ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Where the Banks Have Failed Us

The benchmark prime lending rate, far from being a competitive and transparent mechanism that determines interest rates charged by banks, has instead turned opaque. In order to ensure that the cost of bank credit is not unreasonable for any productive enterprise, it is necessary to limit the spread over BPLR, beyond which the banks should not be allowed to set lending rates. If the economic stimulus has to be truly genuine and effective, a more rational system of interest cost to bank borrowers has to be introduced with the utmost urgency.

Resource Constraints for Infrastructure Investment

Infrastructure investment is a priority area for the Eleventh Plan, and close to half of this investment is to be financed by debt. Yet, many of the institutional channels for debt financing are not functioning effectively. A dynamic institutional structure consisting of a number of development finance institutions promoting a hierarchy of gestation period financing is needed; but the ideology of reforms has no room for the DFIs. Banks have not been encouraged to lend to the infrastructure sector and the corporate bond market is not active enough. Considering the importance assigned to the sector, the institution of DFIs may have to be resurrected even if its benefits are derivable only in the medium term. It is also possible for banks to expand their long-term lending with their existing asset-liability structure as there is a degree of permanence to many of their so-called short-term liabilities. And the reform of the commercial bond market has to be undertaken on a war footing.

Time to Rescind FRBM and Stabilisation Policies

The fiscal constraints on providing any substantial stimulus are evident from the revised estimates of the budget for 2008-09. In such a situation and given the current economic environment, exhorting banks to provide an intensive stimulus makes sense provided the monetary policy and banking operations are not constrained by stabilisation goals. The government and the Reserve Bank of India therefore need to desist from persisting with the Fiscal Responsibility and Management Act-mandated environment insofar as borrowings from the central bank are concerned. The RBI also needs to take a deeper interest in the sectoral distribution of bank credit by monitoring, applying moral suasion and by providing an appropriate incentive structure.

Stimulus Packages Facing Institutional Constraints

The massive liquidity injected into the system cannot translate into additional bank credit because of both supply- and demand-side constraints. In the gloomy economic scenario, instead of expanding commercial credit, banks prefer excessive investments in government securities as well as secondary market operations. They also tend to persist with high interest rates despite steep reductions in the Reserve Bank's benchmark rates. Following fiscal compressions, the capacity of the administration to absorb higher productive expenditures has suffered in recent years.

The External Sector: A Tightrope Walk

The situation in the external sector has become an extremely challenging one for the authorities. Foreign currency assets have begun to deplete and there is considerable uncertainty on the exchange rate front. The authorities are hard put to contain the depreciation of the rupee. Above all, if large forex assets have to be deployed every month to protect the value of the rupee, the available foreign currency assets of $237 billion may be depleted soon.

Monetary Measures Lack Developmental Focus

The financial crisis should give the Reserve Bank of India an opportunity to do some soulsearching about its delivery of credit. Over the years, the layers of money market transactions indulged in by low deposit-based foreign and new private sector banks have determined the interest rate structure and thus distorted the structure for the real economy, which is where the larger crisis is taking place. This distortion has been prompted by the RBI's policy of non-interference in the prime lending rate system. In the accompanying neglect of agriculture, artisanal and smallscale industry, the interest rate charged has been higher at times than the average rate for the system as a whole. It is clear that a calibrated set of central bank guidelines with rigorous enforcement is necessary to realise social goals in credit policy prescriptions, along with a strengthening of banking institutions and the establishment of a rational interest rate structure.

Paradigm Shift in Financial Policies: Need of the Hour

The unravelling of the global financial crisis sends a clear signal that India has to make fundamental changes in its management of the banking and financial sector. The first prerequisite is a return to relationship banking, the arrangement under which contacts between the lending bank manager and the borrower are direct and not impersonal. The immediate Indian response to the global crisis should be to work towards lowering interest rates which at their high level have hurt manufacturing investment in both the large- and small-scale sectors. The economy also needs the pursuit of an expansionary policy by waiving the fiscal rules.

Policy-Induced Financial Market Vulnerabilities

There is an unwarranted smugness in the Indian response to the crisis sweeping global financial markets. If Indian institutions are, as of now, unaffected by the turmoil, it is not because of the correctness of Indian policy decisions, but because of intense social pressure which has prevented the authorities from inflicting radical reforms on the financial sector. It is also not entirely correct to claim that the Indian financial system is not exposed to the new and complex instruments, which have been a source of distress in the United States. A number of instruments of securitisation have been introduced in the Indian market; what has protected the system is the institutional structure of banking with over 70 per cent of assets still held by the conservative public sector banks. The explosion in trading in individual stock futures and of commodity futures are two obvious examples that suggest that the Indian financial system is vulnerable because of an inadequate regulatory architecture.

Sustainability of External Liabilities

The debt-service ratio may appear low and satisfactory, but it is high time the official agencies conceived of a more meaningful concept of sustainability of total external liabilities in the face of reserves built substantially on volatile flows. Persistent disinvestment by foreign institutional investors ever since signs of discouraging economic prospects surfaced earlier this year should be an eye-opener.

Inverted Yield Curve

The recent behaviour of interest rates and the yield curve is a reflection of the monetary policy stance that has succumbed to market expectations. The monetary policy actions have naturally had an impact on shortterm interest rates, the upward revisions in benchmark rates leading to a rise in the former; but the long-term rates are restrained by what the market can bear. Hence, in a situation of sluggish economic activity, long-term rates rise in sympathy with short-term rates but only fractionally; this leads to narrowing of the spread and flattening of the yield curve, even at times leading to an inversion.

Keeping the Rupee Competitive

In 2007, the rupee appreciated by as much as 12 per cent against the dollar, leading to an adverse effect on exports, investment proposals and employment - the policy was perhaps to use an appreciating rupee to fight inflation. While letting the rupee rise was a reversal of long-standing policy, the Reserve Bank of India has now restored the earlier approach. In spite of the acceleration in inflation since January 2008 the rupee has depreciated by as much as 7.5 per cent against the dollar so far in the current calendar year. India cannot be aggressive like China in undervaluing its currency. However, it is necessary to moderately undervalue the rupee in order to aid exports.

Blinkered Formulation of Monetary Policy

The Reserve Bank of India currently uses indirect instruments of monetary control that operate through the market mechanism. Signals are sent by injection or contraction of liquidity, or by changing bank reserves and short-term interest rates. But there is no direct correspondence between the instrument and the ultimate policy objective of higher growth and price stability. On the other hand, the availability of credit is the most potent direct instrument of monetary control, which can bring about an one-to-one correspondence between the instrument (such as credit ceilings) and economic objectives (sectoral growth). With the Planning Commission too talking about the role of credit in promoting inclusive growth, the monetary authorities cannot but integrate policy objectives with policy instruments, with the application of direct instruments of monetary policy such as the use of directed credit and interest rate bands.


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