Monetary Policy: January 2009

Maintaining the Status Quo?

N.A. MUJUMDAR

Amid market expectations, corporate sector lobbying, and persistent pressures from some Government of India policy makers, Dr. D. Subbarao, Governor, Reserve Bank of India (RBI) chose to maintain the status quo in respect of further injection of liquidity and reduction of interest rates. In his Third Quarter Review of Monetary Policy 2008-09, announced on January 27, 2009, the Governor kept the Bank Rate unchanged at 6 per cent; the cash reserve ratio (CRR) was kept unchanged at 5 per cent; the Repo rate and the Reserve Repo rates were kept unchanged at 5.5 per cent and 4 per cent respectively.

The only change introduced was the extension of the two liquidity support facilities under Liquidity Adjustment Facility (LAF), which were valid upto June end 2009 to end September 2009. These facilities were designed to meet funding requirements of mutual funds (MFs) non-banking financial companies (NBFEs) and housing finance companies (HFCs).

In a 37 page highly analytical document, Governor Subbarao has spelt out the rationale for this action. He argues forcefully that we should not be swayed by what other Central Banks, particularly of developed countries which have been afflicted by the deepening recessions, have done. These Central Banks may have had their won reasons for injection of massive liquidity and for reducing interest rates to near zero levels. “While we have certainly studied and evaluated measures taken by other central banks around the world, we have calibrated and designed our responses keeping in view India’s Specific economic context” (page 31; emphasis supplied). This is the key statement which forms the basis of the analysis embodied in Governor’s policy response.

How is India different from other developed countries suffering from recession? First, the world economic outlook is bleak. According to the IMF, global real GDP growth is expected to decelerate from 2.6 per cent in 2008 to 1.1 per cent in 2009. The U.S., the U.K., the Euro area and Japan which together account for nearly half of World GDP are already in recession. In contrast, the growth projection for the Indian economy is still high. Admittedly there is some slowing down in industrial activity and weakening of external demand as reflected in the decline in exports. The growth projection has been scaled down from 7.5 to 8 per cent to say, 6.5 to 7 per cent. Thus India continues to be the second fastest growing economy in the world even in 2009-10.

Second, the international financial system continues to remain dysfunctional amid extreme risk aversion, freezing of money and credit markets, and disruption of international capital flows. The global financial system which was passing through an unprecedented turmoil since August 2007 experienced a jolt in September 2008 when the failure of Lehman Brothers led to widespread panic. Many systemically important commercial banks, investment banks insurance companies and other financial institutions in the U.S. and Europe collapsed and quite a number of them had to be bailed out.

The Indian scenario offers a contrast “Barring some tightness in liquidity during mid-September to early October 2008, the money, foreign exchange and government securities markets have been orderly as reflected in market rates, spreads, and transaction volumes relative to those observed during normal times. India’s banking system remains healthy, well-capitalised, resilient and profitable Credit markets have been functioning well and banks have been expanding credit, notwithstanding the perceptions in some quarters of lack of adequate credit from banks to the commercial sector” (page 20). In fact the incremental credit – deposit ratio at 81 per cent on January 2, 2009 was higher than the corresponding ratio of 63 per cent, a year ago.

A number of measures taken by RBI since mid-September 2008, like cumulative reduction in the Cash Reserve Ratio (CRR) and unwinding of Market Stabilisation Scheme (MSS), have resulted in the injection of massive liquidity of Rs.3,88,045 crore (page – 29).

Although the January 2009 measures did not reduce any policy interest rates, the Governor’s message to banks is unmistakable. “As a result of several measures initiated by the Reserve Bank since mid-September 2008, banks’ cost of funds would come down. This should encourage banks to reduce their lending rate, in the coming months” (page 16).

What strengthened further the case for reduction in lending rates was the sharp decline in inflation. Headline inflation, as measured by year-on-year variations in the wholesale price index (WPI) declined by more than half from its intra-year peak of 12.9 per cent on August 2, 2009 to 5.6 per cent by January 2, 2009. Although, the fall in international commodity prices has helped the decline in the index the contribution of effective management of domestic demand cannot be overlooked. In fact the rate of inflation is anticipated to decline further to some 3 per cent by end March 2009.

Following this exortation of RBI to banks, the Finance Minister Mr. Pranab Mukharjee met public sector banks (PSBs) on February 2 and stated. “We must support the development of sectors which will immediately boost growth and throw up employment opportunities. In view of the contracting global demand we have to focus on the development of domestic demand by stimulating demand in rural areas and in labour intensive sectors”

Thus nudged by both RBI and Government, PSBs appear poised to cut lending rates. In fact following RBI’s exortation, the Punjab National Bank (PNB) cut its benchmark lending rate by 50 basis points to 11.5 per cent – the lowest among all banks. Similarly, the state Bank of India (SBI) announced, on 1st February, that it would provide housing loans at a rate of 8 per cent to all fresh borrowers. The going rates ranged from 8.5 per cent to 11 per cent depending on the size of the loan. The lead given by PNB and SBI may probably result in easing of lending rates generally by most, if not all, PSBs.

On the whole, a superficial reading of the January 27 monetary and credit policy measures may give an impression that RBI is keen on maintaining the status quo in terms of the interest rate structure. However, the net result has been the easing of the lending rate structure. This was rendered possible because RBI had prepared the ground for reduction of cost of funds to banks.

There is another analytical misapprehension about bank credit which the Governor’s statement has clarified. The growth in non-food bank credit as on January 2, 2009 at 24 per cent was higher than the expansion of 22 per cent witnessed a year ago. Despite this, a view is often expressed that there is dearth of credit. This is attributable to the fact that there is shrinkage in the flow of funds from the non-bank sources, notably the capital market and external commercial borrowings: for instance, such flow was around Rs. 1,91,470 crore in 2008-09, (upto January 2) as compared to Rs. 2,74,563 crore during the corresponding period of 2007-08. While bank credit has substituted for the shortfall in other sources of funds, to some extent, it has been unable to fully substitute for it.

To sum up, our response to the global financial crisis is India-specific. “…… while policy responses in advanced economies have had to contend with both financial crisis and recession, in India, the policy response has been predominantly driven by the need to arrest moderation in economic growth” (page 35).

To tackle the external sector led slow-down in growth, two stimulus packages were announced on the fiscal front: the first, announced on December 7, 2008 included raising of public expenditure by Rs. 20,000 crore to boost infrastructure development. The second, announced on January 2, 2009 was wide-ranging in scope: enhancing spending power of States, offer of sops to exporters and small-scale sector and raising the level of protection of cement and steel sectors. RBI’s massive injection of liquidity in the financial system to facilitate easing of lending rates has to be viewed in the totality of the context of stimulating the economy.

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