NEWS
COMMENTARY
INTERVIEW
CHAT
ARCHIVES

The Rediff Business Special / Dr C Rangarajan

The Indian Economy: What Lies Ahead?

Outgoing Reserve Bank of India Governor Dr C Rangarajan's forecast for the Indian economy

The monetary and credit policy for the first half of 1997-98, announced in April 1997, seeks to achieve the twin objectives of inflation control and promotion of growth. In pursuing these objectives, the accent has been placed on creating an environment to aid credit flow to the real sector -- to support the expected buoyancy in economic activity, to consolidate and make further progress in the financial sector reforms, and to maintain a strong vigil on the price front.

There are four major areas which have been given focused attention in the current monetary and credit policy. The first relates to maintaining reasonable price stability in the economy by regulating the money supply to moderate inflationary pressure. Based on the assumption of a real GDP growth of six to seven per cent, the money supply growth has been targeted in the range of 15 to 15.5 per cent, to restrict the inflation rate to below six per cent during 1997-98.

Such an inflation target should be viewed as reasonable to dampen the long-term inflation expectation in the economy, to reduce the impact of inflation related uncertainty on output, and to maintain the external competitiveness of the economy.

The second important objective addressed by the monetary policy relates to improving the credit situation and reducing interest rates. While the full impact of the four percentage point reduction in CRR effected in the last financial year will be seen in the current year, a number of measures have been announced to further improve banks' lendable resources.

Introduction of a general refinance facility for banks equivalent to one per cent of the fortnightly average outstanding aggregate deposits during 1996-97 and exemption of inter-bank liabilities from maintenance of cash reserve ratio of 10 per cent are the two important measures in this direction. These measures will augment the banking sector's liquidity to the extent of Rs 55.5 billion. Apart from its liquidity impact, the exemption of inter-bank liabilities from maintenance of CRR will help promote the term money market and facilitate the development of a realistic rupee yield curve.

An important step in the direction of improving the monetary management has been the operationalisation of the bank rate as an instrument to transmit signals of monetary policy and as a reference rate to influence the direction of interest rate movement in the economy. Keeping this in view, while the bank rate has been reduced from 12 per cent to 11 per cent, its linkage with the short-term deposit rate of banks has ensured one percentage point reduction in the interest rate on deposits of 30 days to one year maturity. Interest rate on RE has also been linked to the bank rate, while the banks will decide their own interest rates on FCNR (B) deposits.

Due to these measures, the average cost of funds to banks has reduced, bringing down lending rates. Responding to the policy announcement, many banks have already brought down their prime lending rates by 50 to 100 points. On a four year horizon, i e between 1993-94 and 1996-97, the lending rate has come down by nearly three percentage points from a high of 17 per cent in 1993-94. The bank rate was further reduced by one percentage point, from 11 per cent to 10 per cent in June 1997.

Consequently, interest rates on domestic deposits of maturity of 30 days to one year and on NRE deposits of maturity of six months to one year, were brought down from nine per cent to eight per cent per annum. Some public sector banks have reduced their PLRs by 50 points, to 13.5 per cent per annum.

Interest rate on post-shipment export credit up to 90 days was reduced by one percentage point, from 13 per cent to 12 per cent per annum, and for export credit beyond 90 days and up to six months, from 15 per cent to 14 per cent per annum.

The third areas of emphasis in the monetary policy is the revamping of the credit delivery system by empowering the banking system. The freedom given to banks to evolve their own methods of assessing the working capital requirements will speed up decision-making and the flow of funds from bank to borrower.

The fourth major objectives relates to improving the functioning of various markets -- the money market, the government securities market and the foreign exchange market. Some important changes in the areas of money and capital markets include the removal of CRR on inter-bank liabilities, the reduction in the minimum period of maturity for commercial paper to 30 days, the reduction in the minimum size of certificates of deposit, an improved access to cash surplus entities through primary dealers, an enlargement of eligible government debt instruments for Repo transactions, the entry of non-bank entities with SGL accounts to enter reverse Repo transactions and the introduction of treasury bills of varying maturity.

These measures will carry forward the ongoing institutional and policy reforms in the money and government security markets to strengthen the role of interest rate in the economy and to improve the conduct of monetary policy.

Some major policy initiatives have been also announced to promote the foreign exchange market, such as the permission to book forward contracts on the basis of declaration of exposure, the permission given to the authorised dealers to borrow from the invest up to $ 10 million abroad and to engage in foreign exchange-Rupee current swaps without the prior approval from the Reserve Bank.

These measures propose to widen and deepen the foreign exchange markets and integrate them with the other markets, so that a unified financial system would lead to the achievement of higher efficiency in resource allocation. Integration of various segments of financial markets has also become a necessity to improve the transmission channel of monetary policy and to achieve a greater degree of openness in the economy.

The monetary policy for the first half of 1997-98 has, therefore, adopted a package approach to improving the functioning of the financial system, to augmenting the flow of credit from the banking system to various segments of the economy, and to keeping inflation under control.

Trends in Money and Credit

Banks's deposits have grown well in the current year. The deposits of scheduled commercial banks increased by Rs 280.45 billion in the current year up to September 12, as compared with an increase of Rs 209.91 billion in the previous year. During the period March 28 to September 12, 1997, non-food bank credit declined by Rs 30.03 billion as against a decline of Rs 50.70 billion during the corresponding period in the previous year.

However, banks investment in commercial paper, PSU bonds and shares and debentures of the private sector increased by Rs 69.88 billion as against an increase of Rs 10.20 billion last year. The total flow of funds from scheduled commercial banks to the commercial sector is thus positive, at Rs 35.56 billion during the current financial year so far as against a negative figure of Rs 40.27 billion in the corresponding period in the previous year. Thus, there is a turnaround of Rs. 76.93 billion.

In this context, it must also be noted that normally, during this period, bank credit declines from the peak reached at the end of March. The decline in non-food credit during the corresponding period was particularly sharp in 1993-94 and 1994-95 when the fall was as high as Rs. 76.28 billion and Rs 64.16 billion respectively.

The decline in non-food credit during current financial year so far was the lowest in last five year period 1993-94 to 1997-98. There are also other indicators of a pickup in credit in 1997-98. For example, the additional credit limits sanctioned by banks (under the credit monitoring arrangement) to borrowers with working capital limits of Rs 100 million and above, or of term loan of Rs 50 million and above during April to mid-September 1997, amounted to Rs 133.25 billion, a 72 per cent increase over sanctions of about Rs 77.55 billion during the corresponding period in 1996-97.

Interest rate

The interest rates have begun declining. The PLR has been brought down to 13.5 per cent by some public sector banks, and to 14 per cent by other public sector banks. Private sector banks and foreign banks have also brought down their PLRs, though not to the levels of public sector banks. The rate on the 91 days treasury bills has declined from 10.17 per cent, as on September 26, 1996 to 6.88 per cent. as on September 26, 1997. In the case of 364 days treasury bills, the rate has come down from 12.61 per cent, as on September 25, 1996 to 8.47 per cent, as on September 24, 1997.

The inter-corporate rates have also come down. The decline in the rate of interest is seen in the long-term rates as well. The 10-year bond rate has come down from 13.85 per cent in 1996 to 13.05 per cent in April 1997. The yield on the three-year government bond has declined to 12.14 per cent in May 1997, as compared with a rate of 13.7 per cent in June 1996. In July 1997, the rate on six-year bonds came down to 11.83 per cent, as compared with 13.82 per cent in September 1996. The yield on four-year government bonds declined sharply to 109.85 per cent in July 1997 from 13.72 on four-year zero coupon bonds in July 1996.

The outstanding amount of commercial paper witnessed a pronounced increase from Rs 6.46 billion, as on March 31, 1997, to Rs 31.59 billion, as on September 15, 1997. The typical discount rate offered on commercial paper steadily declined from the range of 11.25-12.25 per cent to 8.25-9.50 per cent during the same period.

Questions have been raised about the appropriate level of interest rates in the Indian context. As I mentioned earlier, the interest rate should be such as to provide incentive for saving and, at the same time, to encourage investment. In the developing countries, this dilemma continues to pose policy challenges.

The interest rates in India have not only come down from the very high levels reached in 1990 and 1991 but are perhaps at their lowest level since 1988.

Critics point to the high level of real interest rates in India. There are difficulties in computing the real rates of interest. The real rate of interest computed on the basis of the consumer price index will not be as high as the one that uses the wholesale price index, because of the substantial differences between the WPI and CPI in the last two years. Strictly speaking, the real rate of interest is the nominal rate of interest less the expected inflation rate.

As the inflation rate remains at a reasonably low level and inflationary expectations are broken, it should be possible to bring down the nominal interest rate. It is also hoped that as the operational efficiency of the banks improves, they will pass on some part of the gains in the form of lower interest rates to the borrowers by reducing the spread.

Prospects for 1997-98

To sum up, despite a deceleration in industrial growth in 1996-97, the current economic scene reveals several positive trends, which can accelerate the growth momentum in the economy in the coming months.

On the monetary and credit side, there has been a substantial expansion in deposits in the recent period. Interest rates both short term and long term have shown a steady decline. These coupled with some of the major tax incentives announced in the Union budget for 1997-98 and a better prospect for export growth should help accelerate the industrial growth during the current fiscal year.

World trade is expected to grow at 7.3 per cent in 1997 as against 5.4 per cent in 1996. The favourable monsoon this year has also brightened the prospects of higher agricultural output. Overall, the economy will show an improved performance in the second half of 1997-98.

Over the past five years of reform, the internal and external balances of the Indian economy has undergone a fundamental positive change, contributing to the sustainability of the macro-economic system and realisation of the objectives of higher growth and stability.

Accelerating the growth momentum on a continuous basis, will depend on how quickly and effectively the various segments of the economy respond to the various policy initiatives and the emerging investment opportunities in the economy.