The sharp spike in interest rates on overnight money is yet another warning that the banking sector could run out of resources to fund economic growth.
There are a host of immediate reasons to explain why call money rates rose to nine-year highs on Tuesday. Among them: the demand for funds to pay advance tax and the fear of the public sector bank strike that is due at the end of March. But is that all?
Over the past three years, bank credit has been expanding twice as fast as nominal GDP, which is way beyond the zone of safety. Deposit growth has lagged behind. Banks have had to sell the excess government bonds they own to raise funds for loan growth. This game can be played as long as there are excess bonds to sell. At one time, in 2002, banks were holding more than 40% of their assets in their investment portfolio. Most banks have now pared their investment in these bonds to the bare regulatory minimum of 25%.
So banks need to collect more deposits if they are to maintain robust credit growth. This is one reason why banks have been pushing up deposit rates in recent months—to entice savers. Depositors can now demand a good 2% extra for three-year money, compared to a year ago.
Even then, a compounded annual growth rate in bank credit of 30% is clearly unsustainable. There are already early signs that bank lending is slowing down. The shortage of funds in the interbank market suggests that there could be a more severe lending slowdown ahead.
There is a broader lesson here. Most discussions on long-term economic growth veer around to the popular (and correct) view that growth cannot be sustained unless infrastructure constraints are removed. India needs more roads, ports and power plants. The recent funds crunch tells us quite clearly that the more immediate threat comes from an overstretched banking sector. While a growth-stifling credit crunch of the sort we saw in the mid 1990s is unlikely, even a significant slowdown could harm the real economy.
There is one immediate solution—securitization. Banks can package their old loans into securities and sell them to investors. The money that banks get from these sales could be used to fund new loans. There have been securitization deals in India since 1992, though the market has picked up since 2002.
The problem is that most of the activity has been restricted to the sale of one type of loan—those made to buy cars, trucks and two-wheelers. These are what are called asset-backed securities (ABS). The other types, such as mortgage-backed securities (MBS) and collateralized loan borrowing obligations (CLBO), have not taken off, even though the underlying loans for these types of securities account for a far greater portion of bank loans.
It is now a little more than a year since the Reserve Bank of India (RBI) introduced new regulations to encourage the local securitization market. Without going into the specific reasons why it is so, the fact is that securitization has not taken off in India, especially in the MBS and CLBO categories. The inability of Indian banks to recycle money using the securitization gambit was not a very serious issue till now, because banks were flush with funds and securitization was a side option.
The situation has changed radically over the past six months or so. There are clear signs that banks are struggling to fund credit growth. It is high time they started liquidating old loans through securitization, so that new loan growth does not suffer.
At stake: economic growth.
Is a credit squeeze round the corner? Comments are welcome at email@example.com