The Hindu Business Line : Striking the fine balance

In the background of conflicting factors, the RBI's monetary policy stance still manages to mitigate the risk of declining credit quality in certain areas of the financial sector.

The Monetary Credit Policy Statement for 2006, announced on April 18, is unique because, though it left key interest rates untouched (the bank rate at 6 per cent, the repo rate at 6.5 per cent and the reverse repo rate at 5.5 per cent) in the interest of supporting growth, it still managed to mitigate the risk of declining credit quality in certain areas that the financial sector is facing.

Determinants

The economy posted a GDP growth rate of 7.5 per cent in 2004-05 and 8.1 per cent in 2005-06, the latter being one of the highest in the world. Since 2002 it has posted an average growth rate of 7 per cent.

Whereas the growing economy has led to job creation and higher income levels, it has changed social mores on accepting credit, especially among the urban middle-class, leading to an explosion in personal loans and the home-loan market.

The increased liquidity of a more globalised economy (with access to overseas funds) led to low rates of interest which, in turn, contributed to this phenomenon.

Tax incentives on housing loans have also played a crucial role in giving a fillip to this sector. Growing cities have also created a real- estate boom. Realty prices in such key cities as Mumbai, Delhi, Gurgaon and Bangalore witnessed a 35 per cent hike in prices in 2005, and are set to go up further.

A close look at loan portfolios of major banks brings out the ground reality (see Table). At an aggregate level, non-food credit has grown more than 30 per cent for two successive years.

As banks have continued to increase their exposure to commercial real-estate, the stock market and home loans to take advantage of these developments, risks of erosion in credit quality, and the creation of an artificial bubble in asset prices have crept in. Something similar happened in Japan in the mid-1990s, leading to a slew of bank failures and almost a decade of stagnant growth.

In the 1980s, Japan's post-War success story was the toast of international financial markets. It was presumed that the stratospheric land prices in its crowded islands would continue to rise. But between 1989 and 1993, average land prices fell 75 per cent.

Consequently, loans secured on real-estate became non-performing assets.

Eight banks keeled over in 1995. Some of Japan's largest banks had to consolidate and re-structure to survive, after writing off billions of dollars in bad loans. Our banks may not have the deep pockets to sustain such losses.

Key drivers

Inflation in the economy is another key driver of the monetary policy. Despite the supply-side threat of higher crude oil prices, 2005-06 was characterised by benign inflation. Wholesale price inflation at the end of the financial year stood at 3.5 per cent compared to the RBI's target of 5-5.5 per cent for the year, and 5.7 per cent a year ago. Even if these figures are not completely correct (going by the rumblings in the bond market) they do indicate that the economy, in general, is not over-heated

The financial system also had to face a severe liquidity crunch in the last quarter of 2005-06.

Following the Rs 30,000-crore India Millennium Deposit redemption outflows in December 2005, and the high credit off-take, the liquidity position worsened leading to an increase in deposit rates across banks.

Benchmark Prime Lending Rates (BPLR) rose 50-100 basis points for most private sector banks.

The ever-rising capital market added fuel to the fire with mutual funds diverting money away from traditional bank deposits as the preferred parking space for household savings.

Banks' credit-deposit ratio shot up to 70 per cent. Given the benign inflation and the recent liquidity crunch, tightening of interest rates at this juncture was not an immediate necessity and may have actually slowed the economic growth rate.

So policy-makers faced the dilemma of supporting growth while minimising the risk of declining credit quality.

The Balancing Act

With this background, it appears that the RBI Governor, Dr Y. V. Reddy, decided to go in for a targeted approach that would tackle potentially troublesome areas without impacting overall growth and liquidity.

The risks of exposure to sensitive sectors such as real-estate and the capital market have been checked by increasing provisioning from the existing 0.4 per cent to 1 per cent on standard assets in commercial real-estate loans, personal loans, capital market advances and home loans above Rs 20 lakh.

In an economy where the average home loan size is around Rs 10 lakh, this indeed shows precision in intervention, since it curbs the speculative element in real-estate without, hopefully, affecting the middle-class home-owner.

The risk weight on commercial real-estate loans has been increased from 125 per cent to 150 per cent. This is also part of the larger effort to stem a possible asset-bubble from building, as in Japan, in the early 1990s.

The RBI also sought to mitigate the risk of increased exposure of banks to the capital market indirectly, via venture capital funds, by assigning a higher risk weight of 150 per cent to these exposures.

(The authors are with the Domain Competency Group of Infosys Technologies Ltd. The views expressed are their own.)

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