The credit policy announcement by the RBI next week must ensure lower lending rates and higher credit supply by banks. We have seen the resistance of commercial banks to cutting lending rates in the last three months. This has been despite the cuts in repo,reverse repo and the cash reserve ratio. On the one hand,the RBI should push banks to pass through the interest rate cuts the RBI has already implemented to customers. On the other,it should continue easing credit policy. The RBI should cut the repo and reverse repo rates as well as the cash reserve ratio further. This will help to discourage banks from buying government bonds in order to reap the benefits of a further fall in interest rates. In order to take the focus of banks away from holding government bonds the RBI should tighten regulations on interest rate risk so that those banks buying long-dated government paper in order to benefit from the increase in their prices when interest rates come down will have to be more cautious. The risk weight on government paper should be increased. At the same time,the reduction in the cash reserve ratio will reduce the tax on banks as money held in with the RBI is unremunerative and the loss in interest has to be compensated by charging higher rates from other borrowers.
The coming credit policy should take the overdue step of allowing banks to determine the saving rate. Banks should be allowed to choose their own savings deposit rate. There is no logic for making this an administered rate. In todays environment banks may choose to lower it; when times change they may raise it. Today banks are arguing that they cannot lower their lending rates because their deposit rates are high,and they cannot lower their deposit rates because they have to compete with small savings whose rates are not falling. Whether this is true or not,or the extent to which this is true,can be questioned. However,this is a good time for the government to chip in and reduce the distortions in the financial system by making small savings rates free or linked to a benchmark rate.
In the last policy statement Governor Subbarao did not meet market expectations of cutting rates. He has done very well since. Next week he will be tested again. This time,he needs to send out a clear message that he will be ahead of the curve rather than behind it. The signs of deflation and of slowdown in consumption,export and investment require strong action from the RBI.