MacroScan (Printable Version) - Mid-term Credit Policy for the year 2002-03: More of the same

Over the last three days of October this year, the financial media were completely preoccupied with the Reserve Bank of India's mid-term review of credit policy for the year 2002-03, released on October 29. This interest is partly explained by the fact that these twice-in-a-year "reviews" include announcements or projections of changes in monetary policy. This time around, among the many changes announced by the RBI governor, the three most noted were: (i) a 25-basis points (a quarter of a percentage point) reduction in the Bank Rate (or the rate at which the central banks loans funds to the banking system); (ii) a similar cut in the repo (or repurchase option) rate, which is the implicit rate at which securities can be parked with the central bank for short periods in return for funds; and (iii) a reduction in the cash reserve ratio required to be maintained by banks from 5 to 4.75 per cent. In sum, at the core of the policy change announced by this October's monetary and credit policy is a continuation of the RBI's effort to reduce nominal interest rates by reducing the cost at which the banking system can access funds from the central bank and to increase the ability of banks to provide credit to the corporate sector and the public at large. Lower nominal interest rates and easier liquidity conditions are the continuing mantra.

We must recall that after an initial period at the start of the reforms, when in the name of stabilisation the central bank maintained an extremely high interest rate and tight control over money supply, the RBI has for more than five years now been pushing to reduce interest rates and ensure easy liquidity conditions. This shift over time from a stringent to an extremely relaxed monetary policy stance occurred because the inflation rate fell to extremely low levels, allowing the RBI to shift its attention from what is its declared principal concern of controlling inflation to that of facilitating growth. Inflation itself fell for a combination of reasons: the comfortable food stocks created by consecutive good monsoons, the reduction in domestic demand and absorption as a result of the reform-led curtailment of government expenditures and the easier access to imports as well as the fall in import prices ensured by liberalisation and slowing of global growth.

The transition to a lower-interest-rate and easy-money policy was also necessitated by two consequences of the financial reform process adopted since the early 1990s. First, the more conventional means of spurring growth through an increase in government expenditures was no longer seen as feasible. Tax revenues to finance such expenditures could not be mobilised, it was argued, without generating disincentives to save and invest for the private sector, which was seen as the lead engine for growth under the new dispensation. And, deficit financing as a means of undertaking such expenditures was ruled out by the fact that one of the aims of reform was to curtail the deficit on the government's budget, and prevent it from subverting the effort at controlling inflation through use of the monetary levers. Thus, if growth had to be stimulated by the government at all, monetary rather than fiscal levers were the ones that were seen as appropriate.

The RBI's mid-term credit policy statement for 2002 confirms two relatively less-discussed tendencies in the Indian economy. First, easy liquidity and lower nominal interest rates relative to the levels recorded through much of the early and mid-1990s are proving inadequate to reverse the slow rate of non-agricultural growth in the system. In the RBI's own words: "During 2002-03 so far, financial markets in India have been generally stable, liquidity has been adequate, and the interest rate environment has also been favourable to promote investments." What it refuses to recognise is that growth has been disappointing, despite these facilitating trends. Second, there has been an embarrassingly large accumulation of foreign exchange reserves in the system, from US $ 45.2 billion as on October 26, 2001 to US $ 64.0 billion by October 25, 2002, an increase of US $ 18.8 billion. Rather than seeking to understand this peculiar accumulation of reserves, the statement seeks to defend the development as an indicate of prudent external sector management.

Confronted by these developments the RBI has chosen either to ignore them or justify them with seeking to explain them. For example, it is widely known that with inflwtion being subdued for some time now, there has been a shift in the focus of the central bank's attention from inflation control to growth promotion. What the evidence on growth suggests is that the central bank's strategy of using a regime of easy liquidity and lower nominal interest rates to trigger growth has failed to deliver results.

The RBI, however, appears to be reluctant to accept this evidence that has been corroborated by recent trends in the index of industrial production. While admitting that overall GDP growth for the year 2002-03 is likely to be in the range of 5.0 to 5.5 per cent as against the earlier projection of 6.0 to 6.5 per cent, the mid-term credit policy statement attributes this solely to the shortfall in agricultural production due to the poor monsoon, and believes that this has occurred despite a recovery in industrial production during the first half of this financial year. To quote the statement: "On balance, the present indications are that agricultural GDP for the year 2002-03 will decline by around 1.5 per cent. On the other hand, there are indications of a recovery in industrial production during the first half of the current year." It is indeed true that the Index of Industrial Production for the April-August period points to a rate of growth of 4.9 per cent this year as compared with 2.4 per cent during the corresponding period of the previous year. But even this rate is extremely poor when compared to the high rate achieved during the immediate post-reform boom of the mid-1990s or the growth rates recorded during the 1980s.

One consequence of this persistence of slow growth is the fact that despite easy liquidity, credit offtake from by the non-agricultural sector has been disappointing. As the statement record, excluding the impact of mergers, scheduled commercial banks' credit increased by 6.6 per cent (Rs.38,800 crore) between April 1 and October 4, 2002 as against 6.8 per cent (Rs.34,700 crore) in the corresponding period of the previous year. The other consequence of the slow growth has been the fact that non-oil imports, especially non-oil, non-bulk imports have been subdued. This combined with the fact that the higher returns offered by the domestic financial market resulted in substantial international investor interest and led to large capital flows, led to a build-up of reserves, since foreign exchange inflows were being inadequately absorbed to finance imports. In brief, to prevent an appreciation of the rupee the RBI was forced to buy into the excess supply of dollars, leading to the $18 billion reserve accumulation over the year ending October.

Thus the principal problem that confronts the Indian economy is that of slow growth, which rules despite the large stocks of food in the system, the huge reserves of foreign exchange and the massive excess capacity in much of the industrial sector. As the RBI itself, makes clear, inflation is not a problem at all. Annual inflation, as measured by variations in the Wholesale Price Index (WPI) (base: 1993-94=100) was on an average basis ruling at 2.3 as on October 12, 2002 as against 6.3 per cent in the previous year. Measured by variations in the Consumer Price Index (CPI) for industrial workers on a point-to-point basis, it was 3.9 per cent in August 2002 as against 5.2 per cent a year ago. This domination of slow growth over inflation and the evidence that growth was not responding to lower nominal rates clearly requires the government to rethink its proposition that it is monetary rather fiscal policy initiatives that need to be emphasized. But so long as the current thinking on "financial reform" persists this is unlikely to occur.

Not surprisingly the mid-term review for 2002-03 promises more of the same. By further reducing the Bank rate and the repo rate, by enhancing liquidity in the system through cuts in the CRR, and by encouraging banks to reduce spreads over PLR the RBI is still trying to use the twin levers of lower interest rates and easy liquidity to impart some dynamism to the system. This failure to change the way it looks at the big picture, has been combined with a large number of specific micro-level policies and adjustments that are unlikely to impact on the problem of slow growth confronting the economy today.



Themes > Current Issues	05.11.2002


Mid-term Credit Policy for the year 2002-03: More of the same

C.P. Chandrasekhar

Over the last three days of October this year, the financial media were completely preoccupied with the Reserve Bank of India's mid-term review of credit policy for the year 2002-03, released on October 29. This interest is partly explained by the fact that these twice-in-a-year "reviews" include announcements or projections of changes in monetary policy. This time around, among the many changes announced by the RBI governor, the three most noted were: (i) a 25-basis points (a quarter of a percentage point) reduction in the Bank Rate (or the rate at which the central banks loans funds to the banking system); (ii) a similar cut in the repo (or repurchase option) rate, which is the implicit rate at which securities can be parked with the central bank for short periods in return for funds; and (iii) a reduction in the cash reserve ratio required to be maintained by banks from 5 to 4.75 per cent. In sum, at the core of the policy change announced by this October's monetary and credit policy is a continuation of the RBI's effort to reduce nominal interest rates by reducing the cost at which the banking system can access funds from the central bank and to increase the ability of banks to provide credit to the corporate sector and the public at large. Lower nominal interest rates and easier liquidity conditions are the continuing mantra. We must recall that after an initial period at the start of the reforms, when in the name of stabilisation the central bank maintained an extremely high interest rate and tight control over money supply, the RBI has for more than five years now been pushing to reduce interest rates and ensure easy liquidity conditions. This shift over time from a stringent to an extremely relaxed monetary policy stance occurred because the inflation rate fell to extremely low levels, allowing the RBI to shift its attention from what is its declared principal concern of controlling inflation to that of facilitating growth. Inflation itself fell for a combination of reasons: the comfortable food stocks created by consecutive good monsoons, the reduction in domestic demand and absorption as a result of the reform-led curtailment of government expenditures and the easier access to imports as well as the fall in import prices ensured by liberalisation and slowing of global growth. The transition to a lower-interest-rate and easy-money policy was also necessitated by two consequences of the financial reform process adopted since the early 1990s. First, the more conventional means of spurring growth through an increase in government expenditures was no longer seen as feasible. Tax revenues to finance such expenditures could not be mobilised, it was argued, without generating disincentives to save and invest for the private sector, which was seen as the lead engine for growth under the new dispensation. And, deficit financing as a means of undertaking such expenditures was ruled out by the fact that one of the aims of reform was to curtail the deficit on the government's budget, and prevent it from subverting the effort at controlling inflation through use of the monetary levers. Thus, if growth had to be stimulated by the government at all, monetary rather than fiscal levers were the ones that were seen as appropriate. The RBI's mid-term credit policy statement for 2002 confirms two relatively less-discussed tendencies in the Indian economy. First, easy liquidity and lower nominal interest rates relative to the levels recorded through much of the early and mid-1990s are proving inadequate to reverse the slow rate of non-agricultural growth in the system. In the RBI's own words: "During 2002-03 so far, financial markets in India have been generally stable, liquidity has been adequate, and the interest rate environment has also been favourable to promote investments." What it refuses to recognise is that growth has been disappointing, despite these facilitating trends. Second, there has been an embarrassingly large accumulation of foreign exchange reserves in the system, from US $ 45.2 billion as on October 26, 2001 to US $ 64.0 billion by October 25, 2002, an increase of US $ 18.8 billion. Rather than seeking to understand this peculiar accumulation of reserves, the statement seeks to defend the development as an indicate of prudent external sector management. Confronted by these developments the RBI has chosen either to ignore them or justify them with seeking to explain them. For example, it is widely known that with inflwtion being subdued for some time now, there has been a shift in the focus of the central bank's attention from inflation control to growth promotion. What the evidence on growth suggests is that the central bank's strategy of using a regime of easy liquidity and lower nominal interest rates to trigger growth has failed to deliver results. The RBI, however, appears to be reluctant to accept this evidence that has been corroborated by recent trends in the index of industrial production. While admitting that overall GDP growth for the year 2002-03 is likely to be in the range of 5.0 to 5.5 per cent as against the earlier projection of 6.0 to 6.5 per cent, the mid-term credit policy statement attributes this solely to the shortfall in agricultural production due to the poor monsoon, and believes that this has occurred despite a recovery in industrial production during the first half of this financial year. To quote the statement: "On balance, the present indications are that agricultural GDP for the year 2002-03 will decline by around 1.5 per cent. On the other hand, there are indications of a recovery in industrial production during the first half of the current year." It is indeed true that the Index of Industrial Production for the April-August period points to a rate of growth of 4.9 per cent this year as compared with 2.4 per cent during the corresponding period of the previous year. But even this rate is extremely poor when compared to the high rate achieved during the immediate post-reform boom of the mid-1990s or the growth rates recorded during the 1980s. One consequence of this persistence of slow growth is the fact that despite easy liquidity, credit offtake from by the non-agricultural sector has been disappointing. As the statement record, excluding the impact of mergers, scheduled commercial banks' credit increased by 6.6 per cent (Rs.38,800 crore) between April 1 and October 4, 2002 as against 6.8 per cent (Rs.34,700 crore) in the corresponding period of the previous year. The other consequence of the slow growth has been the fact that non-oil imports, especially non-oil, non-bulk imports have been subdued. This combined with the fact that the higher returns offered by the domestic financial market resulted in substantial international investor interest and led to large capital flows, led to a build-up of reserves, since foreign exchange inflows were being inadequately absorbed to finance imports. In brief, to prevent an appreciation of the rupee the RBI was forced to buy into the excess supply of dollars, leading to the $18 billion reserve accumulation over the year ending October. Thus the principal problem that confronts the Indian economy is that of slow growth, which rules despite the large stocks of food in the system, the huge reserves of foreign exchange and the massive excess capacity in much of the industrial sector. As the RBI itself, makes clear, inflation is not a problem at all. Annual inflation, as measured by variations in the Wholesale Price Index (WPI) (base: 1993-94=100) was on an average basis ruling at 2.3 as on October 12, 2002 as against 6.3 per cent in the previous year. Measured by variations in the Consumer Price Index (CPI) for industrial workers on a point-to-point basis, it was 3.9 per cent in August 2002 as against 5.2 per cent a year ago. This domination of slow growth over inflation and the evidence that growth was not responding to lower nominal rates clearly requires the government to rethink its proposition that it is monetary rather fiscal policy initiatives that need to be emphasized. But so long as the current thinking on "financial reform" persists this is unlikely to occur. Not surprisingly the mid-term review for 2002-03 promises more of the same. By further reducing the Bank rate and the repo rate, by enhancing liquidity in the system through cuts in the CRR, and by encouraging banks to reduce spreads over PLR the RBI is still trying to use the twin levers of lower interest rates and easy liquidity to impart some dynamism to the system. This failure to change the way it looks at the big picture, has been combined with a large number of specific micro-level policies and adjustments that are unlikely to impact on the problem of slow growth confronting the economy today.



© MACROSCAN 2002