The Hindu : Business : RBI's guarded approach to interest rate changes

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Monday, May 02, 2005

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RBI's guarded approach to interest rate changes

The repo rate hike is seen as signalling harder interest rates

The absence of any increase in the Bank Rate and CRR has had a favourable impact on the money and stock markets.

THE GOVERNOR of the Reserve Bank, Y.V. Reddy, had to be circumspect when formulating the Credit Policy for 2005-06 as he had to take into account the developments in the money market in the past year, which were suggestive of a hardening of interest rates. Interest rates have been rising in the U.S. and elsewhere and, in India too, the trends in gilt-edged prices were creating problems for those seeking to secure their requirements on a cheap as in 2001-04.

The monetary authorities had also to take a major decision if the Bank Rate had to be hiked even marginally by 0.25 percentage point to 6.25 per cent. During 2001-04, the exercise in this regard related to a lowering of interest rates with a periodic reduction in the Bank Rate as well as the Cash Reserve Ratio (CRR).

No attempt has been made to raise the Bank Rate as the objective of the Government is to provide credit to agriculture and small industry at around 9 per cent.

Banks' cautious approach

Towards this end, bank managements have been directed to extend credit to all borrowers, particularly those in the priority sectors, and the banks have been using available resources quite effectively.

The search is now for mobilising additional resources rather than their utilisation. Many bankers were coming to think that the era of cheaper money was over and it was time to raise deposit rates marginally and lending rates selectively.

In spite of increased yields from government securities and declining market values of medium and long-dated securities, the RBI Governor has decided to maintain the Bank Rate and CRR unchanged at 6 per cent and 5 per cent respectively. The latter ratio was, of course, raised to 5 per cent from 4.5 per cent in two stages on September 18 and October 2 last year leading to the immobilisation of Rs.8,000 crores.

As deposit growth has remained encouraging and inflationary pressures are likely to be under control this year thanks to an expected rebound in agricultural production and sustained rise in industrial output, a squeeze in the money market may not emerge. In fact, it is even visualised that prices for select items may drop in line with recent trends in world markets and the cost of crude and petroleum products may not increase in a disturbing manner as it did in 2004-05.

Optimistic outlook

The outlook for the economy in 2005-06 is viewed with cautious optimism as the growth in Gross Domestic product (GDP) is estimated at 7 per cent and the inflation rate at 5.0-5.5 per cent. The increase in GDP may be even 7.5 per cent under favourable circumstances.

However, much will depend on the monsoon during the kharif season and this is perhaps why it has been indicated that there will be a quarterly review of the Credit Policy, even though the mid-term assessment will be in October this year.

The absence of any increase in the Bank Rate and CRR has had a favourable impact on the money and stock markets. But it is being discussed in knowledgeable quarters whether it would be possible to have credit expansion at a faster rate and facilitate also borrowing on a bigger scale by the Central and State governments.

The hike in the reverse repo rate to 5 per cent from 4.75 per cent has also given rise to speculation that interest rates for borrowers as well as on new government loans will tend to rise slowly. In 2004-05, the expansion of credit by Rs.2,66,849 crores against only Rs.1,31,360 crores earlier necessitated a significant reduction in fresh investments to Rs.62,988 crores as compared to Rs.1,20,087 crores. The more than doubling of incremental credit in the 12 months ended April 1, 2005 would not have been feasible but for the large liquidity in the banking system in earlier years.

The additions to deposits were quite sizable at Rs.2,15,220 crores. The unutilised funds in earlier years, thus, came in handy and the credit deposit ratio had zoomed to 64.63 per cent from 56.39 per cent, with a drop in the investment deposit ratio to 42.52 per cent from 44.36 per cent. The question now is whether credit expansion at the visualised rate can be sustained without a faster growth in deposits and the ability of other financial institutions to meet the needs of the different classes of borrowers in the form of term loans and support to initial public offers. The steady rise in foreign exchange reserves and the emergence of current account surpluses in 2001-04 were helpful factors. Because of the unexpected rise in the trade gap in April-December 2004 according to RBI data, the current account surpluses have given place to a modest deficit in the whole of 2004-05

However, without the desired dovetailing of fiscal and monetary policies, the estimated doubling of credit to the agricultural and allied sectors in three years cannot be easily accomplished. This is because the requirements of borrowers in other segments of the economy also will have to be met.

Bank managements are aware of the new opportunities for utilising their increasing resources advantageously.

But their immediate worry to the maintenance of gilt-edged values, as the working results of many institutions for 2004-05 indicate that they could not any longer conduct treasury operations as profitably as in 2001-04, as stated above.

The absence of any big increase in other income and indeed the emergence of losses under this head for particular banks will be compelling the lending institutions to lay greater emphasis on maximising the credit deposit ratio and minimising excess investments in government and approved securities. As the Central and State governments have to increase their net borrowing and also prevent a further depreciation of gilt-edged securities, there will have to be tightrope walking by the Finance Minister as well as the Reserve Bank.

Fresh developments in the money market in October-March 2005-06 should provide a clear indication of how interest rates get stabilised at the prevailing levels and a squeeze in the money market avoided with the much needed augmentation of the aggregate pool of resources.

P. A. SESHAN

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