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The Rediff Business Special/Raghbendra Jha

Policy With Potentially Profound Implications

The Reserve Bank Governor released the Mid-term Review of Monetary and Credit Policy for 1999-2000 today. The announcement of the credit policy has, in the recent past, become a vehicle for pursuing various objectives. First, it has become an opportunity for announcing major changes in policies that are essentially meant for short-term targeting. The reference is to interest rates which, invariably, follow the lead given by CRR or cash reserve ratio. (CRR = the fortnightly cash balances maintained by commercial banks with the central bank.)

Second, the RBI uses this opportunity to review policies with regard to medium-term targeting, in particular the growth rate of money supply.

Third, various regulatory norms for banks and other financial institutions are reviewed.

Fourth, some financial sector reforms that are to be pursued are announced.

Last, but not the least, the Credit Policy is an opportunity to get a view on what the RBI thinks the medium term prospects for the real and financial sectors of the economy are.

The present Credit Policy makes contributions in all these areas. Coming as it does, when a new central government has just been sworn in and industrial growth is showing the first signs of sustained recovery, this is a policy announcement with potentially profound implications.

The RBI has taken for granted that industrial recovery is imminent and taken a decisive step to aid it, that is, cut in the CRR by a full percentage point and a withdrawal of the incremental CRR of 10 per cent on FCNR(B) deposits. (foreign currency non resident Indian -- banking deposits.)

These together would pump in over Rs 80 billion crores into the economy, by the RBI's own calculations. This would help moderate interest rates at the shorter end of the yield curve. Higher availability of funds and lower cost of borrowing (both because of potential cuts in the interest rate following CRR cuts and withdrawal of interest surcharge on import financing and on pending export bills) could result in a sustained increase in investment as well as in consumer expenditure on durables.

To the extent that Indian industrial growth is constrained by sluggish demand, these measures could provide relief. Aiding this would be the various simplifications that have been promised in regard to the processing of imports.

The Credit Policy recognises the fact that public sector banks, in particular, are disadvantaged in that they have higher costs: their operating expenses are of the order of 2.5 to 3.0 per cent of total assets. If these banks are forced to cut interest rates too much, there would be further pressures on their margins.

The new credit policy addresses this problem by giving banks considerably more freedom to set interest rates with the Prime Lending Rate now playing less of a central role in such decisions. However, no major policy initiative has been taken to address one of the key reasons for this problem to exist in the first place: the high SLR requirements.

Important policy measures announced for the money market include loosening the hold of the RBI on Money Market Mutual Funds and passing on of their control to SEBI, like other mutual funds.

Mutual funds are now allowed to indulge in forward rate agreements and interest rate swaps just like corporates. These two measures would significantly lower the bias against mutual funds and, to the extent that the small saver is attached more to mutual funds, serve to buttress his position in the market.

The RBI has also promised to take steps to deepen the government securities market although no concrete steps are announced in the Credit Policy itself. Reforms are promised in the retail segment of government securities, treasury bills market and the opening up of repo market to public sector unit bonds.

The discussion so far relates to RBI's role in addressing the first, third and fourth points listed at the beginning of this review. Essentially, these points deal with the RBI's reaction to the policy problem confronting it and in effecting changes in financial instruments and markets. The second and fifth points require the RBI to look ahead a bit and pontificate on matters of slightly longer-term concern.

So far as the medium term problem of targeting the growth rate of money stock is concerned, the RBI is still looking at 15 per cent to 16 per cent over 1999-2000. If it anticipates the growth rate of the economy to be in the region of about 6.5 per cent, this would indicate that the RBI is expecting inflation to the tune of about 4 per cent to 5 per cent over the year.

Given that we have had inflation lower than this in the first half of 1999-2000, this would imply that inflation in the second half is expected to be higher. If inflation goes up, interest rates cannot be far behind, since the market typically looks at the interest rate as a proxy for expected inflation. To keep interest rates down, then, would become a challenge.

The Credit Policy says virtually nothing about expected path of exchange rates over the next six months. If the immediate effect of the Credit Policy is to lower interest rates in India (while our inflation rate is expected to go up in the medium term), interest rates in the US are on the way up (in the short run) in the context of an overheating American economy. So pressures on the rupee are going to remain unabated. The Credit Policy is silent on this point.

Similarly, the Credit Policy warns that the fiscal deficit should be brought under check. But the primary responsibility for this lies with the fiscal authorities and it is not at all clear that they will be successful in this. The RBI should have prepared a contingency plan for what would happen if its fiscal deficit assumptions are belied.

In sum, this Credit Policy has shown that the RBI is responsive and ready to aid the incipient revival of industrial growth and that it is taking financial market reforms steadily further. In this it has proven, yet again, to be a good monetary manager in dealing with immediate problems. However, it is a bit short in planning and spelling out a medium term strategy.

(SLR = statutory liquidity ratio. Banks in India are required to maintain 25 per cent of their demand and time liabilities in government securities and certain approved securites. These are collectively known as SLR securities. The buying and selling of these securities was the seed of the 1992 scam. Back to the review.)

The writer is Professor of Economics at the Bombay-based Indira Gandhi Institute of Development Research

ALSO SEE

RBI Governor Bimal Jalan's policy statement

RBI's Credit and Monetary Policy 1999-2000

RBI's Credit and Monetary Policy 1998-1999

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