The Government asking public sector banks to keep in abeyance lending rate hikes reveals a muddled approach to Monetary Policy-making. If the Government wants the system to subserve its political interests it should be honest about it instead of making spurious claims about a deregulated banking environment, says A. SESHAN.

A. Seshan

The Ministry of Finance has advised public sector banks (PSBs) to keep in abeyance any hike in lending rates. It has asked them to wait until the matter is considered by their boards. The justification for the instruction: The Government can do it, as it is their owner.

The provocation for this meddling in the internal working of banks is the pressure being brought on by Congress members to roll back the rate increases announced by some banks in the wake of the Reserve Bank of India (RBI) raising the repo and the reverse repo rates.

Monetary vs Credit Policy

A Monetary Policy is distinguished from a Credit Policy in textbooks. While the former concerns money supply the latter deals with the terms and conditions under which credit is issued. It has been the general contention of economists for long that the RBI formulated only a Credit Policy, and that the Monetary Policy was a sub-set of the fiscal policy.

All these years the Monetary Policy was designed, contrary to what was said for form's sake, to assist the government in raising adequate resources in the market at minimum cost. The RBI underwrote the government securities and took on its books any amount left unsold in the market, or what constituted deficit financing. In its credit planning exercises when the monetary budget was drawn a few days before the commencement of a new financial year, the first charge on the resources of the financial system was claimed by the market loans of the Centre, as indicated in the Budget, after the pre-emptions under the Cash Reserve and Statutory Liquidity Ratios.

Thereafter came the priority sector, accounting for 40 per cent of the total outstanding debt. The reminder was available for industry and, to some extent, wholesale trade. In fact the term "residual sector" was often used in credit planning to refer to this balance indicating its importance, or rather the lack of it, in the economy.

FRBM demands

With the coming into effect of the Fiscal Responsibility and Budget Management Act from the beginning of the current fiscal, the situation has changed insofar as government draft on central bank resources is concerned. The RBI can buy and sell only in the secondary market for government securities for Open Market Operations. Of course, there are enabling provisions to bail out the government in extraordinary circumstances. Also there is the facility of Ways and Means Advances. Thus, one may say that perhaps the central bank can really afford to have a Monetary Policy. And, what is more, it is well integrated with the Credit Policy, blurring the distinction between the two.

But as a setback to this welcome development, the RBI's role in Credit Policy has been sought to be diminished by the latest missive from the Finance Ministry to the PSBs. The RBI is reported to have been not consulted in the matter. So much for the autonomy of the central bank and the deregulation of the financial system about which we hear from government spokesmen from time to time.

Planning for tomorrow

Recently, the RBI raised the repo/reverse repo rates after giving deep thought to the current economic situation and the runaway expansion in money supply and advances to certain sectors. It certainly wanted to curb the excessive growth in credit not matched by the rise in deposits. After all, the process of credit creation is the process of money creation. It adopted the healthy practice of planning for tomorrow, like the central banks of the West. Because economic variables have lagged effects the RBI needs to forecast to the extent possible the likely course of developments a few months hence, particularly on the inflation front, so that the fires can be doused early. It also needs to reckon with the trends abroad now that the country is increasingly integrated with the rest of the world.

Unlike in the closed economy of the past, the RBI needs to take into account the impact of any event abroad on domestic money supply, exchange rates, prices, stock markets, etc. These are specialised matters about which the politician is least concerned as his eyes are on winning the support of his constituency in the next election. It is why,

ceteris paribus

, an autonomous central bank, free of political interference, is the best guarantee for the financial stability of the country.

What the direction means?

What are the implications of the government instruction? In the first place, banks which have been raising deposit rates to mobilise resources will desist from doing so. This means a raw deal for the depositor who is getting a negative real return, as it is. Banks still have some leeway for liquidating excess SLR investments of nearly Rs 1 lakh crore to meet the additional demand for credit. They are likely to be lukewarm in responding to new market loans. They may just demand a high enough yield that is not likely to be agreed to. If it is granted, it will mean an aggravation of the very heavy interest burden that the government is already bearing.

It would also mean further depreciation of the value of the securities in the portfolios of banks with the attendant complications in provisioning. The private sector banks are free to raise their deposit and lending rates. There is likely to be a diversion of business from PSBs to them. We already see the competition in interest rates on term deposits announced by some private banks. It will get a further fillip now that the official notification on income-tax benefit for five-year term deposits is out.

The Government should make up its mind as to whether it wants a banking system run on modern lines, as in the West, or, as an appendage to the North Block. We already have a system of directed credit and investment in the form of priority sector advances and CRR/SLR, respectively. No purpose is served by a neither-here-nor-there approach. It will only fall between two stools!

If the Government wants the system to subserve political interests it should be honest about it instead of making spurious claims about a deregulated banking environment.

Better still it could instruct the central bank on all such matters so that there is no need to issue so many letters to so many PSBs and the former need not waste its time on a thankless job.

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

(This article was published in the Business Line print edition dated August 9, 2006)
XThese are links to The Hindu Business Line suggested by Outbrain, which may or may not be relevant to the other content on this page. You can read Outbrain's privacy and cookie policy here.