The coming budget session could well see an amendment to the section 20(f) of the Indian Trust Act, 1882 (called Trust Act hereafter) with the objective of providing greater options for registered trusts (called trusts hereafter) to invest their funds. Section 20 of the Trust Act deals with the approved investment avenues for trusts to invest their funds. Subsection (f) of this section provides that registered trusts may invest in securities notified by the Central government. The proposed amendment plans to broaden the scope of this subsection by allowing trusts to invest in shares, bonds and debentures as well as other marketable securities and securities expressly provided for in the instrument of trust.
The amendment is welcome change for trusts as trusts were primarily allowed to park their funds in GOI securities and to some extent in units of the UTI and deposits with the banking system. Trusts claiming exemption under section 10(23C) of the Income Tax Act are required to invest 85 per cent of the funds received annually in the assets notified under section 20 of the Trusts Act. The proposed amendment to the Trusts Act is seen by various journalistic accounts to release quite a few thousand of crores of trust funds for channeling into the capital markets primarily by these trusts shifting out of bank deposits and into these freshly approved capital market securities. This would be expected to push the booming stock prices even further higher.
The negative impact of this amendment on demand for government securities and hence the yields on the same are expected to be insignificant. There is another channel, through which there could be serious repercussions on both the government securities markets and the equity markets as a consequence of this amendment. Statutory Liquidity Ratio (SLR) requirements by banks could well end up being the culprit in this case. SLR requirements have been in place for the banking system since the 1950'swith the primary objective of providing a captive demand for government securities so as to enable the government to meet its plan financing requirements. SLR requirements for banks are laid down in section 24 of the Banking Regulation Act, 1949 which requires banks to maintain 25 per cent of their net demand and time liabilities in cash, gold or other unencumbered approved securities. Approved securities for this purpose are defined by section 5(a) of the Banking Regulation Act to mean securities approved for investment by trusts under the various subsections of section 20 of the Trusts Act.
Hitherto, section 20 of the Trust Act effectively restricted the portfolio choices of trusts primarily to government securities and earlier securities of some PSU'sand the Development Financial Institutions. However, easier access to refinance from the RBI against government securities resulted in the same becoming a large and preferred component of SLR investments of banks. The proposed amendment to the Trusts Act going through without corresponding changes in the Banking Regulation Act has serious negative potential for the government securities markets. As per figures in the December 2007 bulletin of the RBI, the total investment in government securities by all Scheduled Commercial Banks (SCB?s) on the last reporting Friday of October 2007 stood at around Rs. 9.3 lakh crores, a good part of which goes towards meeting the SLR requirements of banks.
Banks would now have the additional option of investing in shares, bonds debentures and other marketable securities of listed companies. There are also signs that banks would be happily willing to exercise this option if made available to them. During 2003-07 the average government securities holdings in the portfolios of banks has been growing at around 12 per cent, much lesser than the growth rare to total assets which has been around 23 per cent on an average (Source: CMIE). Banks investments in marketable securities have grown at a much faster rate of around 32 per cent during the same period which is suggestive of their appetite for these securities.
If the option to invest in these marketable securities is exercised, one might well see a movement in bank investment portfolios out of government securities and into these securities on account of the higher returns on the same. The flow of funds from this avenue towards the capital markets would well-nigh exceed the funds released by trusts for the purpose in multiples from the current portfolio of government securities not to mention the future SLR requirements consequent to increases in bank deposits. This could well result in difficulties to the government in meeting its borrowing requirements at relatively low costs which is now possible due to the compulsion to hold government securities for SLR requirements. One might well see a rise in the cost of government borrowing in this scenario. With government securities comprising the risk free portion of the term structure of interest rates, this is likely to result in a general increase in interest rates with its consequent negative impact on economic activity.
The other issue at stake is the conduct of monetary policy by the RBI. Repos are the primary instrument of adjusting liquidity in the system and maintaining interest rates at desired levels around the Bank Rate. Government securities being ?risk-free? and having highly liquid markets are the preferred asset for such repo transactions. Though the RBI is permitted by section 17 of the Reserve Bank of India Act, 1949 to use other securities for conduct of monetary policy, the lower liquidity of markets for such securities and the existing stock of government securities in the RBI'sportfolio made government securities the preferred choice of asset for carrying out repo transactions. Experiences of developed country monetary policy, though, do not seem to suggest a requirement for SLR-type requirements for effectively carrying out open market operations. All that is needed is a demand by the banking sector for the securities offered for repo transactions.
The RBI and the Ministry of Finance should take these considerations into account and accordingly plan for changes to the SLR qualified investments by banks.
(The author is a research student in economics at Indian Institute of Management Calcutta and can be contacted at [email protected])
