that, current investor preference for debt over equity appears to be a short-term trend. A study of returns from various investment options, based on the RBI report on currency and finance shows that over a long period of time, investment in equities has given the best returns. The study also shows that the risk of investing in well-chosen equities diminishes with time. Security of capital, like political stability, is an essential condition, but it cannot be an end in itself in the long run. As soon as the financial markets begin to settle, investors will start looking for better options --- just the way voters ask their politicians for better governance.