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

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Exchange Rate Appreciation: A Major Policy Reversal

There has been a sharp appreciation in the value of the rupee against the dollar in recent weeks, a change in policy track from the tightrope walk of promoting export competitiveness while holding the cost of imports. This policy change, occasioned by the continuing upsurge in capital inflows, is intended to combat inflation but it is cause for worry since any major appreciation in the value of the rupee will have a direct impact on export growth and therefore on the current account deficit as well. It will, at the same time, not help fight inflation, since prices are rising due to domestic supply shortages and growing liquidity.

Will Basel II Norms Slow Financial Inclusion?

The Basel II norms, which will cover all banks by March 2009, will introduce tightly controlled and comprehensive coverage of risks that could militate against financial inclusion. The norms may not per se be against the spread of bank lending to those who are now excluded, but with the inherent biases in the functioning of the banking system, banks will seek cover under the norms to half-heartedly move towards inclusion. With serious inter-regional, inter-class and inter-sectoral disparities in banking services in India, the approach should be based on a calibrated balancing of prudential norms and the provision of genuinely inclusive as well as regionally and functionally well-spread services.

Need for Calibrated Policy in Interest Rates and Credit

The indirect measures taken by the central bank to control inflation have led to a situation where banks are pushing up rates on both deposits and loans, more on the latter than on the former, ending in a widening of the spread. This is of a piece with banks' recent behaviour in ignoring the credit requirements of a number of productive sectors. What is called for is a calibrated intervention by the monetary authority with a combination of regulations and measures of moral suasion on both the cost of credit as well as its distribution in favour of the productive sectors.

Effects of Multiple Arbitraging

The developments in the call money market in December 2006 have exposed the tenuous nature of the financial markets in a possible environment of liquidity shortages. A considerably unequal distribution in investment-deposit ratios creates scope for varied forms of arbitraging. Such arbitraging has been spawned by a situation of vast structural differences between different groups of players in the financial markets. These developments point to the substantially changed market structure, wherein arbitraging operations between markets, which are generally believed to remove misalignment of rates, have instead increased disparities.

Exuberance in Financial Markets: Towards What End?

Annual turnover in five financial markets is now equivalent to more than 300 per cent of GDP. Across the gilt, forex, equity, derivatives and commodity futures markets, an easy policy environment has led to the current mood of extreme exuberance. Secondary market trading and even speculation do have a legitimate role to play in hedging of risk, price discovery and providing liquidity. But we need a range of measures to discourage froth in the markets. Such measures must include a change in the tax regime, a ban on trading in individual stock futures, demutualisation of commodity exchanges, and closer surveillance of FII investments.

Curtailing Capability of NABARD

Credit delivery to the farm and informal sectors has deteriorated because the institutional structures have been allowed to weaken. The latest example is the curtailment of the refinancing capabilities of the National Bank for Agriculture and Rural Development. The time has come to reorient such an approach and ensure that NABARD operates as a non-commercial apex institution engaged in refinancing and promoting bank lending activities for the informal sector. For this, a number of steps have to be taken: restarting RBI contributions to the National Rural Credit (Long-term Operations) Fund, continuing the general line of credit limits, allowing market borrowings through priority sector bonds and providing tax exemption on NABARD profits.

Need for Flexibility in Financial Sector Reform

Successive governments have failed to adopt a macroeconomic perspective that allows for flexibility in the application of reform measures, a failure which is proving to be a hurdle in achieving healthy and inclusive growth path. In the financial sector, as in the case of fiscal and revenue deficit reduction, be it in universal banking or the earlier practice of differential interest rates in working capital and term loans or provision of institutional credit, the absence of such a flexibility has had many negative consequences.

Case for Government Direction on Interest Rates

Interest rate deregulation has led to skyrocketing costs of borrowing for informal sector borrowers and also a relative decline in credit delivery. There is evidence that it is the informal sector which bears a higher cost of borrowing as a result of positive discrimination in favour of corporates. There is also corroborative evidence that banks charge rates of interest far beyond their PLRs for rural households. All this is a clear case of market distortions and failure in achieving appropriate allocation of institutional credit. This can be corrected only by the application of the public interest theory of regulation in which calibrated central bank interventions can allow freedom to banks, but within an accepted industry discipline. The finance ministry's concern about the possible increases in the interest burden on the informal sector is to be appreciated in that light.

Dear Money Policy, Rising Yields and High Interest Costs

Increases in yields on government securities are indicative of a dear money policy of the central bank, which has decided to base its actions on market signals and on assigning "more weight to global factors than before while formulating the policy stance". This is to be contrasted with the earlier policy which had resisted such pressures with a view to establishing an environment conducive to economic recovery. The current policy thus makes a determined effort to push up interest levels. Apart from the adverse consequences on the economy, this will also have a possible serious impact on central and state government finances.

Pitfalls of Synchronisation with Global Policy Trends

During the past couple of years or so, the economic system has been readjusting itself to the new congenial financial sector environment of a relatively soft interest rate. Therefore, the current policy posture of pushing up rates of interest on the ground of inflation and rising global rates is likely to cause harm. In a developing economy there is enough evidence to prove that"â??even in a world with significant economic integration, the welfare gains from international coordination are likely to be quantitatively small in comparison to gains from domestic stabilisation policy".

Financial Inclusion in a Deregulated Regime

The RBI's avowed objective has been to progressively deregulate the financial system to allow it to operate in an environment of competition and efficiency. But, the system cannot be oblivious of its broader role in furthering the process of economic and social development. After a series of farmers' suicides, the main causes of which are found to be indebtedness, all banks are being urged to adopt "financial inclusion" as an operational policy. Banks, it seems, have failed to grasp the challenges of fulfilling their developmental responsibility and this has tended to question the tenability of financial sector reforms without adequate checks and balances.

Can Primary Dealers Replace RBI in Security Issues?

With the RBI now prohibited from participating in the primary issues of government securities, the management of liquidity has become a more delicate and complex task. In this context, the RBI has sought to expand the role of the primary dealers of securities; this is in the right direction but it may prove insufficient. The entire edifice that is being constructed for the PDs is on shaky ground. The PDs are highly vulnerable to market conditions wherein, for instance, a rising interest rate situation may wipe out the entire net worth.


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