Rather than prescribe the wrong medicine, it is better not to prescribe any medicine. This aptly applies to the Reserve Bank of India’s decision to opt for a reduction in cash reserve ratio in its mid-quarter review.
This move was uncalled for, going by both theory and the ground realities. Let us first look at the latter. The arguments offered by the central bank to defend its policy move rest on three grounds.
The upcoming festive season, advance tax payments and busy credit season are the factors cited for releasing additional liquidity into the system.
In this context, the approach, ‘cross the bridge when you get to it’, would have served the purpose.
The liquidity situation, gauged by the daily borrowings of banks from the RBI, has been within acceptable limits for the past two months. There was hardly any need for activism on the CRR front in the present context. Will the additional liquidity not have an inflationary impact?
Outside Lag
Theory suggests that monetary policy is generally associated with a long outside lag —
the time it takes for policy actions to have the desired impact on the real economy. The outside lag is particularly long for changes in policy rates.
However, the CRR is a more direct instrument and has an instantaneous impact on liquidity. In contrast, the transmission of a reduction of policy rates depends on whether the banks will follow suit. Hence, the CRR is considered a blunt instrument.
With another Rs 17,000 crore being pumped into the system, banks would have to do something with the additional liquidity.
In an atmosphere when growth has decelerated significantly and non-performing loans are a major cause for worry, the additional liquidity is likely to be deployed away from loans and towards investments.
The RBI has merely facilitated government borrowings at cheaper rates. To that extent, there will be less pressure on the government to take strong corrective steps towards fiscal consolidation.
When the goal is to revive growth and curb inflation, a reduction in policy rates would have been more effective than infusing liquidity in the system.
A rate cut would take longer to work its way through the economic system. Therefore, its inflationary impact, if any, would be muted.
The central bank needs to be more forward-looking on the rate front, given the time lag factor. If we are planning for a revival of growth momentum in the fourth quarter, the time to act should have been now.
Real, Nominal Rates
The RBI seems to take comfort from the fact the real interest rates in the present slowdown are much lower than those prevailing during the high growth years of 2004-08. It attributes the current problem of negative investment growth to factors other than interest rates.
The RBI is correct in its assertion that Government inaction on real-sector issues is responsible for a drop in investment.
However, it is perhaps overlooking the impact of high nominal interest rates on the economy. While real interest rates do matter for current investment decisions, which will affect future output, high nominal interest rates can affect the servicing of loans that have already been taken. In a situation of slowdown, it becomes that much harder for producers to service their loans, or pass on higher interest burden to the ultimate consumer. Policy rates began to increase from March 2010 through November 2011 and were maintained at those high levels till April 2012.
Consequently, the interest burden of borrowers increased by 30-40 per cent in a small span of one year between July 2010 and July 2011 and continued at those high levels for roughly one more year.
When growth dropped to 6.5 per cent in 2011-12 from 8.4 per cent in 2010-11, borrowers were unable to pay their larger interest component on existing loans; this became a headache for banks in the form of NPAs or restructured assets. Once banks are in trouble, it can have a major economic fall-out.
As banking regulator apart from the monetary authority, the RBI is duty-bound to protect banks in the larger interest of the country. Though it is common to expect the government to own up to responsibility for governance, it is time the RBI lives up to its responsibility of protecting the health of banks.
That high nominal interest rates have adversely impacted bank NPAs, impeding banks’ ability to lend, should have been accorded due policy consideration.
What RBI should have done
Now that the Government has made some positive moves and the Finance Minister has indicated a slew of measures in the coming one-and-a-half months, the RBI could have chosen to either leave things alone, or lower policy rates.
By sticking to the status quo , the RBI would have obtained more elbow room to manoeuvre policy during its next review.
A baby step towards lowering rates would have given more space to banks for reducing rates, apart from lifting sentiments to facilitate growth.
(The author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)