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Business Commentary/ R C Murthy

Rate Cut I won't be earth-shaking, mid-year Cut II may be necessary

Now that Bimal Jalan, governor of the Reserve Bank of India, accepted the need for a bank rate cut, the question is when it is to be effected. And, by how much.

This belated recognition by Jalan came only after the government slashed public provident fund interest rate by one percentage point to 11 per cent. By not acquiescing to industry's demand for bank rate cut all along, Jalan's message is loud and clear: He will wait to see the shape of the coming budget.

Is the rate cut not overdue? Well, in a sense yes. In fact, the growth impulses and signs of a turnround in the Indian economy seen almost a year ago have certainly weakened.

First, by political instability till the Natioinal Democratic Alliance returned to power in October 1999 and then by the anxiety on the part of the RBI to push through successfully the government's market borrowings programme. There was also concern over the bank rate cut impacting adversely the already fragile banks further.

The widely accepted view is that the rate cut could have been part of busy season credit policy package announced in October 1999.

But Jalan did not oblige.

The then proposed bank rate cut was to be a step to boost the faltering economic recovery. There was certainly a danger of growth impulses getting dissipated in the absence of an adequate monetary stimulus. Fortunately, that did not happen.

Jalan just loosened the monetary strings and eased liquidity by cutting the cash liquidity ratio by one percentage point so that commercial banks could meet the expanding credit needs of the economy during the six-month busy season that began technically on November l.

What the Reserve Bank did was to leave more cash with banks but it did not work for a reduction of its cost.

Jalan wanted action by the administration. But Finance Minister Sinha delayed by three months the PPF interest rate cut from 12 per cent to 11 per cent.

But Jalan's concern now is over the size of next year's market borrowings of the central and state governments. Their combined fiscal deficit this year is placed at more than 10 per cent of GDP.

Of course, Sinha is talking of taking tough decisions and "biting the bullet". Jalan and market analysts would like to see how these words are translated into action. After all, Jalan would have to bear the cross of open market borrowings programme.

There is yet another aspect. On the fragile banking system, Jalan is on a better wicket now. The adverse impact of an interest rate cut now would only be for a month this fiscal and and will enable bank managements to present acceptable working results. There is enough time to absorb the adverse impact next year.

Had the bank rate been cut by one percentage point to eight per cent in October 1999, and had banks lowered their deposit interest rates as a sequel, the average cost of deposits would not have dropped significantly this fiscal.

Because some 85 per cent of banks' deposit portfolio are long-term deposits. They are contractual obligations and banks cannot unilaterally alter their interest rates.

Until such time each bank develops its deposit rate structure to eliminate the mismatch in its assets-liabilities portfolio, and achieves flexibility, the banking watchdog will have to reckon with this problem.

So too, the non-banking financial companies, which are just recovering from the impact of regulatory norms the RBI had announced last year.

Now, the financial sector is aware of the shape of things to come with respect to interest rates and the companies have a full year to adjust, though performance is monitored on a quarterly basis.

Alert institutions like the ICICI deferred launch of bond issues soon after the PPF rate cut in order not to be saddled with high-cost funds.

The other main element of bank rate cut is the quantum -- one per cent, two per cent or three per cent.

In 1991, the then RBI Governor, S.Venkitaramanan, increased dramatically the bank rate by two percentage points to 11 per cent.

But that was a crisis situation and the RBI wanted to drive home the sense of urgency.

Having watched Jalan playing with monetary instruments, I don't see anything dramatic coming from the Reserve Bank now. Jalan believes in letting the sleeping dogs sleep. And, if inevitable, he will wake them slowly.

Which he has done by announcing early February that the time is ripe for a bank rate cut. When the event occurs, it won't be a surprise.

Businessmen and bankers would discount the cut. Stock markets would move the least if the bank rate cut is just one percentage point.

And, that is exactly what Jalan will do budget time. He does not want to stir and move the market either way. Shorn of surprise element, the bank rate cut would impact the economy rather slowly if only the cut is passed on down the line.

The crucial issue is how the public at large perceives the actions of the government and the RBI. The finance minister is moving in the right direction. But the PPF rate cut is only a step.

If Sinha is seen to be moving towards a lower fiscal deficit but within an appropriate time-frame and without indulging in gimmicks, banks, as anyone else, will certainly see the writing on the wall.

They will have to cut the deposit and lending rates and move to a low-cost economy.

In such a situation, businessmen will look for a second bank rate cut mid-2000, other things being equal.

R C Murthy

Business