The Hindu Business Line : Monetary policy at the crossroads

There is an erroneous perception that lower interest rates are a necessary concomitant of distributive justice.
Obsession with reducing interest rates would only create distortions in the system requiring painful adjustments later, says S. S. TARAPORE.

— A. Roy Chowdhury

The perception that bank lending rates are too high is attributed to the faulty formulation of the Benchmark Prime Lending Rate.

The focus of most economic agents, policymakers and opinion makers is on Budget 2009. Expectations are that the Budget will be growth oriented and that there will be a further fiscal stimulus. The temporary fiscal stimuli could become the norm and fiscal permissiveness could make it that much more difficult to return to the fiscal deficit targets as per the Fiscal Responsibility and Budget Management (FRBM) Act. The formal stance of the new government will be known on July 6 and this will be a key input for the RBI’s monetary policy to be unveiled on July 28.

There are loud noises that the central concern of the RBI of inflation control should be put on the backburner and it should swim with the tide, pursuing an unbridled expansionary policy. Given that monetary policy has a lag of 12-18 months, the RBI cannot automatically take such a view.

Cautionary signal

Given the unprecedented wide divergence between the wholesale price index (WPI), which shows a year-on-year decline of one per cent, and the Consumer Price Index (CPI) increase of 9 per cent, there is a need for a cautionary monetary policy.

Given the uncertainties of the monsoon and the slower than expected global recovery, the RBI would do well to stay with its April 2009 projections for 2009-10 — 6 per cent real growth, WPI year-on-year inflation rate of 4-4.5 per cent, 17 per cent M3 expansion, growth of scheduled commercial banks’ deposits of 18 per cent and credit expansion of 20 per cent.

To its credit, the RBI has provided the first hints of a possible reversal of the prevailing expansionary monetary policy. The Governor, Dr D. Subbarao, has sent the right cautionary signal (while addressing the National Institute of Bank Management Convocation) that the reversal of the expansionary policy, at the appropriate time, would certainly be on the RBI’s agenda .

The Deputy Governor, Ms Usha Thorat, has stressed that while reducing interest rates, banks have to take into account the divergence between the WPI and the CPI.

There is an erroneous perception that lower interest rates are a necessary concomitant of distributive justice. The policymakers’ attention is excessively focussed on lowering lending and deposit rates. It is the depositor, and not the shareholder, who is the real owner of banks. Sacrificing the depositor at the altar of the borrower is not a viable policy, as without the depositor there would be no bank.

Borrowers (large, medium and small) often feel low interest rates is their right. The average depositor’s income is much lower than that of the average borrower and, therefore, relentlessly reducing interest rates is an anti-poor policy.

In India, large portion of the savings of the poorer sections are lodged in savings bank accounts at a nominal rate of 3.5 per cent, which, viewed in the context of the CPI, would mean a negative real rate of return. Thus, the RBI, which controls the savings bank interest rate, should refrain from lowering this rate.

Of late, Government policy has been one of pressuring banks to reduce lending and deposit rates. It should, therefore, come as no surprise if the interest rates on government small savings schemes are reduced on July 6.

This would be iniquitous and the Government must be prepared for a severe political backlash. In a country where there is no social security for the masses, the small savings schemes and bank deposits provide some semblance of security. The interest rates on such schemes have already been reduced over the years and a further reduction would go against the canons of distributive justice.

If the interest rates on government small savings schemes are lowered, be sure that the Government would ensure that banks too obediently reduce deposit rates; such a stance would do the dirigiste regime of the 1970s proud.

There is a dangerous view gathering strength that savers have nowhere to go and that they will meekly accept lower interest rates. Let there be no mistake about it: banks that do not resist pressure to reduce deposit rates will become unviable in the medium term.

If the authorities pressure banks to further reduce deposit rates, the All India Depositors Association should initiate a nationwide agitation by depositors. Depositors would surely miss the missionary zeal of the indefatigable warrior, the late M. R. Pai.

Faulty formulation of BPLR

The perception that bank lending rates are too high is attributed to the faulty formulation of the Benchmark Prime Lending Rate (BPLR). There are three flaws in the system. First, 75 per cent of bank credit is at rates well below the BPLR.

Second, banks are required to provide credit to exporters and small borrowers at interest rates linked to the BPLR. Third, for some sectors the lending rate is fixed by the authorities.

The Working Group to review the BPLR system needs to dispense with the baggage of the past. The ingredients of a revamped system could be as follows:

The BPLR declared by a bank should be the lowest rate at which it would be willing to lend to its best customers; no credit should be permitted at rates below the declared BPLR.

Lending rates for exports and small loans up to Rs 2 lakh should be de-linked from the BPLR and fixed as in the case of agriculture. The resulting BPLRs of banks would then be significantly lower than the present rates. The demands by chambers of industry that lending rates should be in the 4-6 per cent range, should obviously not be acceded to.

The various liquidity facilities available from the RBI should be quickly wound down. The facility for non-bank finance companies should not be extended beyond June 30, 2009. Again, the special refinance facility for banks and mutual funds should be terminated on the due date of September 30, 2009.

The reverse repo absorption by the RBI, which is consistently above Rs 1,00,000 crore, is dangerous. The reverse repo interest rate should, ideally, be lowered but this would give a forceful policy signal to banks that the RBI wants lower interest rates.

The absorption should be drastically reduced by modulating the timing of the borrowing programme. Needless to say, the repo rate should not be lowered. To the extent a Liquidity Adjustment Facility (LAF) corridor is felt necessary, it would be meaningful only if, over time, both the repo and reverse repo facilities are operative.

In other words, the present large and persistent reverse repo absorption reflects massive excess liquidity in the system and invariably such excess liquidity gets misused and some times encourages fraudulent transactions.

Obsession with reducing interest rates would only create distortions in the system that would require painful adjustment during the next 12-18 months. Monetary policy is truly at the crossroads and, hopefully, the RBI would choose the right road, even though it may be the difficult road to traverse.

(The author is an economist. blfeedback@thehindu.co.in)

More Stories on : Monetary Policy | RBI & Other Central Banks | Maverick View

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Invisible support

Power of attorney transactions decried

Monetary policy at the crossroads

See acquisition as a growth platform

Leveraging info for greater organisational value

Financial products

Board exams