Impact of the Budget on the financial sector

ISSUE

ASHVIN PAREKH
Executive Director,
Deloitte

The Finance Bill has some brilliant promises to offer and yet there are several initiatives which are adverse to the financial services sector.

The decision to permit 49 per cent foreign direct investment (FDI) in insurance is welcome. The industry will agree that there is an acute need for it to grow and to write more business.

If one were to analyse the growth of some new private sector insurance players the underlying strength seems to be their ability to get more capital and meet the solvency requirement to perform, write more business and grow faster. Let's not forget that these insurance companies will be able to tap the capital market in two to three years.

The best performers in the sector have also expanded their capital to about Rs 700 to 800 crore. A look at the non performers suggests that they do not have adequate capital to grow. Hence the increase in the FDI limit would help.

More importantly, this will give greater control to the foreign partners in areas of management control and governance. They will now be more willing to bring in their expertise in product development, technology, and implement best practices.

A striking feature of the Finance Bill is that the government has accepted defined contribution as the way forward for pension reforms, particularly for new government employees.

One could have expected some clarity on the subject of multiple regulators for pension. Though there may be some benefits in having a separate pension regulator, one supposes that there would be a strong case for just one regulator, namely the insurance regulator, to regulate both the pension and insurance sectors. The government must examine the confusion that may arise on account of having multiple regulators.

Banking and insurance companies are significant players in the securities market today. Midsize public sector banks may have made a turnover of about Rs 40,000 crore on securities trade and larger banks would have made two to three times the number. The transaction tax of a 0.15 per cent would certainly eat away a good part of banks' profits.

Likewise, all services rendered by banks (except the fund based assistances) would attract service tax. Banks would be able to conveniently pass on some of these costs to the customers.

So, each time an individual goes and gets a demand draft or pay order, they will end up paying much more than the existing rates. However, if competition becomes acute, banks would have to bear it, which is bad news for the banking companies.

The funding to agriculture credit as well as infrastructure would certainly bring in more NPAs. If these sectors were bankable in the first place, banks would have certainly lent to them earlier.

Public sector banks may now have to bend over and participate in some non-banking projects. Under the Basel accord, these losses could come out of a higher pricing of some of the products through cross subsidisation or, alternatively, banks would need more capital. Either way, commercial borrowers will end up paying for it.

The finance minister's reform to strengthen risk management in banking companies is a healthy step. But, let's not forget that it would mean more capital requirement for banking companies.

Fiscal deficit a concern

MADAN SABNAVIS
Chief Economist,
NCDEX Ltd

The budget announcements need to be looked more closely to understand their implications for the financial sector. The important direct signal sent by the Budget to the banking system is that the government is not really interested in changing the benchmark rate over which it has control i.e. the rate on small savings.

To this extent, it has been non-committal about the future direction of interest rates. This means banks will have to take their own decisions on the direction of interest rates based on their subjective perceptions. To form such a perception, the following should be kept in mind.

The budget talks of a nominal growth of 13.5 per cent in GDP, and a real GDP growth rate of 7-8 per cent, which translates to an implicit inflation rate (GDP deflator) of 5.5-6.5 per cent. This is higher than the rate of 5.4 per cent registered last year.

Higher inflation means lower real interest rates and, with the current one-year deposit receiving a nominal return of 5-5.5 per cent, we would be moving into the negative real interest rate zone during the year. Therefore, all projections on interest rates must keep in mind these facts.

The Budget has also given a contrary view on its own implicit perception of interest rates by showing a lower average interest rate on public debt, from 7.59 per cent last year to 6.98 per cent in FY05.

However, our monetary and fiscal histories have not necessarily shared the same canvas in the past, and the two rates could move in different directions.

A more serious concern for the financial sector is the magnitude of the fiscal deficit which is expected to be Rs 1,37,000 crore in FY05 and involves a net market borrowing of Rs 90,000 crore. To this one must add the market stabilization bonds of Rs 25,000 crore which are to be garnered.

This really means the government is going to access the market for Rs 115,000 crore in the form of fresh borrowing.

We need to now look at the monetary policy, which has projected deposits to grow by just under Rs 210,000 crore (adjusted for the CRR) and credit to increase by 16.5 per cent in FY05.

This translates into an incremental credit of Rs 140,000 crore. Quite clearly, the inflows into the system are lower than the projected outflows.

Where will the money come from since there is a gap of Rs 45,000 crore? May be the current funds in the repos would move to dated paper, but the pressure is bound to mount of the system to sustain this level of deficit and some intervention in the form of a CRR cut could be necessary as the dispersion of funds to fill in the gap may not always synchronize.

Banks have been permitted to increase their exposure in equities but this will not really matter as banks are already well below the permitted limits and may not be inclined to increase it given that growth in credit is expected to be more buoyant this year against the background of industrial acceleration.

The mention on Securitisation Act for banks is not really significant as, despite the positive intention of the system to help banks against defaulters, nothing much has really happened to provide the necessary redress to them.