Jalan's master stroke

MUMBAI NOV. 7. The recently announced cut in Bank Rate by the Reserve Bank of India is unlikely to translate into credit offtake and as a result the increase in liquidity available to banks, already awash with liquidity, to the tune of Rs. 3,000 crores by cutting the cash reserve ratio (CRR), would remain idle in the banking sector.

The RBI is aware of the situation that rate cuts are unlikely to draw investors in droves. "Nobody will invest only because interest rates are highly favourable," RBI Governor, Bimal Jalan, said while announcing the mid-term review of Monetary and Credit Policy for 2002-03. Policy watchers of the central bank feel that if normal investment demand does not use this liquidity, there is a danger of its getting into undesirable use. They feel it is dangerous to leave the excess liquidity lying unutilised for long periods — recall the lessons of the stock market scams in 1992 and 2001. There are, however, different views to this.

While reviewing the policy, Dr. Jalan was comfortable with the situation on the monetary front at the beginning of the busy season (October-March) of the financial year: Inflation is low, foreign exchange reserves are growing, there is enough liquidity in the system and there are signs of credit offtake. However, drought forced the RBI to revise downwards the growth rate by one per cent from 6-6.5 per cent to 5-5.5 per cent. On the whole, Dr. Jalan was able to achieve the broad objectives set out in the annual monetary and credit policy for 2002-03 last April.

Now the task confronting the RBI is how to use the favourable conditions in the monetary front to engender growth in the economy.

There are limitations under which Dr. Jalan functions, having only the framing of the monetary policy under his control and not the country's economy. The vital issue then was how the Reserve Bank Governor encourages growth with the help of monetary policy.

"Dr. Jalan delivered a master stroke," said Sudhir M. Joshi, Treasurer, HDFC Bank. He cut Bank Rate, repo rate and CRR too, making a clear statement that the RBI would provide the necessary support for keeping interest rates low. While markets were expecting a cut in the Bank Rate and repo rate, they never expected a cut in CRR.

The cut in CRR injects liquidity in the system. The present cut in CRR by 25 basis points from 5 to 4.75 per cent would inject another Rs. 3,000 crores to the banking system. In the case of CRR cut, the Reserve Bank has pursued its medium term objective of reducing it to the statutory minimum level of 3 per cent. The RBI has reduced CRR from 11 per cent in August 1998 to 5 per cent in June 2002.

Bank Rate is the key rate at which commercial banks and the States and the Centre borrow from the central bank. Now banks are not availing themselves of this re-finance which is much below their entitlement. Bank Rate is a general indicator of interest rates while the repo rate is a market related rate being the rate at which the RBI borrows from the market against Government securities. When repo rate is reduced, call money rates and other short-term rates also come down.

Over the last four and a half years, Bank Rate has been reduced from 11 per cent to 6.25 per cent, that is, by as much as 475 basis points.

This is the sharpest reduction in Bank Rate since Independence. The sharp reduction has also been reflected in a drop in call money rates and Treasury Bills rates and yields on Government securities across all maturities. The yield on benchmark Government securities (G-Sec) of 10-year maturity is now 7.07 per cent, a little above 7 per cent.

One statement by Dr. Jalan, however, tickled the banking sector. Ruling out any change in the Bank Rate in the near future, the RBI Governor said, "unless circumstances change, the policy bias in regard to the Bank Rate is to keep it stable at the present level at least until the end of the financial year". This encouraged banks to sensitise their prime lending rates (PLR) to the ground realities. Unlike earlier days when banks took days and months to reduce interest rates after announcements of the Bank Rate cut, this time they started cutting their deposit rates immediately and lending rates one day after the announcement of the policy.

Banks are now confident that rates will remain stable at this level. "When there is no expectation of substantial decline in interest rates, banks feel that there is not much profit by trading in bonds or capital appreciation," said Mr. Joshi, adding, "now banks will look for asset creation". Banks are increasingly looking at smaller and medium enterprises to lend to.

The other effect is that because of excess liquidity, credit spreads have been contracting. Last year, AAA-rated corporate bonds and Government securities were 180 basis points above Bank Rate. But it has gone down to 60 to 80 basis points above the Bank Rate. So corporates may see an opportunity in borrowing long-term funds, they can now borrow five-year funds at around 7 per cent.

Another school of thought believes that the Reserve Bank should always have unfettered options for altering interest rates.

The announcement in April this year that the Bank Rate could come down by one half or one percentage point in the period up to October constrained the policy option. "Given the commitment, the RBI had little option but to deliver a small rate cut of 0.25 percentage point.

Having dug itself out of this hole the RBI has once again constrained future policy options by indicating that there would be no reductions up to March 2003," said S. S. Tarapore, former Deputy Governor of RBI.

In a sense, the RBI has cut itself into a moral bind also not to increase interest rates before March 2003. What seems to be driving such commitments is the underlying proclivity towards soft and softer interest rates.

There is obviously some point at which the interest rate cycle has to turn and the RBI is making things difficult for itself by making such commitments. It is clear that financial markets will have difficulty in adjusting to rate increase when it takes place.

In particular, players in the gilt edged market are particularly vulnerable. In this overall context, banks, which have responded with rate changes, have been wise to first cut deposit rates before cutting lending rates. But in all this, Mr. Tarapore concluded, savers have been sacrificed at the altar of investment aspirations, which are unlikely to be realised.

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