India - The liquidity puzzle

One of the mysteries of the current monetary scene is the combination of liquidity tightness (the overnight call money rate is back in double digits), and the figures on bank credit growth, which show a handsome increase of 29 per cent on the position a year earlier. This has caused the Reserve Bank of India to argue in its latest monetary policy statement that it would like to see the rate of credit growth drop significantly by the year-end, a position which has surprised almost everyone in the market at a time when the scarcity of money stares them in the face. It is important to find out where the money is going, and one explanation could be that international trade credit has dried up because there is virtually no lending in overseas markets. As a consequence, exporters as well as importers have turned to domestic bank finance as a substitute. A second explanation could be that Indian companies which have made large acquisitions overseas have been unable to find the money abroad to finance the acquisitions, and they have therefore borrowed from Indian banks and repatriated the funds from here.

Both categories of borrowings would show up as having added to bank lending, but neither would having helped the domestic liquidity situation. External observers can only look for anecdotal evidence to propound such hypotheses; it is the RBI that will have access to system-wide data that can tell the true picture. So it would be a good idea for the RBI to disaggregate bank lending in order to establish whether the growth in bank lending is in fact adding to domestic liquidity. If it is not, then the RBI should revise its macro target for the end of the financial year insofar as it extends to bank credit.

Meanwhile, if the government wants to bail out the sectors that are suspected to be holding illiquid assets (like real estate), the sensible way to do this would be to encourage banks to lend to real estate companies after covering for a sufficient margin to account for a drop in capital values. Additionally, if bank lending is directed towards finishing projects that are held up midway for want of cash, and therefore bank finance allows illiquid real estate assets to become liquid, that is something that should be encouraged as it helps to detoxify the real estate sector to some extent.

What the government and banks should not do is to be indiscriminate in the bail-out packages that they offer to the sectors that are believed to be toxic, whether it be real estate companies, non-banking financial companies or mutual funds. Those who have taken bad business decisions will have to pay the price, and the state should not offer them a safety net. If bank money is to be provided, it should be with sufficient safeguards to ensure that banks can recover their cash, and not add to their existing list of non-performing assets.

A good example of policy action that may not make much of a difference from a systemic perspective, but which may help specific companies, is the announcement that company promoters have greater leeway in acquiring shares without triggering the requirement for an open offer. The list of large companies where promoter holdings are close to the existing 55 per cent limit, which are the ones that can benefit from the new cap of 75 per cent, is quite small.