Calling for more financial prudence from the centre and state governments, a Reserve Bank of India report says pressure to support India's economy and drive growth during the global turndown could impede efforts to put its fiscal house in order.
"Given the current pressures to maintain growth at a reasonably high level it would not be possible to resume the fiscal correction path after the current financial turmoil," the report on the country's financial sector, released on Monday, said. It added that once the current turmoil had passed, fiscal discipline would need to be reasserted to support growth.
"For the growth momentum to be sustained, it is necessary to return to the path of fiscal prudence by both the central and state governments," the report said. The federal government's finances have suffered in the 2008-09 fiscal year that ends Tuesday, after making solid gains over the past few years, as a slowing economy has hit revenues and increased spending.
The government expects the deficit to widen to six per cent of gross domestic product in 2008-09, more than double its initial estimate. The country's combined deficit, including state deficits and off-budget items such as fuel subsidy costs, is estimated by analysts at around 10 per cent of the GDP.
The six-volume report is a comprehensive review of the country's financial system. It was prepared by an RBI committee formed by the government and central bank in 2006, and was headed by Reserve Bank of India deputy governor Rakesh Mohan.
On a more positive note, the report says the Indian banking system can easily weather a doubling of bad loans or a sudden spike in interest rates that could send bond yields soaring. It also forecast economic growth of 8 per cent in the medium term, concluding that India's banking sector was an ''oasis of stability'' in a battered global financial sector.
The panel, which explored various so-called "stress test" scenarios, said most Indian banks had raised enough capital and could easily cope with a steep jump in bad loans. "Even in a worst-case scenario, capital remains comfortably above the regulatory minimum," it said.
The panel also suggested that the regulation of housing finance companies be transferred to the RBI, whose permission should be sought before any change in strategic shareholding.
The other stress test involved an interest-rate shock, and the committee noted that an overnight impact of a 244-basis point increase in bond yields resulted in an erosion of 19.5 per cent of a bank's capital and reserves.
"The capital-to-risk-weighted assets (CRAR) would reduce from 13 per cent to 10.9 per cent for a 244-basis point shock," it said, adding that only in case of 20 banks, which account for 36 per cent of total assets, would the CRAR slip below the regulatory 9 per cent.
The report, however, said the increased dependence by several banks on wholesale funds was a problem area, and suggested that these banks set aside additional capital if their dependence on borrowed funds does not decline.
Another cause of worry was the increase in the dependence on bulk deposits by some banks to fund credit growth. This could have liquidity and profitability implications, the report said. It suggested considering a specific regulatory capital charge if dependence on "purchased liquidity" exceeded a defined threshold.
The committee also noted that some public sector banks lacked the leeway to raise fresh equity capital, as they could breach their minimum prescribed government shareholding of 51 per cent, and suggested mergers between state-run banks as the way out.
"One option would be for the government to consider merging banks that are on the borderline of 51-per cent state ownership with banks where government holding is significantly higher," the report said.
Until now, consolidation activity in the state-run banking sector has typically involved RBI forcing weak private banks to merge with stronger banks.
The panel warned that this flexibility enjoyed by RBI to force such mergers could be lost under the new competition act, which requires a 210-day wait period before such mergers can be brought into effect.
A Goldman Sachs report, also released on Monday, says the central bank has some leeway in funding the government due to a buffer it has built up over the past several years, but this could get exhausted quite quickly.
"Our calculations show that the RBI (Reserve Bank of India) can fund about Rs150,000 crore ($30 billion) of the government's borrowing needs without creating a sizeable monetary overhang and stoking inflation," it said.
"However, given the size of the deficit, this would still require the market to absorb more government bonds than in FY07 and FY08. Further, this would leave the RBI with little space to finance the government beyond FY10. Therefore, we think long-term government bonds may remain under selling pressure," Goldman Sachs cautioned.
It noted that broad money supply growth rose to 19.7 per cent year-on-year March 13, from 19.6 per cent in the previous week, "due to increased lending to the government", even as growth in lending to the commercial sector and net foreign exchange assets continued to fall.
On the liability side, growth in base money has "fallen dramatically" to about four per cent March 20, from 28 per cent year-on-year a year earlier, Goldman Sachs said.
"The largest contributor to the decline is a fall in bank deposits at the RBI. Growth of currency in circulation has also declined somewhat from about 22 per cent year on year in end-October to 16.6 per cent in the latest reading."
Taking note of the RBI announcement last week that it would purchase Rs80,000 crore ($16 billion) in government bonds in the first half of 2009-10, it said: "Even with the additional headroom for the RBI, it leaves about Rs200,000 crore to be financed by the market, which is higher than the government's market borrowings in FY07 and FY08."
According to Goldman Sachs, if RBI chose to purchase more government securities to contain the increase in bond yields, it would either have to shrink credit to the private sector or prepare for a much higher reserve money growth target. "This would create a monetary overhang, and could spill over into inflation."
Meanwhile, a report by a US think-tank rates the RBI as the least transparent of central banks in South Asia. The study, 'Central bank transparency: causes, consequences and updates', by the National Bureau of Economic Research, or NBER, has given RBI a score of two, lower than that awarded to counterparts in Pakistan, Bangladesh, Bhutan and Sri Lanka.
A non-profit research organisation founded in 1920, NBER drew on information available on 100 central banks' websites, their annual reports and other documents between 1998 and 2006 to reach the conclusions.
The study said the most transparent central banks in 2006 were the Reserve Bank of New Zealand, Riksbank of Sweden, the Bank of England, the Bank of Canada, the Czech National Bank, the European Central Bank and the Hungarian Central Bank. The Reserve Bank of New Zealand scored 14 in transparency against the US Federal Reserve's 9.5.
The six least transparent banks were those of Aruba - an island in the Caribbean - Bermuda, Ethiopia, Libya, Saudi Arabia and Yemen. In South Asia, Bangladesh's central bank scored 3.5, Bhutan's three, Pakistan's four and Sri Lanka's seven in the NBER study, an update of a March 2007 report.
Worse still, while the transparency level in other countries, including those in South Asia, has increased over the years, that of RBI remained the same through 1998-2006.
The study's findings echo those in the Country Report on India published in February 2008 by the International Monetary Fund, which criticised RBI's lack of transparency. ''With regard to the timing of policy signals, the RBI's approach over the past year has been discretionary,'' the IMF study said.
IMF had criticised RBI's tendency to adjust interest rates between scheduled policy review meetings. It called for increasing the frequency of reviews with pre-announcements of review dates. ''Increasing the frequency of policy meetings would reduce the need for such inter-meeting measures, allowing the public to anticipate and prepare for a possible change in policy stance,'' IMF said.
RBI does not make public the minutes of its technical advisory committee meetings although its counterparts in other countries, including the Federal Reserve's monetary policy committee, publish such minutes.
Unlike other central bank that tend to focus on a single policy objective set by the government, RBI pursues multiple and broadly defined objectives including price stability, credit growth, overall growth and financial stability, yetserday's RBI report said. These objectives are transparently articulated over time, it added.