Solid growth needs liquidity

It has been a rollercoaster ride for global banking and capital markets. Economic and political upheavals have wreaked havoc. Even before the global market could recover fully from the sub-prime crisis, a series of crises—the Middle East turmoil, earthquakes in Japan, the Euro zone’s sovereign debt crisis, downgrading of the US government’s credit rating, and increasing commodity prices—dented global growth rates and sentiment. Due to stringent regulations and supervision, and the rupee being only partially convertible, the Indian banking sector has remained relatively isolated from international developments.

Having said that,India’s growth rate is currently showing signs of slowing down. Registering an average GDP growth rate of 8.4 per cent in the past five years, the economy skidded to 5.5 per cent in the first quarter of FY2012-13.

A weakening currency, lower industrial production, volatility in financial markets and flickering investor sentiment are all indicators of a slowdown. While the Indian banking system has managed to remain relatively decoupled from the global economic conditions until now, it will be difficult for it to stay unaffected in the long run, despite the support of a robust financial system.

The Indian banking sector has evolved over the last decade from being merely a source of capital and repository of excess funds, to offering broking and advisory and wealth management services and also distributing mutual funds and insurance products. Banks also carry the onus of financial inclusion, and are required to comply with priority sector norms.

Economic liberalisation set in motion in 1991 and the opening up of the banking sector in 1994-95 helped Indian commercial banks achieve a higher growth rate in the subsequent decade. Nevertheless, recognising the nascent stage ofIndia’s economic development and the inherent dangers in offering too much freedom in too short a time without the necessary controls and systems in place, the Reserve Bank of India (RBI) and the Ministry of Finance ensured that Indian banks continued to adhere to strict guidelines. These regulations were also aimed at maintaining a balanced regional economic growth, equitable income distribution, financial inclusion and priority sector development.  However, this directed lending is a burden on the financial sector, and increases the cost of borrowing for all.  I believe the time has the time come to review this policy.

The Indian banking sector continued to improve its performance despite several hurdles like the global economic slowdown in 2008 and 2009, tightening liquidity, and changes in banking regulations by the RBI.  However the intensification of  these challenges and the addition of new problems — tightening of monetary policy, and a burgeoning fiscal deficit, the need for increased infrastructure lending, deregulation of interest rates on savings accounts, etc. – have diluted the robust performance of banks in comparison to other sectors.

While the banking sector is struggling to maintain the growth momentum— as of now, Indian banks do not have the ability to match the pace of growth of Indian industry. Some sectors like Technology and Consumer products are performing well, and have managed to post encouraging numbers. However, while companies with strong cash reserves will continue to increase their revenues for some time to come, in due course they will be required to invest in capital formation and capacity enhancements.  And then the 12^th Plan projects a Trillion USD to be spent on infrastructure, largely from the private sector.  Our banks will need to provide some of this funding.  Where is the money going to come from?

In looking at the banking sector in other emerging markets we find that the performance of banks in China and Brazil too have weakened in 2011 and banking stocks have plunged dramatically due to increasing consumer defaults and rising borrowing costs. Only a few years ago, loans to Indian real estate developers, Chinese infrastructure projects and Brazilian consumers fuelled their respective economies. The size of these assets boosted the market value of many banks in these emerging markets, earning them a rank amongst the largest companies in the world. However, worries over high inflation, along with tightening monetary policy and increasing NPAs, have raised serious concerns over the continuance of the growth momentum of banks in these countries.

Notwithstanding the similarities in the growth trajectory, there is one key difference between Chinese and Indian banks: scale. The sheer size of the Chinese banking sector and the scale of its businesses sets it apart from its Indian counterpart. With more than 250 commercial banks, 196,000 business outlets and nearly 3 million employees (as of 2010),Chinaout-scalesIndiawhich has just 167 commercial banks 87,768 outlets and around 0.8 million employees.

Even when it comes to asset and market size, Chinese banks overshadow Indian banks. At least 11 Chinese banks figure in the list of the top 100 global banks based on market size, compared to only 3 Indian banks. The scale of difference of these banks is significant too. For instance, Industrial and Commercial Bank ofChinahas a market size of $230 billion while SBI’s market size is just $27 billion.

There is a perception that Chinese banks may not have the best quality of assets, but the growth in their loan book in the past few years remains unmatched by the Indian banking sector.

According to an Oliver Wyman report, the fact that banking revenues as a percentage of GDP are a mere 4 per cent in bothIndiaandChina(as against 22 per cent in more developed markets like theUKandSwitzerland) points to great growth potential. Increasing wealth is boosting consumption, fuelling growth in both lending and wealth. This acceleration is generally accompanied by an increasing percentage of banking growth over GDP growth. A range of macroeconomic, demographic and other factors (regulation, legal framework, etc.) also impact the variation in banking growth over GDP growth.

Thus, the report puts countries likeIndiaandChinain the high potential and medium enablement categories and expects them to experience significant growth. Growth forecasts are also evaluated in the light of capitalising of the banks and the long-term availability of adequate funding. The report forecasts banking revenues in markets like India and China to grow four times in this decade and around three times in the next decade (2020-30). Much of this expected growth is a function of the addition of nearly one billion ‘bankable’ people across emerging markets, 70 per cent of which would be fromChinaandIndia.

The deepening of the financial sector and broadening of reach, however, is fraught with risk without the availability of organised and trusted customer data. Thus, while we need to increase banking and financial product penetration this needs to be done carefully as the institutions (eg credit rating agencies) are still not of sufficient scale to support unbridled growth.

According to Indian banking regulations, a percentage of bank deposits needs to be secured with the RBI in cash to ensure that the banks remain solvent. This amount, currently 4.5 per cent, that is kept in reserve is known as the cash reserve ratio (CRR) and does not generate any interest income for banks. Banks also have to deposit some statutory liquid assets, known as statutory liquid ratio (SLR),[1] in the form of cash, gold, or government bonds on a daily basis before lending any credit to their customers. Currently, this stands at 24 per cent (Reserve Ratios in China and Brazil are around 21 and 20 per cent respectively). When combined, Indian banks have to put aside a total of 28.5% of their deposits (among the highest in the world), leaving that much less for lending.

Although high SLR & CRR is one method of lending stability to the economy, it also means tighter liquidity as it leaves banks with that much less to lend. Besides, a hike in these rates has a larger impact than a hike in the repo and reverse repo rates. The impact of a rise in repo rates might differ from sector to sector, but a minor hike in CRR hits all sectors.

Another challenge is, cash in the system or currency with public.  This expanded by Rs 52,000 crore in the first 3 months of 2012 which is almost equal to a 1% CRR hike.  In other words this undoes the CRR cut of 1.25% effected by RBI.

Indian banks are also governed by an RBI mandate to disburse at least 40 per cent of their loans to the priority sector, which includes agriculture, small-scale sector industries and exports. The RBI believes that these sectors are under-served and should be considered a priority as they drive economic growth. However, after lending 40 per cent to this sector and some amount to retail clients, Indian banks are eventually left with very limited resources to lend to corporate clients.

Besides, the government has been borrowing heavily from the market to meet its financial requirements. It recently increased its borrowing estimation from Rs 4.17 lakh crore (US$ 83  billion) to Rs 4.7 lakh crore (US$ 94 billion), a rise of 13 per cent. Such heavy borrowing by the government at higher rates causes ‘crowding out’, wherein there is an overall increase in interest rates due to the rise in government borrowing. So, while it would not be difficult for the government to borrow more funds at a higher rate, borrowing becomes even more expensive for companies.

The RBI realises the consequences of high CRR and SLR rates, and is committed to bringing these down, thus providing more liquidity to banks, and ensuring that the private sector is not crowded out.

The Indian banking sector is resilient. But in order to maintain this resilience, a few major challenges will need to be addressed. A specific concern that has come to the fore recently is the increased lending of Indian banks to the infrastructure sector, with increasing risk of non-repayment of loans because of a variety of factors.  These loans are long term in value, ideally 10-15 years while the longest tenure of deposits is 5 years with the average around 2 years, creating an asset-liability mismatch.  Disproportionate growth in credit to some sectors like retail, NBFCs and real estate leads to concentration in sectors that are showing signs of stress. This increased exposure to specific sectors, mismatches in assets and liabilities and increase in NPAs requires continuous attention.

In addition, it would be challenging for Indian banks to increase their capital to achieve consistent growth and comply with Basel III norms. In a scenario where the cost of borrowing is high and government support is limited due to a high fiscal deficit, banks will have to raise capital through other market-based channels.  This is a growing challenge as the government begins to set aside large amounts of capital to invest in its owned banks in order to retain their shareholding.  These banks could easily raise capital from the equity markets as indeed the private sector banks have done.  They raise money when markets are strong and hence have comfortable capital adequacy ratios, enabling them to weather the downturns and to fuel growth.

The time has come to ask – should government be spending tax payers’ money to shore up its shareholding in banks or put this money to better use into social schemes? The budget of 2012 has set aside USD 3.5 bn (Rs 15,888 crore) for the banks over and above the USD 1.7 bn (Rs 7,900 crore) investment in SBI. A Crisil report estimates that the capital requirement of Indian public sector banks would be in the region of USD 83 bn (Rs 3.75 lakh crore) over the next ten years.

The government should now take a call to hold on to 51% in a limited  number of banks and let the others raise  money from the capital markets even if their holding drops below 51%.