The Finance Ministry asking public sector banks to keep in abeyance their prime lending rate hikes can affect the independence and efficacy of the PSBs. Hopefully, the Ministry will withdraw the letter and permit banks to function as before.

K. Subramanian

When the Reserve Bank of India announced its first quarter Review of the Monetary Policy on June 25, the reaction of the Finance Ministry seemed favourable. The Finance Minister, Mr P. Chidambaram, said, "The RBI policy statement is in line with what the Government thinks." Between the last week of July and the first week of August, something seems to have happened in North Block. On August 3, a senior Ministry official wrote to public sector banks to keep in abeyance any planned hike in their prime lending rate till their boards took a view on the rise.

A tricky situation

This created an awkward situation for some banks, which had already increased the PLR by 25 basis points in keeping with the current procedures. It led to an impasse as public sector banks had to hold the view on loan agreements. There were doubts whether there was any difference in the policy on interest rate between the Government and the RBI. The letter was defended on the ground that the Government, as the majority shareholder of the banks, has a right to advise.

Leaving aside legal niceties, the letter raises a number of important issues. It puts the clock back, at least in the interim till the cloud over it clears. It denies public sector banks' operational autonomy, which is a crucial component of public sector and financial reforms. It turns public sector banks into second grade players in the Liquidity Adjustment Facility (LAF) built assiduously by the RBI in recent years. Thereby it may erode the independence of the RBI and the efficacy of its monetary management.

In the current system, there is full flexibility for banks. The procedure was brought to public attention in RBI literature as also in its Credit Policy reviews. The Indian Banks Association advised its members in November 2003 to announce benchmark prime lending rates (BPLR) with the approval of their boards keeping in view their operational requirements. "Furthermore, banks were allowed to freely price their loan products below or above their BPLR and offer floating rate products by using market benchmarks in a transparent manner."

Banks are also advised to align the pricing of credit to their credit risk assessment so that credit delivery and quality improves.

Complex money market

All banks, whether in the public or the private sector, operate within this policy frame. Money and credit market operations are rather complex and taken up on an hourly basis. Therefore, boards of banks have delegated these operations to Asset-Liability Committees (ALCOs). ALCOs consist of senior officials and are often presided over by a top executive of the bank. They operate under the mandates given to them by their boards. All ALCOs use complex computerised models, as the margins are wafer thin and fluctuate at very short notice.

Liquidity management

Central to the RBI's monetary management is liquidity management. Since June 2000, it has been able to introduce a full-fledged LAF, permitting banks and primary dealers (PDs) to manage their liquidity through recourse to this facility. Within the domestic sector, a bank cannot get a better rate than the repos offered by the RBI under the LAF. By the same token, a bank has to cover the higher repo through higher loan, deposit, etc., rates. The transition to this framework was the result of far-reaching changes in monetary policy and enabled specifically by the introduction of market-based price discovery mechanism and reduction of financing of government deficits by the RBI. The change came about decisively from April 1997. Since then, the entire government borrowing has been conducted through the inter-bank call market. By that date, the monetary policy came within the domain of the RBI and its independence guaranteed.

Fiscal and monetary regimes

Some Western economists had warned of the risks attached to the decoupling of fiscal policy from monetary policy. For instance, Prof Richard Werner wrote, "Uncoordinated monetary and fiscal policies, implemented by two separate entities (the Ministry of Finance and the RBI) could lead to a major macroeconomic misallocation of resources" (

Rising to the challenge in Asia: A study in financial markets

, Vol.5, India, 2000, Asian Development Bank).

This doom scenario has not come about thus far in India. The RBI deals with this issue perspicaciously in its

Report on Currency and Finance 2004-05

(Pages 231-6.)

In great measure, the RBI's liquidity management has brought about the harmony between monetary and fiscal regimes. Unlike in other countries, the RBI's liquidity management is not driven so much by interest rate considerations as by its aim to provide adequate liquidity and ensure price stability.

As described in a RBI Credit Policy review, "The LAF rate corridor has emerged as an important tool of monetary management." Variation in LAF rates is perceived by the market as short-term interest rate signals arising from a change in monetary policy stance.

The RBI expressed satisfaction in its Report that a reasonable degree of monetary and fiscal policy coordination had been achieved through the operationalisation of a short- term LAF model. However, it felt the need for a model to suit the longer-term needs, particularly in the light of evolving macroeconomic scenario arising out of Fiscal Responsibility and Budget Management (FRBM) situations.

Though the RBI anticipated `problems' with the fiscal authorities in the longer run, it seems to have surfaced in the shorter run. This is because the financial reforms, especially the structural break between fiscal and monetary realms, were put through during the years of declining interest rates globally and in India. It was practicable for the RBI to reduce the bank rate from 11 per cent to 6 per cent. Further, the Finance Ministry began to view low interest rates as the road to higher growth. More than growth, low interest rates kept the cost of government borrowing low.

There are grounds to believe that the era of low rates is over and interest rates are moving north. When the rates move up, they push the cost of borrowing to fill budgetary gaps; the Ministry has reasons to worry. Current estimates clearly suggest that the fiscal caps have been crossed and the Ministry has pressed the panic button. It has issued a circular ordaining austerity measures. The bank circular and the austerity circular were issued around the same time. If this assessment is in order, was the Ministry seeking to engage in a silent war with the RBI over interest rate? It will not win the war but the collateral damage will be incalculable.

Public sector banks have the lion's share of the banking transactions in India and their direct and unhesitant participation in the financial playground is vital for the success of RBI's monetary policies.

Even as the RBI is trying to broad base the call money market and turn the LAF into an efficacious tool, an attempt to keep the public sector banks away from them, even temporarily, will disrupt their operations and reduce efficacy.

Hopefully, the Finance Ministry will withdraw the letter and permit public sector banks to function as before.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

(This article was published in the Business Line print edition dated August 12, 2006)
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