The best option today for conserving capital would be cash.
We have seen the equity market going into free-fall, liquidity drying up, industry and investors losing confidence in the financial stability of the Indian and global markets. The Indian financial system is on the sick-list, and doesn’t seem to be getting better.

We examine here some capital-conserving options available for the cautious.

The RBI and SLR, CRR levels

The Reserve Bank of India (RBI) has instituted a few measures measures to try and stimulate the financial system. Two of these are significant.

Last month the RBI reduced the Statutory Liquidity Ratio (SLR) level of Banks to 24% from 25%, and from October 11 the Cash Reserve Ratio (CRR) is to be reduced from 9% to 8.5%.

These terms are meaningful for understanding what implication these have for the economy. The SLR is the minimum level of the total deposits that the banks need to put into government securities. The CRR is the amount of cash the bank needs to keep with the RBI as a percentage of total deposits.

What is liquidity and why is it drying up?

‘Liquidity’ in the banking system means how much money is being made available for interbank lending on a short term–overnight or one week basis. This is the ‘call rate’. In early September, this interbank lending call rate was around 6-8% (on a yearly basis), and then by end of September it was around 16%.

For some reason the RBI interpreted this as a shortage of available cash with banks to lend. The reality is that banks were afraid of lending to foreign banks particularly those who are seen to have an over-exposure to bad credit risks such as the US housing market. This has spread to Indian banks as well as they are not sure of the risks these banks have exposed themselves to.

Last week ICICI bank chief K.V. Kamath had to go on TV to assert that his bank was liquid and had no problems in payouts. This was in response to rumors that ICICI Bank was in deep financial trouble due to its exposure in the US housing loan market and possible massive defaults in its 2-wheeler and other loan segments.

This did not restore confidence to stock-holders of ICICI Bank, and it’s shares plumetted on the stock markets. Finally the Finance Minister had to bail out ICICI by appearing on a televised interview giving the bank a clean chit. Only then did the stock revive somewhat.

The SLR and CRR reduction
In response to the apparant lack of liquidity, the RBI had reduced the SLR by 1% point to 24%. This would have made available 40,000 crores for the banking system. So what happened? The call rate dropped from 16-17%% to only 15% after this massive injection. The patient is indeed very sick!

Today, CNBC-TV18’s Latha Venkataraman reported that this call rate had reached around 30% on an annualized basis. In response to this the RBI has reduced the CRR to 8.5% from 9%. This is supposed to inject 20,000 crores into the financial system. I doubt very much that this will do much good.

• All it means is that banks are holding onto their cash wihtout lending to other banks. The extra liquidity available from Banks’ own RBI deposits will help them to honor their lending commitments to corporates and industrial borrowers. In effect, the banks are ‘borrowing back’ their own money from the RBI. This may be a temporary measure.

Market Mayhem!
As I write this, I am watching an interview with Mr. Deepak Parekh, Chairman of HDFC who said that not even 100 crores could be borrowed from any bank. The Indian Sensex is down to 11,800–a 40% drop in a year. There is breaking news that the US Dow Jones Industrial index has dropped below 10,000 for the first time since October 2004. Global and Indian stock markets are in a free-fall.

What does an investor do now?

The best place to be today with money available to invest would be in cash, and not necessarily in banks. The banks are short on liquidity for various reasons and mainly the fact that (technically) if more than 8.5% of depositors ask for their money back–the bank will have no money to pay–Unless the bank is keeping a little more than that on call.

And as we we just saw, the banks seem to be fully loaned out and are unable to meet their pre-approved loan requirements as they cannot get more money from anywhere.

If we factor in the 12% inflation running in the Indian economy, even if there is a 8-12% return on the conservative investments, there is a loss after taxes. However, this is better than a total disaster or wipe-out of assets. The same issue has been dealt with in a previous newsletter Preserve and protect what you have (opens new window).

• Keep cash or invest in Government securities.
• Your cash deposits in any bank up to one lakh rupees are insured in case the bank fails. If you have more than one lakh on deposit you may consider opening accounts in other banks. (Also use these Wealth attracting methods (opens new window).

Investing in Gilt Debt mutual funds gives a better tax break than bank deposits, but again return is not fixed–but it is considered to be of the highest safety level.

• You could invest in Debt mutual funds that invest in government securities, treasury bills and securitized debt where the mutual fund would be as risk-free as possible. I have identified 3 funds that may be suitable for such investment. These are listed below with their Valuresearchonline.com star rating. (Links open in new windows.)