By Hemant Manuj
Associate Professor and Area Head, Finance, SPJIMR, Mumbai
The recent demand by the Union government from the Reserve Bank of India (RBI) to transfer its surplus funds raises two kinds of issues. One is on the principles. What is the ideal level of reserves to be maintained by RBI to perform its functions? And does the government have the right to appropriation of the reserves from RBI? Such questions are being debated in the public domain. A majority of economists and the legal fraternity is tilted towards allowing the control with RBI in the absence of a rules-based approach. While I too agree with this opinion, it may be useful for RBI and the government to enter into an agreement on a dividend distribution policy. But that would need some discussions and a more conducive environment to be crystallised.
The second issue is why is the government displaying an almost desperate attempt to appropriate the reserves? Does the government have an economic model to cite for its belief that RBI is sitting on excessive capital? If it has, the same has not yet been put in the public domain.
Or is it that the government is actually avoiding raising funds from the markets and is, therefore, looking at RBI as an easy source of funds?
I have analysed some data and it shows that the government is finding it to be increasingly difficult to raise funds from market sources. The data, as published by RBI in its weekly statistical supplement, relates to the trends on money stock in the economy. This data explains, at a macro level, where the money supply comes from and how it gets utilised between the government and the commercial (non-government/private) sector. The findings from the data are as follows:
l The banking sector credit to the government (basically the investments by banks in government securities—G-Secs) increased from Rs 30.9 trillion on November 11, 2016, to Rs 38.4 trillion on January 6, 2017, and has since fallen to Rs 37 trillion as of October 12, 2018.
– This is an annualised increase of 9.9% over the close to two-year period from before demonetisation till now, and is back in the normal range after a slowdown.
– The investment in G-Secs as a proportion of banking deposits (I/D) had shot up briefly during the demonetisation phase, and is now back to a normal level of 29.5%.
– The ratio of credit to commercial sector to deposits of banks (C/D) stands at 76.4%. Historically, over the last 15 years, this ratio has exceeded this level for about 20% of the times. The ratio has never exceeded 79% in this data period.
– The sum of credit to commercial sector and G-Secs investments as a proportion of aggregate deposits of banks (C/D+I/D) stands at 105% of aggregate deposits. Historically, over the last 15 years, this ratio has exceeded 105% for about one-third of the times. The ratio has peaked at 108% in this period.
So, what does the above data mean?
– One, the credit flow to the commercial sector is quite robust. There could be distortions with respect to credit flow to certain sectors like non-banking financial companies (NBFCs); however, on the whole, the credit flow is doing fine. Any push to artificially increase the credit flow at an aggregate level would be harmful to the banking system.
– Two, the investment by banks into G-Secs is also closer to the higher end of the historical range. There is yet some space to further increase in this, but would now need to be incentivised through higher interest rates. Also, it would likely be at some cost to the credit growth.
– Three, if the government wants the banks to either increase the credit flow or invest more in G-Secs, the banking sector will be getting into a zone of crunch of funds. If this has to be done, banks will need to raise additional equity capital, which can be leveraged, and then enter credit or investment channels.
The government has been asking for lifting the restrictions relating to the prompt corrective action (PCA) imposed by RBI on weaker banks. Even if the same is done, how will these banks lend in the absence of a sound capital base? Is the government, as the majority shareholder, prepared to infuse a significant amount of capital into these banks?
Considering the data cited above, I would suggest that the government accept the fact that the banking system, as a whole, is doing quite fine. Banks have gone through a difficult, though necessary and corrective, phase in the last two years. Now that the parameters are getting back to normal, the government must allow RBI to enable the following conditions in the banking and money markets:
1. Differentiate between strong and weak banks on the basis of their capital base, risk management systems, and business acumen. Stronger banks should continue to lend based on their internal assessments of risk-adjusted business opportunities. Weaker banks should not be primed for lending until they are in a position to raise equity capital.
2. Allow the normal process of lending and recovery to/from all the borrowers in a fair manner. The excuse of special situation or systemic risk being applied to power sector companies, NBFCs, etc, is neither required nor healthy for the banking and monetary system.
3. The government needs to rely on, and respect, the money markets for its own requirement of funds. Rather than pushing RBI to draw upon its capital, the government needs to access money markets and borrow at the clearing rate. It cannot raise its borrowings and wish that interest rates are kept under its desired threshold.
4. The minimum capital ratio requirement for banks, currently at 9% of risk-weighted assets, has an economic reason behind it. Any relaxation of this threshold to artificially increase the lending limit would be counterproductive to banks themselves. In fact, banks have an option to work on improving their risk-assessment models and shift to internal-model-based capital requirements.
The writing is on the wall. The government cannot ask corporate borrowers to increase borrowings from bond markets and itself resort to non-market sources. As for the banking system, weaker banks will have to either shape up or close down.