With the global macroeconomic environment deteriorating further, challenges however remain in the near term for Indian policy makers to restore business and consumer confidence. In an environment where business confidence is low and investment plans are adversely hit, pump priming can break the vicious circle by stimulating demand through higher government expenditure. In the absence of robust private sector investment, the threat of crowding out is minimal.
The government and RBI have taken wide ranging policy actions with alacrity to preserve and stimulate domestic demand and stem the prospects of a serious economic downturn. The fiscal stimulus package by the Government has aimed to alleviate stress in different sectors. Likewise the active policy stance by the RBI has seen the policy rates decline by 350 bps on Repo, 200 bps on Reverse Repo and 400 bps on CRR.
For the real economy to respond to fiscal and monetary stimuli, it is imperative that the financial sector, notably the domestic banking sector remains resilient and an effective and efficient channel of resource allocation. With tighter external financing conditions, the Indian banking sector has emerged as a dominant source of funding for domestic growth. The liquidity shock in September 08 faced by Indian banks got further exacerbated by the rapidly deteriorating macroeconomic environment. Recent data indicates that there has been substantial decline in non-food credit growth from 29.3% in early October to 19.4% by end-January. Incremental credit growth between October 2008 and January 2009 has contracted by 83% over the corresponding period last year. The compression in credit growth is a manifestation of shrinking demand as well as banks de-risking their balance sheets and preserving capital in an environment that spells uncertainty about the duration of the economic downturn. To lend more, comfort of steady earnings is a prerequisite.
With RBIs liquidity-augmenting measures and higher government spending, liquidity in the banking system has remained comfortable since December with net LAF averaging around Rs 41,000 crore. Furthermore, with the sizeable cut in policy rates against the backdrop of declining headline WPI inflation, the government bond yields fell sharply in December. These have had salutary impact on banks earnings in the third quarter of FY09. A significant part of banking sectors SLR holding is under the hold to maturity category which is not marked-to-market. With falling interest rates, the HTM portfolio of the banks appreciates in value, thereby providing a cushion to earnings.
However since January, although liquidity conditions have remained comfortable, the Government bond markets have witnessed considerable volatility with G-Sec yields hardening from 4.80-5.0% to 6.25%-6.50%. Higher government borrowing has raised over-supply concerns, depressing the bond prices and pushing up the yields significantly. Volatility in G-Sec yields has the potential of creating uncertainty about availability of funds at predictable prices.
In the context of current global financial turmoil, Indian banks have demonstrated resilience with the underpinnings of a strong regulatory framework and sound practices. The policy makers could invest this period of global turmoil to further strengthen the domestic banking sector by facilitating higher capitalisation of banks. Highly rated foreign banks with sovereign backing could be viewed favorably to grow their presence in the country.
-The author is MD & CEO, Yes Bank. These are his personal views