The Reserve Bank governor has presented the credit and monetary policy for 2001-02. The focus of the policy, as expected, is to strengthen the banking and financial system. The policy announcement has come at a time when many blame the RBI for the banking and financial sector crisis that has emerged in recent weeks. Accordingly, the governor has taken note of the serious lacunae that have emerged in certain segments of the financial system and attempted to address them. Taking into account the recent experiences of banks in capital markets, guidelines were recently issued by the SEBI and RBI to reduce exposure of banks, especially small banks, to the stock market by limiting advances against shares to a few broking entities.

Dr. Bimal Jalan's time as Governor has been marked by consciously making the credit policy a non-event in terms of the monetary policy stance. It has been done in an effort to make monetary policy more flexible so that it can respond to the needs of the economy as and when they arise, rather than at specific points of time. Earlier interest rate and CRR (cash reserve ratio) changes used to be made at the time of the policy announcement in April and its mid-year review in October.

Both last year and this year interest rate changes preceded the policy announcement. In fact, the bank rate and CRR were lowered in February and the bank rate again in March responding to the slowing down in industry, the cut in US Fed rates and the proposed reduction in the PPF rate.

In the policy announcement for 2001-02, the Guv has not cut the rate further but said that he would "explore the possibility of further softening in medium and long run rates". One of the reasons it did not make a lot of sense for the RBI to cut the bank rate further is that for a rate cut to be effective, commercial banks must cut their lending rates. But reducing lending rates without cutting deposit rates is not very feasible for banks. Their intermediation costs continue to be very high. And cutting deposit rates might have made bank deposits relatively less attractive.

The way to introduce flexibility in the structure of interest rates is if intermediation costs can be cut. Towards this end the statement stresses that the financial system should improve its operational efficiency. The experience of new private banks shows that the governor has a valid point in believing that this is possible.

Because, 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. One of the reasons for this is that while public sector banks like the State Bank group had a wage bill (as a per cent of total assets) of 1.76 per cent in 1999-2000, new Indian private sector banks had a wage bill of merely 0.28 per cent of their gross assets.

The policy, however, warns that "banks and financial institutions should be prepared for a reversal or tightening in case of unfavourable and unexpected developments". In other words, they are being warned not to lock their lending at lower rates. Let us see under what circumstances this can happen.

Interestingly, last year's policy announcement also contained exactly the same warning. The bank rate had been cut by 1 per cent, from 8 per cent to 7 per cent, and then in July the rupee came under pressure. Immediately the RBI responded by raising the bank rate again to 8 per cent.

This year also the bank rate has been cut from 8 per cent to 7 per cent. and the RBI has warned that this may be reversed. In general, the relevant unfavourable circumstances could by a much higher inflation rate or pressure on the rupee. The first is less likely. One, because the RBI will look at the "core inflation" rate rather than the headline inflation rate. This means it will look at price inflation in items other than food and fuel. So even if world oil prices increase or power sector reforms push up electricity prices, or a drought raises food prices, the core inflation rate is likely to remain low and may not be the reason for a tightening of money supply. Two, international commodity price inflation is low. And since India is now a relatively open economy low inflation in international markets is likely to keep prices in India low as well.

Pressure on the rupee is thus a more likely reason for the interest rate cut to be reversed. Even though it would be in the interests of the economy to have a depreciated rupee especially when the slowing of world trade may also slow down Indian exports, the strength of the rupee is almost a fetish. And, if there is pressure on the rupee do not be too surprised if the RBI steps in to counter it, raises rates again forgetting why it had lowered them in the first place. After all, it has happened before, hasn't it?