Manas Chakravarty: The U-turn in the banking sector

Bank deposits have declined by Rs 7,530 crore in the four weeks to September 17, over a period in which bank credit moved up by Rs 16,280 crore. In the absence of deposit inflows, what did banks do to garner resources?

Why, they sold their investments, of course "" that has the double-edged benefit of not only raising funds to cater to the credit boom, but also to lighten exposure to market instruments, welcome at a time when interest rates are under pressure to move up.

Banks sold a net Rs 5,155 crore worth of statutory liquidity ratio (SLR) investments during the four weeks from July 23 to August 20, and the sell-off threatened to turn into a flood the following month, when banks sold another net Rs 12,014 crore.

Now this is not just a case of some banks selling government paper to other banks "" when that happens the investments of the banking system as a whole do not decline. What has happened here is that banks have sold this paper to entities outside the banking system.

In other words, non-banking financial companies such as Life Insurance Corporation (LIC), or the provident funds or even housing finance companies may have bought these investments. This also ties in with anecdotal reports that LIC and the provident funds have been picking up government paper.

So far as the market for corporate paper is concerned, the less said the better. As on September 3, the latest date for which Reserve Bank of India (RBI) data is available, bank investments in corporate bonds amounted to Rs 85,639 crore, less than the Rs 87,560-crore level they had reached two years ago.

This year, these investments have been falling more or less continuously since March.

What's more, the fall has been broad-based, extending from banks' investments in commercial paper to investments in corporate bonds and debentures as well as investments in shares.

The data seems to suggest that corporates have not been keen on raising money in the past couple of years, which is undoubtedly true as far as the top-rated companies are concerned, and that banks have preferred not to invest in second-rung corporate paper, thus, limiting the size and growth of the market.

While the decline in deposits has so far been limited to a month, incremental deposits this fiscal have been around Rs 13,500 crore lower than during the same period last year.

That suggests that even though the fall in the absolute level of deposits may turn out to be a one-month wonder, there's no doubt that there has been a deceleration in deposit growth this fiscal.

What are the reasons for the decline in deposits? Is this trend going to sustain? The decline in bank deposits is not because depositors prefer other instruments such as post office deposits or RBI Relief bonds or even mutual fund deposits.

The funds that go into these avenues come back into the banking system, and, for the system as a whole, liquidity is not affected. We need to look elsewhere for the slowdown in deposit accretion. The money supply figures show that M3 also declined during the last month by almost Rs 10,000 crore.

Moreover, M3 growth this fiscal has also been much lower than money supply growth over the same period last year. Until September 17, M3 growth this fiscal has been 4.7 per cent, compared to 7 per cent for the same period last year.

But why has money supply growth been lower? The RBI data for the "Sources of Money Stock" show that "net bank credit to the government" fell during the four weeks to August 20, while a closer look shows that credit advanced to the government through banks, as distinct from that advanced through the RBI, fell for the last two months.

These numbers bear out the data of banks selling SLR investments to non-banking financial institutions.

The other reason for a contraction in money supply in the last month and slower growth in earlier months has been the decline in the "net foreign exchange assets" of the banking sector. These assets fell by Rs 1,514 crore in the four weeks between July 23 and August 20, and by a further Rs 8,349 crore in the four weeks between August 20 and September 17.

Taken together, both the reduction in net bank credit to government and in net foreign exchange assets has been large enough to offset the rise in money supply on account of bank loans to the corporate sector.

Will these trends be sustained? There's no doubt that banks are reluctant to hold government paper. Much depends on the strength of forex inflows "" recent trends show a pick-up in foreign institutional investor inflows, which, if continued, could well lead to a rise in banks' foreign exchange assets, and consequently to a rise in money supply.

And finally, of course, there's the question of how rapidly credit will rise. The consensus view is that investment demand is poised to take off and will lead to a sharp rise in credit offtake as companies expand capacities. On the other hand, much of the recent rise in credit is on account of borrowing by oil companies, who are strapped for cash as a consequence of high crude prices on the one hand, and their inability to raise product prices on the other.

Nevertheless, it certainly looks like high oil prices are here to stay, and, from the point of view of bank liquidity, it really doesn't matter what the credit is being used for. Bankers predict liquidity to be much tighter by the first quarter of FY 2005.

In other words, if current trends of lower deposit accretion, rapid credit growth and a tighter money supply persist, banks will have no alternative to raising interest rates.