The Hindu Business Line : An exercise in political economy

The first impression that one gets from a reading of the latest Credit Policy is that it has cleverly bypassed many pitfalls a central bank faces in working in an environment where decisions are made under compulsions of political economy rather than economics. The statement carries the overtones of what it wants to convey to the system in no unmistakable terms, while at the same time not upsetting the apple-cart.

Head over heart

If one were to follow the cautionary signals raised in the policy one should have logically expected the RBI to raise the repo and reverse repo rates. But in the conflict between the heart and the head the former has won. There is, of course, a fear that any hike in rates would tantamount to taking away the punch bowl when the party is at its peak, as one US Federal Reserve Chairman famously said. Remember the mid-1990s when the RBI doused the fires of inflation stoked by an unsustainable boom with a tight monetary policy. It was blamed for the subsequent long recession that the economy fell into. That is the price one has to pay for trading off long-term interests with short-term ones.

Until such time that we have a legally or, even better, a constitutionally-guaranteed autonomy of the central bank it has to walk the tightrope, of satisfying the politician and still performing according to its dharma. Thus, the RBI has kept all the rates unchanged so that there is no grouse in the North Block. This is despite the large increases in reserve money and money supply which portend trouble in the future because they have lagged effects. The US Federal Reserve decides its policy keeping in view the likely inflation rate a year or so from now. It was a coincidence that even as the RBI policy was being unfolded the Prime Minister was expatiating in a Delhi conference on the possibility of a 10-per cent growth for the economy! Vested interests would argue that raising the interest rates is not the route to reach that goal forgetting that growth and inflation do have a trade-off.

So under the circumstances what the RBI could do was to minimise the damage or the dangers to the system arising out of a run-away credit flow, which also raises the question of its quality.

The three pillars

As the Governor articulated so well at the first phase of the press conference the policy has three pillars: (1) Continued growth; (2) improved credit quality; and (3) being in readiness to respond to any situation arising domestically or internationally. He admitted that he was a little hesitant in not making the changes in rates but justified the stance in a masterly way in the context of the above three basics. He had already taken pre-emptive action on the last occasion when he made changes.

Second, he saw the need for bringing the money supply and credit growth to a normal pattern. The growth in credit to certain sectors was somewhat out of alignment with the rest of the trends raising doubts about its quality.

Credit to services sector

During April-January 2005-06 credit to the services sectors emerged as the dominant category, increasing by 36.2 per cent against 25.1 per cent a year ago and accounting for 63.1 per cent of the incremental non-food credit.

Within this category, retail lending expanded at rates ranging between 22-41 per cent since 2001-02 and accounted for 26.7 per cent of the incremental non-food credit in 2005-06. The share of advances to `individuals' increased from about 10 per cent of total bank credit in March 2002 to nearly 25 per cent in January 2006. Loans to commercial real-estate rose by 84.4 per cent in 2005-06, constituting 4.4 per cent of incremental non-food credit.

Housing loans increased by 29.1 per cent and accounted for 14.6 per cent of incremental non-food credit.

In the light of the somewhat higher flow of credit in the areas of housing, real-estate, shares and personal loans the RBI could seek to minimise the damage without increasing the rates directly by raising the prudential standards. It is indeed clever. Because such a rise has an effect on interest rates but indirectly so that it does not affect the sensibilities of those who matter.

Review of trends

A day before the release of the policy the RBI published its narration of the developments in the economy and its interpretations of trends. They are of the usual high professional standards that one has come to associate with the staff drafting the document. Besides providing an update on the data contained in the recently-released Report on Currency and Finance it also provides rich additional information useful to analysts and policy makers. There are, however, a few caveats that could be entered in the spirit of a researcher.

The review covers the developments in the stock markets but does not go deeply into their causes. It says that the capital market exhibited buoyancy with the benchmark indices reaching record highs driven by strong support from foreign institutional investors and domestic mutual funds on the back of robust macroeconomic fundamentals, congenial investment climate and strong corporate profitability. These factors can certainly explain a boom in the market of normal proportions. But how does one explain shares with a face value of Rs 10 and Rs 5 or even Re 1 bought and sold at prices running into four digits?

All the textbook norms on the relationship of the price of a share to its yield and other factors have lost meaning in an age where quick short-term capital gain is the predominant motive for the market player. And therein lies the danger of asset inflation and the damage to the financial system.

It is interesting to note that stock market volatility reflected in Sensex, as measured by the coefficient of variation, at 16.68 in 2005-06 was higher than in 2004-05 when it was 11.16 but in 2003-04 it had been even more at 22.95.

There is a reference to the `phenomenon' of year-end bulge in aggregate deposits and credit. It is a euphemism for window-dressing of the balance sheet.

This phenomenon has been observed for more than half a century despite counselling by the central bank. Is it really beyond the control of the RBI? Is it unique to India? Is it not possible for the Bank's inspection teams to bring out the fraudulent manipulation of data for punitive action?

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

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