Category: Finance


Reserve Bank of India (RBI) reduced the repo rate by 50 basis points to 8.0 per cent in its annual monetary policy review on April 17, 2012. While the markets were expecting a moderate 25 basis point cut to be in place, a sharp 50 basis point cut surprised many. Reserve Bank does seem to have its own logic for this rate cut but it seems like a step which is too fast and too furious. Is it a gamble for growth that RBI is willing to play or are they succumbing to demand and pressure from industry for some easing in policy rates?

Rate cut from RBI comes on the back of declining growth rate to sub 7% which apparently is below the desired/expected growth rate which RBI has targeted. While the growth rate has been impacted due to continuous rate hikes by RBI in the past 2 years, there has been moderate impact on inflation. Headline inflation still hovers at around 7%, however there has been moderation from last year’s rate which has prompted RBI to take this cautious step of rate cut.

Although inflation levels are yet far off from RBI’s comfortable target of 4-4.5%, but declining growth rate has prompted RBI to shift its focus on growth over inflation for the time being. This is a risky approach.

Firstly, risks to inflation spiraling high again are looming at large. The reasons remain the same which have till now not let the monetary measures by RBI control inflation. Large fiscal deficit which has been further fuelled by focus of government on spending and giving benefits and subsidies has led to increase in demand which further triggers inflation. Further, inflation is driven by supply side factors primarily in the food category. Sturdy supply chain measures are yet to be taken by the government to counter these challenges. Further the decline in investment activities has more to do with weak fiscal policies than high interest rates. Policy-related bottlenecks, higher cost of inputs, weak rupee and slowing external demand has all led to decline in investment activities. Foreign investments also have seen to take a dwindling in wake of weak confidence in Indian Economy in the backdrop of slow growth, non-industry friendly policies, political uncertainties and row of scams. Amidst all these, there is also pressure of fuel prices to rise in the global markets. Even if the prices remain steady, government has but little choice to increase retail fuel prices given the already burdened subsidy budget.

While the RBI has said it has taken a cautionary approach and intends to closely monitor inflation and growth rates and if needed might even go for rate hike, but it is moving into dangerous grounds. Growth does certainly seems to be a significant factor on RBI’s mind when playing the repo rate cut card but for it to be significantly effective, Banks need to pass on the rate cut to corporate so that investments can be boosted. Apparently the banks are reluctant to do so. Given the slow deposit growth, banks are hesitant to drop the deposit rates as it may further slow down deposits and so if the lending rates are cut it will hit the profitability of Banks. The banks will ultimately pass on the rate cut but it will be crucial to see who wins in the race – inflation or growth. We all hope that the measure turns out beneficial and gets Indian Economy back on track of solid growth.

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A unique discussion came up with a fellow customer while buying my weekly groceries. It caught my attention for the uniqueness, simplicity and yet the potential dangers in it. It’s a way which is used(quite frequently to my surprise) by local people belonging to lower middle class societies to fulfill their debt needs and investment aspirations. It’s something they call the Committee System.

Now the traditional means of getting debt at a local level involves either dealing with a bank (which grants loans based on lots of financial criteria) or borrowing from a friend (lot of trust involved if you ask for a big amount) or the local money lenders (which charge huge interest). These are all difficult avenues for lower middle income class and lower income class people. Similarly investment options are very limited to PPF and Post Office Savings. It is probably these reasons which led to the development of this unique methodology of investment and debt raising. How legal is it I am unable to comment but I thought it would be interesting to share and get views.

The Committee System involves a group of people (can range from 5-20) coming together to form a “Committee” where each person contributes certain amount of money towards a corpus of funds. Typically the person initiating the committee is the cashier and is responsible for each transaction and servicing of everything that goes for that particular committee.  So for example lets assume that Mr. X is the cashier of a committee floated by him having 10 members and each member contributes Rs. 10,000 towards the corpus which amounts to Rs. 1,00,000. Now the committee holds an auction among the 10 members for granting this corpus as a debt. The auction amount is basically the interest portion on the corpus. So in our committee of Mr. X with a corpus of Rs. 1,00,000 the auction starts at lets say Rs. 5000. What is means is that the person bidding Rs. 5000 will, if he wins the auction at that bid, take the Rs. 1,00,000 corpus for a cost of Rs. 5000 so effectively he will get Rs. 95,000. The start amount is declared by the cashier because in case their is no higher bid he has to take on the debt. So each member is given a chance to bid. Let’s assume that Mr. Z is the winner of the auction at Rs. 10,000. So Mr. Z will get and Rs. 90,000 (Corpus of Rs. 1,00,000 at a loss of Rs. 10,000). The Rs. 10,000 bid amount is divided among the 10 people forming the committee. So at a investment of Rs. 10,000 each member get profit of Rs. 1,000 upfront. The principal amount has to be paid by Mr. Z in a time-frame (lets assume 12 months) on 15th of each month.

For Investor

Upfront investment = 10,000

Upfront interest = 1,000

Principal per month for 12 months = 833

(Effective Rate of Return) IRR = 20.2% per annum

Similary,

For Borrower

Loan Taken = 1,00,000

Upfront interest paid = 10,000

Principal Installments for 12 months = 8330

Effective interest Rate (IRR) = 20.2% per annum

Innovative and effective ! And most importantly useful for those who can’t get debt from banks. Now obviously there are risks here. The biggest is the credit risk that the person does not pays the principal payments. In that case the burden falls on the cashier to pay the members of committee. For the same reason committee are often formed between close members of society where trust level is high. As I said before, I cannot comment on the legality of this system although my fellow buddy did tell me that they do paperwork (enforceability of which is again doubtful to me).

Have you heard or know such a system in place ? Are there other such unique models out there among the local masses. Let me know 🙂 !

Government recently raised the prices of diesel, kerosene and LPG cylinder on 24th June 2011. With the increase in prices of diesel by Rs 3 per litre, cooking gas (LPG) by Rs 50 per cylinder and kerosene by Rs 2 per litre, there has been a huge outcry about its impact on the economy and the masses. It also eliminated the 5% custom duty on crude oil and reduced the excise duty on diesel from 4.6/l to 2.0/l which will further increase the fiscal deficit. With the increasing inflation constantly biting the government which is already bruised by multiple controversies in terms of XIX Common Wealth Games Fiasco, 2G scam and social movement by Anna Hazare & Baba Ramdev, the questions arises if the hike in prices is wrong move or a bold move?

The Cause

With as estimated losses of INR 1,77,000 crores in FY12, government has tried to reduce the losses to an extent of INR 21,000 crores through price hike and INR 49,000 crores through reduction in taxes. These losses occur because the oil that is used in the form of diesel, kerosene and LPG is available to us at a huge subsidy from international market rates. The OMC – Indian Oil, Bharat Petroleum and Hindustan Petroleum were losing INR 18.11 per litre of diesel, INR 28.33 per litre of kerosene and INR 315.86 per 14.2 kg of LPG cylinder – before the recent hike. This loss burden is shared to the extent of 33% by upstream companies (ONGC, Oil India & GAIL), and the remaining by Government of India through Oil Bonds and the OMCs.

Another worrying factor is that subsidized oil prices have led to diversion and wasteful consumption of certain petroleum products. Due to artificially depressed prices for diesel, the demand for industrial products such as FO, LSHS, Naphtha, and LDO has been partially substituted with increased consumption of diesel by certain industrial consumers in sectors such as cement, coal, steel, and mining etc. for captive power generation. 

The Impact

The cumulative weight of diesel, kerosene, and LPG in the Wholesale Price Index is about 6.3%. With the upward revision in prices last week, headline WPI inflation will increase by about 65-70 bps (direct impact) over Jun-Jul 2011. Apart from this the transporters will feel the pinch from the hike in diesel prices and will pass on the cost to the users causing inflation to rise by approximately another 20-30 bps indirectly.

The price hike can be considered a bold move given the fact that the government would be taking a hit on the fiscal deficit for FY12 after its move to reduce taxes which will give benefit to the oil PSUs to the tune of INR 49,000 crores. With expected oil subsidy of INR 40,000 crores in FY12 the fiscal deficit to GDP ratio is likely to touch 5.5% vis-à-vis the government target of 4.6%.

The Advantage

The advantage of the price hike would be first and foremost in terms of reducing the losses of the oil companies. Moreover the step by government to increase the prices amidst so much opposition can be taken as a feeler that the government is willing to break the decision inertia, which is most certainly expected to improve the market sentiments and confidence in the government. Also the move towards price hike and deregulation is expected to create level playing field for private players. Not only on the downstream front, but also on the upstream side, price deregulation would attract huge investments in the refineries.

Way Forward

Swaminathan S. Anklesaria Aiyar in one of his articles, proposes to revive the Oil Pool Account (OPA), which in the 1980s and 1990s smoothed fluctuations in product prices.  When price control imposed losses on oil marketing companies, they got compensating cash from the Oil Pool Account (OPA). If, however, world prices dropped below the controlled Indian price, the surplus went into the coffers of the OPA. A similar situation occurs today when the prices of crude oil are on a decline and creation of an OPA account would help in creation of surplus if the government doesn’t gives in to pressure to reduce oil prices.

Further there is a need for phased abolition of subsidies as advocated by Kelkar committee in 1990s. The recommendations of the committee have not been implemented till date because of political reasons and for appeasing the masses. Learning can certainly be taken from countries that implemented oil price hike/deregulation and took steps to mitigate the effect and protect the poor.

There is a strong need for oil price hikes to be taken more rationally and at the same time stronger and sincere efforts from government to implement measures to soften the impact of price hikes. A necessary evil it is, to be managed and never to be let out of sight.

A more detailed discussion paper can be downloaded from the Downloads section of the blog.

Rupee appreciating again…

We’ve seen the highs and lows of Rupee with it reaching Rs/$ = 39 mark and also depreciating to Rs/$ = 52 in March 2009. Now again it is on an appreciating spree. Since March 2009 last year it has now reached on the verge of breaking the Rs/$ = 45 mark. Till the time this blog was written the currency exchange rate was Rs/$ = 45.7. According to Business Line Rupee forwards in the non-deliverable forward (NDF) market are trading at a discount to spot rate resulting in arbitrageurs becoming active in the Indian currency, thus contributing to the current up-move. Moreover, given excellent equity returns in the Indian Stock market compared to global indices, FII inflows have been very positive which has also led to rupee appreciating. BSE gave a 70% return in 2009. Although, the dollar has been trading strong against other major currencies over the last fortnight but it has not made any headway as strong economic data brought back risk appetite stunting the greenback’s gains.

Such an appreciation has implications for companies whose revenues are dependent on exports. One such sector is the IT sector which is already facing the lows due to less business given the recent financial turmoil. Companies like Reliance, Hindalco, Tata Steel which have a significant portion of revenues from exports might take a hit.

According to Business Line in the intermediate term, trend in the currency is up and it can move to 45.2 or even 44 over the medium term. In the short term of 5 day span the rupee can spend a few sessions moving in the zone between 45.8 and 46.5. Rally above 45.8 can take rupee to 45.2.

The views expressed in the blog are personal of the Blog Author. Feedback and Comments are welcome.

The recovery phase from the global turmoil is under progress. Although still shaky, the financial firms are stabilizing. It started out with plummeting interest rates to promote consumption in the US market which prompted the housing prices to go up. Irrational lending and plethora of new complex financial product which were overlooked by the regulators created a bomb which exploded the moment the string was loosened and defaults started happening. India although was quite isolated from the US mortgage market, still had to face shaky impacts through the financial channel, real channel and the confidence channel. The Indian Banks had little exposure to the US market couple with the sound and conservative pillars on which they lie, were able to save themselves from any catastrophe. But they were also swept in the booming economy spirit and went into a reckless lending mode. There may be a possibility of a financial bubble bursting in the Indian Retail Lending market if enough care is not taken. It is only prudent for Indian Banks to take a wise look at the recent crisis and incorporate the lessons for survival in the future.

Retail Lending in India basically consists of Mortgage/Home Equity Loans, Vehicle Loans, Loans against shares, Personal Loans & Credit Cards, with Mortgage Loans being the least risky as its secured by assets and Credit Cards being the most risky.

Retail Banking

Traditionally banks have been lending to individuals based on their purchasing power, requirement and demographics. Retail banking was not very popular earlier and only caught speed in the mid 90s when due to liberalization, the purchasing power of consumers and standard of living started increasing. Since then it has been a fast growing market. Retail credit constitutes about 25% of the total credit and has grown by 28.0% to INR4,218.3 billion. During 2006-07, gross credit extended by Indian commercial banks grew by 34.83% to touch INR19,495 billion. Till 2010, retail banking is expected to grow at a CAGR of 28% to touch a figure of INR9,700 billion. It’s a sector which is going to be a profitable segment for the banks always. This charm coupled with the booming economy provoked banks to venture aggressively in it. Numerous loan schemes came out in India and it was pretty easy to get loans during 2007-08. This can be verified by the numerous calls from banks about loan and credit card offers that were on the rounds. Since income levels were rising banks perceived low risk in lending and often shifted towards reckless lending.

Now that a slowdown in there, bonuses and salary increments are on a decline, banks are fearing of defaults on the huge pile of loans that they have given out. Non-performing assets(NPA) for banks have increased from 2% to 4% and it is a cause for worry. The biggest worry is from the credit cards market. In a drive to provide each consumer with multiple credit cards, banks have ended up with a wide spread of low frequency card users. This is turning out to be non-profitable since the transactions costs involved are high. Moreover, the probability of defaults and frauds in credit card payments have been rising. Industry estimates showed that the default has increased by 50-70% over last year. Given the high interest rates that are being charged for credit cards, the risks of defaults are obviously higher.

Credit Cards scenario is just an example to show that despite the isolation of Indian Banks, the risks are there and lessons from the sub-prime crisis to avoid one in India. The first lesson is that multiple borrowings should be regulated and appropriate credit analysis needs to be done before lending in such cases. Banks should also opt out of high growth trajectories driven by debt-financed consumption and housing spending. Specifically for Indian scenario, Indian Public banks which have majority market share and can be easily regulated should be strengthened,so that during times of crisis the situation can be well managed through these banks. The strengthening should be in terms of a stronger top management and efficient risk profile. Banks and regulators have to ensure that frauds in housing loans and credit cards are strictly dealt with and reckless lending is avoided. Moreover, SPV and innovative financial products designed by banks and financial institutions should be reviewed for risk factors and released only after moderation. These products although heavily profitable during good times can act as disaster triggers during weak times as was seen in the recent global turmoil. More specifically from the banking side, banks need to ensure greater transparency and accountability in their operations. Customers need to be educated about all the hidden costs and such hidden costs should be included when evaluating the credit capability of the customer. Customers should also be advised on their financial needs and strengths so that a healthy relationship can be maintained from both sides.

Banks need to devise strategies and look at retail lending in the future from a structured and balanced viewpoint. Banks have to now focus on Strategic Retail Lending. This implied having well defined allocations for different segment of lending so that risk limits specified for each sector can be adhered to. Upper limits needs to be defined and strictly followed in accordance with the retail portfolio that the bank intends to have in accordance with its risk appetite. Banks could also look at implementing a Credit Appraisal System where a credit rating is given to individuals and it can be consistent across all banks. CIBIL can play a major role here with it already having started the process of forming a database of the credit history of individuals. These credit scores can also be used by banks to look at the possibility of risk based pricing where interest rates are charged based on the risk profile of the customer. This will also be beneficial for an individual with excellent credit history who can then negotiate for a lower interest rate. In the rural segment, where probability of defaults are high given high dependence on monsoons, the banks can act as facilitators. Given the increasing need for financial inclusion, apart from giving loans, banks can provide value based services like tie ups with farming equipment manufacturers and encouraging non-agricultural sources of income. This would not only ensure a better living standard for farmers but also ensure a constant source of cash flow for banks that have lent out, reducing default probabilities.

The future outlook for the Indian Retail Banking Industry looks good. Given the huge untapped market of semi-urban and rural areas, the opportunities are huge. The future will see Banks with well defined systems and procedures emerge as leaders. Learning lessons from every event at every step and moving with a well developed strategy would certainly be the key to success.

The article expresses personal views of the blog author. Comments are appreciated.