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

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Blurring of Development Goals in Refinancing

The acute liquidity shortage occasioned by the Rs 32,000 crore redemption of India Millennium Deposits last December raises the larger question of the need for the RBI to be ready to inject funds into the banking system through sector-specific refinance facilities so that banks are encouraged to lend in favour of needy sectors - agriculture, small-scale industries, and other small borrowers. If the injection of massive liquidity by the central bank of the country is unrelated to broader developmental goals, the end result could only be a highly distorted one, as has been happening during the past few years: multiple layers of secondary market transactions unrelated to the development of the real sector.

Need to Rethink Fiscal Strategy

The dispute between the finance ministry and the Planning Commission on the fiscal deficit for 2006-07 is indicative of the dilemmas that the government now finds itself in, after the passage of the Fiscal Responsibility and Budget Management Act. The focus on reduction in deficit numbers is counter-productive and needlessly ties the hands of the government. The ban on government borrowing from the RBI from April 2006 onwards, except for ways and means advances, is yet another new constraint on resources. There is therefore a need to rethink the government's fiscal reform strategy. Apart from more dynamic measures of resource mobilisation, the focus of attention should shift from the size of the gross fiscal deficit to the productive purposes for which deficits are incurred. Increasing social expenditures will also create some pressure on the revenue deficit of the government, which will have to be tolerated. Fiscal discipline and prudence are better achieved by concerted reforms on the administrative front, including effective decentralisation, rather than by controlling single measures like government deficits.

Movements in the Exchange Rate

The new indices of nominal and effective exchange rates of the rupee have been thoughtfully constructed and have been expanded rather significantly in their scope and coverage. What stands out in the coverage is the very rapid expansion in trade with Hong Kong and China, with the latter turning out to be the largest source of India's imports. The most illuminating revelation is that through the divergent interventions and non-interventions, the Reserve Bank of India has succeeded in pursuing an exchange rate policy that has sustained the effective rate "around the benchmark" - truly a commendable feat despite having to shock the market occasionally with sharp interventions to curb the speculative proclivities of some dealers.

Perils of Overemphasis on Secondary Trading

In India, arbitraging and speculation in stocks and other instruments are today far beyond the proportions prevalent in advanced and healthy markets. There is therefore a need for debate on the unmitigated increases in secondary market transactions, on the relevance of individual stock futures, on the role of hedge funds as part of inflows of portfolio funds and on the shortening of settlement periods beyond a point. On all these areas, those familiar with the intricacies of the working

Correcting the Distortions in Bank Lending

The union finance minister has recently highlighted the continued neglect of a large section of the farm community from institutional credit and the tendency by banks to raise interest rates on loans at the slightest opportunity. Banks have been asked to raise credit to 50 per cent of GDP as against the present 35 per cent and bankers are expected to move away from the rigid lending policies pre-empted by the existing customer base. The new business opportunities need not be inconsistent with reforms and efficient business goals: higher profitability could be achieved by risk mitigation models and expansion of the share of non-fund businesses. A lesson in this for the monitoring authorities is to incorporate into their policies the considerations of a larger credit base and more importantly its wider distribution amongst sectors, regions and size classes.

Inequity in Bank Lending at Below Prime Lending Rates

Market expectations are generating pressures on the central bank to raise the bank rate. However a close analysis indicates that there is little justification for a hike in interest rates. Public policies ought to lead market expectations rather than being driven by them. What is required, at the same time, is that pressure be brought to bear on banks to end the unhealthy practice of lending below the prime lending rate to large corporates. The RBI governor has observed that there is underpricing of risk in corporate lending and there could be overpricing in lending to small borrowers and agriculture. This inequity in lending is unhealthy for the development process; a policy directive is called for that directs banks to lend only to small borrowers at sub-PLR rates and keep the spread beyond PLR to within 3 to 4 percentage points.

Dealing with Competition from China

The revaluation of the Chinese yuan in late July has compelled the RBI to go on an aggressive dollar-buying spree. An additional factor has been the large inflows in the capital account. There was an accrual of as much as $ 3,066 million in reserves in the last week of July as the central bank sought to prevent the rupee from appreciating. To take into account the changing scenario, the RBI now plans to include the Chinese yuan and the Hong Kong dollar in a new six-country index to track the effective exchange rate of the rupee.

Sustaining the Momentum

To maintain the current pace of growth, there is a need to further pursue expansionary policies. However, even as the government announces new initiatives, the adherence to the fiscal responsibility rules, which is truly restrictive from a development perspective, makes the public posture on expenditure programmes appear less serious in reality and when the funds are finally allocated they turn out to be too meagre to have any decisive impact. Similarly, there has to be an appropriate policy on credit delivery, which also calls for efforts to strengthen institutional and instrument development amongst banks.

Does Competition among Banks Favour Customers on Interest Rates?

The freedom of banks to set lending rates and almost all deposit rates has ended up in a situation where, since the mid-1990s, the latter have fallen far more sharply than the former. The result is that while savers now earn interest only a little higher than the inflation rate, for most borrowers the costs of bank finance remain stubbornly high. Competition has not led to any reasonableness in banks? behaviour in setting rates of interest on deposits and loans. The situation calls for greater intervention by the central bank, which apart from moral suasion, needs to prescribe a definitive spread over the prime lending rate.

Burden of Gold Imports

The volume of gold imports has touched Rs 46,000 crore, most of it for household consumption (jewellery and investment). Thus, over 1.5 per cent of GDP is being diverted into this unproductive holding of assets, at a time when the economy?s domestic saving and investment rates have remained effectively stuck at around 23 to 34 per cent of GDP. It should be possible to restrain gold imports, with a combination of policies that is consistent with an environment of policy reforms. A sizeable increase in import duty and imposition of wealth tax seem to be the obvious candidates. The weaning away of people from gold to financial assets, while it is the answer in the long run, can only be a gradual process. A healthy capital market with vigorous regulations curbing unhealthy practices may go a long way.

RBI's Withdrawal from Primary Issues of Government Paper

If the RBI, in conformity with the FRBM Act, withdraws, beginning in April 2006, from primary issues of government paper, it will lose its leverage on interest rates. The chances then are (i) government loan rates determined by market forces will reach unreasonably high levels, and (ii) this will in turn set the pattern for commercial deposit and loan rates which will not be conducive for a healthy growth in the real sector. The government and the RBI will then be left with no effective devices to contain the financial market's proclivity to push up primary yield rates on government securities to unrealistically high levels. This is happening at a time when, apart from increased borrowings by the central government, the states are being pushed to the market for higher borrowings entirely in lieu of the centre's plan loans. The situation is thus replete with dangerous implications for the macroeconomy.

Uncertainty in Financial Markets

High levels of market borrowings have been possible so far because of three favourable factors: burgeoning liquidity due to sizeable foreign inflows; sluggish bank credit demand from commercial sectors; and softer interest rates in India and abroad. The chances are that none of these favourable factors will be present during the new fiscal year, which raises questions about the government?s borrowing programme.


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