How the banking system lost Rs 6,00,000 cr because of high real estate prices

Notes in circulation is a statistic released by the RBI every week. The notes in circulation is nothing but the rupee held as cash by the general public (individuals and institutions). The cash held by the general public stands at Rs 13.276 lakh crore as of 18 April 2014. In other words, Rs 13.276 lakh is out of the banking system and held in the form of cash.

The notes in circulation stood at Rs 7.04 lakh crore as of 17 April 2009 and this has gone up by Rs 6.236 lakh crore over the last five years. The leakage out of the banking system is Rs 6.236 lakh crore since April 2009.

The Rs 6.236 lakh crore of leakage out of the banking system is a big headache for the RBI. The banking system has been short of liquidity for the last four years and has been borrowing from the RBI on a daily basis to fund its daily liquidity requirements. Banks have been borrowing anywhere between Rs 50,000 crore to Rs 2 lakh crore on a daily basis over the last four years.

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A liquidity deficit in the banking system hits credit growth as banks have less funds to lend to the economy. It also hits the government’s borrowing programme as banks have less funds to invest in government bonds. The funds crunch will also increase the interest rates.

The RBI has been trying to ease the liquidity shortage by lowering CRR, buying bonds through open market operations (to infuse liquidity the RBI buys bonds through such OMOs) and by encouraging banks to garner FCNR B deposits. The RBI has reduced CRR by 2 percentage points from 6 percent to 4 percent, adding over Rs 1 lakh crore into the system. The RBI has bought bonds through OMOs for Rs 4.8 lakh crore over the last five years. The central bank also opened a swap window for FCNR B (foreign currency non-resident B) deposits for banks that garnered $34 billion, adding Rs 2 lakh crore into the system.

The RBI has injected Rs 7.8 lakh crore into the banking system through CRR, OMO and FCNR B swaps, apart from the daily injection of funds through repos, term repos and marginal standing facility (MSF) of any where between Rs 50,000 crore to Rs 2 lakh crore.

The MSF is the RBI window, where banks can access funds once they hit the limit from the daily repo window. The interest rate at the MSF window is 100 basis points higher than the repo rate. While daily repo is for one day, term repo auctions are conducted for seven and 14 days.

The heavy liquidity injection by the RBI is inflationary in nature as it is addition of primary liquidity into the system. OMOs are also seen as back door deficit financing by the RBI, which is again inflationary in nature. The CPI (consumer price inflation or retail inflation) has been averaging over 9 percent levels over the last five years largely due to government borrowing and spending.

The government’s stock of outstanding debt has gone by Rs 24 lakh crore over the last six years. The stock of debt has tripled since 2008-09.

The RBI needs to curb the money going out of the system as it leads to actions that have long-term negative repercussions as mentioned above.

Why is there such a high level of currency leakage?

Inflation is one big cause of currency leakage as rising prices of goods and services in an economy that is still largely cash driven leads to higher demand for holding cash.

The next big reason is the property bubble that has seen value of real estate rise multi-fold despite economic growth slowing down from levels of 8.4 percent seen in 2010-11 to below 5% levels as of 2013-14. The real estate sector is largely dominated by the politician-builder nexus that predominantly deal in black money. Money goes out of the banking system to the real estate sector and stays there as black money.

The RBI needs to control inflation and also keep the real estate market in check to stem the currency leakage from the system. Hopefully both inflation and property prices will cool down going forward as the RBI keeps policy on hold and prevent banks from excessive lending to the real estate sector.

Arjun Parthasarathy is the founder of Investors are Idiots.com and INRBONDS.com.