Basel-III could trigger recession

Before the formal beginning of the Twelfth Plan, ambitions about growth prospects of the Indian economy were set to double-digits.

This was based on the the economy recording a growth of around 9 per cent during 2004 to 2008 and a strong rebound post-global financial crisis during 2009 and 2010. The draft Plan document, however, set the growth targets at a less ambitious 9-9.5 per cent.

After continued inflationary pressures and an underperforming industrial sector, doubts are being expressed about the economy's potential growth rate. The RBI's macroeconomic review for 2011-12 acknowledged this and indicated that “recent experience suggest that the non-inflationary growth rate for India may have somewhat declined from the pre-Lehman crisis period”. The first two years of the Twelfth Plan may not see an average growth exceeding 7.5 per cent.

Therefore, the final Plan document is likely to scale down growth projections to around 8 per cent and, that too, will require achieving growth rates of around 9 per cent in the later years.

Decline in savings

The financing of this effort has to come from increase in domestic and foreign savings. Since a widening current account deficit poses a serious challenge to the sustainability of the external sector, financing has to come more from domestic sources. But, there are some discouraging trends here. The domestic savings rate declined in 2010-11 to 32.3 per cent, from 33.8 per cent in 2009-10.

The decrease in 2010-11 was due to both household and the private corporate sector savings, which more than offset the improvement in the public sector savings rate. The household sector savings rate declined to 22.8 per cent in 2010-11, after touching a record high of 25.4 per cent in 2009-10.

Within household savings, the financial savings rate declined sharply from 12.9 per cent to 10 per cent during the same period. The decline in the net financial savings rate was further explained by the slower growth in households' savings in bank deposits and life insurance, as well as an absolute decline in investment in shares and debentures, mainly driven by redemption of mutual fund units.

The declining trend in savings in financial assets, in general, and bank deposits, in particular, shows that the household sector has shifted to inflation-hedging assets such as real estate, which shows up in increased savings in the form of physical assets, and diversion to gold, which does not show up as savings.

This may also be partly due to dissaving and increase in household debt to meet the needs of consumption on the face of higher cost of living. The prospects for improving household savings in the coming years will hinge on control over inflation rate and strengthening the process of bank as also non-bank intermediation through capital market instruments. In particular, strengthening of the bond market would be a prerequisite.

Basel Standards

Basel standards for capital requirements of banks starting from the late 1980s were an outcome of international cooperation among central banks on the face of indiscriminate cross-border bank lending and debt repudiation from certain debtor countries. India had always set an example in implementing these standards, but the compliance was gradual and easy-paced, so as not to disrupt the banking system.

The compliance levels were relaxed from time to time to accommodate even the weakest link in the banking chain. The idea was to enable the entire system to adapt to these standards. The pace of implementation of Basel-II was an example.

But even before full compliance with Basel-II, in all its dimensions, now there is a jump over to Basel-III.

Before the onslaught of the global financial crisis originating from the West, even the US never bothered about compliance with Basel norms. Now, the US and Europe are forced to do so due to international pressure.

The compliance guidelines in Europe and the US are still under debate. There is a widespread view that Western banks will see their balance-sheets shrinking and margins getting compressed. Hence, the implementation is over a very long period extending up to 2019, with country-specific flexibilities.

In this environment, it is rather surprising that India has ventured into over-compliance with Basel III with higher and more stringent requirements( see table ). The implementation of new liquidity standards may follow the same strategy.

The guidelines released on May 2 do not yet provide for a counter-cyclical capital buffer or additional capital for systemically important banks.

Implications for Growth

The Indian banking system has switched between risk-averse and risk-appetite situations. With the commencement of Basel implementation in the late 1990s and till early last decade up to 2003, banks preferred to increase their investment deposit ratio, by reducing credit deposit ratio, which led former RBI Deputy Governor, Dr Rakesh Mohan, to dub the practice as ‘lazy banking'.

This was simply because SLR investments did not require additional capital. Once the satisfactory level of compliance was reached, the trend reversed and credit growth touched peaks of around 30 per cent per annum, which also coincided with huge assets build-up in the corporate sector and India touching growth levels of around 9 per cent. This was also the period of fiscal consolidation and moderation in government borrowings.

The trend has rather reversed in the last two years. Credit growth has become sluggish and investment deposit ratio of banks has increased along with burgeoning government borrowings and fiscal laxity ( Graphs A and B). If this continues, the growth ambitions of industry will be thwarted.

Last week, Moody's Indian subsidiary, ICRA, said banks in the country will require Rs 3.9- 5 lakh crore as capital to comply with Basel-III requirements, most of which will fall on the public sector. Since the government's ability to meet matching requirements will be limited, as per the second Tarapore Committee's recommendations, the government holding in public sector banks will have to be diluted to around one-third, from 51 per cent.

Alternatively, if new bank licences are issued to industrial houses, then the public sector banks' share in the total banking system assets will further shrink to the gain of private and foreign banks. If new licences are not issued, it will be a recipe for industrial recession in the coming years.

(The author is Director, EPW Research Foundation. The views are personal.)

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