The Hindu : Economic and financial integration: An end in itself?

Online edition of India's National Newspaper
Monday, Dec 16, 2002

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Business

Economic and financial integration: An end in itself?

One is quite struck by the similarities in the underlying propellants of the banking sector performance in India and the U.S.

A RECENT Government policy note talks of globalisation and getting integrated with the world economy as quite inevitable. Besides traditional measures of integration such as the ratio of external trade/investment flows to GDP more clinching evidence seems to be available from the broad similarity of the financial (banking) sector of the Indian and global economies. (Trade (exports plus imports) has moved up from 10 per cent of GDP in 1991 to around 20 per cent now.)

The upward movement of the Indian currency in the past year — completely defying a well-established historical pattern — on the back of generalised global dollar weakness, is another evidence of the meshing of the domestic and global markets.

Taking the U.S. economy as representing the global economy, one is quite struck by the similarities in the underlying propellants of the banking sector performance in India and the U.S. What this seems to indicate is an Indian economy whose up/down cycles are now gradually following the pattern set by global economic cycles.

The year 2001 marked the start of a recession in the U.S. from which the economy has only tentatively come out. That year also saw big corporate collapses (these are continuing still) and therefore sizable losses on the corporate loan portfolios of banks.

The situation was no different in India — though India has not had headline grabbing corporate disasters, the baggage of bad loans that the Indian banking system is carrying would pack substantial damage potential.

But what about banking sector profitability in that year?

It remained quite high (statistics from the Fed attest to that) and has continued that trend in 2002 also, if the observations of the Fed Chairman in a recent speech are any indication.

At 14 per cent and 1.25 per cent the return on equity and total assets respectively for the U.S. banking system did not deviate in 2001, if at all, from the trend of the late 1990s. This has been despite some high profile collapses — apart from the normal level of corporate delinquencies — such as Enron, WorldCom and money down the drain in Argentina for banks such as Citigroup and JP Morgan Chase.

Key drivers behind the profitability numbers were: (a) The secular fall in interest rates sparked off by aggressive Fed easing which should have boosted the transaction (core) deposits base of the banking system (up 11 per cent in 2001 against 7 per cent in 2000); (b) Strong mortgage lending (residential and commercial) and consumer loan growth on the back of the historically low level of interest rates and which made up for the decline in commercial and industrial lending (mortgage lending up 8 per cent against C&I loans down 7 per cent) and (c) Realised gains from the securities portfolio thanks to declining interest rates.

Unrealised gains, on account of marking to market of the non-traded portion of the portfolio, helped boost the capital / assets ratio lending further solidity to the financials of the banking system.

One cannot but note the similarity with the happenings in the Indian financial system in the same period — sustained central bank policy easing, continued deceleration in commercial and industrial lending but a strong pick-up in mortgage lending (residential) by commercial banks, energetic forays by commercial banks into the consumer/retail loans segment, massive gains on the securities portfolio of commercial banks with benchmark yields crashing to the 7 per cent level from 10 per cent plus, and all this translating into improved returns on equity/assets (exceptions, of course, in terms of bank failures have been there — despite the balance sheet-favourable policy stance of the Reserve Bank of India designed to mitigate the damage potential of the cyclical downturn in the economy).

Banking performance

Trading profits of PSBs (profit on investments sale) in 2001-02 were Rs. 6,000 crores against Rs. 2,250 crores in 2000-01 and the net profit was Rs. 8,300 crores (Rs. 4,317 crores). Housing loans were up 38 per cent in 2001-02, credit to industry was up 5.8 per cent (up 10 per cent), housing credit/total credit 11.6 per cent (3.8 per cent) and return on assets 0.75 per cent (0.49 per cent).

That the Indian financial markets are integrating with the global markets is now getting well established. In fact, going farther, it could be said that the Indian financial system enjoys some kind of a "best of both worlds" situation.

The incrementalism in respect of external sector policies has meant that the Indian system remains somewhat insulated from systemic global crises (such as Southeast Asia 1997 or Russia/Argentina 1998) while benefiting from favourable tides as in the past two years.

The more important question though is: Is the increasing level of integration an end in itself? It cannot be, for the following reasons:

Consumption spending accounts for two thirds of the U.S. economy and consumer/ mortgage loans did not suffer the same level of delinquencies as did C&I loans in the past two or three years. But this has still not been enough to take the U.S. economy firmly out of the `soft patch' it is in now.

A kickstart to business spending is seen as critical and the larger than expected recent Fed rate cut has to be seen in that light. If even the U.S., where the transmission / conversion of consumption demand on to aggregate demand should be a far smoother process than in countries such as India, should see the need for aggressive counter-cyclical policy, the case for such a policy in India also is well established.

Such an aggressive approach would possibly call for action to counter the effects of `integration', so to say. An appreciating Indian currency, for instance, would be non-conducive to reviving investment demand and could lead off to a long-term shrinkage in aggregate demand in the economy.

Sans direct market intervention, how can generalised dollar weakness be countered? The RBI is already addressing the question if the slew of recent liberalisation measures on the forex side are any indication. More such questions will come to the fore in the days ahead.

T. B. Kapali

Senior dealer in Vysya Bank.
(The views expressed are personal.)

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