The Hindu Business Line : Back to directed credit

The Finance Minister's advice to bankers to trim excess investments in government securities and lend more to agriculture, small industries and infrastructure has serious implications.

AT A meeting on September 9, the Finance Minister, Mr P. Chidambaram, is reported to have advised commercial bankers on the agenda he had drawn up for them. Earlier, he had asked banks to trim their excess investments in government securities.

He said he would like them to engage more in lending, particularly to agriculture, small industries and infrastructure. He had also indicated in the Budget a target of doubling the agricultural advances over the next three years. These proposals have serious implications.

Whither deregulation?

The first major philosophical issue is about deregulation and liberalisation of the banking sector. These, as often claimed by the authorities, are important facets of the economic reforms introduced in the wake of the Gulf crisis in the early 1990s. One would interpret deregulation as dispensing with directed credit.

In the past, banks were under the tight control of the government and the Reserve Bank of India (RBI). There was a target of advances to the priority sectors at a minimum of 40 per cent of net outstanding credit. There was a sub-target of 18 per cent for agriculture.

Somewhere on the way, another target of 12 per cent for export credit was also added, though one hears little about the last one nowadays. The RBI played its part well in the reform process, reducing the cash reserve ratio (CRR) in stages from a high of 15 per cent — the maximum permitted under the law — to 4.5 per cent on June 14, 2003. It also removed the shackles placed on banks in determining the interest rates for deposits and lending.

The central bank left the exchange rate to be determined by market forces, except for occasional interventions to curb volatility. It promised to lower the statutory liquidity ratio (SLR) level too, in course of time. What remains is only the limited control in such areas as interest rate for export credit or for savings deposits.

There is also the pre-historic Differential Rate of Interest Scheme (DRIS) with its own target of 1 per cent of outstanding credit. However, it is no longer taken seriously by anyone except for occasional pro forma advice from the authorities reminding the banks of the target! At end March 2004 the achievement was negligible at 0.1 per cent. Like old soldiers, it will not die but just fade away in course of time.

It was often a major grievance of bankers at the height of the pre-reform directed credit regime that statutory ratios and targets pre-empted 80 per cent of their deposit resources, and the scope for discretionary financing was limited to 20 per cent. In fact, it was even less taking into consideration the consortium arrangements for financing food credit, which banks had to agree to, under the RBI's moral suasion. Looking back, there is not much change in the environment except for the softening reformist role of the central bank The total resources involved in credit targets and statutory ratios are still around 80 per cent of deposits ignoring the excess investment in securities.

There is no likelihood of a substantive change in the situation in the foreseeable future. With the exception of the statutory ratios, the targets were set by the Government. On the other hand, whatever directives the central bank has issued pertain mostly to prudential control in line with international best practices. It is one of the bank's major responsibilities and a fundamental dharma to ensure the viability — nay, solvency — of the country's financial system.

If India had never gone through the hyper-inflationary experience of the Latin American or East European or African countries it is due to the central bank performing its duty in a remarkable way, for which the citizens of the country should be deeply indebted.

Financing agriculture

During April 1999-March 2004, outstanding agricultural advances of commercial banks rose from Rs 41,099 crore to Rs 103,721 crore with a compound growth rate of 20 per cent. (RBI Annual Report 2003-04). This includes non-performing loans and accumulated interest. Still it gives a broad idea of the growth in commercial bank credit for agriculture.

While public sector banks recorded a growth rate of 18 per cent during the period, private sector banks growth was more impressive, at 38 per cent. The share of the latter in the total doubled from 8.4 per cent to 17.0 per cent.

The public sector banks have to achieve an annual growth of 26 per cent in agricultural credit in the next three years. One shudders to think of the massive task before the banks and its possible consequences, especially in contributing further to non-performing assets.

Recoveries as a proportion of demand for repayment of loans hovered around 70 per cent in recent years. In the past, both the Government and farmers were used to the practice of waiving of land revenue payments, or taccavi (government) credit, on account of drought. The writing-off of bank loans is seen by both as a logical extension of that practice.

Marketing new securities

The second major implication of Mr Chidambaram's proposal is for the RBI's open market operations (OMO). If banks are to liquidate their excess investments in SLR securities, they cannot do so by going to the market in a big way and selling them. It will result in a collapse of the market with prices declining drastically and yields shooting up. So, the orderly way to work this out is to fully deploy the new deposits in lending after providing for the CRR.

In other words, incremental credit should broadly match incremental deposits for the system as a whole though the position may differ from bank to bank. The relative SLR requirements can be met through the investment in securities. In fact, the latter are now large enough to comply with the law for another four years or so, if one goes by the existing trends in deposit growth and investments in approved securities!

It means that banks need not buy government securities in the medium term to meet statutory requirements. They can, of course, bid for them to satisfy the authorities quoting very low prices and, hence, high yields, instead of non-participation in auctions, hoping they will not be accepted! In that scenario, the securities will devolve on the RBI.

The role of Primary Dealers in absorbing the securities is limited at their current stage of development. In view of the implication of created money being injected into the system there may be no alternative to raising the CRR. In the recent past, the RBI has itself indicated the possibility of resorting to CRR as the weapon of last resort.

For reasons articulated in an earlier article of this writer, the central bank need not be apologetic on the ground that it is a return to `financial repression'.

The Government would also get some relief as, in a consolidation of its balance-sheet with that of the central bank, there is no net outgo of interest when the securities go into the portfolio of the latter, unlike in the case of OMO.

While banks may be blamed for the excess investment in securities the authorities should not forget the important and helpful role they have played in OMO in the efforts to mop up the surplus liquidity in the system generated through the inflow of foreign funds in the recent years.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)

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