The Monetary and Credit Policy for 2001-02 will be announced next week. Since February the bank rate has been reduced from 8 per cent to 7 per cent. This is similar to the situation last year. But the similarity ends here.

This year’s macro outlook is in sharp contrast to last year’s. The 2000-01 credit policy was formulated against the backdrop of a favourable macroeconomic environment. Now growth is slower, inflation is higher, and crisis after crisis has hit the country, especially the financial sector.

The objective of last year’s monetary policy was to accommodate the credit needs of what was expected to be healthy growth in manufacturing. Interest rate cuts and liquidity expansion were expected to ease credit.

However, the rate cuts were reversed in July in response to pressure on the rupee. Higher interest rates, high oil prices, and a slowdown in industry characterised the economy. Growth expectations were belied.

In April 2000-01, the RBI had projected a GDP growth rate of 6.5 - 7.0 per cent. As growth slowed down, the RBI reduced its growth projections. By the time of the mid year review of the credit policy in October, the RBI was projecting GDP growth to be 6-6.5 per cent.

Faced with prospects of slow growth, a lower core inflation rate (even though headline inflation is higher), cuts in US Fed rates, and a generally stable rupee to set the stage, there were no great policy dilemmas. Cutting interest rates was the obvious step.

February saw a reduction in the bank rate and the CRR by 0.5 percent. The budget cut interest rates on small saving rates by 1-1.5 per cent. March saw a further cut in the bank rate of 0.5 per cent. The cuts led to a general lowering of interest rates in the economy.

In the face of the sharp deceleration in industry, low investment and the slowdown in the US that may hit Indian exports, the outlook for 2001-02 can only be lower. The question now is: should the bank rate be lowered further?

The reasons for cutting the rate further remain the same as they were in February. Essentially, reducing interest costs for corporates and making consumer credit cheaper to push aggregate demand.

Also, inflationary pressures continue to be low, the rupee remains generally stable and Fed rates are still on their downward journey.

But then everything is not the same as they were in February or early March. The stock market has seen a major crisis that has shaken the confidence of small investors completely. Sops that the finance minister might have offered in the budget have been long forgotten.

Regardless of what steps are taken, for the market to entice small investors this year will be very difficult, if not impossible.

With small savings less attractive and with the stock market down, can the economy afford to make bank deposits also less attractive? Would the general decline in the attractiveness of financial assets not turn households away from financial savings?

Indeed, it can. And that gives us one very good reason not to cut the bank rate further. Because when the RBI cuts the bank rate, for the cut to impact the economy, commercial banks must cut their lending rates. But reducing lending rates without cutting deposit rates is not very feasible for banks. Their intermediation costs are simply too huge.

Any move towards lower lending rates can, in the short run, come about only through cuts in deposit rates. But it is important that post tax real returns on bank deposits remains positive. Especially after the scams in the financial markets when the small investor can no longer look towards the stock market for getting higher returns.

Corporates have already been given sops in the form of cuts in interest rates just last month and removal of the surcharge on corporate tax.

Not only will cutting interest rates further reduce household wealth and incomes, especially of vulnerable social groups like the retired who have already been hit by the cuts last month, it will encourage a diversion of household savings from financial assets to physical assets. And, with the tax deduction limit on interest income being reduced to Rs 2,500 from Rs 10,000 this is even more probable.

The strategy for bringing about softer and more flexible rates needs to be more medium term. The only way to reduce lending rates any further without lowering deposit rates is to reduce banks’ interest spreads, or net interest income . While this cannot be done overnight it can, nevertheless, be done.

This is illustrated by the fact that while the SBI and its associate banks have a spread of 2.76 as a percentage of gross assets, new Indian private sector banks have a spread of only 1.87.

Because of high operating expenses the SBI group that accounted for over 30 per cent of the total assets of scheduled commercial banks, was unable to offer loans at lower lending rates. But if new private banks can have lower spreads, then it shows that it is possible under Indian conditions.

One of the issues that nationalised banks clearly need to address is that of their high wage bill. The State Bank group for instance had a wage bill (as a per cent of total assets) of 1.76 per cent in 1999-2000, compared to that of 0.28 per cent of the new Indian private sector banks.

But, the solution to the problem, which was to offer voluntary retirement to its staff, has, if anything, aggravated the problem in the short run. This is because the scheme placed huge immediate costs on the banking sector.

Though the exact figures are not yet available, an approximation can be made. About a total 1,00,000 employees have given voluntary retirement compensation at the rate of Rs 5,00,000 each. This has placed an approximate burden of Rs 5,000 crore on the banking sector. It has further reduced banks’ room for manoeuvre as far as quick rate cuts are concerned.

The credit policy must thus take a medium term view and focus on measures to improve efficiency and profitability of banks to make the interest rate regime more flexible.

In the meanwhile, the government can do its bit because the main macroeconomic constraint to softer interest rates is the size of the fiscal deficit. The size of the borrowing programme of the central government remains high. In 2000-01 the central government borrowed Rs 1,11,972 crore. In 2001-02 it proposes to borrow a larger sum of Rs 1,16,314 crore.

As long as the fiscal deficit remains high, the government siphons off a huge volume of financial resources available within the system and keeps the pressure on demand for funds high.

This, along with high banks’s preads, are the real villains. It is they who need to be fixed.