The Future for India Remains Bright
The credit crisis has caused a liquidity crunch in India. The global dollar shortage, FII outflows (and purchase of dollars by Indian banks looking to fund overseas operations has all caused the Rupee to depreciate against the US dollar, (FII’s have been net sellers this year selling almost US$10 Billion or Rs 49,000 crore, compared to buying or net inflows of US$ 17 Billion or Rs 83,300 crore in 2007). The Rupee is now at a six year low contradicting any relief that resulted from the fall in crude oil prices. India’s oil import bill in Rupees continues to remain high.
A depreciating Rupee has meant that India’s central bank, the Reserve Bank of India (RBI) has had to intervene heavily in the foreign exchange market, to keep the Rupee from precipitously falling. The RBI has sold as much as US$ 2 Billion or Rs 9,800 crore a day, purchasing Rupees with the proceeds, and this has caused an altogether different problem, a lack of Rupee liquidity.
The RBI has tried to counter this issue by increasing its repurchase agreements and injecting funds into the market. There is also added pressure on interest rates caused by large amounts of government borrowing, sustained credit demand and high inflation rates, which has forced the central bank to raise its lending rates repeatedly.
All of this has resulted in rates in the cash market rising to a remarkable high of 17.5% during the first week of October.
The Story So Far
The Government has done its best to alleviate the situation removing restrictions on FII’s wishing to buy Indian equities through participatory notes (Instruments FII’s use to obtain exposure to Indian cash equities without registering with the regulator and central bank).
External Commercial Borrowing (ECB) rules have been liberalised to include mining, exploration and refining in the definition of infrastructure. That has increased the government imposed borrowing limits on firms who operate in those industries from US$ 50 Million (Rs 245 crore) to US$ 500 Million (Rs 2,450 crore). Though that change for the moment is largely cosmetic since borrowers around the world are having trouble tapping international debt markets.
In the first week of October, the RBI cut its cash reserve ratio (CRR) by 50 basis points. The CRR is the amount of money that banks must hold with the central bank and this has fallen a whopping 9% to a still substantial 8.5%.
The measure was designed to release US$ 4.2 Billion (Rs, 20,580 crore) into the banking system, however all that money will be mopped up by the RBI’s foreign exchange interventions and government bond auctions.
All of this has failed to halt the increase in cash rates and as they increased to 20%, the RBI stepped in with a further 100 basis point cut in the CRR, reducing the amount of deposits that lenders must hold with the central bank to 7.5% last week.
The Indian government is faced with the dilemma that governments all over the world for most of this year have faced, how to contain inflation whilst easing liquidity.
In the rest of the world commodity prices have eased, giving central governments the ability to cut interest rates aggressively. This has not been the case for India, since the rupee has depreciated at the same time as commodity prices have fallen, moderating any impact on headline inflation.
Inflation touched a 13 year high in August hitting 12.6%, though it has fallen since then, and is expected to continue doing so. Record high inflation has prompted the RBI to raise interest rates repeatedly over the last year. High Interest rates, inflation and commodity prices, alongside slowing global growth have had an impact on India’s projected growth rates. India’s first quarter GDP growth was the slowest in 3 years coming in at 7.9%.
The Government Seems Wise
Most private estimates of GDP growth disagree with the governments view that growth will recover to 9% in 09/10.
Even with an agreement to disagree, if growth came in at a full 2% lower or 7%, India would still be one of the fastest growing economies in the world, and the fundamentals behind its growth story continue.
The dollar value of exports rose 35% whilst its imports increased by about 37% implying sustained domestic demand.
Capacity continues to be added in various industries comprising power, steel, oil refining and automotives. FDI during the period of April-August of 2008 was a record US$14.8 Billion (Rs 72,500 crore), which represented year on year growth of 114%.
Indian banks are extremely well capitalised and 2 years ago the industry was thought to be over regulated, which has now become a synonym for being well regulated. There is no domestic bad loan crisis, though some banks are paying for lax unsecured lending tactics in the past, which they seemed to have learned from. Most Indian banks have almost no exposure to overseas credit markets. some of the Indian banking regulations include :
- Indian banks are restricted to devoting only a specific proportion of their balance sheet to unsecured loans.
- The RBI’s monetary policy defines a limit to which banks can invest in the stock market.
- Indian Banks are limited on the use of foreign funds (either foreign direct investment or foreign borrowing). This ensures that during times of crisis, even if foreign players pull out their money, the bank is not substantially affected.
- Indian Banks have strict audit and disclosure requirements. This keeps a check on the bank’s lending and borrowing.
- Indian Banks must maintain a large minimum capital as a buffer against any unforeseen risk. Banks also need to keep liquid funds and these are defined by the cash reserve ratio (CRR) and the statutory liquidity ratio.
The current crisis and to some extent the larger debate over capitalism and financial deregulation in general has made India’s at times almost snail’s pace of reform look almost prescient. India’s reluctance to privatise its state owned banks, which control some 70% of assets, seems sage like in its wisdom with European countries and America rushing to nationalise their lenders.
For every Rs 100 a bank collects as deposit, Rs 25 must be invested in government bonds and as stated earlier, the RBI requires banks to keep hold 7.5% of their deposits as CRR, a system which can only be looked upon right now with envy.
Leverage in the Indian financial sector is low compared to the western banking model.India has yet to introduce full capital account convertibility, which to a large extent protects its currency.
Where there was sharp criticism, there is now applause, tight regulations on foreign currency borrowings by domestic corporations, has meant that a seizure in international debt markets will have limited impact on the country, because Indian companies have never relied on them in the past as source of capital.
The Future Look Bright
All of this means the future is quite bright for India regardless of the problems it faces immediately. India will once again re-emerge as an attractive investment destination. India’s flagship IT services sector is heavily reliant on financial services clients as a source of revenue, and a fall out in this space will no doubt have a substantial impact on their short run profits, though a depreciating Rupee will mitigate that to some extent and increase the profits of other exporters. Fallout in financial services is likely to cause IT services companies to diversify their earnings base going forward, so that when the dust does settle, they emerge stronger companies, less reliant on a single industry to deliver profits.
No country will escape the banking crisis untouched, everyone will have to change the way they do business going forward. For the moment though, India is showing the rest of the world how it should be done. Whether that remains the case 10 years in the future is unlikely, and reform should not be abandoned simply because the existing model is flawed. Reforms must be adapted so the country can avoid those mistakes in the future and regulators should stand ready to guide the ship.
The concept however that the government knows best, that seems to permeate every aspect of Indian politics will never have credence, even if in the short run it is indeed being validated.
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[...] credit crisis has had the effect of causing a rupee liquidity crunch in India in spite of very little Indian exposure to the international credit markets. This has had a [...]