The Hindu Business Line : RBI Annual Report 2003-04

Though the RBI, in its Annual Report 2003-04, has failed to shed light on the tremendous risk of the depreciation of government securities faced by commercial banks in case of a rise in interest rates, it maintains high standards of data presentation and analytical rigour. The narration of the developments in the year, and the assessment and prospects for the near future are on lines, which few will question, says A. Seshan.

THE much-awaited Annual Report of the Reserve Bank of India (RBI) for 2003-04 continues to maintain its high standards of data presentation and analytical rigour. The narration of the developments in the year, and the assessment and prospects for the near future are on lines which very few will question.

This author looked forward to the RBI shedding light on the tremendous risk of the depreciation of government securities faced by commercial banks in case of a rise in interest rates. There is a warning to that effect in the document. However, there is only a cursory reference in para 10.89. The banks have themselves to blame, and not the RBI, for their predicament.

In the distant past, there were complaints of `financial repression' from them due, inter alia, to the stipulation of the Statutory Liquidity Ratio (SLR) of a minimum of 25 per cent of their net demand and time liabilities. It was contended that banks could lend the amounts involved in such investments to other customers and earn better returns. But, in recent years, they have built up their SLR portfolios to more than 40 per cent of their liabilities.

One reason was the lack of demand from the industrial sector due to either recessionary conditions or the act of disintermediation by entrepreneurs' direct access to the market or their borrowing from more attractive foreign sources of finance.

Second, prudential standards and the fear generated among the loan-sanctioning staff due to various scams, made investment in securities a safe option so long as the balance-sheet bottomlines were not affected.

However, one does not know what prevented the banks from going into agricultural financing in a big way to compensate for the lack of industrial demand.

After so many years of priority status for the sector and experience in financing farmers, and despite frequent urging by the authorities, many have not attained the target for the farm sector.

Any rise in interest rate envisaged by the RBI will have to reckon with the large-sized depreciation of the assets of banks. It will, of course, depend on the extent of the rise in interest rate and the composition of the portfolios of individual institutions.

Solvency of the system

According to some experts, there may well be cases of the entire capital being wiped out at a time when prudential standards are being followed in a satisfactory manner by the banking sector. This problem was not faced till about the late 1990s because banks did not have such excessive investments in securities. It did not arise in the recent past too, in an environment of declining interest rates, which enabled banks to make gains in treasury operations. The central bank will have to find a viable solution even if it is convinced of the need to raise the interest rate. This is understandable because it is a question of the solvency of the system, not just of one or two banks. Thus, it is caught in a cleft stick. It may have to do a cost-benefit analysis of the options available.

Farm credit

Agricultural credit has been referred to above. There is no information or data available, except for episodic reports, on the extent to which farm credit needs are met by traders and moneylenders to assess the performance of institutional agencies. The decennial All-India Rural Credit Survey (AIRCS) conducted by the RBI in the 1950s and the 1960s were handed over to the National Sample Survey a few decades ago. But the reports have come with a time-lag of about 9-10 years, making them useless for policy-making!

The RBI had a Division of Rural Surveys in its research department from around 1957 till the middle of the 1970s. It used to conduct follow-up rural credit surveys every year in select districts where the seminal AIRCS were being done in the early 1950s. Besides, it investigated special problems. It was in pursuance of one of the recommendations of the high-power Committee of Direction of AIRCS of the early 1950s. Over a period, the central bank and the government could get a full understanding of the prevailing trends in farm credit in different parts of the country and the role of both institutional and non-institutional agencies in purveying rural credit. The unit, which had field staff posted in the districts in many States, was wound up due to administrative reasons. It is time the RBI revived the unit with a structure that should avoid the staff problems of the past. The Bank has still its obligation towards agricultural credit enshrined in the RBI Act 1934. Otherwise, the National Bank for Agriculture and Rural Development should be advised by the RBI to set up a field survey unit.

The references to government finances delineate the fiscal problem well. Under the Market Stabilisation Scheme (MSS), the RBI carries out its open market operations and gets the funds into a blocked account from which the Government cannot draw. However, the latter bears the interest liability, which will aggravate the fiscal deficit. During the Gulf crisis of the early 1990s, there was a similar situation. The credit in foreign exchange extended by the International Monetary Fund did not accrue to Government and was absorbed in the reserves of the RBI. The Government had to purchase foreign exchange from the central bank to meet its needs. However, it paid interest to the IMF. This arrangement went on for some time until a Finance Ministry official raised the question as to why Government should pay interest on a loan, the funds of which it did not get! After considerable discussion, the RBI agreed to compensate the Government for the interest payment.

The MSS also may see a similar outcome. If one looks at the consolidated balance-sheet of the Government and the central bank, there may be no material improvement in the fiscal situation by following the earlier practice during the Gulf Crisis. However, it has a cosmetic effect in reducing the fiscal deficit shown in the Budget.

One is reassured to know that "in terms of overall external debt and total external liabilities, India's external reserves were broadly adequate" (para 6.66).

The earnings, as a percentage of average foreign currency assets and the same net of depreciation, are stated to be 2.8 per cent and 2.1 per cent, respectively, as on June 30 compared to 3.2 per cent and 3.1 per cent, respectively, a year earlier. Certainly, the average rate of interest on external debt, net of soft loans from the World Bank, should be much higher than these percentages.

There is also the opportunity cost of deploying the funds for the modernisation of the economy. The pre-payment of external debt has been somewhat on hesitant lines — $3.8 billion in 2003-04 and $3.1 billion in the previous year. The country needs to take a bold step to wipe off at least 25 per cent of its external debt of $112.59 billion at end-March 2004 in two-three years. A reduction of such a magnitude should enable the country borrow on good terms in external markets if the need arises again.

There are a few other minor points. Para 3.21 starts with the following statement: "Liquidity in the banking system surged in the first quarter of 2003-04 essentially because of the build-up of deposits by banks to meet year-end targets for 2002-03."

It looks like an euphemism for window-dressing! Offshore banking units started with much fanfare more than a year ago. In line with the general lack of interest in this innovation, the Report also does not make any reference to it. One hopes that it will be covered in detail in the Report on Trend and Progress of Banking in India.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India.)

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