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India Inc's efficiency becomes bankers' headache

Tamal Bandyopadhyay | September 25, 2003

Three years ago, a mid-size company, located in a technology park in a southern city, raised a term loan from a public sector bank at 12.5 per cent.

Early this year, the company approached another public sector bank to take over the loan. The second bank was too happy to do that, offering 8.5 per cent interest rate.

But before the loan documents were completed, a third bank -- this time from the private sector -- stepped in and lowered the rate to 8.25 per cent.

Naturally, the second public sector bank, which had decided to take over the old loan, had no choice but to cut the rates to 8.25 per cent to match the competition.

Still, it did not manage to strike the deal. A day before the loan document was to be signed, the first bank -- the original lender -- agreed to lower the rate to 8.25 per cent.

This incident, as recounted by the chief executive officer of one of the three banks involved in the deal, highlights the increasing bargaining power of companies and the plight of the bankers.

When the corporations are not drinking old wine from a new bottle (read: enjoying the old facility from a new lender at a much cheaper cost) or new wine from an old bottle (that is, forcing the old lender to drastically lower the rates), they are slicing the long-term loan cake into small pieces of short-term corporate loans and rolling them over. The objective is to cut interest costs.

How is this done? A double-A-rated corporation had raised Rs 200 crore (Rs 2 billion) term-loan from a financial institution a couple of years ago.

Last year, it raised an equivalent amount of loan from a bank for one year at two-third of the original cost of raising money and pre-paid the term loan of the financial institution.

This year, it has raised one more one-year loan from another bank to repay the first bank. Through this loan shopping, the company has brought down the cost further. Bankers cannot do much except for watching the phenomenon and cursing competition.

A possible way of stopping this practice could be charging hefty penal interest for pre-payment. Life Insurance Corporation, which extends term loans to corporations, has started doing that.

If any outfit wants to pre-pay a term loan, LIC now calculates what would have been the interest earning had the loan been there for its full tenure.

Then it works out the net present value of the interest and asks the borrower to pay 50 per cent of it if it wants to pre-pay the facility.

Unless a borrower is sure of getting huge benefits by drastically reducing the interest cost, it will not pre-pay the loan under such conditionalities.

But what LIC can do, all banks cannot as they care for relationships with borrowers that provide them with fee-based businesses like cash management, letters of credit, guarantees and so on.

So, what do the bankers do? Typically, a bank chief's day starts with the investment committee meeting where the liquidity situation and possible avenues for deploying the surplus funds are routinely discussed.

At least, some of the banks have their management information system in place and the CEOs in the beginning of each day know how many hundred or thousand crore of rupees are in the chest earning nothing as there is no corporate borrower in sight.

In the absence of borrowers, the surplus money flows into the overnight interbank market (interest rate 4.25 to 5 per cent), Reserve Bank of India's repurchase window (4.5 per cent), interbank term money market (5 to 5.25 per cent), commercial papers (around 5 per cent for top customers), treasury bills (less than 5 per cent), corporate bonds (a shed over 5 per cent for strong companies) and government securities (5.3 per cent for 10-year paper).

Once in a while, the state-run oil companies knock the bank doors for short-term loans to take care of their temporary cash flow mismatches. Even there, banks fight for every basis point of interest as the competition is fierce.

Since the deposit rates are crashing, the incremental cost of funds for most of the banks is less than 5 per cent.

But once the establishment cost is added to this, the return from most of these assets are less than the cost of banks' liabilities. Still they are deploying funds in these avenues as idle money has its holding cost.

In the first five months of 2003-04 (till September 5), the overall bank credit has increased by only Rs 3,689 crore (Rs 36.89 billion) or 0.5 per cent in contrast to Rs 68,271 crore (Rs 682.71 billion) in April-August last year.

Frankly, the figures are not strictly comparable as the last year's credit growth included the loan book of the former ICICI, the financial institution, which got merged with the ICICI Bank.

On a year-on-year basis, the credit growth is to the tune of Rs 74,911 crore (Rs 749.11 billion), down from Rs 1,30,206 crore (Rs 1,302.06 billion) last year.

Does that mean that all talks about the economy looking up are baseless? Is India's growth story, echoed at every possible business fora, mere hype? Possibly not.

One of the reasons for the lack of credit offtake is the increasing efficiency of the Indian corporations. There is no demand for bank funds because a large part of India Inc does not require working-capital any more.

The Centre for Monitoring Indian Economy data shows that the working-capital cycle of manufacturing companies had drastically fell from 60 days to 21 days over the last decade between 1990-91 and 2000-01.

In 2001-02, the cycle further fell to 14 days and it became negative in 2002-03. A company reaches a negative working-capital cycle when it uses the suppliers' credit or the customers' advance payments to fund daily operations. Consequently, its dependence on bank finance for operations comes down.

Shorn of technicalities, a negative working-capital cycle simply reflects the reality that companies do not need funds to meet their operational needs because they have become more efficient.

The increasing efficiency is the result of manufacturing companies' new-found focus on supply-chain management. They are using suppliers' credit or customer prepayments efficiently and cutting down the inventories.

There is a clear link between the working-capital cycle of manufacturing companies and the banks' relentless chase of government securities.

As the working-capital cycle from most of the companies reduce, banks' investment in government papers increase.

In 2002-03, banks had invested Rs 1,04,775 crore (Rs 1,047.75 billion) in government securities. This was 50 per cent higher than their gilts investments in the previous year (Rs 67,832 crore (Rs 678.32 billion).

In the first five months of the financial year, the gilts portfolio of all scheduled commercial banks has swelled by Rs 81,563 crore (Rs 815.63 billion).

The picture becomes clearer when one looks at the outstanding gilts portfolio and the loan book of the banking sector.

The outstanding government securities portfolio of the industry is Rs 6,01,705 crore (Rs 6,017.05 billion) while outstanding non-food credit book is Rs 6,91,298 crore (Rs 6,912.98 billion). In other words, the size of banks' advance book is hardly 15 per cent fatter than their gilts portfolio!

RBI norms require banks to park 25 per cent of their net demand and time liabilities in gilts. However, most banks have parked over 40 per cent of their net demand and time liabilities in government papers as there is no demand for credit.

The trend will continue as corporations are turning more aggressive in managing their treasury and working-capital cycle.

Growth in retail loans alone cannot prop up the credit offtake of the banking industry. Credit can only swell if corporations are ready to make fresh capital investments for capacity expansion or setting up new units.

But as and when that happens, banks will not only be fighting with their peers to get a slice of the new business but also with the market as strong companies can directly raise resources from the market at a cheaper rate.

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