Will the pick-up in credit take place? It seems unlikely, given the policy environment

A month after the mid-year credit and monetary policy was announced by the RBI, it appears more than ever that the policy was designed to fail. It is not surprising that despite the Rs 6,000 crore already released into the system, there is no sign of a pick-up in credit.

Though the policy included both a cut in the bank rate and CRR, it was the large CRR cut that allowed the RBI to counter criticism that it was doing nothing to push growth. Had it not been for such a big cut in the CRR, it might have been expected to cut the bank rate by a greater degree, instead of the mere 0.5 per cent.

In other words, the RBI cut the CRR by two percentage points, higher than most expected, to appear as if it was trying to give a serious monetary stimulus to the economy. Given the RBI’s aversion to inflation, a measure that could increase money supply in the economy seemed to be risky.

However, the move was mainly cosmetic. Because, as developments in the first half of the year indicate, a reduction in the CRR was a no-risk option. It is likely to do little to increase the growth in money supply. And this is why the inflation- averse RBI Governor could take the risk of cutting the CRR by 200 basis points — because it was no risk at all!

This is because growth in money supply is determined by the value of the multiplier and growth in reserve money. And when the CRR is cut, it increases the value of the multiplier. But such an increase will not push up M3 growth if reserve money growth declines enough.

And indeed, in the current situation, not only is the value of the multiplier not expected to increase as it would have if demand for credit and the consequent money creating capacity of banks had been high, reserve money growth is in control.

Again, the reason for this is the low demand for credit, thanks to which commercial bank lending to the government has increased so much that the RBI credit to the government, a source of increase in the monetary base, has hardly increased. In other words, there is little danger of significant money growth because the cut in the CRR made it an option that has little danger of being inflationary.

The variables that determine the money multiplier — the credit-deposit ratio and the ratio of currency to bank deposits held by the public — have both declined. This implies that the theoretical value of the multiplier has risen.

There has been a decline in the currency deposit ratio since 1999. At the same time (except for a short period), the RBI has consistently cut the CRR. This indicates that the potential value of the money multiplier, which is inversely related to both these variables, has risen.

However, the value of the multiplier need not be that which is predicted by its theoretical value if the slackness in demand for credit does not allow money to be created to the extent possible. Even if banks have to hold a lower percentage of their deposits in cash and can lend it out, they may actually not be able to do so if there is insufficient demand for credit.

Under these circumstances, they tend to park their funds in investments. Thus M3, the sum of currency — demand and time deposits — will not see the kind of growth that is possible, given the cuts in reserve requirements. The realised value of the multiplier (M3 divided by reserve money) indicates that the multiplier has risen. It remained around three till April 1996, after which it rose steadily and stood just above 4.5 in September 2001.

Interestingly, the RBI has been able to keep reserve money growth in check despite rising foreign exchange reserves and the large fiscal deficit. Of the two main sources of change in reserve money, while foreign exchange assets witnessed an increase, there was very little increase in the Reserve Bank credit to the government.

While in the period from April to October 2000 there was a decline of Rs 3,103 crore in the net foreign exchange assets of the RBI, in the corresponding period in 2001 there was an increase of Rs 19,707 crore.

At the same time, while in the same period in 2000 the increase in the Reserve Bank lending to the government had been Rs 16,275 crore, in the corresponding period in 2001 there was an increase of only Rs 2,129 crore. If the RBI credit to the government had continued to increase at the same rate as last year, there would have been a very sharp increase in the monetary base!

This may appear surprising in the face of the fiscal deficit size. But given that the demand for credit is so low, there was a sharp increase in investments in government securities by commercial banks.

As demand for credit was slack, investments in government securities by commercial banks increased significantly — Rs 44,628 crore during April-October 2001, compared to Rs 25,502 crore during the corresponding period last year. Consequently, commercial banks held government securities to the extent of over 36 per cent of their liabilities, much in excess of the prescribed SLR.

As banks became increasingly risk-averse, lending rates fell, and as demand for credit was low, the flow of funds to the government rose. The government’s large borrowing programme kept returns on government securities adequately attractive for banks to park their funds in them. The response to the RBI auctions of government securities was warm and devolvements on the RBI were limited.

It was thus possible for the government to finance its fiscal deficit without resorting to borrowing from the RBI. And so, despite the large fiscal deficit, money supply growth has been under control.

The cut in the CRR, therefore, has little danger of being inflationary. Unless there is a pick-up in demand, at which point the RBI can, of course, step in and take measures to tighten it. But will the pick-up in credit take place? It seems unlikely. Especially if the finance minister fails to provide industry with a stable policy environment.

As illustrated by the case of the tariff structure for edible oils (see the editorial “Slippery duties” on November 23 in Business Standard), policy changes are often unpredictable, acting as a disincentive to industry. Dr Jalan can hardly be expected to step in with a magic wand that will make economic prospects look bright and attractive and have corporates rushing to banks for funds.