Economic Highlights

New Delhi, 2 February 2013

Tottering Economy

RATE CUT NOT A SOLUTION

By Shivaji Sarkar

The recent rate cut by the Reserve Bank of India may have more to do with politics rather than reality. In all probability the apex bank’s move will have little impact on lending rates or prices of realty or other goods.

This raises a moot question whether the RBI decisions have become less effective. Its tight monetary policy has not been able to reduce food inflation. Its hiking of lending rates could not bring down the realty prices. Certainly, the RBI has a limited role. It alone cannot make the difference.

The RBI has taken the step of cutting rates to 7.5 per cent of repo – money lent by RBI to banks – from 8 per cent with much reluctance. It has found inflation rates still not conducive and has concern for the slowing economy as also the critical deposit situation of the banks.

The apex bank believes that inflation would moderate, but in reality, it is becoming more stubborn. Promptly after the declaration of the rate cut food inflation has touched over 10 per cent.

The Reserve Bank finds India as a high cost economy. It also notices earnings of individuals either stagnating or falling. It impacts the health of commercial banks. The outgo of banks – lending increases and inflow – deposits shrink. The banks are getting into critical area. They have lent a total of Rs 4,87,659 crore  but at the same time have borrowed only Rs 4,04,786 crore. Hence the ratio of what banks have lent to what they have borrowed over the past six months, which is referred to as the incremental credit deposit ratio, comes to a whopping 120 per cent. This is clearly not a good sign.

It means the banks are giving out Rs 120 of loans for every Rs 100 raised as deposits. The banks may be lending out deposits it had collected in the past and not given out as a loan or it may be tapping other sources of funding like certificate of deposits. This means that banks have not been able to raise enough deposits to match their loans over the past many months.

The cut in cash reserve ratio (CRR) makes available Rs 18,000 crore more for lending. While this is being seen as positive by some, there is a flip side too. This would put banks deposits further at risk.

As per 24 per cent statutory liquidity ratio a bank has to invest Rs 24 of Rs 100 raised as deposits in Government securities, basically bonds issued by the Government or its affiliates.

Other than this, of every Rs 100 raised a bank has to maintain a reserve of Rs 4.75 with the RBI. This ratio is referred to as the cash reserve ratio. Thus, 28.75 per cent of the deposits raised by banks cannot be given out as loans. That leaves Rs 71.25 out of every Rs 100 that can be given out as a loan.

While bankers clamour that this is too high, there is a rationale. It is a safety shield against the collapse of the banking system in a critical situation like this when lending exceeds deposits. The RBI says that. Incremental credit deposit ratio for the six month period ending December 2012 had stood at 68.5 per cent indicating situation has tightened up.

Given that banks are finding it difficult to raise deposits to match their loans means that they will have to continue offering high interest rates on their deposits. A high interest rate on deposits will lead to banks charging a high interest on loans as well, which of course means higher EMIs. There is not much the RBI can do about it.

Though some banks marginally reduced home loan interests, most of them have increased rates on other forms of lending, including personal loans. Another flip side is many banks are refusing to grant home loans and are forcing people to avail personal loans at high interest rates of 16 to 18 per cent, sometimes more than that.

The banks are cutting into their reserves. But as per the RBI’s quarterly review there is overall credit slowdown. It indicates tepid demand conditions and lower credit expansion by public sector and foreign banks. This reflects their risk aversion.

Are the tepid demand conditions due to high interest rates, in which case a reduction thereof would have helped? Both the agriculture and export sectors are protected from interest rate changes due to subventions provided to banks by the Government. It is the industrial and service sectors that are mainly affected by changes. The big companies have been able to tap the commercial paper market on a large scale recently due to a fall in interest rates, besides accessing bank credit. It is the small and medium industries that have problems of credit, if one goes by anecdotal evidence. The increase in liquidity through the injection of Rs 18000 crore is not a big deal for them.

The latest moves would have least impact on price of houses. Property prices remain high despite fall in demand. Developers say they have had to increase property prices by 5 to 10 per cent as cost of funds – due to lack of credit from banks - has increased along with input costs and other expenses. After banks tightened credit to the real estate sector, developers were forced to borrow money from non-banking finance companies at 16-18 per cent interest and from private equity funds at rates between 20 and 24 per cent, builders claim.

The increases in interest rates had kept many prospective buyers away. Moreover, due to high property prices and rising mortgage rates, the sale of residential and commercial properties fell. The builders are unwilling to cut on rates even if now loans are available to them at cheaper rates. They aver that their costs have increased so much that they would not be able to reduce the prices. There is no policy or mechanism of the Government that could force them to do that. Despite low sales, it has not impacted their profits.

Thus, the rate cuts may have more politics into it than reality. Deposit rates cannot be reduced as banks have to infuse more funds into their system. High inflation is eroding the yields from interest earnings. Considering the fact the GDP numbers indicated – 5.5 per cent growth – a further slowdown, alternatives too are missing. Tax laws are also hindering flow of money into the banking system. Banks want that they should be freed of the burden to collect taxes on interest earnings. If that is done more funds would flow in.

If deposit rates are to remain at around 6 to 8 per cent, lending rates have to remain at least two percentage points higher than that. Can a slowing economy afford that? Probably not. But it also calls for taking steps that are beyond the purview of the RBI. During the past over three years little has been done to pep up the economy and check prices. The RBI is rightfully apprehensive of an economy that shows little growth. ---INFA

(Copyright, India News and Feature Alliance)