Indian crisis - Liquidity crunch and workaround

The recent step by RBI to reduce CRR by 250 basis points is perhaps the most drastic step in the history of Indian economy. Reducing the CRR is an attempt to inject liquidity into the system. The GoI should review other features such as reduce the SLR, repo rate (rate at which the RBI lends to the banks).

It is important to understand the problem in Indian context. The economic crisis is further complicated in view of the upcoming election in 2009. At the heart of the problem in the global financial system is excessive leverage. Many of the financial institutions even now are leveraged at close to 25-30 times their equity, which means capital adequacy in the western financial system is between 3-6% of the assets. Indian banks on the other hand have a capital adequacy ratio of 10-20%. Moreover, with CRR and SLR Indian banks they have almost 30% of the money with GoI and RBI. Hence banks can be trusted in India; however PSU banks will command more faith than their private counterparts.
(N.B. – The present trend shows huge rise in the deposits with PSU banks; PSU banks are likely to see a increase in deposits by 30% this year. This would enable PSU banks to have huge funds at their disposal. Thus it is expected that performance of PSU banks would improve dramatically in near future consequently a spiraling stock price once the markets swings to +ve. Caveat: Waivers like the one provided by UPA govt may prove otherwise!)

With the global finance companies going bankrupt, the ECB (external currency borrowing) options are drying up. The Indian banks are facing a-never-before-situation of higher borrowing demands from the corporate today. Issuing equity (through rights issue) is not a feasible option, and with the debt markets (even debt-mutual funds have been enormous liquidation pressures from small investors) collapsing there is increased pressure on banks to provide loans to these corporate.
However, there is a trick – a typical vicious circle has formed – with banks unwilling to lend to the corporate because they are apprehensive that the corporate may not be able to pay back as a recession may set in. On the other hand corporate with shortage of funds may not perform thus pushing the economy into recession. This may prove catastrophic in growth figures of both companies as well as that of the GDP. In fact, inter-bank lending has reduced drastically – as banks no longer trusts other banks regards paybacks. The GoI must positively interfere to instill confidence into the whole system.
There is a serious need of a BIG BANG in Indian banking system is required (as suggested by Mr. Amit Mitra):
1. Reduce CRR
2. Reduce SLR by 2% without having major impact on the economy
3. Reduce bank rates – otherwise SMEs (which employ about 40%) may flop.
4. Rethink Foreign investments strategy (revival of old P-notes/ban short selling etc)
5. Reduce repo rates ( as I am writing this article RBI has already reduced the repo rate by 100 BP)
6. Increase interest rates for NRIs to increase foreign inflow of funds.
Higher interest rates make many projects unviable for execution.
On the other hand there have been remarkable changes taking place on the commodities front. Wheat, Rice Steel, Oil etc are all down from their all time highs (about 50-70 % correction in some cases). Thus inflation may see single digits in the coming months. Interesting to note that the steel / cement companies clamoring for removal of price control may end up asking for price protection! Thus the UPA govt may get a sigh of relief temporarily. The fall in food commodities is primarily due to huge productions across the globe (with the exception of Australia) – in fact this time it’s a record production. But with decreasing area under cultivation, especially in Western Europe, food prices may not be as low in next FY.

Another bout of regulations is sure to come both for Indian as well as global financial institutions – but tricky brains still exists, who would device new financial instruments to get around the regulations.