By Renu Kohli
Recent GDP estimates indicate growth acceleration amidst global uncertainties with early signs of revival of private investment. These green shoots need to be carefully nurtured. After more than a decade, bank credit growth seems to have played a critical role in boosting business investments. More promisingly, the credit cycle appears to be at a very early stage and could potentially sustain its momentum for several years ahead. But there are risks — near-term headwinds from a tightening monetary policy cycle and constraints on raising deposits as households’ financial savings decline.
Even though the banking system is currently flooded with the foreign currency non-resident (bank) scheme deposits, the situation could change in a couple of quarters as the RBI gradually uses these forex reserves through intervening sales in the FX spot market and for meeting liabilities in the derivatives’ markets. The central bank seems to have already consumed above $50 billion — nearly 35% of the total $143.6 billion mobilised — apart from the mop-up through open market operations. If so, weak deposit mobilisation could re-emerge as a binding constraint to sustained bank credit growth in the medium term. Policymakers must respond in anticipation, therefore.
SLR reduction, a structural solution
The RBI mandates commercial banks and other financial entities to invest in highly liquid assets — mostly dated central and state governments securities, RBI-approved PSUs — and maintain the required statutory liquidity ratio (SLR), supposedly for prudential reasons. The stipulated SLR securities’ investment is presently 18% of the banks’ net demand and time liabilities (NDTL). Economists generally view such directed investment as impounding of household savings to create a captive market for public borrowings, resulting in financial repression — akin to a tax on the banking system, and indirectly on the savers. There’s near unanimity among economists that an SLR reduction would be growth-enhancing because private investment is generally more productive than public, especially revenue expenditure.
Recall that based on the Committee on Financial System (1991) recommendations, the SLR which was a staggering 38.5% in 1992 was lowered by 13.5 percentage points in six years to 25.0% by 1997. The pace, however, slowed down as both the government and the RBI developed cold feet, unable to restrain public borrowings and constrained to reduce SLR by another seven percentage points in 23 long years thereafter to 18.0% by April 2020. As private investment is recovering from its long slumber, it is time to further reduce the SLR and free resources for the private sector to nip any potential crowding-out in the bud.
LCR, not SLR, is the way forward
Following the implementation of Basel’s liquidity coverage ratio (LCR), a global standard requiring banks to keep 100% or more high-quality liquid assets (HQLA) to meet 30 days net-outgo in stressed conditions, the argument for prudential investment to justify a higher SLR has considerably weakened. In fact, the RBI has gradually expanded the avail liquidity for liquidity coverage ratio for accounting a larger share of SLR securities under the LCR. Since April 2022, banks are allowed to reckon SLR securities up to 16% of NDTL plus 2% securities under the marginal standing facility as Level 1 HQLA under the LCR. This allows scope for cutting the SLR by 200 basis points — from 18% to 16% — for immediate consideration.
Why the time is now?
Any reduction in SLR at a time of sustained credit demand from the private sector could potentially raise the treasury yield, directly impacting borrowing costs across governments. We would like to argue that this is a desirable outcome for the following reasons. From a monetary policy perspective, this could be a complementary structural measure as the RBI prepares to raise the policy rate. With global bond markets in descent and key central banks raising rates, the RBI runs the risk of getting drawn into multiple policy rate hikes, possibly much sooner than anyone expected even one month ago. This could be potentially disastrous in an external benchmark lending rate framework, where a rate hike transmission would be immediate, virtually halting retail credit demand with an elevated risk of default. Moreover, with core-core inflation still trending below 3.0%, there is barely any domestic pressure to raise rates so early and certainly not steeply. Reducing SLR would contribute in multiple ways: minimise the number of rate hikes that otherwise would have been required, protect the retail credit cycle from a premature slowdown, avert deterioration in asset quality, and more importantly tilt the relative cost of borrowing in favour of the private sector vis-à-vis the government, securing the private investment momentum.
From a fiscal policy perspective, a reduction in the size of the captive market would signal belt-tightening to sustain debt, creating fiscal space, and averting any potential crowding-out of the private sector. Recurring adverse global developments need not be an excuse but a reason for setting the fiscal position in order in a world afflicted with debt overhang. Implications for the states could be more pronounced as the yield premium could rise disproportionately for the poorly managed states, pressurising them to rationalise their expenditures. One positive fallout of a tighter fiscal outcome could be falling import demand, helping reduce the current account deficit and stabilise the exchange rate.
Looking ahead
Since most banks have been maintaining the LCR much above the regulatory requirement (100%) in recent quarters, both policymakers could do more by rolling out a road map for future reduction in the SLR. Such structural reforms would allow flexibility to the banks for dynamic adjustment of their LCR and a more efficient allocation of their investments between Level 1 and Level 2 (A&B) liquid assets, potentially creating more room for investments in highly-rated corporate bonds whose yield premia have been at par with poorly run state government securities. One hopes that this should reduce financial repression, minimise interest rate distortion, normalise the real equilibrium interest rate (r*), and bring down the relative cost of funds for the private sector, enabling sustenance of private investment into the medium to long run.
The writer is senior Fellow, Centre for Social and Economic Progress.
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.