Run up to the credit policy
Business Standard, October 17, 2002
The RBI would do well to deregulate the savings rate and cut the CRR further in the credit policy
The credit policy for the second half of 2002-03 will soon be announced. There seems to be less of a searchlight on the credit policy than has been the case in the past.
In the run-up to this credit policy, conspicuous by its absence is the usual clamour for a reduction in interest rates. Today “tight money” is no longer seen as a serious bottleneck. The year saw interest rates decline by nearly 3 percentage points.
While this helped reduce costs for firms, credit off-take remained slow. It is likely that now, even if the bank rate is cut, it will not have a big impact in terms of the lowering of lending rates or the off-take of credit.
There has been some modest acceleration in inflation in recent months. However, broadly speaking, since the loosening of monetary policy has not resulted in building up of inflationary pressures, there is no good rationale for not reducing rates further.
The problem facing central bankers today, including the RBI, is that the construct of the “Barro-Gordon game” which assumed that there was a trade-off between inflation and growth no longer appears to be in force. Growth could be raised by easing monetary policy and causing unanticipated inflation.
Conservative central banks who put a large weight on controlling inflation would thus not follow a loose monetary policy. This was evident in India in the mid-nineties when controlling inflation was the “dharma” of RBI’s policy. Its tight money policy was, to a large extent, responsible for pushing down the industrial growth in India after 1996.
Central bankers trained in the tradition of forming monetary policy in a framework based on this trade-off are, not surprisingly, a little lost. No standard models are available for monetary stances in an environment where lowering interest rates does not raise growth.
The problem was supposed to be that it would come at a cost — higher inflation. Recent Japanese and US experience with low interest rates, low inflation and low growth rate have shaken the foundations of the theoretical construct of monetary policy formation.
Indian experience with interest rates was fairly dramatic from 1992 till 1998. In the mid 1990s, interest rates rose by 400 bps, and then fell equally. As recently as early 1998, interest rates rose by as much as 200 bps in one single day. These large movements may have been related to the adjustments required in the economy in the aftermath of liberalisation.
From mid 1998 onwards, this volatility seems to have died down. We seem to now be in a phase of the business cycle where inflation and real interest rates hover between 2 per cent and 4 per cent. In such a phase, credit policy announcements cannot be particularly exciting or effective.
One question that Dr Jalan faces today is should he cut the bank rate any further. Even if there is a case for reducing lending rates, simply because it can do little harm as the threat of inflation remains low, the answer depends on whether cutting the bank rate can indeed lead to a significant reduction in lending rates. In the current situation it does not seem that it will.
With banks being able to lend at below PLR rates and investing more than the statutorily required amounts in government securities, banks are still flush with funds. Further, as Tamal Bandopadhyay argued (‘Cheap Money for Whom’, Business Standard, October 10) banks lend to priority sector borrowers at PLR rates and these small borrowers are effectively subsidising the large corporates. Any further cuts in PLR rates would squeeze the margins of banks.
That is why the effectiveness of the bank rate as a signal to banks to lower PLR has become less effective. Even when the RBI cuts the bank rate, banks do not move in to cut the PLR.
The reason for this lies in both the low flexibility available for reducing margins and for the remaining interest rate rigidities in the system. While the former is more true for public sector banks, the latter handicaps banks across the spectrum.
One of the major sources of interest rate rigidities in the system remains the savings deposit rate which continues to be administered by the RBI. In a period when RBI policy aims at making interest rates market determined, increase competition and productivity in banks and improve credit off-take, it is time that the RBI allows the savings deposit rate to be market determined as well.
The last time the savings deposit rate was changed was in April 2000. It was reduced from 4.5 per cent to 4 per cent. Since then, lending rates have declined sharply but the savings deposit rate has remained unchanged.
The RBI has argued that since interest is not paid on the balance held over the full month, the effective rate is 3.4 rather than 4 and so the rate has not been revised. The key point, however, is not that the rate should be cut, but that it should be deregulated.
This is, however, only a way in which the RBI can help improve the functioning of the market. The impact on lending rates and credit off-take may still be very limited. The same is true for the impact of a Cash Reserve Ratio (CRR) rate cut. As part of its reform process to reduce financial repression, the RBI plans to reduce the CRR to 3 per cent over the next couple of years.
As part of this agenda the RBI could cut the CRR further in the current policy. A reduction in CRR would release liquidity in the system. But since liquidity and credit is not the constraining factor, easing this constraint is unlikely to reduce rates much further or to increase the off-take of credit.
Nonetheless, Dr Jalan should deregulate the savings rate and cut the CRR. The necessity to do so arises from the need to reduce distortions in the market. Indeed, since the danger of inflation is low, the RBI should use this opportunity to announce those policy changes that it was holding back due to the fear of price rise.