Combining sweet-n-sour for banks

Updated: Jan 18 2002, 05:30am hrs
Governor Jalan in his inaugural speech at the recently concluded bank economists conference began by saying that the economy was in a sweet-n-sour situation. He said that we live in the best of times and the worst of times. By which he meant the queer mix of macroeconomic fundamentals. That on one hand we have the lowest inflation, low interest rates, more than adequate foreign exchange reserves, a great current account deficit and low foreign indebtedness (at least of the short run kind). And of course our GDP growth is among the highest in the world. And yet it is one of the worst years in recent times, for manufacturing output, for exports, for new jobs created, for fiscal deficit, and the record levels of procured but unsold foodgrains.

Some of this type of unprecedented macroeconomics is being witnessed in developed economies as well. For instance, most earlier recessions in the United States have been associated with high inflation caused by oil price shocks, and high interest rates. Thus there was always room for prices and interest rates to drop, causing a revival in consumer spending and demand to follow. This time however, inflation is already low and interest rates have been cut several times, and the economy (like also in India) is awash in liquidity. And yet because of a huge capacity overhang, and the terrorist attacks, the revival is slow and uncertain. The recession might continue for much longer despite easy money and low inflation.

Just as for the macroeconomy, so also for the financial sector, or more specifically banking. The sweet-n-sour metaphor translated for the case of banks, means that on the one hand, they have plenty of liquidity in the form of deposits, and yet there is very little credit given out. Credit offtake has been well below par. Almost a case of credit phobia, maybe Similarly, on the one hand there is tremendous squeeze on margins, as deposits continue to be paid at the old rate, but lending rates are dropping. Even though the announced prime lending rates have not fallen much, prized corporate clients have managed to access low rates by borrowing through commercial paper. The yields on AAA corporate bonds are quite close to sovereign rates implying low profits for investors, that is, banks.

And while bank profits from lending or investing in new corporate paper are getting squeezed, banks find that they have windfall profits from another source. The gilts in their possession, ie government securities, have suddenly become as precious as gold. 2001 has been a year when the yield on a ten year duration government bond dropped by almost 3 per cent. That means that a typically traded bond with a face value of Rs 100 now commands a price of almost Rs 124. That is why the trading operations of bank treasuries will probably show a handsome profit this fiscal year. This is indeed a best-worst combination.

However this realised profit from trading government bonds wont nearly be as high as can be since most of the profits remain caged in unsold bonds. The banking sector holds Rs one trillion more of government bonds than necessary. The statutory liquidity requirement is to hold 25 per cent of deposits in the form of government securities. Banks now hold 36 per cent. If lets say, government bond values have swelled by 20 per cent, this means a potential profit of Rs 20 thousand crore. This is then the size of unrealised gains of an asset which has enjoyed price inflation.

Banks now have two sweet-n-sour class of assets. The sweet class is gilts which have gained in value. The sour class is the non-performing, distressed or unrecoverable assets. The estimate of gross non-performing assets is about Rs 65,000 crore. Of course, the net problem assets may be much lower because of provisioning, partially recoverable collateral and near-zero exposure to volatile assets like stocks and real estate. Even then, the NPA problem is a big concern.

The new capital adequacy framework will mean that some banks will have to be recapitalised with fresh capital infusion from the owners of those banks, the government. The estimates of recapitalisation requirement is between Rs 5 to 10 thousand crore. The irony is that the sale of one class of pricey assets can easily cover the gap required to provide for the NPAs. However this cannot be achieved without some system-wide coordination. Thus if all banks suddenly tried to unload their Rs 124 bonds, hoping to make a Rs 24 profit, bond prices would crash as there wouldnt be any buyers. But if the government itself is willing to be counter-party through some sort of a swap arrangement, perhaps this can be workable. Most importantly, this window of opportunity is extremely temporary the bonds might not retain their high prices for too long. The embedded profits in those gilts will soon evaporate. So can we mix the best and worst times to come out even

Ajit Ranade is Chief Economist, ABN Amro Bank, India