The Hindu Business Line : Reflections on the Credit Policy — Prioritise lending to small enterprises

THE markets have absorbed the benign signals that the RBI Governor, Dr Y. V. Reddy's Credit Policy sent out on October 25, 2005. There has been neither euphoria nor shock. The episode had some drama about it, partly because an anxious Finance Minister, Mr P. Chidambaram, stepped out of his boundary to declare, in effect, that a benign interest rate regime was what he expected.

It has, of course, been the tradition of many Finance Ministers to tread where Governors ought to be masters of the domain. The historians of RBI will tell you of many instances where redoubtable Finance Ministers, including T.T.Krishnamachari, thought it fit to second-guess the RBI Governor. So, too, did Sir Chinthamani Deshmukh, in a manner of speaking, and Governor Rama Rau had to say Et tu Brutus. But Mr Chidambaram's intervention was ever so gentle, just letting Dr Reddy know what the master of North Block thought. Ultimately, all is well that ends well.

The Governor has had his way, with a slight tweaking of the reverse repo rate, making it tougher for bankers to borrow from the RBI ever so little, but enough to signal that the easy times are over. But the Finance Minister has also had his way — the bank rate remains unchanged. With abundant liquidity sloshing round, it is doubtful whether the markets will push the bond rates too high. The Finance Minister can continue to draw on the banking system's resources so long as he keeps his demands within the reasonable limits laid down by the FRBM Act.

There is some fine-print in the Credit Policy which seems to call for further reflections on a more careful reading of the statement of the Governor. First, there is the well-considered remark of the Governor on the external environment, especially the growing current account deficit.

While the Governor does note that exports have risen robustly in the recent period, he cannot conceal his concerns about the need to incur liabilities abroad to finance a growing deficit on trade deficit. This calls for action to enhance export competitiveness and increase export earnings, both from goods and services.

Of particular interest is the stance on exchange rate. While the Governor and his deputies have been making a distinction about volatility of the exchange rate, which has to be reduced, there is no indication whether the current exchange rate stance will be good enough to boost exports.

To what extent does the real exchange rate indicate the continuing attractiveness of Indian exports? The case is all the more significant insofar as it concerns the critical sector of textiles, where China is scoring significant victories over India. The reasons for China's triumph lie in its economics of sale and technical advance in textile manufacture. It is time India's textile manufacturers learnt a trick or two from China's textile giants.

The subtext of the Credit Policy is an implicit declaration that inflation, so far, has been moderate, and that very drastic steps are not called for on the monetary policy front to reign in inflation. Governor Reddy does not also seem to look kindly on measures such as are popular with the present UPA Government — of insulating the consumer of petro-products from the effects of crude oil rise.

The options before Government, presiding over an ungainly coalition, are, however, difficult. To allow the petro-product rise to be modulated through fiscal transfers is counter-productive in the long run. It runs contrary to the goal of conservation of energy. But a politically responsive Government running on the strength of a coalition cannot be totally insensitive to demands from political parties, especially its coalition partners, to absorb some of the costs through cross-subsidies.

That the fiscal cost is excessive and unsustainable in the long run is obvious. But Governments learn such lessons with difficulty and forget them easily. Governor Reddy has to persevere a bit more and longer in persuading the political masters of the inherent unwisdom of mollycoddling the consumers of LPG, kerosene, patrol and diesel at the cost of the fiscal stability and/or of the health of public sector oil giants. One of the interesting aspects of Governor Reddy's Credit Policy is that it opens the window a bit wider for banks to invest in equity and bonds. True, the relaxation will amount to a very modest effect on India's capital market. But, on second thoughts, I wonder whether this opening is in keeping with the risk appetite of India's bank managements and, more importantly, their ability to handle the potential dangers of India's stock market. I do hope it does not open the doors to a repeat of earlier unfortunate episodes when bankers forgot their role as receivers and investors of public savings, but donned the pose of speculators extraordinaire. There is considerable danger in allowing such an exposure, although within prescribed limits. The RBI needs to be particularly alert on this. In this context, the central bank may like to consider the option of allowing banks to invest in mutual funds. These are considered more secure and intrinsically professionally managed. While it is definitely a bold step for Dr Reddy to liberate bankers from restrictions on equity investments, the dangers of the equity market and its temptations are still fresh in the minds of many observers.

Thus, Governor Reddy might do well to rethink or modulate his liberal gesture — at least to the extent of modifying it to cover only portfolio management schemes, where investors place funds at their own risk with banks specifically for such investment and exclude proprietary funds, viz. depositors' resources.

Dr Reddy needs to introduce some specific risk-based norms on bankers' venturing on the wide open seas of investments in equity, particularly derivatives. Leeson's lessons are not easily forgotten. The Barings' story is a pertinent warning.

While on the subject of norms, the RBI Governor may also need to reconsider the ingrained habit popular with developing country central bankers of extending developed country norms without specific adaptation to India. I refer, in particular, to the whole issue of exposure norms, which have been in vogue in India from the beginning of the 1991 reforms and confine banks' exposure to individual borrowers to a specified percentage of their net worth, or assets.

While our corporates have been growing by leaps and bounds, our banks and institutions still remain relatively small, especially in respect of their net-worth. The net result is that even some of our biggest banks run out of their exposure limits when big corporates or financial institutions approach them for loans.

This means that while the banks are flush with funds — liquidity is, in fact, obviously high — they are not able to extend loans to such corporates or institutions. Exposure norms thus lead to loan markets migrating abroad.

One consequence is that external commercial borrowing becomes attractive not only because of the lower rates perceived by borrowers but also because of the restrictions imposed by exposure norms. The regulator needs to explore this unintended consequence of the Indian exposure norms, which may be quite appropriate in developed economies, where banks have much higher and more robust net-worth.

While exposure limits are alright to prevent undue commercialisation of loans to individual corporates or types of borrowers, the RBI needs to look at the nature of borrowers, their specific purpose and the public interest served by their on-lending operations. If the objection of exposure limit is raised in respect of a borrower whose on-lending activity is of high priority, such as housing, the exposure limits may need a radical overhaul with a view to making an exception in their favour.

A common complaint about our credit structure is that small and medium enterprises do not get as easy an access to credit nor on benign terms in respect of interest as the larger corporates. The fact is that they do not get the soft option of an ECS, which requires scale and creditorship. It is also pertinent to recall that the rates of interest offered to some sectors are higher than for bigger corporates for the reason that banks have made it so, not so much because of the higher risk factor.

It is time the RBI applies its mind to this pervasive anomaly and enables the more benign interest regime to operate effectively in sectors that matter, like the small and medium industries. True, many steps have been initiated in this regard, but a complete reform of lending priorities to this sector is essential, if economic growth is to translate into prosperity and growth of incomes at various levels of entrepreneurship.

India may well have to copy the model of the US' Small Business Administration, which played a role in sustaining such giants of today, like Intel, in their initial tentative years.

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