Rx: Start With Consumption, Start Small

The trick to jump-starting the economy might lie in creating demand for basic goods, besides increasing liquidity and other revival measures

IN THE movie Batman & Robin, arch-villain Freeze gate-crashes into an antiquities exhibition and announces: “In this universe, there is only one absolute. Everything…freezes.” Credit markets across the world have frozen over, and though there’s no nasty piece of work yet (at least not on the scale of Freeze), there are no early signs of thawing. Spring may still be far away, but attempts by regulators and governments from across the world to end the economic chill don’t seem to be working. In India too, the government and the central bank, Reserve Bank of India, seem to be working hard to loosen winter’s cold grip over the Indian economy, but with little success.

The RBI has been infusing the economy regularly with large doses of liquidity ever since the system was beset with worries of money drying up. The RBI tried everything in the book — cut cash reserve ratio, freed up part of the statutory liquidity ratio, opened a special lending facility for banks to on-lend to NBFCs, housing finance companies and mutual funds, created a special refinance window from where banks could borrow without providing any collateral. Additional liquidity was pumped in by buying back bonds issued under the market stabilisation scheme. In all, since mid-September, the RBI pumped in Rs 300,000 crore through the sluice gates.

But, even that did not help hydrate the financial system. When banks were swamped with liquidity, they took the cash and dumped it with the RBI for a 6% return, even when lending it to prime borrowers might have fetched better returns. The central bank even cut its benchmark repo rate by 150 basis points (bps) to 7.5% on October 19 in an attempt to get some of that money moving out of the bank vaults. Still no go.

The RBI recently turned up the thermostat once more, this time to prod banks to start lending at reduced interest rates. It cut its benchmark repo and reverse rate by 100 bps. But, again, there’s hardly any movement. The banks are still carting their surplus cash over to the RBI and dumping it there for safe-keeping, for even as a low a return as 5%. Take a look at the money being tipped over at the RBI window.

For the first five days of the month, till the RBI cut the rates, banks plonked Rs 243,310 crore with the Reserve Bank, for a return of only 6%. Then on December 6 — a Saturday — it cut rates again. Over the next three working days, banks again deposited Rs 84,635 crore with the central bank, for a return of just 5%. The total — for just eight days — works out to over Rs 327,000 crore! In fact, the RBI was forced to comment, while announcing the new rate cuts, that the liquidity adjustment facility operated by the central bank, “has largely been in an absorption mode.”

In effect, this means banks are still wary of lending to corporates, despite the sea of liquidity and rate cuts unleashed by the central bank. This also then conveys how banks are still uncertain about the future and that they are doubtful about the ability of their corporate clients to pay up in time. In short, the vital glue of financial system — trust — seems to be missing and the authorities designing the various economic packages are unable to supply it in sufficient quantities.

Here's an example — a public sector unit was able to issue five-year bonds to banks with a coupon of 9.33%. Around the same time, one of the Top five India Inc companies also borrowed three-year money, but at 10.10%. Clearly, banks are willing to take a risk on the government, even if it is a subsumed sovereign guarantee, but not on even AAA-rated private companies. Banks have not forgotten the nightmares of the early 1990s, when bank NPAs ruled around 10-14%. This time, despite the prodding from the government and the central bank, they are unwilling to stick their necks out. The RBI has allowed banks to restructure loans — a euphemism for looking the other way when a loan turns bad — that might in ordinary times have been called for stricter treatment. But, the banks are still not biting.

The problem also seems to be in the system’s liquidity absorption capacity. Whatever steps the government takes at the moment — such as, providing cheap cash to corporates through a variety of refinance windows — not only are banks reluctant to lend, even corporates are loath to load up their balance sheets with fresh debt. Many of them are drawing down their existing credit lines with banks — emboldened somewhat by the new restructuring space — to finish existing projects but are unwilling to bet on new projects. With aggregate demand having fallen, India Inc is also contending with reduced topline and bottom line projections. In such a scenario, they may not be in a mood to pile up additional debt.

Therefore, the key to the current economic impasse might lie on the demand side. The government has tried addressing the issue by spending on infrastructure and by cutting taxes to boost demand. These are also not without their associated problems. Any investment in infrastructure will yield results only after a long lag, and the nature of improved technology does not allow for the higher employment generation that one saw a few years ago. Plus, to get an infrastructure project started is also time-consuming — financial closure in these days of clammy credit markets is a tough call.

Some economists say that the production orientation of the economy has changed in favour of expensive consumer products, a sector that might be slow off the blocks in reviving. In such a situation, reviving demand for wage goods might just do the trick. Even this hypothesis needs to be tested. The occasion might present itself soon — with experts forecasting a better-than-average winter crop, the government should facilitate hassle-free movement of the harvest to the markets and consumables to centres where the ensuing agricultural income can be spent. This may sound simplistic, but sorting the physical, infrastructural infirmities could be one of the first achievable steps on the long road to recovery.

Published as an Op-Ed in The Economic Times (December 15, 2008)

Pre-empt Regulatory Arbitrage

The Reserve Bank of India’s reputation as a regulator is rock-solid in the global financial system. It now has to ensure that its regulation on NBFCs has the life span of a turtle

SOMEONE once gave regulation one-fifth the life span of a chimpanzee. India has seen numerous examples where the regulator tries to erect walls around a particular sector, only to find that business has found a way around. Some of these sidesteps can be labelled as criminal, but most of these instances can be clubbed into what is now known as “regulatory arbitrage”, which means utilising gaps in the existing regulatory framework without violating the law of the land. There is a regulatory arbitrage occurring right now, which has the Reserve Bank scrambling to plug the loopholes. This involves nonbanking finance companies (NBFCs), especially those promoted by foreign banks or even those sired by international financial giants. The central bank is now planning to come out with regulation that endeavours to eliminate the NBFC-spawned arbitrage.  

Foreign banks are keen to expand their footprint, and given India’s growth rate, they want it all done now! India is currently the hot new thing on the global investment block and everybody desperately wants in. Even foreign banks that once found business in India only marginally engaging now suddenly want to hitch their wagons to this emerging economic powerhouse. For example, certain European banks, which, in an exemplary display of foresight, had deliberately shrunk their Indian businesses in the ’90s, are today jostling to catch a piece of the action. And, this requires branch expansion of an unprecedented scale. 

But then the RBI thinks otherwise. The central bank has been deliberately going slow in granting new branch licences, driven by larger apprehensions of systemic risk. As an alternative, some foreign banks have been expanding their presence through finance companies, or NBFCs. These NBFCs don’t need to approach the RBI for opening branches. Most of them don’t even accept deposits in order to escape the RBI’s gimlet gaze. As a result, foreign banks have been opening NBFC branches furiously. These branches are, for all practical purposes, like bank branches with only one crucial difference — these can grant loans for buying houses, cars or two-wheelers, but cannot issue cheque books. According to a report of an RBI internal group on ‘Level playing field, regulatory convergence and regulatory arbitrage in the financial sector’, banks are likely to set up NBFCs to benefit from regulatory arbitrage: “A bank’s NBFC subsidiary which grants retail loans such as consumer loans, vehicle loans, housing loans, etc., coupled with a bank ATM can circumvent the branch authorisation restrictions imposed on the bank by extending its outreach substantially. The customer can deposit or withdraw cash at the bank ATM, obtain a loan from the NBFC and make repayments into the loan account by using the bank ATM. Thus, the bank together with its NBFC subsidiary can perform more or less all the functions which a bank branch undertakes.”

The trend has now taken a curious twist. The RBI has now stopped a few banks from opening or operating NBFCs, without doing anything about the existing ones. Barclays, Deutsche Bank and HSBC find their applications for NBFCs lost in a black hole. Interestingly, NBFCs launched by non-banks have sailed through — in addition to GE Money, US insurance giant AIG recently got the nod to launch and operate an NBFC. So did Singapore’s Temasek, which bought over an existing NBFC (something reportedly done by Goldman Sachs). In the midyear review of its 2006-07 credit and monetary policy, the RBI has even allowed these NBFCs to issue co-branded credit cards and sell MF products. This puts them somewhat on par with banks.

The RBI’s concern with bank-run NBFCs is not totally out of place. Many of these NBFCs extend risky loans, including loans to speculate in the capital markets. This is risky on two counts — first, any default can lead to an impairment of the parent bank’s capital. But the riskier proposition is the contagion effect it may have on the system as a whole. Most of these NBFCs are heavily leveraged, which means they borrow in multiples of their capital (can be 10-15 times) from the market to finance their lending operations. So, any slight slippage might affect even the lenders, who in turn might knock over another chain of financial agents in the system. 

In all likelihood, the RBI might opt for stricter regulation of the banks that have promoted NBFCs. For instance, it might choose to treat a bank and its family of NBFCs as a conglomerate, inviting consolidated supervision, including imposition of ceilings on the conglomerate’s lending to industrial groups. There might even be stricter norms introduced for bank financing of NBFCs against shares, debentures and PSU bonds, in addition to finding ways that staunch the flow of bank funds to the capital market through NBFCs. Another alternative would be closer coordination with Sebi for regulating finance companies that are engaged exclusively in the stock markets. The overall purport of the new NBFC policy will be to make a distinction between bank-sponsored NBFCs and independent ones, against the current difference of deposit-accepting and nondeposit accepting NBFCs.

All that’s fair enough. But there’s another problem here: if the RBI shuts the door now, it presents a new kind of hazard. It provides the existing foreign banks with an unfair advantage over the others, which might then induce the excluded lot to indulge in an extreme form of regulatory arbitrage. The top five foreign banks already account for 82% of the total profit reported by all the 30 MNC banks in the country. Any form of prospective selection through regulatory fiat might only enhance this discrimination. The Institute of Chartered Accountants of India shut the door on foreign accounting firms some years ago, but only after it had allowed in a couple of the foreign firms. However, the ones left standing outside the gates still managed to sneak in through cracks in the wall. MNC banks, deprived of either branches or NBFCs, might be also tempted to attempt something extreme, thereby putting the entire system to even a greater risk. The RBI’s reputation as a regulator is rock-solid in the global financial system; it now has to ensure that its regulation on NBFCs has the life span of a turtle.

Published as an Op-Ed in The Economic Times (November 1, 2006)