This loss
of the fiscal lever was seen as a small price to pay for the greater
autonomy the new regime affords the central bank and the greater ability
provided by that regime to the central bank to use monetary levers to
stabilise the economy. This view held by the advocates of reform was
strengthened by the rather early success achieved after the 1990-91 crisis
in reducing inflation and the deficit on the balance of payments. What is
unclear is whether this success was attributable primarily to monetary
policy effort to rein in the growth of money supply and increase the cost
of credit. Fiscal compression combined with a fall with in the unit value
indices or prices of imports could have also delivered these results. In
fact, circumstantial evidence suggests that both these factors did play an
important role.
The
ambiguity regarding the factors responsible for stabilisation is of
significance because success on this front diverted attention away from an
analysis of the efficacy o monetary policy, which was being made the
principal means for macroeconomic regulation of the economy. There are two
ways in which monetary policy can seek to affect real variables: it can
affect the level of potential liquidity in the system, rendering the
access to credit of investors and consumers easier or more difficult; it
can alter the cost of credit, making it cheaper or more expensive for
investors and consumers to borrow to finance their expenditures. A regime
which privileges monetary policy would see enhanced access to liquidity at
cheaper interest rates as the means to revive flagging economic growth.
Exploiting the availability of cheap credit investors would undertake
capital expenditures and consumers would increase their consumption
spending, triggering a recovery.
In India,
long before the onset of recessionary trends in the economy, the central
bank had made a transition from a tight money policy aimed at stabilising
the system and dampening inflation to an easy money policy aimed at
stimulating investment and growth. As a result, for quite some time now
the banks have been awash with funds and in search of creditworthy
borrowers. They were helped in the search by the presence of a government,
shunned by the central bank, as a major borrower in the market.
The
difficulty was that despite this recourse to a liquidity enhancing
strategy, interest rates proved to be quite sticky. They fell in nominal
terms, but not enough to make much of a difference to real interest rates
since inflation too was on the decline. This led up to the view that the
problem of reducing the level of interest rates in India was no purely a
monetary one, but structural in nature. To quote the RBI, "Following are
some of the factors which reduce downward flexibility in the interest rate
structure in India:
-
Banks, particularly public sector banks, continue to be the
primary mobilisers of domestic financial savings (in addition to Provident
Funds, Small Saving Schemes, and Life Insurance Corporation). Holders of
term deposits in banks generally belong to fixed income groups and expect
a reasonable nominal interest rate, in excess of the long-term rate of
inflation. The recent reductions in deposit rates and return on small
savings have caused widespread concern among depositors because of lack of
other risk-free avenues for financial savings. This constrains the
ability of banks to effect further reduction in their lending rates
without affecting their deposit mobilisation and the growth of financial
savings over the medium-term.
-
Banks have been given the freedom to offer
"variable" interest
rates on longer-term deposits. However, for various reasons, the
preference of depositors as well as the traditional practice with banks
tended to favour fixed interest rates on term deposits. This
practice has effectively reduced the flexibility that banks have in
lowering their lending rates in the short run, since the rates on the
existing stock of deposits cannot be lowered.
-
For public sector banks, the average cost of funds is over 7.0
per cent, and for many private sector banks, the average cost is
even higher. The non-interest operating expenses generally work out to
2.5 to 3.0 per cent of total assets, putting pressure on the required
spread over cost of funds. Relatively high overhang of Non-Performing
Assets (NPAs) pushes up further the lending rates.
-
There is a
persistent and large volume of market borrowing requirements of the
Government giving an upward bias to the interest rate structure.
In view
of the above rigidities in cost, spread, and tenor of deposits, the link
between variation in the RBI's Bank Rate and the actual lending rates of
banks, particularly at lower levels, is not as strong in India as in
industrialised countries. PLRs of banks for commercial credit
are entirely within the purview of the banks, and are not set by the
Reserve Bank. Decisions in regard to interest rates, therefore, have to be
taken by banks themselves in the light of various factors, including their
own cost of funds, their transaction costs, interest rates ruling in the
non-banking sector, etc."
Unfortunately for the RBI and the government, even while it recognises the
rigidities that constrain the ability of monetary policies to bring down
interest rates, they have few other levers available in their arsenal to
deal with the growth slowdown the economy is experiencing. Hence, as
elsewhere in the world the current deflationary trends are being
confronted not with a fiscal stimulus but with renewed efforts at reducing
interest rates and increasing liquidity in the system. That is what the
mid-term monetary policy statement sets out to do. However, once again ,
as elsewhere in the world, the evidence is now overwhelming that both
investment and consumption spending do not respond adequately, if at all,
to the availability of cheap credit. Consumers spend when incomes are
rising, incomes rise when investment is buoyant, and investment tends to
be buoyant when there are adequate "inducements" to invest. In India,
exports have never provided the inducement to investment. In any case,
with the world economy sluggish exports cannot provide the stimulus now.
The inducement must come from an expansion in the home market, which seems
clearly dependent on a fiscal stimulus. So long as the government retains
its obsession with capping and regulating the deficit, irrespective of the
state of supply in the economy, growth is bound to be a casualty. Attempts
to tinker with or even dramatically alter monetary policy, as reflected in
the mid-year credit policy statement, would not change this scenario.
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