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The financial crisis and its management

For some time now the focus has been, and rightly, on the liquidity crunch and credit squeeze in the domestic economy. The exposure of Indian financial institutions to complex derivatives and securitised sub-prime mortgages is nowhere as wide or deep as in the developed countries. The financial system is well capitalised and, thanks to alert regulation, is in good health both in terms of non-performing assets (NPAs) and profitability. Nevertheless, the crisis in the world system has impacted our financial system basically by drying up the scope to resort to external commercial borrowing (ECB), American depository receipts (ADRs) and other forms of borrowing abroad; and by making it difficult for exporters and importers to avail themselves of normal terms of credit. Considerable losses have also been incurred on account of hedging against interest and exchange rate fluctuations. All this has certainly led to our banks also coming to share the worldwide pessimism on the economic outlook.

Credit expansion in the past decade has been driven by the rapid growth of overall gross domestic product (GDP), especially in the tertiary sectors (information technology, telecommunications, financial services, and real estate) and in the demand for consumption credit for upmarket housing, commercial real estate and durable consumer goods generated by the boom in employment at unprecedented salaries. This and the phenomenal rise in the prices of land, residential and commercial real estate, and shares induced a degree of optimism about the future that bordered on euphoria. Despite the Reserve Bank of India’s efforts to counsel restraint and contain the growth of lending for these activities, retail credit has grown to be a large part of the banks’ loan portfolio.

This mood had begun to change partly because of the high volatility in the share and foreign exchange markets and partly perhaps reflecting over-expansion in some sectors. There have been reports of increased vacancies and fall in prices in the real estate sector. NPAs in retail credit loans, though at a low level, have been inching up. The mood has since become increasingly pessimistic with the meltdown of the world financial system, the volatility of oil and key commodity prices, the steep fall in share prices, and the bleak prospects of getting loans and equity from foreign markets. As a result, there is a general consensus among economists and financial experts that the domestic GDP growth rate will be lower.

This slowdown will affect what were rapid growth sectors; the squeeze on business profits will intensify; growth of demand for upper end real estate and for consumer durables will be dampened; ongoing projects will be put on hold or given up; and interest in undertaking new investments will fall. Loan defaults, especially in the housing and retail credit segments, are expected to increase significantly. Given all this, and faced with excess demand for credit and the prospect of earlier expectations of growth in sales and profits not being realised, and the attendant risks of increased defaults in servicing past loans, naturally banks are cautious about increasing lending.

The cumulative effect of all this has been to increase the stress on the banking system. Despite the slowdown in the economy, the demand for finance has increased sharply for several reasons. It has had to compensate for the shrinkage in non-bank and external sources; credit needs have increased due to further shrinkage in internal resource generation; the costs of carrying larger inventories have been higher in the face of slackening demand; working capital is needed to increase output and finance ongoing and new investment projects; and there is higher demand to meet the credit needs of exporters and importers. The fact that the fiscal deficits of the government and its enterprises has been rising is also a factor.

So far the government has focussed on measures to increase liquidity in the banking system, reduce interest rates and ease regulatory regimes. That regulatory bodies have acted on directions given by the Finance Ministry without any discussion by their own boards has seriously dented their autonomy and their credibility with respect to exercising independent assessments of proposed measures. That crisis calls for quick and considered action is no excuse when the decisions have been spread over a couple of months. It is important to ensure that regulators’ autonomy is seen to be respected even in such situations to avoid potentially serious erosion of the integrity of the regulatory regime. In the process, unfortunately, an impression has been created that some recent decisions have been overly influenced by demands from powerful sections of business.

The measures taken so far to inject more liquidity, and cut interest rates, have not made much of a difference in easing their predicament. Nor has the liberalisation of regulations concerning foreign institutional investment, ECBs and deposits by non-resident Indians resulted in any significant increase in foreign inflows. Whether it is realistic under present conditions or prudent in the light of experience to rely on inflows of volatile portfolio and debt investments to cushion the erosion of foreign reserves is also questionable.

Despite recent measures such as the reduction in cash reserve ratio (CRR), statutory liquidity ratio (SLR) and repo rates to increase liquidity in the banking system, banks have been cautious about rolling over loans and increasing lending even to reputed undertakings. They have hiked lending rates. This reflects their concern over considerable uncertainties about future economic prospects, the likelihood of a slowdown in growth and its effects on the capacity of borrowers to service their loans. In fact, a substantial part of the increase in funds available to the banking system is being kept with the RBI.

A substantial part of the increased credit disbursements has gone to oil and fertilizer companies to meet delays in disbursement of government subsidies. Their full impact on the supply of bank credit for lending to other sectors will be considerably greater when the government meets its commitment to oil, fertilizer subsidies, and loan waivers whether in cash or through bonds, and depending on whether the extent to which monetisation of deficits will be governed by concern to contain inflation. Increasing liquidity without addressing the fiscal and monetary impact of the yet-to-be cleared subsidy commitments in the face of slower growth of revenues and various claims for tax relief is worrisome. Financing it by raising SLRs can only be at the cost of reducing the funds available to banks for lending. Financing it by recourse to deficit financing will only aggravate inflationary pressures which are already double the rate that is considered tolerable.

Demands for debt restructuring, fiscal relief and other concessions are rising and will become more widespread and insistent. Short-term financial and fiscal relief to cope with the immediate crisis must focus on measures to ease the credit constraints faced by exporters and importers, and by ensuring for domestic producers adequate credit to facilitate the use of their existing capacity and the completion of ongoing projects in key productive sectors.

Relief for those who have incurred highly leveraged debt for purchasing or financing durables or for investments in highly speculative sectors (real estate, housing development, and stock markets) should be decided after rigorous scrutiny keeping in view the fiscal constraint. In any case, enterprises which have made or initiated new investments on the basis of the rates and pattern of growth of the last five to 10 years will face a difficult and painful process of adjustment. The government can give only limited help in a highly selective manner. It cannot be expected to impose the burden of this adjustment on public resources. The revival packages of most other countries recognise the principle that bail-out of institutions for defaults and bad debts that have come about due to their own mistakes is not a solution. The emphasis is on injecting more capital into such institutions.

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