India Is nowhere close to curbing credit binge

Updated: Jan 20 2007, 06:43am hrs
In deciding whether to increase interest rates on Jan. 31 or to stay pat, Indian central bank Governor Y.V. Reddy has to look beyond inflation.

The Reserve Bank of India raised the rate at which it adds liquidity overnight into the banking system by 25 basis points to 7.25 percent on Oct. 31; the rate at which it drains money is 6 percent, unchanged since July 25. The latter has gone up 150 basis points since monetary tightening began in October 2004.

At 5.6 percent, prices arent rising much faster than the upper end of Reddys target inflation rate of 5 percent to 5.5 percent. What must be a bigger worry for him is the runaway growth in credit, especially the loans that banks are dishing out to individuals for home-buying and consumption.

Citigroup Inc. is promising as much as 1 million rupees ($22,500) of uncollateralized personal loans at your doorstep in 48 hours. HDFC Bank Ltd., Indias third-biggest lender, last week reported a 33 percent increase in loans in the three months ended Dec. 31. More than half the money, it said, went to individuals.

First Global Securities Ltd. said in a report last week that the credit officers of a large, non-state bank in Indiathe researchers didnt name the lenderare under pressure to throw money at any loan applicant who walks in the door.

Employees are rewarded solely for how much they can disburse with targets of 20 percent growth every month, First Global said. This, to our mind, is most disquieting.

$3 Billion Removed

The key risk here, one that the central banks monetary policy has to be acutely mindful of, is that many of these loans, which are being granted with little due diligence, might turn bad when the business cycle changes.

Early last month, the Reserve Bank of India tried to squeeze excess liquidity by increasing the reserve ratio, or the part of deposits that commercial lenders have to keep with the monetary authority as cash, by half a percentage point.

This move is estimated to have removed the equivalent of some $3 billion of surplus funds. Is it enough to cool the lenders exuberance Perhaps not; and thats because the central bank is pouring money back into the domestic banking system.

Prime Minister Manmohan Singhs economic advisory council predicts that the Reserve Bank will add almost $23 billion to its foreign-exchange kitty in the fiscal year ending in March, up from $15 billion last year. This accretion means additional domestic liquidity and more opportunities for banks to continue their lending spree.

Growing Fund Shortage

The tightening impact of the reserve-requirement increase has dissipated. One can see some evidence of that in the demand among banks for overnight funds from the central bank. This amount of so-called repurchase borrowings, which touched a record of 361 billion rupees on Dec. 28implying a growing shortage of fundshas since fallen to an average of 92 billion rupees in January.

Liquidity has to be moderately tight for changes in benchmark interest rates to affect the price of credit. However, as long as the central bank is also expected to keep the home currency competitive by buying dollars, it will struggle to control the amount of money in the system.

That isnt all. The Indian government passed an ordinance last week allowing the central bank some flexibility to lower the statutory liquidity ratio, or the share of bank deposits that must be invested in government bonds. There may now be political pressure on the Reserve Bank to go ahead and cut the ratio from its current level of 25 percent.

Consumer Lending Boost

If that happens, banks will be able to pare their holdings of government bonds and use the money to lend to companies and individuals. According to estimates by Siddharth Mathur and Vikas Agarwal, fixed-income strategists at JPMorgan Chase & Co., every percentage point cut in the liquidity ratio will free up 260 billion rupees to 275 billion rupees. Consumer lending will receive a further boost.

Governor Reddys challenge is a complicated one. Already, there are murmurs that he has gone too far with monetary tightening. Maybe the economy isnt overheating Perhaps, as some economists have argued, the trend growth rate of the Indian economy has jumped from 6 percent to 9 percent

The economy may indeed be ready for sustained 9 percent growth, but the financial industry isnt. Indias state-dominated banking system doesnt have the risk-management capacity to handle 30 percent credit growth for a fourth straight year without accumulating vulnerabilities.

Foot on the Brakes

The Reserve Bank would remember how a similar rush by financial intermediaries to lend to steel companies in the early 1990s sank in the quicksand of bad loans a few years later.

RBIs mood seems clear to slow monetary expansion through higher deposit buildup and lower credit advances given by the banking system, Derivium Capital & Securities Pvt., a debt research firm in Mumbai, said in a note last week.

Even if crude oil dips below $50 a barrel and the United States. Federal Reserve shifts into an easing mode, its doubtful if Reddy will be in a hurry to take his foot off the money brakes.

Bloomberg / Andy Mukherjee