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India Today, May 3, 1999
May 3, 1999

KAUTILYA
RBI Signals its Intentions

The central bank's bi-annual credit policy is more than a ritual.

By Jairam Ramesh

Amid all the political shenanigans last week, that citadel of continuity and stability, the rbi, announced the credit policy for the first half of 1999-2000. This is a bi-annual event that takes place every mid-April and mid-October. Till 1997, mid-April was billed as the slack season policy and mid-October as the busy season policy. This slack/busy distinction reflected the crop cycle of cotton, sugarcane and other farm commodities and was a throwback to the times when the bulk of bank lending was for agricultural trade.

Since 1997, however, the intellectual justification for this half-yearly event has changed. The budget is usually presented by the end of February. March is the busiest financial month and the nation's books close on March 31. The mid-April monetary policy takes into account budget expectations and the performance in the previous year. The mid-October announcement is a mid-term review of sorts after 75-80 per cent of the government's borrowing programme gets completed and the commercial sector's appetite for credit picks up.

If inflation is raging, credit policy tries to arrest the growth of money supply and in normal times, it seeks to expand the availability of credit for business and trade. The two main instruments it uses are the statutory liquidity ratio (SLR) and the cash reserve ratio (CRR). The SLR stipulates the amount that banks have to invest in the securities that the government issues to raise money to meet its expenditures. The CRR stipulates the amount banks must park with the RBI.

Before the 1991 reforms, 40 per cent of the increase in a bank's deposits was pre-empted by the SLR and another 25 per cent by the CRR. Since then, however, the SLR has declined to 25 per cent and last week the RBI reduced the CRR from 10.5 to 10 per cent. Thus the government's pre-emption of incremental deposits, that is, the yearly increase on deposits, has reduced from 65 per cent to 35 per cent in seven years.

Herein lies the significance of the fiscal deficit. Simply put, lesser the fiscal deficit lower will be the pre-emption of bank deposits by a profligate government -- leaving more resources to be made available for lending by banks to agriculture, trade and industry.

The RBI influences credit availability. It cannot by itself do much about credit delivery, which is the bottleneck today. The choke in the credit delivery system can be gauged from the fact that banks are holding over Rs 56,000 crore in government securities over and above the rbi stipulated level.

Sometimes, a credit policy that appears routine may actually be the harbinger of a paradigm shift. For instance, the October 1998 credit policy stipulated new norms for capital adequacy for banks. To meet these norms, over the next two years the public-sector banks have to mobilise around Rs 26,000 crore of fresh capital, assuming 75 per cent of the non-performing loans are written off. Recap money can no longer come from the government's budget which, over the past six years, has already provided Rs 20,000 crore for recapitalisation. This money will have to be raised from the market. But as long as the government retains over 50 per cent equity, these public issues will not command the needed premia. This makes the privatisation of banks a financial imperative.

Last week's policy disappointed industry since it did not herald a cut in interest rates. But there is more to private investment than interest rates. In 1992-96, interest rates were high but private investment zoomed. In 1996-98, interest rates declined but private investment was stagnant, showing the "demand" factor's importance.

But can interest rates be "cut" by the RBI when they are mostly deregulated? The rbi controls only the interest rate on savings deposits, on loans up to Rs 25,000 and on export credit. Interest-rate controls now apply to just 20 per cent of the commercial portfolio of banks. The only instrument the RBI has is its own reference bank rate -- the rate that it charges the banks for loans. But this is really a signalling device. This explains last week's focus on the "transmission mechanism", so the preference for lower interest rates is actually translated into practice by banks.

The most masterly exposition on the complex issue of interest rates has been by Y.V. Reddy, the erudite deputy governor of the rbi, in the July 1998 rbi Bulletin. He identifies five factors that cause an upward pressure on real interest rates.

the high levels of government borrowing, especially the persisting revenue deficits.
the stickiness of spread between the deposit rate and the lending rate of banks brought about mainly on account of government ownership.
the interest tax that the Centre imposes on banks, which is passed on to customers
the high effective rate of return offered on small savings, relief bonds and provident funds
the lack of depth and efficiency in the government securities and money markets Reddy's most fundamental point is that as long as expectations of inflation do not fall -- and they have not -- real interest rates will continue to be high, even though inflation may itself decline.

The author is secretary of the AICC's Economic Affairs Department.
The views expressed here are his own.

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