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Central banks world over open purses

— FILE PHOTO

COUNTERING RECESSION: The Bank of England headquarters in London. The central bank had slashed its key lending rate by 100 basis points to 2 per cent last week, the lowest since 1939, amid mounting evidence that Britain faces a deep recession.

Policy makers across the globe have been devising new ways of spending more and more public money to stimulate their rapidly slowing economies. Conventional canons of prudent public finance such as keeping spending within the bounds of revenue — in short, fiscal rectitude — have been given the go by as the global economic crisis now appears far more menacing than earlier assumed.

Equally important, monetary measures taken with great vigour by the U.S and other developed countries ever since the financial crisis first surfaced have had some value but are not adequate to arrest the rapid slowdown. Almost all governments are therefore relaxing their fiscal policies which in more normal times would be considered imprudent.

However, these are hardly normal times. The serious financial crisis, now morphed into a global economic crisis, has so far defied even extraordinary monetary measures. Central banks around the world have flooded their economies with massive sums of money. Structural as well as individual flaws in banking systems are being rectified as and when specific fault lines threaten monetary systems.

The bailout package for the Citigroup is one of several recent examples of government assuming liabilities, both real and contingent, to save an iconic institution. Its failure would have had catastrophic consequences.

More significant than all the bailouts have been the relentless driving down of interest rates to historic lows. This was partially achieved through large liquidity infusions but in leading economies policy interest rates have been cut to their lowest levels in decades. For instance, in the U.S. benchmark interest rates are down to one per cent. In the U.K., it is at a 50 year low. China, India and a number of other developing countries have effected cuts in their interest rates besides pumping in liquidity.

On December 6, the RBI came out with a fresh stimulus package. It reduced the policy rates, the repo rate and the reverse repo rates by one percentage point each. The repo rate, the rate at which the RBI lend to banks against securities has been brought down to 6.5 per cent and the reverse repo rate (at which the RBI borrows) to 5 per cent. There are a number of other measures to provide additional liquidity to specific sectors including housing and commercial real estate. However, the RBI admits that the demand for bank credit is slackening despite comfortable liquidity. Thus although inflation could be brought under control, the outlook for the economy is mixed.

There are some textbook reasons as well as a few unconventional ones explaining the limitations of monetary policies in India.

Monetary transmission — the ways through which the RBI’s interest rate signals affect actual interest rates of banks — had been inefficient even before the acute financial stress manifested itself.

Second, inflation, though coming down, is still potent and monetary policy cannot ignore it. Third, a slowing economy brings in its wake solvency issues. Freezing of credit markets has been a universal problem.

Even after the system has been doused with liquidity, banks are unwilling to lend.

Four, the dominant public sector banks in India have a history of being ‘credit-shy’. Credit availability with them has not translated into robust lending. In a slowing economy there are bound to be many borrowers who will not repay. A fairly large proportion of loans will thus become non-performing. Everyone understands these in an academic sense but in India the risk-reward equation in banks’ human resources policies is heavily skewed against even normal risk taking.

Thus, the control of banks by vigilance commissions and so on will be a particular hindrance even as the Finance Ministry has been trying to talk banks into lending at much softer rates.

Governments around the world are stepping in to tackle the unprecedented crisis. At the recent Washington summit of some 20 odd nations, it was agreed that all of them would announce fiscal stimulus packages in a synchronised manner. In the U.S., the massive rescue packages — the latest one is around $800 billion — involve close co-ordination between the Federal Reserve and the Treasury. China has announced a package of nearly $600 billion. The money is to be spent on a variety of infrastructure projects in a time-bound manner.

In India, the case for fiscal stimulus is strong. There has been a decline in exports and a fall in investment and consumption demand. Large public investment has always been deemed necessary in areas such as physical and social infrastructure (schools, health care programmes among others).

At a time when the private sector is likely to fall short of its targets and will be increasingly constrained for resources the case for public spending becomes stronger.

On Sunday, the government announced a fiscal stimulus package that will complement the RBI’s measures of the previous day. Its main features are: additional plan expenditure of Rs. 20,000 crore during the remaining part of this year. This along with other items budgeted and non-plan expenditure will work as contra cyclical stimulus.

An across the board reduction in CENVAT by 4 per cent on most items, export finance for labour intensive export industries (textiles, gems and jewellery will be cheaper through subventions on interest rates), additional money for the textile industry under TUF (Technology Upgradation Fund) scheme, (export guarantees will be made more comprehensive) and increase in the coverage under Indira AwasYojana to boost housing sector have been announced. To help infrastructure projects under the public-private model achieve closure ,special funds will be provided by the India Infrastructure Finance Company, which will raise tax free bonds of a value of Rs.10,000 crores.

As for large infrastructure investment, there has been a need to provide incentives to the private sector. So far there has been little success. Finally, public sector decision making is likely to be inhibited. The situation that obtains in government banks — extreme risk aversion — is likely to prevail.

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