Governor’s choice

Governor’s choice

RBI Governor D. Subbarao will make his second credit policy announcement on Tuesday,January 27.

RBI Governor D. Subbarao will make his second credit policy announcement on Tuesday,January 27. After a series of steps that helped greatly in easing the liquidity crunch that India faced from the middle of September,market expectations about the RBI’s actions have been largely met as the RBI maintained adequate liquidity in the system. However,today with bank lending rate cuts not keeping pace with RBI rate cuts and credit not expanding as policy makers might have hoped,what should Governor Subbarao do? In addition to cutting rates further,he needs to initiate long-pending reforms that would improve the monetary policy transmission mechanism.

The first question is,should the RBI cut interest rates further? Today there is little disagreement that interest rates need to be lowered further. The real question is whether the RBI should cut rates now,or wait for banks react to its earlier rate cuts. With the latest price data suggesting that the fear of inflation has receded,the concern about a slowdown in growth of output outweighs worries about inflation. There is disagreement on the speed and magnitude of rate cuts. Advocates of gradualism believe that the RBI should wait,just in case inflationary pressures rise again. But today the best policy would be to immediately cut rates sharply.

First,the unfolding of the crisis warrants quick and decisive action. In the past we have seen that the deeper the crisis the longer it takes for the economy to recover. In other words,while we wait and watch and act upon actual data,the economy will continue to deteriorate at a rapid pace. This in turn will make the recovery period slower and longer. India has limited fiscal space and a slow and poor monetary policy transmission mechanism. A 100 basis point cut in the repo rate does not lead to a 100 basis point cut in lending rates immediately. That is why the need for a larger cut in policy rates.

Second,banks in India hold a large share of their assets,roughly one-third on average,in government bonds. (This often goes beyond the statutory requirement of holding one-fourth of their assets in government bonds. In developed countries this number varies from 0.25 per cent to 5 per cent of total assets.) The impact of interest rates movements on bank balance sheets goes beyond the loan portfolio as banks choose between holding bonds and giving loans. At present,the expectation that interest rates will fall further creates a favourable environment for buying bonds. If interest rates fall further,the price of bonds will rise. This makes buying bonds a more attractive proposition. However,if the market believes that rates can’t fall any further,it would make government bonds less attractive. This calls for a “zero interest rate” policy. The rate does not actually have to be zero,it can be,say,1 per cent for the reverse repo and 2 per cent for the repo. What is important is that the market should believe that they cannot be reduced further.


In this uniquely Indian context the impact of expectations of a rate cut on the loans versus holding government securities by banks is illustrated by the experience of 2002 to 2004. At the beginning of 2002 banks held 28 per cent of their total assets in government bonds. The repo rate was 10 per cent. It was slowly cut to 6 per cent over the next two years. Throughout there were expectations that interest rates would be cut further. Over this period government bonds as a share of total bank assets rose to 46 per cent. As banks were betting on interest rates going down further,they moved away from loans to buying government securities. This happened despite the fact the real economy was witnessing healthy growth and giving loans was not as risky as it may be today. Today with banks already scared to lend as companies may see trouble as the economy slows down,a policy of gradual interest rate cuts is fraught with the risk of worsening credit growth.

In addition to cutting the repo and reverse repo rates,the RBI needs to cut the cash reserve ratio to 3 per cent. Money kept in reserves is not remunerative and raises the interest rate that needs to be paid by bank customers.

Even after taking these steps we may find that banks are still reluctant to reduce lending rates immediately. Given the existing liabilities in fixed deposits on which they will have to continue paying higher rates,it makes sense for them to postpone the decision to cut lending rates as much as possible. However,if banks were allowed to reduce the interest paid on savings deposit,the interest payment of a part of their liabilities could be reduced,helping to push lending rates down. Today the RBI administers the interest rate of savings deposits. Making this a rate that each bank determines on its own for its depositors has been a long overdue reform. In the forthcoming credit policy the RBI should announce that it will no longer administer the savings deposit rate.

Though the competition from small savings does not constitute a good reason for banks not to cut deposit rates given the falling share of small savings as well as the growing importance of bulk deposits,this is also a good time to review the policy of administered interest rates. If it is difficult to make the rate fully market-determined,then as an intermediate step it could be benchmarked.

Finally,bankers express the fear that the government’s borrowing programme is going to push up interest rates and so they don’t want to lend at lower rates and get locked in. With a slowdown looming large and an easy monetary policy,there is not much danger of a significant prolonged rise in interest rates. Regardless of that the government should take steps to reform the bond market. There is a long list of actions outlined in the Percy Mistry and Raghuram Rajan reports that are action points on currency,derivatives and bond markets,which need to be taken up to improve the transmission mechanism of monetary policy. The time to act on these is now.

The writer is senior fellow,National Institute of Public Finance and Policy,Delhi