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The Rediff Business Special/Raghbendra Jha

Precautionary policy, no hope of an early end to recession

The Monetary and Credit Policy for 1999-2000 was announced today by the RBI Governor Bimal Jalan. Perhaps, more than at other times in the recent past, the credit policy comes against a pessimistic background.

Consider, for example, the following:

• There has been a shortfall to the tune on Rs 80 billion in corporate tax collections (reported by the government on April 16). This is on top of shortfalls in indirect tax collections and a rise in the fiscal deficit to 6.5 per cent of GDP (as per the old measure of GDP).
• There has been excessive monetary growth during 1998-99 partly due to RIB worth more than $4 billion entering the balance sheets of the banking system as well as large borrowings by the government.
• Despite this liquidity, the demand for credit from the industrial sector has been lagging behind.
• It is not just the government debt profile but also the corporate debt profile that is showing alarming tendencies. With stock prices so low for so long, debt has become the preferred mode of financing investment and this is beginning to impact on balance-sheets.
• Exports are very sluggish and the balance of trade is getting progressively worse.
• In order to keep the balance of external payments at a reasonable level, funds have to be attracted which means keeping the exchange rate high. This requires, under the current situation, that interest rates be kept high.
• The investment outlook is very pessimistic with political uncertainty an almost continual feature of the economy. Many important economic legislations have been indefinitely postponed.
• Fiscal policy is hamstrung on two counts. First, although the Budget for 1999-2000 is to be passed, there is still the worry that the next government will, under populist pressures, severely exceed the borrowing limits specified in the Budget and on the basis of which interest rates had come down a bit. Second, the forecasted revenue growth depends on how fast the economy grows and there is little room for optimism here.

It is against this background that the Credit Policy announced today has to be evaluated. Typically, a credit policy should consider at least three different aspects.

• First, it must give guidelines for the evolution of basic monetary aggregates (in the medium term) and cost of capital (short term).
• Two, it should try to affect the supply of liquidity through the banking system by changing the reserve requirements of the banking system (CRR) as well as by affecting the direction of credit (reducing SLR). These two measures would also help it affect prospects for economic growth.
• Three, it should make financial operations for the central bank, the banking sector, the corporate sector and the non-banking public easier and more transparent.

How does the Credit Policy measure against these criteria? It has set a monetary growth (M3) target. (M1: A measure of money supply which includes all coins and notes in circulation, and personal current accounts. M3: A measure of money supply, including those covered by M2 -- a measure of money, supply, including M1, plus personal deposit accounts -- plus government deposits and deposits in currencies other than rupee.) However, in the recent past, the RBI has not been able to target M3 well -- partly because this aggregate is at least partly determined from within the system and is not amenable to exogenous targeting.

The RBI has not changed interest rates but CRR has been reduced by half a percentage (50 basis points) to 10 per cent effective May 8, 1999. This step was taken to forestall the effects of an anticipated increase in government borrowing. With higher borrowing there might be a strain on the liquidity in the system. This strain would be higher if interest rates were lowered. Hence interest rates have been kept fixed. The RBI does not expect a large increase in corporate demand for liquid funds.

The RBI has not made any effort to affect the SLR. Hence the same extent of direction of credit as of now will prevail. This is not a pleasant development. Although banks have been given more liquidity and greater flexibility of instruments, their choice of loan portfolios is still very much circumscribed.

The RBI has announced some measures to facilitate financial transactions. These include:

• The introduction of an Interim Liquidity Adjustment Facility through repos and lending against collateral of government of India securities.
• The withdrawal of general refinance facility and introduction of Collaterialised Lending Facility.
• Making scheduled commercial banks eligible for Export Credit Refinance Facility at the bank rate.
• Nod to public sector financial institutions such as UTI, LIC, IDBI to access short term liquidity through repos.
• Nod for setting up mutual funds for government of India securities.

In addition, banks have been given more freedom in their interest policies. Proposed changes include:

• Freedom to offer interest rates on deposits of any maturity above 15 days.
• Freedom in regard to Prime Lending Rates for all maturities.

Typically, fiscal policy has a longer-term perspective than monetary policy. In the presence of political uncertainty, fiscal policy has had to take on a short-term focus and monetary policy will have to provide, to some degree, a longer-term perspective.

The RBI has analysed this as implying the following: the government will borrow more than anticipated (hence the cut in CRR), and there will be need to attract foreign funds to improve the Balance of Payments situation. It has chosen measures to stabilise the rupee for which it needs to keep interest rates high. But these policies have a cost.

In the best case scenario the political uncertainty will lift soon and government borrowings will stabilise near predicted levels. In this case, the CRR cut can be translated into a cut in interest rates which would make investment more profitable and help strengthen the rupee. In the worst case scenario, political uncertainty will prevail for considerable time, an election will follow and government borrowings will rise.

In this case, the levels of interest rates required to stabilise the rupee will be much too high especially in view of continuing export sluggishness. How badly the economy would be in the second case also depends on what the RBI does now. It has chosen to be precautionary at this stage. This means that the credit policy does not give much hope for an early end to the recession.

Perhaps a small cut in interest rates could have been contemplated. The rupee is under pressure, no doubt, but that is because of political uncertainty. A lower interest rate could have improved investor sentiment and this could have helped strengthen the rupee in the next few months. The lower interest rates would have helped corporate and government debt servicing positions and the lower value of the rupee could have helped exports. But this course of action was not followed.

In sum, then, this is a precautionary credit policy. The RBI is preparing itself and the economy for the outcome of political turmoil. It has also effected some improvements in the ways in which financial transactions are done. But it has not attempted to provide any stimulus to the efforts to end the ongoing recession.

Dr Raghbendra Jha is professor, the Indira Gandhi Institute for Development Research, Bombay

RBI Governor Bimal Jalan's policy statement

April 20, 1999: The RBI's Credit and Monetary Policy

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