Abheek Barua: The SLR question

With the government's liberal position on the statutory liquidity ratio, there will be a tendency for gilt yields and credit yields to converge.

Indian banks are a rather unenviable lot. Even after a decade and a half of financial liberalisation, there are a number of restrictions on both assets and liabilities that crimp their freedom. For every rupee raised the Reserve Bank impounds five and a half paise through the cash reserve ratio (CRR) and banks are forced to buy 25 paise worth of government bonds to meet the statutory liquidity ratio (SLR). Forty per cent of its loan book is "directed" credit and banks are mandated to lend this to the so-called priority sectors""agriculture, small-scale production units and exporters. Of this, 18 per cent is earmarked for the farm sector. Thus, any move to give banks a greater degree of operational freedom is welcome not just for banks' bottom line but also for greater efficiency of the financial system. In short, I think the move to allow the RBI the freedom to pare the SLR below the current floor of 25 per cent is a particularly good idea.

However, there could be some difficulty in implementing this. Reducing the SLR floor effectively gives greater flexibility to banks in deciding their asset portfolio. Given strong credit demand and increasing yield on credit, the return on loans is higher than the yield on government bonds. If the SLR is pared, banks whose holdings are close to the 25 per cent floor would be tempted to dump these bonds and switch to credit. This would mean a sharp jump in the supply of bonds and a rise in bond yields. If the supply is large, it could lead to extreme volatility in the markets and set yields soaring particularly for long-tenor bonds. Thus, the RBI is likely to tread carefully in reducing the floor. I expect a phased reduction in SLR spread over a couple of years with each phase involving a cut of no more than half a percentage point. I come across a number of bankers who seem sanguine of a larger cut. I am afraid they might be disappointed.

Besides, a cut in the SLR is de facto a monetary policy signal. It augments the lendable resources of banks and thus implicitly encourages credit growth. One could construe this as running counter to the RBI's current monetary agenda of cooling credit markets down and engineering some degree of moderation in economic growth. It has in the recent past increased the CRR to impound a greater fraction of deposits. Whatever the subtle analytical distinction is between a change in the CRR and SLR, a cut in the latter without accompanying riders would seem to go against the grain of the RBI's current policy stance.

Given this problem of sending apparently conflicting signals, the central bank has a few options. It can of course choose not to announce anything. However, this will ratchet up expectations of an impending cut and could lead fairly serious overshooting in yields particularly of longer-tenor bonds. It can, alternatively, adopt a gradualist approach, set out some kind of timeframe over which the cut will be announced and let interest rates slowly price in this prospect. Finally it can announce an immediate reduction (say in the January 31 policy if the Ordinance is passed by then) and then try and handle the liquidity implications by raising short-term signal rates.

Let me get to the nitty-gritty of what is likely to happen if the SLR is pared. Clearly, the government's cost of borrowing will go up because its regulated draft on funds declines. This is a factor that the RBI perhaps needs to consider. The government's demand for funds is inelastic to interest rates. While there has been significant improvement in the fiscal situation over the last three years or so, the central and state governments remain a fairly large borrower. Its annual demand for funds is unlikely to fall below 6 per cent of GDP over the next couple of years. Given this large quantum of borrowing, a sharp rise in borrowing cost could trigger a spiral of rising interest costs. This could derail the process of fiscal consolidation and start pushing fiscal deficits up again.

While the government's cost of borrowing is likely go up, freer resources available to the banking system would tend to depress the cost of credit over the medium term. In short, there will be a tendency for gilt yields and credit yields to converge. That said, a sharp reversal in credit costs is unlikely. The banking system currently finds itself facing a "credit gap", that is deposits adjusted for the CRR and SLR (free funds in the banking system) aren't adequate to fund credit. Our simulations show that even with a 2 per cent cut in the SLR, the credit gap remains at around 3-4 per cent of outstanding credit by the end of the year. While the cut in the SLR will tend to push credit rates down, the credit gap will tend to pressure rates up. Thus for a period, both government bond yields and credit rates could move up with the wedge between the two declining. Only after credit growth decelerates significantly will interest costs for companies and retail borrowers soften. My sense is that the credit cycle is close to reaching a peak but the subsequent deceleration will be somewhat slow and inadequate to close the credit gap. Only by the end of 2007 could we expect some succour on the interest rate front.

Should the RBI push hard to ensure that the credit gap collapses? I think this is a going to be a tough call. A rapid escalation in rates could just induce a sharper slowdown in the economy than is desirable. Engineering a soft landing for the economy is a tough task. The RBI governor's job isn't enviable, either.

The author is chief economist, ABN Amro. The views here are personal.

abheek.barua@in.abnamro.com