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

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RBI’s Interest Rate Policy and Durable Liquidity Question

The Reserve Bank of India should take into consideration longer term liquidity management for smooth monetary transmission. It must clearly define “durable liquidity” in the form of some quantitative variable and set its desired path for one year or so. This will anchor expectations on future interest rate and liquidity premium, and certainly improve the link between the interest rates in various terms to maturity. Moreover, the desired target for durable liquidity can also serve to improve overall monetary policy effectiveness.

Procyclical Credit Growth and Bank NPAs in India

Despite recent monetary policy accommodation, bank credit growth continues to decelerate in India, partly due to huge non-performing asset overhangs in banks. This paper explores various issues related to surging NPAs in banks and observes that excessive credit growth in the past is a major reason that has led to current NPAs. Other factors such as contemporary economic conditions, capital adequacy and overall levels of efficiency of the banks have also affected the incidence of NPAs. For promoting financial stability and enhancing monetary policy effectiveness, it is suggested that macro-prudential aspects such as counter-cyclical capital buffer and dynamic provisioning need to be strengthened. There is also a need to explore if corporate governance concerns could be instrumental in adversely impacting the loan book of state-owned banks.

Interest Rate Defence of Exchange Rate

While the rationale for raising the interest rate to defend an exchange rate under speculative attack is well grounded in economic and financial theories, empirical validation of the effectiveness of such a policy stance has generally been difficult and is shrouded with conflicting findings. In India, besides forex market interventions and use of several administrative measures, the Reserve Bank of India has occasionally resorted to the high interest rate option during major episodes of significant pressures on the external value of the rupee. An empirical assessment suggests that one standard deviation shock to the call rate leads to rupee appreciation in the very second month. Similarly, for one standard deviation shock to net interventions, the exchange rate appreciates gradually by a few paise over five months. The impulse response also suggests that in response to one standard deviation shock the exchange rate appreciates by about 8 paise in the second month, but subsequently the exchange rate depreciates gradually, more than offsetting the initial impact of the hike in interest rate.

Imparting Dynamism to Credit Delivery

When the economy is in dire straits the Reserve Bank cannot sit back and say it has done enough by reducing interest rates and supplying liquidity to the market. It needs to operate on many fronts - interest rate, general refinance, sector-specific refinance, directed credit norms and moral suasion - to introduce dynamism into the banks' credit delivery system.

Setting Small Savings and Provident Fund Rates

This paper recommends an inflation adjustment formula for setting the interest rate on all Small Savings and Provident Funds and discusses the rationale for the suggested formula.

Realistic Interest Rates Structure

Considering the need for stimulating domestic savings through a strengthened system of banks and other financial institutions, the present structure of bank deposit and lending rates is generally realistic. The average cost of capital cannot be reduced further without hurting the development process.

A Reply to A Reply

It is nice to receive a reply from Prabhat Patnaik to our rejoinder (EPW, May 12, 2001) to his article (‘On Fiscal Deficits and Real Interest Rates’, EPW, April 14, 2001), as it gives us an opportunity to clarify further our position. Let us state upfront that we do not agree, as he claims, with his “weak proposition that there is no theoretical justification for cutting the fiscal deficit as a means of lowering the interest rate” as it applies to the Indian situation. In India, which has a partially open economy (some capital controls) and a floating exchange rate regime (a managed float), cutting the fiscal deficit should theoretically lower the interest rate....

Fiscal Deficits and Real Interest Rates

Deena Khatkhate and Dan Villanueva’s (henceforth KV) rejoinder (EPW, May 12) to my piece ‘On Fiscal Deficits and Real Interest Rates’ (EPW, April 14) is rather intriguing: after castigating me for my position they reach a conclusion which is in conformity with it. I had argued in my paper that the fiscal deficit has no direct bearing (i e, other than through a general equilibrium system, of which IS-LM is the simplest possible example) on the level of the interest rate, and that therefore the proposition that the fiscal deficit must be cut in order to lower the interest rate, lacks theoretical justification. They conclude: “The factual evidence also shows that interest rates can remain higher with a fiscal surplus, depending on other economic variables, than in a situation with a fiscal deficit”. Their conclusion appears to be in conformity with my argument, though not necessarily identical with it (since I was arguing on a ceteris paribus basis, i e, ruling out other simultaneous parametric changes). From their conclusion too the question should follow: what theoretical justification is there for the current official position that the fiscal deficit must be cut for lowering the real interest rate?

Budgetary Policy as Process, Not Event

The Budget for 2001-2002 seeks to kick-start growth through a host of measures including the speeding up of agricultural reforms, furthering financial reforms especially in the debt market, widening the tax base, etc. Central to the strategy, however, is fiscal consolidation and the reductions announced in administered interest rates on contractual savings which were supported by the pre- and post-budget cuts in the Bank rate announced by the RBI.

The Ecstasy and the Agony

The budget's strategy for stepping up growth in the near term rests on certain key premises: (i) fiscal consolidation is under way; (ii) fiscal consolidation and reduction in administered interest rates will lead to lower lending rates; and (iii) lower interest rates, along with continued deregulation, will make for higher investment and growth. Each of these premises needs to be carefully examined.

Monetary Policy Underpinnings

The objective of this paper is to capture the historical perspective in respect of monetary policy underpinnings with particular reference to India, the limitations and constraints in pursuing monetary policy objectives and throw light on current mainstream economic thinking and perspective in the context of changing economic environment worldwide.


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