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Adverse Impact on States

A number of measures in recent years have pushed the states to raise larger and larger resources from the market. The latest is a package of recommendations of the Twelfth Finance Commission, since accepted, which includes the states substituting for central loans with mobilisation from the market. Pushing the state governments to the market on such a sizeable scale for their plan finances may in the first place prevent them from mobilising the required resources, and, secondly, whatever they do mobilise may have to be done at higher interest cost. Overall, a greater dependence on the markets for loans is going to adversely affect the states? finances.

Effects of Sledge-Hammer Sterilisation

Money supply growth has slowed down considerably this year, in spite of a phenomenal increase in bank credit to the commercial sector. This deceleration is the result of the market stabilisation scheme (MSS) of sterilisation which is hard hitting in nature as it absorbs liquidity without leaving any scope for reversal and its secondary effect contributes to a contraction in monetary growth. Such straightjacket sterilisation can impart serious contractionary impulses on money growth and eventually on effective demand, leading to a recession as the intermediary impact may be seen in rising interest rates.

Institutional Constraints on Government Expenditure

The government is seeking to undertake major investment outlays, yet it has accumulated huge cash balances with the RBI. Plan expenditure during the current fiscal has been growing very slowly ? the total by just 3.5 per cent in April-November 2004 and capital outlay by a meagre 0.6 per cent. It is not, as the government argues, seasonal factors that are responsible for the loss of momentum. The institutional structure for decision-making on major developmental programmes, the system of coordination and the commitments of the bureaucracy all leave much to be desired.

Phenomenal Growth in Non-monetary Liabilities

There has been a mismatch between increases in deposit liabilities and bank credit in the current fiscal which has an explanation in the phenomenal increases in non-monetary liabilities of the banking system. This growth in non-monetary liabilities has tended to finance bank credit. The RBI's non-monetary liabilities have shown extraordinary increases due to sterilisation measures but the corresponding numbers for the banking system are much larger. Primarily, the banks are financing assets based on various forms of non-monetary liabilities. To an extent this is explained by the transformation of IDBI into a commercial bank. But a good part of the increase took place before IDBI became a commercial bank. It is likely that sizeable amounts of float money are emerging as a source for banks to expand commercial lending.

Monetary Policy

There are three distinct areas where new policy perspectives have to be brought to bear on the economic system. In the supply of bank credit, the mere availability of liquidity in the system is not enough; credit distribution with defined targets for agriculture, small-scale industries and small borrowers is a necessary condition for expanding effective demand. Second, strong persuasive methods have to be adopted on the structure of deposit and loan rates of banks and their spread. Some calibrated intervention in determining these rates, without excessive micro management, is possible on the part of the monetary authority. Finally, an aspect of the interest rate reform agenda, which has harmed the process of healthy credit delivery, concerns the jettisoning of the system of relatively lower rates of interest for long-term loans as compared with rates for working capital. The principle of asset-liability matching should not prevent the banks and financial institutions from promoting investment credit at concessional rates of interest.

Conventional Wisdom Persists

Apart from financing much-needed developmental programmes, the use of the Ways and Means Advances facility has the advantage that the government could, if necessary, reduce its dependence on market borrowings. The enormous increase in the size of floating securities in the market has given rise to a massive jump in secondary trading in gilt-edged paper, which in turn has begun to influence interest rates, both at the secondary as well as the primary levels. In a developing economy seeking to augment investment, the primary interest rates ought not to be determined by the vagaries of speculative treasury operations of banks.

Interest Rates

The Reserve Bank of India is under pressure to curb inflation, which is showing no signs of abating. However, it should not go by conventional wisdom and raise interest rates, as such a move would curb the recovery in the manufacturing sector that is now under way.

Small Savings

According to the Rakesh Mohan Committee the effective cost of small savings schemes vis-à-vis the cost of market borrowings is such that it is difficult to justify its continuation in the present form. But scrapping these instruments will affect only individual savings behaviour, which includes marginal farmers, agricultural labour, etc, and is likely to affect the finances of the government. It would distort the savings behaviour at a time when huge investments are required for infrastructure development.

Corporate Bond Market

Given the vast potential of the primary market to mobilise huge funds, it is imperative that the regulators try to eliminate structural weaknesses and ensure the long-term health of the financial system. A time has come to look into legal and institutional framework also for promoting secondary market so that both the primary and secondary markets reinforce each other's growth.

Reviving DFIs:An Urgent Need

The importance of development finance institutions (DFIs) in nurturing and stimulating industrial investment and growth has been largely neglected in recent policy-making. It is easy to argue that the absence of demand for industrial credit has been responsible for the stagnation in the activity of the DFIs. But this is not so and the debt market cannot substitute for comprehensively designed project finance with project evaluations and guidance to entrepreneurs to acquire a menu of financing packages.

Critical Neglect of Social Banking

The increasing vacuum in the rural credit system in the post-reform period, continuing neglect of underdeveloped regions, low levels of credit flow in favour of agriculture, small-scale industries and other informal sectors including small borrowers and the reluctance to pass on the benefits of the reduced cost of funds to borrowers, are issues that scheduled commercial banks need to address.

Need for Restraints on Inflows

In the context of the damage that unmitigated unproductive inflows are inflicting on the domestic liquidity and exchange rate management stances, placing some moderating influence on such inflows may not be unrealistic and it may not even contradict the overall policy of external sector liberalisation. The surplus on current account as well as productive investment flows through FDI are to be welcomed irrespective of their size, for they are reflective of many healthy macroeconomic features of the economy.


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