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Suresh Krishnamurthy

Regulation is forcing debt investors to depend more and more on the government, banks and mutual funds. The proposed phase-out of NBFC deposits will only exacerbate the situation. Declining liquidity would, however, counteract these measures and could offer a better deal for investors.

INTERMEDIATION. That is what banks do. They intermediate between savers and borrowers. Disintermediation happens when savers interact directly with borrowers. Mutual funds are a source of disintermediation.

Both the primary source of intermediation and disintermediation is not serving investors well. They operate so inefficiently that the costs bring down returns to savers substantially.

One lucrative source of intermediation — bond offers by ICICI, IDBI or IFCI — is now almost extinct. There have been none so far this financial year. On the other side, a source of disintermediation — fixed deposits of companies — has also dwindled in importance. Now, the Reserve Bank of India wants NBFCs to phase out their accepting of fixed deposits.

In the complete absence of a vibrant corporate debt market or a municipal debt market, this will throw the hapless savers to the mercy of banks and asset management companies. This will only force more and more to seek out government savings schemes, leading to increased borrowing costs for the government as well as explosion in the size of government debt.

Hopefully, the draining of liquidity in the system will come to the rescue of savers and allow the emergence of a number of lucrative investment options.

Handicapped savers: The year 1996 can be considered one of the brighter periods for investors in debt products. That year saw many manufacturing companies tap retail funds alongside many banking and finance companies.

Companies such as Tata Steel and Larsen & Toubro made high profile visits to the debt market.

Rational investors are unlikely to yearn for the interest rates that these firms offered. They offered 15 per cent plus. They are however likely to take the opportunity to invest in them directly.

The inability to invest in these companies directly is costing retail investors dear. Consider this. Yields of 10-year government securities have risen about two percentage points, or by about 40 per cent, in 2004. Interest rates on bank term deposits, in contrast, have not budged an inch.

Some proactive banks are talking about increasing the rates on term deposits. They are generously talking of a 0.25 percentage point increase.

So, can mutual funds help? They can. They do deploy funds at better rates and earn better returns. That is, however, before costs. They charge a hefty rate of about 1.5 percentage points, which reduces the returns substantially.

In this background, RBI wants non-banking finance companies to phase out acceptance of deposits. NBFCs are now not a major avenue for investment. About 800 NBFCs held close to Rs 5,000 crore of deposits at the end of March 2003.

Fixed deposits are also not the primary source of finance for NBFCs. In well-run NBFCs, they form only about 20 per cent of the total funds mobilised.

The prospects for non-banking finance companies are, however, looking up. They could emerge as a major avenue for investment that offers better returns to investors. That opportunity could now be lost.

Hopes hinge on liquidity: One of the major explanations for the predicament that savers find themselves in now is the abundance of liquidity in the system.

At one time, banks had about Rs 50,000 crore in the system that could not be deployed effectively. The excess liquidity forced banks to peg the rates on term deposits at low levels.

The corporate sector also found it easy to borrow from banks at exceptionally attractive terms. Even firms such as ICICI, IDBI and several non-banking finance companies relied less on retail funds as cheaper sources of finance through term deposits, banks and mutual funds became available.

Investors thus had no option - they had to either invest in term deposits or government savings schemes. Inflows into both have risen spectacularly in the past three years.

Thankfully, liquidity in the system is now slowly draining, though it is still at a comfortable level. One more year of excess liquidity and the difference in rates between a ten-year term deposit and the savings bank rate could have come down to 0.50 percentage points.

If liquidity in the system drains further, as is likely to happen if industrial growth is sustained, then a higher degree of disintermediation will set in. Investors will then have the option of investing directly in some rewarding debt investments. Until such time, post-office is the only place to go.

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