Governor's choice
Indian Express, 23 January 2008
RBI Governor D Subbarao will make his second credit policy announcement on Tuesday, January 27th. After a series of steps that helped greatly in easing the liquidity crunch that India faced from the middle of September, market expectations about RBI's actions have been largely met as RBI maintained adequate liquidity in the system. However, today with bank lending rate cuts not keeping pace with RBI rate cuts and credit not expanding as policy makers might have hoped, what should Guv Subbarao do? In addition to cutting rates further, he needs to initiate long pending reforms that would improve the monetary policy transmission mechanism.
The first question is, should RBI cut interest rates further? Today there is little disagreement that interest rates need to be lowered further. The real question is whether the RBI should cut rates now, or first wait for banks to reduce rates in reaction to RBI's earlier rate cuts. With the lastest price data suggesting that the fear of inflation has receded, the concern about a slowdown in growth of output outweighs worries about inflation. There is disagreement on the speed and magnitude of rate cuts. Advocates of gradualism believe that the RBI should wait and watch before easing monetary policy further, just in case inflationary pressures rise again. But in today's environment the best policy would be to immediately cut rates sharply.
First, the unfolding of the crisis warrants quick and decisive action. In the past we have seen that the deeper the crisis the longer it takes for the economy to recover. In other words, while we wait and watch and act upon actual data, the economy will continue to deteriorate at a rapid pace. This in turn will make the recovery period slower and longer. India has limited fiscal space and a slow and poor monetary policy transmission mechanism. A 100 basis point cut in the repo rate does not lead to a 100 basis point cut in lending rates immediately. That is why the need to a larger cut in policy rates.
Second, banks in India hold a large share of their assets, roughly one-third on average, in government bonds.( This often goes beyond the statutory requirement of holding one-fourth of their assets in government bonds. In developed countries this number varies from 0.25% to 5% of the total assets of commercial banks.) The impact of interest rates movements on bank balance sheet goes beyond the loan portfolio as banks choose between holding bonds and giving loans. At present the expectation that interest rates will fall further is creating a favourable environment for buying bonds. If interest rates fall further, the price of bonds will rise. This makes buying bonds a more attractive proposition than giving loans. However, if rates fell so low that the market believes that they can't fall any further, it would make goverment bonds less attractive. This calls for a "zero interest rate" policy. The rate does not actually have to be zero, it can be say, 1% for the reverse repo and 2% for the repo. What is imporant is that the market should believe that will cannot be reduced further.
In this uniquely Indian context the impact of expectations of a rate cut on the loans versus holding government securities by banks is illustrated by the experience of 2002 to 2004. At the beginning of 2002 banks held 28 percent of their total assets in government bonds. The repo rate was 10 percent. It was slowly cut to 6 percent over the next two years, until it plateaued. Throughout this period there were expectations that interest rates would be cut further. Over this period government bonds as a share of total bank assets rose to 46 percent. As banks were betting on interest rates going down further, they moved away from loans to buying government securities. This happened despite the fact the real economy was witnessing healthy growth and giving loans was not as risky as it may be today. Today with banks already scared to lend as companies may see trouble as the economy slows down, a policy of gradual interest rate cuts is fraught with the risk of worsening credit growth.
In addition to cutting the repo and reverse repo rates, the RBI needs to cut the Cash Reserve Ratio(CRR). Money kept in reserves is unrenumerative and raises the interest rate that needs to be paid by bank customers. The CRR should be brought down to 3 percent.
Even after taking these steps we may find that banks are still reluctant to reduce lending rates immediately. Given the existing liabilities in fixed deposits on which they will have to continue paying higher rates, it makes sense for them to postpone the decision to cut lending rates as much as possible. However, if banks were allowed to reduce the interest paid on savings deposit, the interest payment of a part of their liabilities could be reduced helping to push lending rates down. Today the RBI administers the interest rate of savings deposits. Making this a rate that each bank determines on its own for its depositors has been a long overdue reform. In the forthcoming credit policy the RBI should announce that it will no longer administer the savings deposit rate.
Though the competition from small savings does not constitute a good reason for banks not to cut deposit rates given the falling share of small savings as well as the growing importance of bulk deposits which do not go into small savings, this is also a good time for the goverment to review the policy of administered interest rates. If it is politically difficult to make the rate fully market determined, then as an intermediate step the rate could be benchmarked to market determined rate and be allowed to move with it.
Finally, bankers express the fear that the government's borrowing programme is going to push up interest rates and so they don't want to lend at lower rates and get locked in. With a slowdown looming large and an easy monetary policy, there is not much danger of a significant prolonged rise in interest rates. Regardless of that the government should take steps to reform the bond market. There is a long list of actions outlined in the Percy Mistry and Raghuram Rajan reports on action points on currency, derivatives and bond markets which need to be taken up to improve the transmission mechanism of monetary policy. The time to act on these is now.
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