Internationally, the threat to the banking sector has been caused by the meltdown of currencies and their consequent effects on overstretched bank balance sheets. It is imperative, therefore, to accord top priority to managing the exchange rate. This has been the thinking behind the Reserve Bank's hiking of the repo rate and the CRR. The external circumstances which led to that hike continue to be present.Adding strength to the policy of keeping rates high at the short end is the fact that liquidity in the system continues to be adequate.

The money from the Resurgent India Bonds has led to a sharp increase in the money supply, which is now growing at over 19 per cent, well above Reserve Bank's target of 15-15.5 per cent. There is adequate liquidity to take care of credit needs, especially since there are as yet no signs of any pick-up in credit. Although the rate of growth in non-food credit has crept up higher from 10.8 per cent in November, 1997, to 15.2 per cent in September, 1998, that increase needs to be adjusted for the higher rate of inflation this year. If the higher rate is factored in, the real pickup in non-food credit has been just 2.8 per cent, compared with 6.3 per cent last year. All this implies that there is little incentive to loosen liquidity.

However, that stance towards tighter liquidity is offset by several factors. Concerns have been raised about the health of the financial system.There has been much talk of the banks being used to lend funds to the Unit Trust of India, in case there is a rush for redemptions. Even if the redemption pressure abates, markets will have difficulty in rising without the support of the Unit Trust, and a higher market is essential both from the point of view of a higher net asset value for the US-64 scheme as well as for the government's disinvestment effort. This could lead to banks being asked to lend to the Unit Trust, or subscribe to its schemes. There is also a lot of uncertainty about the government's disinvestment scheme, with many reports claiming that the offloading will be done to banks and financial institutions. All these bailing-out operations will affect banks.

Add to that the concerns about the non-performing assets of banks and financial institutions. The market is extremely sceptical about the NPA figures published by the banks and financial institutions. Consider the pathetic price-earning ratios of some of them. ICICI, IDBI and IFCI allquote at around twice historical earnings. Strong banks such as Corporation, SBI and Oriental Bank quote at between 4 and 7 times' historical earnings, at a substantial discount to the Sensex. This newspaper broke the story of published non-performing assets' figures being out of tune with the estimates of Reserve Bank inspectors.

Standard & Poor's estimated NPA figures for Indian banks, as well as those of Thomson Bankwatch, are several times the official estimates.

How can the central bank help shore up confidence in the banking system? First, in spite of the recommendations of the second Narasimham committee, while there is little doubt that NPA norms should be tightened to international standards, this may be the wrong time to do it. The markets may well take fright, if the actual figures for NPAs exceed their expectations. Bank bottomlines are under pressure, points out ANZ Investment Bank head of research Anindya Chatterjee, with softer interest rates squeezing spreads. He says the lack of growthhas forced banks to invest in government securities that have only a narrow spread over the cost of funds. Tighter NPA norms will lead to a flight to quality, which will mean a further contraction in spreads and profitability. The credit multiplier will be thinned out and some banks may be forced to recapitalise. Further, in case banks are required to help out the Unit Trust and the disinvestment process, it is essential that banks stay liquid. These considerations will work against any tightening of liquidity, and in fact, could well lead to a demand for more liquidity.

One of the methods the Reserve Bank can use to strengthen banks is to prescribe a higher capital adequacy ratio. Because of the sluggishness in credit offtake, most banks are comfortable on the capital adequacy front. ABN Amro Bank country treasurer Subir Biswas points out that raising the ratio will send a strong signal internationally about the strength of Indian banks, at a time when many banking systems are floundering.

If anydecision not to tighten liquidity is taken, it will be at the cost of higher inflation. The credit policy is being framed against the backdrop of money supply growth at well over 19 per cent, and a rate of growth in consumer price index of over 15 per cent. Although the inflation is primarily owing to a rise in prices of primary articles and is cost-push inflation, a loose monetary stance will exacerbate the price rise.

The Reserve Bank has made it amply clear that it will not wait for the half-yearly credit policy to take action on parameters such as the CRR, bank rate etc. Which is why they call this year's busy season policy a "monetary policy review". Nevertheless, as DSP-Merrill Lynch economist Kamal Sen points out the review will contain pointers to the Reserve Bank's policy stance during the next six months. If the Reserve Bank talks more of inflation than growth, that could well signal a tightening in the near future.