The RBI has played safe as usual, leaving the economy to be sorry

The mid-year credit and monetary policy has lived up to the general expectations. With an overall deflationary environment, a reduction in interest rates and CRR was warranted, and the RBI kindly obliged.

But not, many feel, by enough. However, in all fairness to the RBI, at a time like this when expectations are abysmally low, there is very little that monetary policy can do. Even if the cuts had been greater, the probability of their inducing an upturn was very small.

Also, the ineffectiveness of the succession of Fed’s interest rate cuts could not have done much to boost the RBI’s confidence in the effectiveness of monetary policy. And that too in the Indian economy, with its inefficient markets, high fiscal deficits and structural constraints.

In fact, the RBI appears to have cut rates more under pressure than out of the belief that it will push the economy forward. With the finance minister talking about interest rates far too often, it does not take a lot of guessing to figure out where the pressure might have come from.

The RBI’s reluctance is obvious. The policy statement suggests that the cuts will lead to more lending to the government and to a problem of excess liquidity which will have to be managed by the RBI.

Indeed, for an upturn it pins more hope on a global turnaround than on its rate cuts: “While financial markets are generally stable, liquidity is adequate and interest rate environment is favourable so far, there has been no perceptible upturn in industrial output ... It is to be hoped that as global markets gain back momentum after some time, it will have a favourable impact on the investment climate in India also.”

The statement also notes that interest rates have already softened considerably. In September 2000, the prime lending rates of public sector banks were ranging between 11.75 and 13 per cent. They come down to 10-12.5 per cent by mid-October 2001.

It argues that as banks were permitted to lend to exporters and their prime customers at sub-PLR rates, the cost of bank borrowings for such corporates was already low. But as even then, these corporates were not borrowing, commercial banks’ investments in government securities had increased significantly. Consequently, commercial banks held government securities to the extent of over 36 per cent of their liabilities, much in excess of the prescribed SLR.

Indeed, the RBI’s statement says that during most part of the first half of the year, there was a situation of excess liquidity resulting from a steady increase in net foreign currency assets and subdued real activity.

The RBI had to actively manage liquidity, not only through outright OMO sales of securities but also through its daily Liquidity Adjustment Facility (LAF). The average daily absorption through repo transactions under the LAF amounted to about Rs 3,600 crore.

The message seems clear. The first half of the year witnessed a lowering of interest rates and indeed a situation of excess liquidity, but did not result in an increase in credit or an improvement in industrial growth. Why then would it do so in the second half?

And the answer to be found in the RBI’s statement is that it is unlikely to do so. The problem, as everyone knows, is one of poor demand for credit. No one wants to borrow because there is nothing to borrow for.

A lowering of the cost of credit and an increase in its availability can have an impact only if expectations regarding sales are high. Otherwise, however low the interest rate is, it is unlikely to lead to an increase in demand. Increasing supply and lowering cost cannot help much.

If expectations about growth and demand are optimistic, neither high interest rates nor large fiscal deficits can prevent the private sector from borrowing and investing. The high growth in investment and output in the Indian economy during 1994-96 is evidence of this.

Yet, the RBI seems to have played along. Why? Partly because the costs of doing so are low. After all, international rates have been cut, so there is no real danger of the rate cut putting an adverse pressure on the rupee. Also, the price situation is comfortable. Not only is the domestic and international manufactured price scenario deflationary, India’s mountains of foodgrain stocks will help keep domestic prices under control.

At the moment, international oil price is also forecast to be low. So, the risk of an expansionary monetary policy leading to price rise is limited, not that inflation is seen to be a monetary phenomenon in India.

So the RBI has done its bit by cutting the bank rate which, it says, would be a signalling instrument to provide “directional guidance to the extent feasible”. But it has sounded two warnings. One, the interest rate environment can change quite dramatically within a very short period. Two, in view of the structural rigidities of our financial system, the scope for further softening in lending rates by banks and other financial institutions is limited.

The factors that reduce downward flexibility include the inability of banks to effect further reduction in lending rates without affecting their deposit mobilisation, their reluctance to offer variable interest rates on longer term deposits, high NPAs that push up costs and, of course, the large fiscal deficit.

In other words, it is up to the government to reduce structural rigidities in the system by removing tax incentives on contractual savings and making interest rates on them market-determined, as has been recommended by the YV Reddy Committee. And it is up to the banks which need to reduce their operating costs over time by improving their productivity and increasing their volume of lending.

But as PPF and other small savings rates become market-determined and their tax incentives removed, there will be little reason for the public to lock up funds in illiquid assets. This will increase the relative attractiveness of bank deposits and increase the RBI’s liquidity management problems.

As the statement notes: “If the surge in bank deposits continues, it may pose a challenge to the banking system in deploying resources, particularly in the context of sluggishness in credit and investment demand.”

Indeed, a reading of the review of the macroeconomic and monetary policy suggests that there is no need to increase liquidity as enough already exists. Yet, why be accused of not doing anything? Here is a rate cut, take it if you think this is what will help, or so the RBI seems to be saying.

Not only does the RBI not have great conviction that its monetary policy will have much impact, even Yashwant Sinha has admitted last week that interest rate cuts have not created magic elsewhere, they may not create magic here.

To which one might ask, if the magic lies elsewhere, Sir, what are you and the RBI doing about it?