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The Rediff Business Special/Raghbendra Jha

Walking the Liquidity Tightrope

Some major changes in the Monetary Policy stance had taken place before the Credit Policy announcement itself. Under pressure from the government, the Reserve Bank of India or RBI cut the bank rate, the repo rate and the CRR by a full percentage point and the interest rate on bank deposits by half a percentage point.

This has happened in spite of the fact that the fiscal deficit both at the central and state levels has gone up by much more than expected and has become increasingly hard to predict, the interest payment on the national debt is to cross one trillion rupees this year and the national debt has crossed 80 per cent of gross domestic product or GDP (IMF World Economic Outlook 2000).

However, M3 growth in 1999-2000 was of the order of 13.6 per cent as against 19.2 per cent the year before. This was primarily because of a lower than expected monetised deficit. This low monetisation, while commendable, is also an indicator of the high level of government borrowing.

Cutting these interest rates under such situations is a gamble. If interest rates come down and industrial recovery picks up in earnest, tax revenues would rise and the burden of the deficit would be lowered. However, although some short-term rates came down, there is no perceptible movement in long-term interest rates since the market expects substantial government borrowings.

The RBI, then, is torn between two competing sources of demand for credit. On the one hand is the government's borrowings, on the other there is the need to support the incipient recovery in the industrial sector.

Since the government has a prior claim to this credit, any concerted push in the other direction might put considerable pressure on prices. The market has anticipated this problem -- the widening of the gap between the short and long term interest rates is a sure indicator of the rise in expected inflation. This is the tightrope that Monetary Policy must walk in the coming months and this is the dominant theme of this Credit Policy.

It is for this reason that the Credit Policy announcement, while laying down broad contours of planned M3 growth (at 15 per cent) and monetary stance, makes it clear that it might have to intervene on a day to day basis to stabilise inflation and inflationary expectations.

The current fiscal stance of the government with expected rollbacks in cuts in subsidies, does not bode well for the RBI's goal to support through easy liquidity the revival of the economy. Demand pressures become important during the upswing of the business cycle. At the present point in time, these pressures are coming largely from an unproductive government sector. Think of the private sector credit requirements if the industrial revival continues and the capital goods sector starts to expand!

The Credit Policy announcement takes some other important policy initiatives and a few may be mentioned.

First, it has taken significant steps to deregulate interest rates further. Several examples of this can be found in the announcement. These range from variable rate repos to lowering the minimum period for Certificates of Deposits from three months to 15 days to allowing banks to charge different prime lending rates for different maturities. These measures will relieve the inertia in interest rate movements and, when there is scope, act as a catalyst for lowering interest rates through interbank competition.

Second, the RBI is aware that such interbank competition might lead (and has in the past led) to sacrifice of prudential norms for banks. Hence, there is considerable stress on the banks satisfying these norms and reaching the capital adequacy requirements.

Two significant additions have been made in this connection:

• Firstly, subsidiaries of banks are to be treated on par with the parent bank in respect of attaining capital adequacy ratios. It is in this context that the RBI bemoans the fact that the banking sector has accumulated government securities of around 34.3 per cent of its net demand and time liabilities against the stipulated SLR of 25 per cent.
• Secondly, while permitting the successful banks to enter into the new area of insurance, the RBI has held out the regulatory stick. These banks will have to get permission from the RBI to enter into the insurance sector. The RBI will, then, be able to monitor the exposure to risk that these banks would face.

Third, the announcement has simplified a number of procedural issues. Such measures range from easing the liquidity needs of exporters to better use of rediscounting facilities to making it easier for corporates to borrow abroad.

In sum, then, the basic thrust of this Credit Policy is trying to play a supporting role to an economy that is emerging out of the shadows of a long recession. However, it is handicapped in these efforts because of a large fiscal overhang.

Subsidiary efforts of this policy have been aimed at making the money markets more efficient by providing more discretion to corporates as well as commercial banks and to reduce the credit exposure of a financial sector with a bad non performing assets or NPA problem.

It is an efficient policy document. However, the success of this policy depends on many imponderables such as the rate at which the economy revives and the commitment to fiscal austerity of the government. For these reasons alone, it might end up belying the targets it had set for itself to achieve.

Repo: repurchase agreements or ready forward deals, a secured short-term -- usually 15-day -- loan by one bank to another against government securities. Legally, the borrower sells the securities to the lending bank for cash, with the stipulation that at the end of the borrowing term it will buy back the securities at a slightly higher price, the difference in price representing the interest. Back to the review.

Raghbendra Jha is Senior Professor of Economics at the Indira Gandhi Institute for Development Research, Bombay.

ALSO SEE

RBI Governor Bimal Jalan's policy statement

Raghbendra Jha on Credit and Monetary Policy 1999-2000

RBI's Credit and Monetary Policy 2000-2001

RBI's Credit and Monetary Policy 1999-2000

RBI's Credit and Monetary Policy 1998-1999

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