Is RBI more of a Government's bank? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Is RBI more of a Government's bank? 

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In this issue:
» Central Government's welfare policies harming states' financial health
» Public sector banks facing shortage of manpower
» Should investors consider gold anymore?
» What lies ahead for Power sector?
» ...and more!


00:00
 
Quantitative easing is a term that has dominated most economic discussion forums over the last few years. The Fed has been getting the flak that use of QE; apparently to promote growth has done more harm than good to the global economy. But what if we tell you that India is running a similar programme? Just that it has been more discreet about it.

What we are referring to here is the Reserve Bank of India's (RBI) open market operations (OMO). Through OMO, RBI buys Government's bonds from the market, apparently to infuse liquidity. As per an article in First post, the RBI has been buying Government bonds through open market operations for quite some years. Since 2008-09, it has bought around Rs 5,850 bn (as on Jan 13).

To understand what it implies, we need to understand the balance sheet of RBI. The central bank has its own balance sheet. The liabilities side includes amounts that banks place with RBI (Cash reserve ratio, popularly known as CRR) and the rupees that it prints etc. On asset side, it has items like foreign currency holdings, gold and government debt etc. For example, when RBI prints Rs 1000 to buy Government bonds in open market operations, the Government debt is added to the asset side while Rs 1000 to liability side.

In buying bonds through OMO, RBI has bloated its balance sheet in a way that has not contributed to productive growth. Further, on the asset side, it has added Government bonds. Now we are all well aware of the quality of governance in India. With corruption cases mounting and regressive policies looming on the economy, it is no wonder that India faces a threat of sovereign rating downgrade. Now that the quality of this asset (Government's bond) is in question, we wonder if RBI is infusing liquidity to promote growth, or inadvertently helping the inefficient Government. For a normal bank, this could have amounted to giving loans that are likely to become NPAs.

Since 1997, the balance sheet of RBI has expanded around 10 times. While foreign exchange purchases accounted for most of the balance-sheet expansion in the period up to 2007; since then, the RBI's balance sheet has expanded by government securities purchases. Overtime, the balance sheet of RBI has seen a shift with rupee assets growing relative to foreign currency assets. This is also the period that signifies a transition in the Indian economic scenario, from better to worse.

An important question that remains unanswered is where the money printed to buy bonds is getting used? While no one knows the exact answer, buying bonds at times when even Government is borrowing and spending heavily could explain the asset price bubbles despite the slowdown in the economy, especially in real estate. Bond monetization is leading to inflation or loss of purchasing power of the rupee. Further, RBI through consistent buying has distorted the bond markets and stalled the much needed correction in low real yields.

Ironically, the general impression is that RBI is targeting inflation. However, as explained above, it is instead contradicting its own moves (like raising repo rates) to rein in inflation. While the central bank has been able to limit government's borrowing rates through its OMOs, it is the domestic currency that seems to be bearing the brunt.

We wonder if Indian economy would have been in a better shape had RBI not gone along with this way of expanding balance sheet. With Government coming up with measures like Food Security Bill, the trend is unlikely to discontinue on its own. But it's high time that the policymakers question the role of such policies in context of current economic conditions. Now that RBI intends to target inflation, we hope that a tight monetary policy will be followed not just in letter but spirit.

What is your take on the open market operations conducted by RBI? Let us know your comments or share your views in the Equitymaster Club.

P.S. - We would like to remind our valued readers that registrations for the The Equitymaster Conference 2014 are set to close in two days i.e. on 25th January 2014. And from what we have been told, there are very few seats left. So make sure you register for the same before it gets too late!

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01:20  Chart of the day
 
While the Indian economy, as a whole, might be slowing down, many states in the country have been doing well. Unlike the central government, they have followed prudent fiscal policies and have not borrowed a lot of money to fund their expenses. Many states in India are now in a fiscally healthy position.

However, the situation may change soon. The Reserve Bank of India (RBI) has warned that the central government's policies, like the food security bill, would place a large burden on the states. The RBI has conducted a study on the health of the states' finances. It has observed that the states have been steadily reducing their debt as a percentage of GDP, since FY 2004-05. In fact, 22 out of the 28 states are said to have a revenue surplus in FY 2013-14. This improvement has been largely due to better control over growth in salaries of state government employees.

In order to improve their finances, many states have also had to cut down on their capital expenditure. However, now the food security bill and other central schemes have placed an additional burden on them. If the states were to borrow money to fund this extra expenditure, it would mean that their interest costs would rise. This would further lower the amount of money that they would have to spend on creating productive assets. If such assets are not created, it would slow down their growth. This would not bode well for the country.

Central welfare policies to threaten states' financial health


02:15
 
As more competition gets ushered in on the back of new banking licenses, public sector banks are facing a problem. There is considerable shortage of manpower at the middle management level. Indeed, these banks had put a freeze on recruitments in the 1990s. With a swathe of employees due for retirement, there are not enough people to fill in the gaps. As reported in Business Standard, about a quarter of 150,000 mid-level managers are retiring over the next three years. Not just that, while for private and foreign banks the growth in manpower has been in tandem with the increase in balance sheets, for public sector banks this has been quite skewed. Indeed, the manpower increase for them has considerably lagged balance sheet growth. So it is quite obvious that the management of these banks will have to find a way of employing and retaining talent. But that is not all. New recruits will need to be adequately trained so that they can be deployed in branches. In this regard, one of the strategies being employed is the outsourcing of grooming and training activities for these personnel. Certain consultancy firms have also suggested lateral hiring to fill in positions. No doubt if public sector banks do want to be treated at par with their private and foreign counterparts, then finding and retaining skilled manpower will have to be a priority.

03:20
 
Investors may have not weaned from gold's anti inflation properties. But the yellow metal's disappointing performance in 2013 has certainly taken off some luster. Add to that the government's efforts to curtail gold imports citing current account deficit. There are also curbs on lending by gold loan companies and sale of gold coins by banks. Thus, even without any meaningful changes in the macroeconomic and inflation outlook, gold does not feature in investors' wish list for 2014. What then have investors turned their attention to? As per an article in Times of India, real estate has once again found favour. After a lean 2013, investors are once again turning to the real estate sector in the hope of quick profits. Do the fundamentals of the sector promise enough upside? We do not think so. But more importantly, investors must keep their asset allocation in mind while investing in illiquid assets like real estate. As far as gold is concerned, the precious metal must comprise at least 5% of one's portfolio irrespective of near term outlook on prices.

04:00
 
If different risks facing Indian stocks are arranged in descending order, we are sure risks arising out of regulation would perhaps top the list. And nowhere this is more evident these days than the Indian power sector. The BSE power index is the worst performer this year. It has fallen by more than 6% against a 1% rise in Sensex as reported by Business Standard. The reason for the underperformance may not be that hard to find. Apparently, political parties want to follow in on the footsteps of the Delhi Government and reduce tariffs in their own constituencies. The recent 20% cut in rates in Maharashtra is a case in point. And soon, there could be other states offering the same kind of reduction. This is obviously going to hurt sector stocks although there are some who believe this is only a near term risk with most reductions likely to be taken back once the elections are over. Even if this happens, there are other risks like fuel supply agreements and poor health of distribution companies that the sector faces on a regular basis. Therefore, the sector stocks are unlikely to become investor favourites any time soon.

04:25
 
If George Soros' prediction happens to be correct we may well see a repeat of 2008 financial crisis soon. However, the source country in question this time would not be US but China. Nonetheless, the reasons could well be the same - emergence of complex structured products and excessive leverage.

It is a known fact that credit boom in China is fuelled by shadow banks. In fact, as per Moody's estimate China's shadow banking debt market was roughly 55% of the nation's economic output at the end of 2013. The problem with shadow debt is that it is created by financial institutions outside the regulatory framework. In other words, it is non-bank debt. Similar to bank debt even shadow debt can be structured into a complex investment product. Since the risk in shadow debt repayment is high the return is also high. This attracts investors. However, higher risk means that probability of default is high. And if default happens it can shake investor's faith in such products resulting into basket selling. Very recently one such Chinese investment trust which issued structured products on shadow debt had to be wound up. This has sent ripples across the Chinese market. If a few other instances like these occur, China may witness a wave of defaults. And this can have cascading effects similar to the 2008 crisis.

04:46
 
After having opened in the red, Indian stock markets continued their downward slant throughout today's trading session. At the time of writing, the benchmark BSE Sensex was down by 245 points (1.15%). All sectoral indices were trading in the red with capital goods, consumer durables and realty sectors leading the pack of losers. Barring China (up 0.6%), most of the Asian stock markets were trading lower led by Japan (down 1.9%) and Hong Kong (down 1.3%). The European markets are also trading weak.

04:50  Today's investing mantra
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets" - Peter Lynch
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4 Responses to "Is RBI more of a Government's bank?"

Siddartha Ramakanth

Jan 30, 2014

I want to get some insight on the article "What lies ahead for Power sector?"

Can that article be backed wit some Data and statistics :)


Like (1)

Ganesh Sastri

Jan 28, 2014

Just as we consolidate holding company and subsidiary company to know the true state of affairs, we should CONSOLIDATE the financials of GOI and RBI to know the true state of affairs. RBI buying GOI bonds is the same person transferring money from left pocket to right pocket or vice versa. I don't know why any so called economists cannot understand this sham accounting. The same thing is obtaining in USA and many other countries.
GOI and RBI have inflated their way during the last thirty years. Thirty years ago, you could a property for one lac. Thirty years from now, you can have a proper tea for one lac. That is the kind of inflation that has been unleashed and likely to be unleashed.

Like (1)

Ravishankar

Jan 28, 2014

Central banking is the biggest fraud in modern human history. It steals money from the savers and transfers it to the borrowers. The biggest borrower is the government which has been kept afloat with RBI's help. Watch the video, Money as debt on youtube to understand the money creation process. RBI is the biggest destroyer of the value of rupee in collusion with the government.

Like (1)

MANSOOR HARIS

Jan 24, 2014

Well since the 2008 crisis every country in a way has and is infusing liquidity so as to keep the average citizen glad that he has something to do. It has also helped to move things which otherwise wud hve stagnated given the global conditions just short of a major crisis.
RBI unlike FED shud know how n when to terminate these inducements and there lies its result in the overall sense.
Jaiho

Like (1)
  
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