India's Financial Crisis Has Ended - RBI

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28 October 2009. The Reserve Bank of India (RBI) has in effect called the end of the financial crisis in India, and is the third central bank to do so, after Australia and Israel.

Amidst the noise of cricket score updates and stock market swings you may not have heard this at all, even if you live in India. Or you may have heard some wonkish technical jargon, such as 'RBI Policy Signals End of Easy Money Era' and moved on to more interesting news.

You may even have reacted with some anger if you have money invested in the Indian stock market, because the Sensex tumbled as the RBI signaled tighter policy and the RBI disappointed the market. Poor market, you might be left thinking, and poor banks, who have been sent reeling.

What nonsense. None of these reports have picked up the true significance of the move, which is that the Financial Crisis has officially ended for India, or the bullishness of this prudent move for India's long term health, and that of its markets.

Let us leave the hype aside for a moment and concentrate on specifics. The Australian Central Bank on 6 October 2009 became the first G7 monetary authority to raise its interest rates, which was a positive sign for both Australia and the world. It raised its rates to 3.25%, with the possibility of a further 50 bps raise next week. Back in August, Israel raised rates from 0.5% to 0.75%, and there are signs Norway and South Korea are set to do the same.

The RBI has not raised interest rates. Since it has kept rates higher than any other developed economy (the key lending rate or repo rate currently stands at 4.75%) it doesn't need to make a drastic change there. The consensus is that it definitely will by April next year, with a 50% chance of a move this year, according to an economist survey.

Instead what the RBI is doing is tightening some of the extraordinary measures it had put in place in response to the credit crunch. A special facility to provide liquidity (ie money)  to financial firms  is being withdrawn, as private funds move back and inflows of FDI and FII into the market. It has raised commerical real estate rates, worried that a new bubble is building up.

Significantly the RBI also tightening some of the capital requirements it has for Indian banks. It is raising the 'statutory liquidity ratio', the amount of money that a bank needs to keep in cash, gold or government bonds, to 25%, up from 24%.

Lets compare this situation to that of western banks, particularly those in the US. Yes liquidity or reserve levels are being increased, but according to the Basel II accord capital requirements, bank holding companies should hold tier I and tier II capital reserves of 10%. Now ask yourself the question; how much safer is a bank with 25% of assets liquid versus a bank with 10% capital? The answer: more than twice as safe. And that is before even discussing the fact that most US banks still have only single digit liquid reserves.

It also intends to standardize provisioning for Non-Performing Assets (NPA) to 70%. What does this mean? Lets say that a bank has loaned money to a private company or fund, and that entity has stopped paying interest on the loan. The loan would now be classified as an NPA, and the bank would need to take 70% of the value of the loan out of its profits and hold that in a provisioning pool. If repayments on the loan resume, it would get out of the NPA bucket and back into the business-as-usual bucket, and the provisioning fund can be released back into the banks working funds. If the NPA finally does default, then the 70% provision will be used to offset any losses, although one would assume that more than 30 cents on the dollar can be earned on average in all but the very worst markets. In other words, the bank should eventually be able to increase its liquidity and should never be brought to its kness by NPAs.

Now look at NPAs and their US equivalent, toxic assets. How has the US responded to the question of these 'damaged goods'? In part by relaxing reporting regulations (mark-to-market), so that their values need not be recognised now. I don't know about you, but I would much rather a bank that keeps a 70% provision to the value of a loan or asset in trouble versus one that doesn't have to report its value.

Indian banks are in much ruder health than western ones - and they are getting healthier. Period.

So let the market and the banks complain, these moves will strengthen the Indian economy and the health of its banks for years to come, and the RBI should be congratulated for unpopular but wise policy moves.

Dwayne Ramakrishnan

EconomyWatch.com