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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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You may want to know this

Posted by Muthu on March 3, 2012

This time I’m writing something different. Something which I feel may be of interest and use to you.

As a financial advisor, I get invited for lot for meetings. Most of which are sales meetings usually happen in a star hotel followed by dinner and some times even with cocktail. I usually avoid sales meetings unless occasionally I want to use that as an opportunity to meet fellow professionals. I neither like food at star hotel nor consume alcohol. So it is of no use to me:-) 

There are other kind of meetings when one gets opportunity to meet fund managers, have opportunity to get updated on latest developments in the industry, knowledge sessions etc. This I make it a point to attend. As I carry my own flask and biscuits, I do not worry whether food or snacks is provided or not:-)

One particular fund house and especially its regional head makes is very keen on both learning and sharing what he has learnt. Our telephone calls are usually long and hence infrequent:-) (he is a very busy man unlike me). As everyone else, he should also be having lot of sales pressure; but I’ve never seen him pushing sales and he mildly ask for business citing the merits of his fund house and its products. 

He invited around 20 of us few days ago for an interactive session in his office to share something he has learnt recently. This piece is on what I know about the subject previously, what I learnt on that particular day plus my own understanding and observations. Fund houses and their officials never comment on governments or politicians. I don’t have any such compulsions:-)

While reading this piece, please keep in mind that though I know macro economics to some extent, I’ve limitations of knowledge in this area. Also I’ve to simplify things to make it understandable and in reality things are much more complex. So if you find any flaw in what I write below, please bear with me and if possible write to me on the mistakes I’ve made so that I can improve my understanding.

Currently there is a very severe liquidity issue going on in our economy and especially banking system. Infact banking system is under severe liquidity stress such that their overnight borrowing is reaching alarming proportions. On last Thursday, their over night borrowing was around Rs.1.92 lakhs crores. This is way above RBI’s comfort zone. What is RBI’s comfort zone?

To know this, you need to know the term NDTL; which means ‘Net Demand and Time Liabilities’. As I’ve told you before the money we deposit with banks are assets in our books but liability as per bank books. By depositing, we are actually lending money to the banks. These are classified as ‘Demand’ and ‘Time’ Liabilities. Savings bank and current accounts comes under demand liability (as they are payable on demand) and fixed deposits comes under time liability. Here you may have a question. Fixed deposits are also paid by banks on demand and then why they are classified as time liabilities?

Though banks do pay fixed deposits on demand, not many of us know that they have right to refuse our request and ask us to hold to till maturity. A bank lends money by borrowing from us and if the requests for such pre-closures go beyond their ability to manage the mismatch between asset and liability, they can refuse pre-closure. If most of us want the money from bank at short notice, it is not possible for them to repay as the people who have borrowed from banks for a fixed tenure would not be ble to close their loans immediately.  

The NDTL in the whole banking system is now roughly around Rs.65 lakhs crores (i.e) sum total of all SB, Current and Fixed Deposits by all of us, companies, trusts etc. The NDTL of all the banks branches in Tamilnadu is roughly around Rs.3 lakhs crore.

RBI is not comfortable if the liquidity deficit in the banking system crosses beyond 1% of NDTL, which is roughly Rs.65,000 crores whereas currently it is thrice this sum which is causing severe stress to our financial system.

When you go and deposit Rs.100/- in banking system; a bank has to deposit Rs.5.5/- with RBI. This is known as CRR or Cash Reserve Ratio. RBI does not provide any interest to banks on CRR. They have to further deposit or buy government securities worth Rs.24/- from RBI. This is called SLR or Statutory Liquidity Ratio. So when you deposit Rs.100/- with bank, around Rs.30/- goes to RBI in the form of CRR and SLR. Infact CRR norms are so stringent that it has to be balanced compulsorily every alternate Friday. No deviation from any bank is permitted in this regard.

Since it is very difficult to predict the liquidity requirements on a daily basis as thousands of crores of money move in and out of banking system, banks keep borrowing and depositing money overnight. They can borrow any amount from RBI everyday. This is called Repo window and the interest charged by RBI on these loans are called Repo rates. This now stands at 8.5%. Likewise banks can deposit their surplus with RBI overnight and the interest paid by the RBI to banks is called Reverse Repo Rate which now stands at 7.5%. Usually the spread between Repo and Reverse Repo would be between 0.5% to 1%.

CRR and SLR are used to regulate the liquidity in the economy while Repo and Reverse Repo determines the interest rates in the banking system.

Banks also use call money market operations every day to manage liquidity. For this purpose they also use what is known as CDs (Certificate of Deposits). For example, due to tight liquidity situation now, the 3 months CD rates are around 11%. You may wonder why banks are not offering such rates for 3 months FDs. One main advantage a bank gets while issuing CD is there is no compulsion to deposit Rs.30/- with RBI for every Rs.100/- raised, which they have to if they raise money through FD.

CDs are in huge denominations and hence mutual funds, banks, insurance companies etc. only deal with them. The maximum tenure a CD can have is only one year. Now banks are issuing lot of CDs at higher rate not only to overcome the liquidity problem they have now but also to roll over the CDs which are maturing now.

Unlike FDs, CDs are both transferable and tradable.

There are few issues which are contributing to the current stress.

RBI rarely intervenes in the forex markets. There is a general impression that lot of foreign money moved out of stock market during the last year end resulting in Rupee depreciating upto Rs.55/- per dollar. Though the depreciation is true the reason given is not true.Lot of speculation in currency market resulted in rupee sharply depreciating. So RBI intervened and sold dollars worth around Rs.60,000 crores. When they sell dollar, what they will buy? They bought rupee to the same extent so that the money got sucked out of the system. I don’t how many people who speculated on continuous depreciation of rupee got killed:-) One should never underestimate the ability of RBI.

Also lot of money is used by government without any productive purposes and it goes out of system. I’ve no comments to make whether government is right or wrong in doing such things because I’ve no idea of whether it really benefits people or not. For example under NREGA (National Rural Employment Guarantee Act), lot of money is given by the central government as freebie. It is estimated that a significant part of it goes out of the system resulting in liquidity stress. This may be due to slippages and corruption. Or this may also be due to the fact that not even 40% of the country is in someway connected with banking system and the rest is only cash economy.

Lot of thrust is being given to increase the banking penetration but it would be long before it happens. Every time some one does something in black or unaccounted money, that money simply disappears from the system. So when someone buys a Rs.50 lakhs property paying Rs.30 lakhs in white and Rs.20 lakhs in black, that Rs.20 lakhs simply goes out of the system. On an average Rs.1 lakh crore goes out of system every year like that. This year the estimated amount is Rs.1.5 lakh crore. The obvious reason is major elections happening. Every political party would be part of this and still would only be keeping blaming the others.

Hawala transactions too contribute to above slippages. If someone is living as illegal immigrant in U.K and wants to send Rs.1 lakh home, what he would do? He would pay a hawala dealer inU.K. pounds worth Rs.1 lakh plus commission. His counter part in India would pay his family Rs.1 lakh after deducting his commission.

 This Rs.1.5 lakh crore slippages includes all the above- both cash economy and unaccounted and or illegal transactions.

As you may be aware, government is not authorized to print currency and only RBI is. They know how much is printed, how much in circulation and how much is slippages. What RBI would not know but our politicians may know is where the slippage is happening and who the beneficiaries are:-) Since entire political class gets benefited by this, they would end up just accusing each other. Some may get caught. My gut feel is more goes unpunished and only few get caught.

One another reason for the liquidity issue is the revenue for the government is less than what it is projected and the expenses are more than what it estimated. After last year budget itself, many good analysts felt that government is over estimating the income and under estimating the expenses. Government happily proved them right.

Accounting is often said as language of business. This is applicable to individuals and governments as well. Different people speaks different languages:-)and some choose to be silent too:-) though regulators all over the world keep trying to make everyone speak the same language. Creativity is expressed most not in arts but in accounting:-) While analysing accounts, only some can be taken on face value. For many others, discounting has to be given. How much discount to give for what is an art and not science:-). That’s why stock picking though it is simple but not easy.

Creativity can be employed in calculating revenue and profits. Some within the sphere of law itself and some even out of it. One simple but powerful tool is cash flow analysis. When a firm shows good revenue and profits but struggle for cash, cash flow analysis and few right questions would reveal where the skeleton is. Another area to look at is foot notes of balance sheet which for some can be longer than balance sheet itself:-) 

In general governments and public companies tries to show more than what is whereas individual and private companies may try to show less than what is. Cash flow analysis can help identify both.

Central government is much better in accounting than states. Many states inIndiaare not in good fiscal health at all. While using the word ‘fiscal’ you may think about often used term ‘fiscal deficit’. This is nothing but the difference between government’s income and expenditure; where the expenditure is more than income. It is always expressed as a percentage of GDP. ‘Fiscal Deficit’ is not bad provided the capital expenditure incurred is substantial as it expands the economy. Unfortunately our fiscal deficit is more due to revenue expenditure (salaries, subsidies etc.) and hence if it is not kept within the limit can be harmful.

As I said creativity can be perfectly legal too. For example, the generally accepted rule is that securities are always valued at MTM (Marked to Market) (i.e.) what they are worth in the market on a given date. You would be surprised to know that banks do not follow it. When they hold debt securities like bonds in balance sheet, when the interest rate rises, the value of the bonds would drop. This would reduce their net worth and affect the capital adequacy. Banks have to maintain a capital adequacy of atleast 9%. In other words, banks have to have as capital atleast 9% of their total lending. When capital adequacy gets affected, it would impact their business, credit rating, cost of rising further capital etc. Hence they are allowed to not to mark it to market. Of course, they have to hold these under a separate category called ‘hold to maturity’. What they keep in trading bucket has to and is necessarily marked to market.

I feel like writing more but realise that this piece has become longer than the usual long piece:-) 

Just a final word on creative accounting. When European Union was formed, lots of norms were laid on the fiscal and government balance sheet side to make them eligible for entry into the union. Unable to change itself, Greece found it easier to change its books:-) It was found out only much later. Can you label a country as rogue nation and bomb it because it cooked its books:-) 

Suddenly remember one of the topics given for discussion when we studied MBA-Finance in IFMR. Financial statements are like a bikini- What they reveal is interesting but what they conceal is vital:-) 

Since we started discussing about liquidity and strayed all over, we may look for a CRR cut or even a SLR cut to ease the liquidity pressure when RBI comes out with their policy on March 15th.

3 Responses to “You may want to know this”

  1. mangesh said

    another great article sir.
    I have never understood the consept of CRR, repo rate, reverse repo better than this.

    love to read more and more articles from you.

    god bless you.!

  2. Arul said

    Superb write up Muthu, thanks

  3. Ritesh Doshi said

    FYI – Repo rate is the rate at which banks borrow from RBI. It is 7.25%.

    Reverse repo is the rate at which banks lend to RBI. It is 6.25%.

    The difference will always be 1%.

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