Bank on it

Some more good reasons to keep the cost of credit relatively low

The current economic crisis could take a toll on Indian banks. Reserve Bank of India statistics reveal that while deposits grew at the rate of 21.8 per cent till July 31,compared to 20.6 per cent last year,credit growth had in the same period decelerated from 25.6 per cent to 15.8 per cent. If the high growth in bank deposits and the low growth in bank credit continues,it will undermine the profitability of the Indian banking system and make banks weaker. One obvious solution to this difficulty is that banks cut deposit rates to reduce the growth in bank deposits. With lower deposit rates,banks will be able to reduce lending rates without hurting their margins. This will allow credit growth to rise. Lower industrial production and a fall in farm incomes due to drought will also pull down deposit growth. However,both developments will also imply a drop in the demand for credit.

While the interest rate mechanism should be allowed to function to create a balance between bank credit and deposits,the government should not direct banks to increase credit to risky projects at lower rates. Since the bulk of the Indian banking sector is in the public

sector,eventually the tax payer bears the brunt of bad loans. In a business-cycle downturn,lending is a risky business. The lack of development of the Indian financial system which lacks,for example,as strong corporate bond market means that the burden of financing investment falls disproportionately upon the banking sector. While there is a need to increase funding from there,there is equally a need to develop other elements of the financial sector to reduce the concentration of risk in banking.

The coming months will hopefully see an increase in business activity. However,they will also see an increase in government borrowing. The increase in interest rates on government borrowing in recent weeks has happened despite the fact that this is a time when demand for credit from the private sector is weak. When it picks up then there will be an overall increase in the demand for credit. With businesses struggling to get back to their feet it will be important that the cost of credit does not increase so much as to kill the recovery. It is therefore important to keep monetary policy loose. While there have been increases in food prices in recent weeks,raising interest rates will not pull down vegetable prices; nor will domestic interest rates affect international commodity prices.