The data on non-food credit show a steady deceleration in the last three months, as is clear from the table. Indeed, since this is the traditional “busy season”, credit growth should actually have accelerated and the trend is, therefore, a reflection of the slowing economy. The trend also ties in with the recent sharp contraction seen in other indicators such as lower car sales and a fall in the manufacturing Purchasing Managers’ Index. Importantly, the credit growth slowdown is occurring despite the fact that external sources of funding have dried up, internal accruals have fallen and gathering funds from the capital markets is no longer an option.
Liquidity is currently ample. As the Reserve Bank of India (RBI) has said, since 18 November, the liquidity adjustment facility or LAF window has largely been in the absorption mode, which means that banks have so much funds they are parking them with the central bank at the reverse repo rate. That’s because between 24 October and 21 November, the incremental credit-deposit ratio (including food credit) was a low 53%. In fact, during the fortnight to 21 November, bank credit fell by Rs2,193 crore, while bank deposits rose by Rs2,616 crore. The inter-bank Mibor rate has also come down quite a bit, also indicating adequate liquidity.
Why then has bank lending come down? Is it because banks are not lending, or has demand for credit dried up? Anecdotal evidence points towards the former reason, but the central bank seems to think that appetite for credit, too, is lower. In its statement on the growth stimulus issued on Saturday, RBI says “recent data indicate that the demand for bank credit is slackening despite comfortable liquidity”. That’s what happens during an economic slowdown. In the late 1990s, for example, when we had a big domestic credit crunch, bank credit growth fell from a peak of 27% to a trough of 10.6%. At present, bank credit growth is 27% year-on-year, or y-o-y, so there’s plenty of room for it to fall.
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Also, banks can hardly be faulted for not lending during a slowdown, when companies are under pressure and the risk of bad loans increases. That is one reason why the banks have been told that restructured standard loans wouldn’t be classified as bad till 30 June next year. RBI’s aim is to force banks to lend, which is why RBI lowered the reverse repo rate to 5%, so that banks do not find it attractive to keep their surplus funds with it. With the cost of funds of banks well above 5%, they would be losing money if they parked their surpluses with the central bank. But with interest rates bound to come down further, banks can make a tidy profit by simply investing their money in government securities. During the credit crunch in the mid-1990s, for instance, growth of bank investments in government securities went up from a low of 9% y-o-y to a high of 31.75% and there was a lot of anguish about banks not lending but putting all their funds in government securities, a strategy berated as “lazy banking”. As Niels Jensen of London-based Absolute Returns Partnership Llp. points out in his latest newsletter, “As many central bankers are about to find out, lending activity is not only a function of the absolute level of interest rates but of factors much less quantifiable as well. In today’s risk-averse environment, these factors suggest anaemic lending activity for quite a while yet, despite a sudden willingness amongst central banks to almost give money away.” Simply put, the latest round of rate cuts may not, therefore, lead to more lending. Also, at 74.80%, banks’ credit-deposit ratio continues to be high—a year earlier, on 23 November 2007, it was 70.95%. Are the rate cuts enough? During the post-dotcom slowdown, RBI had reduced rates much more slowly and the rate at which it accepted funds from banks (at that time called the repo rate and now called the reverse repo rate) reached 5% only in March 2003, when the slowdown had been going on for almost two years. This absorption rate is the effective policy rate during a downturn, because lending falls and banks have extra funds. That rate was further reduced to 4.5% in August 2003, and it remained at that level till the next boom started. But this time we have a global credit crunch and interest rates are likely to go much lower, as is being seen elsewhere in the world. During the 2000-03 downturn, the interest rates on bank deposits of maturities from one-three years were between 4.25% and 6% in 2002-03, falling further to between 4% and 5.25% in 2003-04. The current deposit rates of around 10%, therefore, have a long way to fall. And with interest rates headed south, the party in the bond markets will last a long time.
The rate cuts are pretty much what the stock market expected, although it could well have an impact on the rate-sensitive sectors temporarily. What is likely to be far more important both for stocks as well as for liquidity is whether hedge fund unwinding still has some way to run.
To quote Jensen again, “Bernstein Research has produced a detailed study on the phenomenon. A survey conducted amongst their hedge fund clients shows that less than 20% believe that the current redemption wave will end this quarter. On the other hand, over 40% believe that redemption pressures will continue beyond the first quarter of next year.” The credit crunch overseas, which is the reason for the liquidity squeeze in India, continues unabated. The spread of emerging market bonds over US treasuries, as measured by the JPMorgan EMBI+ index, was at 766 basis points last Friday (one basis point is one-hundredth of a percentage point), compared with 592 basis points on 10 November. Unfortunately, the “solution” to the credit crunch may be brought about by falling demand for credit, as economic growth slows sharply.
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Graphics by Paras Jain / Mint