Thursday, January 25, 2007

Should the RBI rein in credit growth?

The quarterly annoucements of monetary policy by the RBI have by now become a huge media event rather like the budget. More often than not, the hype is overdone. But the forthcoming announcement (due on January 31) is of some importance.

Credit has been growing at around 30% in the past three years. Earlier, growth was of the order of 15-16%. The RBI would like to see slower credit growth- the annual statement made at the beginning of FY 2007 had indicated a target growth rate of 20%. There can be two reasons for worrying about high credit growth. One, it could imply a dilution of credit standards and hence hence pose risks of bank failure down the road. Two, by fuelling monetary expansion, it could stoke inflation. How real are these threats in the present situation of the Indian economy?

Bank credit has grown strongly for three reasons. Economic growth has accelerated; there has been a shift in banks' asset portfolios from investments to credit; and banks have woken up to the potential of retail credit.

Retail loans have been growing at 40%. As a result, the share of retail loans in total advances has gone up from 22%in March 2004 to 25.5% in March 2006. Within retail loans, the biggest driver has been home loans. Home loans grew at 50% in 2003-04 and 34% in 2004-05. Home loans account for nearly 50% of all retail loans.

Home loans are loans made to buyers of homes, as distinct from loans to real estate developers. With real estate developers, banks can burn their fingers badly if real estate prices fall (which is quite likely given today's prices). Banks' total exposure to the sensitive sectors (capital market, real estate and commodities) was 19% in 2005-06, with exposure to real estate being the biggest chunk- 17.2%.

Home loans are made against future income, not against assets. If the price that a borrower has paid for a home drops, the borrower does not lose his ability to service the loan: most borrowers are middle-class, salaried individuals. Besides, banks make sure there is reasonable margin to the loans they make: the loan to value ratio can be pegged at 70% or lower. So, even if the value of the home drops, the banks have enough collateral to protect their loans should the borrower default on loan payment. It is these factors that make home loans one of the safest categories of loans for banks. Similar margin protection is available on another important retail loan, loans against shares.

On the wholesale side, banks are not only experiencing lower defaults, they are actualy effecting significant recoveries against loans written off. NPAs have been coming down not only as a proportion of total assets but in absolute terms. Gross NPAs declined from Rs 59,124 crore in March 2005 to Rs 51,815 crore in March 2006. The ratio of net NPA/ total advances of banks of 1.22% is respectable by international standards. In today's buoyant economic conditions, it is hard to see this changing for the worse.

In short, rapid credit growth does not translate into poor loan quality and pose any systemic risk. That is partly because of the particular composition of credit growth: it has a big retail component which is intrinsically high quality.

What about credit growth as a driver of inflation? Money supply has grown at 19%, driven by large credit growth. This is above the growth of 15% targeted by the RBI. But the RBI had projected GDP growth for FY 2007 was for 7.5-8%. We are likely to see growth closer to 8.5%. A case could be made out for money supply expansion to accommodate higher growth.

The RBI, nevertheless, thinks that money supply has still run ahead of the growth rate- it sees clear signs of 'overheating' in the economy. One sign is the inflation rate which has crossed 6%. Another is soaring asset prices. A third sign to watch out for is the current account deficit. How worrying are these signs?

The rise in the inflation rate to over 6% arises partly from the base effect- there was a sharp fall in the wholesale price index around this time last year. The base effect will continue till June. The inflation rate will moderate thereafter as the base effect is corrected and there is, quite possibly, a cut in the oil price in response to the decline in oil prices internationally.

Housing prices may well have peaked. There are signs of a softening of housing prices in some places and the pace of home loans has slackened going by the pronouncements of bank CEOs. Stock prices remain high but these are open to correction at any point.

As for the current account deficit, this is likely to much lower than thought earlier- 1.5% of GDP as against the forecast of 2.5-3% of GDP. So the external front certainly is not showing any effect of 'overheating'in the economy.

This is the backdrop against we the RBI will announce its monetary policy in January 31. A recent development is the ordinance that provides the RBI flexibility to lower the floor for the Statutory Liquidity Ratio to below 25%. Any cut in the SLR makes more funds available to banks for lending. But the RBI is uncomfortable with the present rate of credit growth. So what should the RBI do?

The betting is that any SLR cut will be phase in over a period of time starting from the point when the SLR holdings of banks comes down to 25% from the present level of 29%. This could happen any time in 2007. Thereafter, if the RBI cuts the SLR, banks can have an incremental credit/deposit ratio of 100%.

The RBI might like to slow down credit growth further through a rate hike announcement on January 31. This will help prepare the ground for a cut in the SLR down the road.

For the reasons mentioned above, I do not believe that a generalised rate hike is called for. If particular banks are under-pricing risk or if particular products are being under-priced (such as home loans), then it is best to focus on those segments alone. A generalised rate hike at a time when credit growth may well slow down in response to earlier rate hikes could adversely affect investment down the road.

See my detailed prescription in my ET column.

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