S.S. Tarapore, head of a panel that outlined the roadmap for ushering in capital account convertibility and a former deputy governor of the Reserve Bank of India (RBI), on Tuesday warned against overheating of economy and said: “If we allow a further acceleration of growth, a sharp and deep recession is inevitable.”
He was talking at a function organized by Dun & Bradstreet, a financial research firm, in Mumbai. “It is… essential that the Indian authorities categorically recognize the overheating of the economy and the government and the RBI should take mutually reinforcing measures to cool the economy,” he added.
Tarapore praised RBI for flagging the issue of overheating and also referred to the note of caution sounded by the chairman of the prime minister’s economy advisory council C. Rangarajan, who recently said, “cyclical overheating should not become structural”.
He also said the present structure of the banking system cannot help the creation of a strong financial sector.
Calling upon the government to reduce its holding in public-sector banks or get out of the business of owning banks completely, Tarapore said the government banks need more capital. If the government is unable or unwilling to provide that, he added, the banking system would become weak. Under existing law, the government’s stake in India’s public-sector banks cannot come down below 51%.
Making a strong pitch for opening up the banking sector for foreign players, Tarapore said, “There are noises that the commitment (of RBI) is only to review the foreign banks issue and as such there is no definitive opening up of the banking sector in 2009. The pertinent question is whether, when the rest of the economy is opening up to the forces of globalization, the Indian banking system will be able to live in splenetic isolation?”
RBI had earlier said that it would review its stance on allowing foreign banks a bigger role in Indian banking sector in April 2009. Under existing laws, no foreign bank can hold more than a 5% stake in any Indian bank.
Tarapore also warned commercial banks against rising non-performing assets (NPAs). Over the past few years, the banking industry’s loan assets have grown at around 30% and this has increased the potential for an increase in NPAs. “The economy is presently close to the upper turning point of the cycle and if banks are overextended, they will inevitably face large NPAs,” he said citing an old adage that says, “bad loans are invariably given in good times”.
He also allayed the fears that rising interest rates would hit banks’ profitability. “It needs to be recognized that when lending and deposit rates rise, the impact is stronger on lending rates than deposit rates,” Tarapore said, adding, “banks have less to fear about a rising interest rate scenario”.
However, banks need to be careful about the maturity of their securities portfolio. They feel tempted to lock themselves into longer-dated paper when interest rates rise, but “when the correction comes, such banks, which have a large portfolio of longer–term paper, will rue at their investment decisions”, he said.
When rates rise, banks need to provide for depreciation in their bond portfolio and that hurts their profitability.