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Cuts without conviction

Haseeb A Drabu

For the first time in the last six years, the Reserve Bank of India governor seems to have succumbed to the pressure to help recovery by reducing interest rates.

This is a bit ironic because Bimal Jalan, more than anyone else in the system, is only too acutely aware of the limits of the Monetary and Credit Policy in managing aggregate demand (and its composition) especially in the context of specific supply side rigidities.

Indeed, he would much rather pump the economy out of recession than do monetary tinkering.

While there is no harm done by the rate cuts--in this desperate bid to aid recovery--it is being forgotten that the macroeconomic objective of interest rate policy is not to provide cheap credit but to ensure a balance between savings and investment.

A cut in the bank rate and the Cash Reserve Ratio will ensure enhanced availability of bank and non-bank finance; but will it be to all sectors and segments? And will it reduce rates on different types of credit and creditors evenly?

Even after banks pare their lending rates and even if investors expect to make a profit, investment may not materialise because of the difficulty in securing the complementary part of the finance from the equity market.

The overall investment climate that is critical for a bank rate to succeed is not in evidence at the moment. All that these cuts will succeed in doing is to further the refinancing activity of corporates which is quite different from growth inducing investment.

By focusing on the rate cuts, this policy continues to operate as if there is a single market with a perfectly flexible rate of interest.

Therefore, an increase in the supply of funds relative to demand is expected to reduce the rates. This is clearly not the case. Instead, the setup is one of multiple markets for bank finance with divergent trends in short-term interest rates.

For instance, today, the problem is really at the short end of the market. While the ‘AAA’ rated corporates can borrow at 7 to 8 per cent, the second rung can only borrow at around 14-15 per cent. Clearly, such a wide spread is unsustainable.

To take it further, the segment that is not getting the credit at low rates is the small and medium enterprises and the agricultural sector.

This policy does nothing to change that situation. With the better and creditworthy corporates accessing the market at rates lower than the financial institutions and banks, these cuts are meaningless for them because the exact liquidity position determines their cost of borrowing.

This leaves only the small and medium enterprises in the bank finance market and their rates are not reduced or will at best be reduced only marginally. The need to redress this skewed distribution in the bank finance market assumes urgency in view of the overall growth scenario.

The biggest enterprises are not the only contributors. The small and medium enterprises do contribute a substantial part of the overall output.

In a mature market, the trend is for the interest spread on government paper and corporates to narrow. In India, this trend has been limited to the ‘AAA’ corporates and gilts. The spread, if anything, has widened across lower grades.

And herein lies the real interest rate problem; the spread needs to be squeezed. Once the bank decides to lend to the less than ‘AAA’ rated corporates, it implicitly acknowledges their creditworthiness.

With that not in doubt, and given that they are taking only a short term exposure, there is no justification to create such deep segmentation. In fact it is counterproductive as it compounds the problem for those corporates who are fundamentally strong but have been caught in the cyclical downswing . This issue has been left unaddressed.

Instead of trying to calibrate the interest rates, RBI would have done well to recognise the simple fact that since 1991 while traditional development finance has been abandoned, no new credit delivery mechanism has been set up.

As such the policy should have been based on selective sectoral considerations. Such considerations include specific supply problems, demand pattern in order to ensure that optimal resource allocation from a growth perspective will be achieved.

Towards this end, the RBI should have focused on the specific issue of the sectoral distribution of credit. Doing that would have gone a long way in alleviating the structural rigidities in the system that is not allowing the interest rate transmission mechanism to function.

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