Distortions in borrowing costs

THE MID-TERM Monetary and Credit Policy for 2003-04 has maintained status quo over the objectives and instruments of monetary policy. The overall stance continues to focus on ensuring adequate credit growth and supporting investment demand while keeping a vigil on movements in the price level. A soft and flexible interest rate environment through appropriate liquidity management within the framework of macroeconomic stability is expected to fulfil the prescribed objectives.

The policy seems to rely mostly on indirect instruments such as Bank Rate and open market operation, that includes repo/reverse repo operation, to ensure a soft interest rate regime. However, the two crucial policy parameters — Bank Rate and Cash Reserve Ratio (CRR) — are left untouched to rule at their current levels of 6 and 4.5 per cent respectively while the repo rate too is not disturbed. The Reserve Bank of India, in its recent Report on Trends and Progress of Banking in India, has hinted at raising the CRR in the coming months.

First, this policy framework begs the central question of how to provide a soft rate regime by manipulating indirect policy instruments when the stock of government securities — the weapon — has already depleted substantially and is expected to decline further with continuous sterilisation of capital inflows. Moreover, the RBI Governor has hinted that the central bank has no plans to issue securities on its own account for its open market operations at this moment. If the present interest rate structure continues, then capital inflows will tend to continue due to falling rates in the international markets. If the RBI does not buy the foreign exchange, then there will be further pressure on the rupee to appreciate and this will place the country's external competitiveness at stake. Continuous sterilisation, on the other hand, will render the RBI weaponless and this will take the country to a "currency board arrangement".

Second, even if interest rates are brought down through successful liquidity management it is doubtful whether this will get translated into lower lending rates which can help investment demand to pick up. A few leading private sector banks have already expressed their unwillingness to reduce lending rates even if the official rates are reduced. Further, reduction in lending rate may not ensure larger credit offtake as demand for credit now is influenced by factors beyond interest rates. And, the return on investment must not only exceed the cost of borrowing but also sustain for a longer period. In an uncertain environment, reduction in interest rate alone is inadequate to boost credit offtake. The issue calls for a thorough study so that the present policy can help achieve the objectives.

The interest rate structure

One can observe multiple rates in the Indian market, reflecting the existence of a number of financial instruments with a continuum of maturity and risk profiles. Broadly, the structure of interest rates can be classified as the floor rate, the rates which prevail in the government securities market (sovereign rate) and the commercial lending rates. The floor rate or the Bank Rate is fixed by the monetary authority to drive the policy towards achieving a few desirable goals. Any change in the Bank Rate, therefore, is expected to produce a wave of changes through the market rates to affect the goals. Such "interest rate pass through effect" can be effective provided interest rates are properly aligned and integrated.

In recent times, there has been a steady decline in the yield on government securities due to a comfortable liquidity position in the market. Indeed, the yield and short term rates in the government security market are less than the Bank Rate. The flat yield curve indicates that the real rates could be lower than that prevailing in the U.S.; hence, there is an argument that the current level of sovereign rate may be unsustainable.

The irony is that the soft rate policy failed to bring down the prime lending rates (PLR) of commercials banks. The median lending rates on demand and term loans charged by public sector banks remained unchanged in a range of 11.5-14 per cent between March and June 2003. The prime lending rates of these banks ranged between 9 and 12.25 per cent during the same period. This provides a wider gap of around 450 to 550 basis points between the PLR and the Bank Rate. It will not be proper to argue that the difference reflects the risk attached to commercial lending as the PLR is the rate at which the best corporates borrow. Therefore, the only valid conclusion is that the interest rates are misaligned.

The fiscal pressure

The fiscal deficits during the past few years have stayed beyond the target levels. Concurrently, there has been a significant change in the mode of financing of the fiscal deficit. In recent years, it has been made mandatory that the Government must not issue fresh securities to the RBI. Further, the continuous sterilisation of capital inflows has resulted in a steady depletion of government securities from the RBI's portfolio, contributing to demonetisation of the fiscal deficit. Also, declining reliance on external borrowing to finance the deficit has flooded the financial market with government securities.

On the demand side, the financial institutions prefer to invest in government securities. The stock of government securities constitutes 41.6 per cent of net demand and time liabilities of banks, which exceeds the SLR requirement by 16.6 per cent. There are two reasons for banks'voluntary investment in gilts. First, it is safe and risk free and helps them in observing prudential norms. The introduction of 90 days norm for classifying non-performing assets has put additional pressure on banks to invest in gilts. Second, falling interest rates can bring windfall gains to banks that hold large volume of gilt securities in their portfolios.

The crucial question is whether the existing interest rate structure is consistent with the objectives of monetary policy or it is demand stimulating to support a sustainable growth process. The answer depends upon the structure of the public expenditure programme or how productively the borrowed resources are spent. According to the budget estimate for 2003-04, the revenue deficit is 73.09 per cent of the fiscal deficit; hence, Rs. 73.09 out of Rs. 100 borrowed is consumed and only the balance of Rs. 26.91 is being invested. This investment must generate a return of 29.32 per cent even to meet the interest payment, given the average cost of borrowing of 7.89 per cent; estimated as interest payment for current year as percentage of stock of the debt outstanding in the previous year. Given the track record of the return on government investment, this is unambiguously a trance.

No doubt, expansion of consumption expenditure will augment demand in the system that will revive the economy. But, it is hard to prove that such consumption led growth will be sustainable in the long run. Therefore, monetary policy must be supplemented with measures that will ensure fiscal rectitude. Given the prevailing situation in the financial market, the liquidity flows to feed the Government's consumption expenditure, which in the absence of adequate investment plans in tandem, will fuel inflation instead of inducing the growth process in the long run.

The policy option

The interest rates are misaligned as evidenced by the large gap between the rates in the government debt and private bond markets. There are rigidities in the financial market for this gap to exist. The banks are still struggling to bring down the level of non-performing assets to international standards. The high financial intermediation costs put pressure on banks to maintain their PLR at a high level, as this will help in maintaining the profit margin and offsetting the loss on non-performing assets. The introduction of Benchmark PLR will certainly bring more transparency. But, it may not bring down the PLR to stimulate investment demand as the average cost of borrowing is 6.25-7.25 per cent and the non-interest operating cost is 2.5 - 3 per cent of total assets. The RBI Governor has virtually instructed the banks that larger exposure to government securities should not come in the way of lending to business and cautioned them that the macroeconomic performance of the banking system would hinge on their ability to fund industrial and other enterprises.

Administrative measures such as bringing down the gap between the interest rate on NRI deposits and LIBOR rate and proposing to reduce the limit on external commercial borrowing will place a constraint on inflow of foreign capital. But it must be seen that the cause for larger capital inflow is not the liberal policy relating to external commercial borrowings. Given the high local PLR and lower rates in the international markets, the corporates prefer to mobilise funds through external commercial borrowings. As it has been pointed out in the RBI's recent Report on Trend and Progress of Banking in India, there is a need to establish "appropriate risk management system, provisioning and building up of reserves in line with the best international practices".

Further, the fiscal pressure in the market must be moderated. The monetary policy cannot succeed without a fiscal correction. It is basically the fiscal profligacy that has a major bearing on the current interest rate structure. A package of fiscal measures to enhance government revenue and thereby reduce revenue deficit as envisaged in the Fiscal Responsibility and Budget Management Bill will certainly bring a gain in operational efficiency of the monetary policy.

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