Asset price concerns

Even though the Reserve Bank of India (RBI) did not change its benchmark interest rates in its quarterly monetary policy announcement earlier this week, it did introduce one measure that seems to have sent the housing finance sector into a tizzy. It raised the risk weight on housing loans of above Rs 20 lakh from 0.4 per cent to 1 per cent. This means that the lender will have to put aside as reserves against losses an additional Rs 12,000 on a loan of Rs 20 lakh. As was reported in this newspaper yesterday, interest rates on home loans have started to climb, although this is not entirely due to the higher risk provisioning. A few weeks ago, major players began to raise rates, citing the tight liquidity situation, and this is a process that looks set to continue. The question is whether this will hurt the growth momentum in the economy, to which housing has contributed quite significantly.

From the borrower's viewpoint, if the additional risk provisioning is passed on fully to the borrower, it amounts to an extra Rs 1,000 a month. This doesn't seem like much when the EMI (equated monthly instalment) is already around Rs 18,000 for a 20-year mortgage. An increase of 50 basis points in the lending rate will have a similar impact on the EMI. For both factors, the lenders have the option, and they have been exercising it, to stretch out the duration of the loan while keeping the EMI constant. As far as the provisioning requirement itself is concerned, in response to the policy announcement, the head of a large bank said that his institution already makes provisions in excess of the statutory requirement, so the change would have no impact. The bottom line, then, is that the affordability of housing finance for this class of borrowers is hardly going to change. The growth momentum in lending should not therefore be seriously impacted by this measure or, for that matter, small increases in interest rates.

However, there is a deeper significance to the increase in the provisioning requirement. Property prices have been skyrocketing of late, with annual increases of 30-40 per cent typical for many locations. This would mean that loan sizes are increasing, with a larger percentage crossing the Rs 20 lakh threshold. Two risks emerge in this scenario. One, the average borrower is stretching his household budget to a point where, say, a job loss or any other shock, however transient, could push him into default. Two, if prices have risen so high so fast, they may well fall before stabilizing. Home buyers who see the value of their properties fall below the outstanding loan value will, quite rationally, default. This is more likely if a significant proportion of purchasers are speculators rather than end-users. At times like this, it is hard to distinguish between the two. It appears that while Dr Reddy is not inclined to take a firm stand against rapidly appreciating asset prices just yet, he is concerned about their implications for the banking system. One could take this as a precursor of further measures to increase the level of protection that the banking system achieves against a sharp decline in asset prices. As with most things to do with central banking, it will prove to be a tightrope walk, but then, that's what governors are paid to do.