RBI?s monetary policy announcement of July 28 maintains the much expected status quo on policy interest rates. Yet, it makes some bold statements that reveals its intent more than its formal stance on interest rates. I find this quote taken from para 67 to be the most important:

?Notwithstanding the temporary hiccups of the crisis period, India is not a demand constrained economy; it is a supply constrained economy. The critical requirement for accelerated growth is to raise the level of investment, particularly in infrastructure.?

This is exactly what the economy needs. Of course, RBI cannot do anything directly about investment in infrastructure or any other sector. It can only ensure that there is enough liquidity in the financial markets so that finance is not a constraint in this investments story. This is a job that RBI has done well since the October crisis.

RBI has over the past nine months infused ample liquidity by reducing the cash reserve ratio and by reducing policy rates?the repo and reverse repo rates. Commercial banks responded by reducing lending rates in return. It is these lending rates that matter to the private corporate sector that invests.

The prime lending rate (PLR) fell from about 14% in December 2008 to 12.5% by June 2009. However, these reductions have been small and tentative. RBI expresses some frustration/hope in stating that ?there is some scope for further reduction.?

Why do lending rates not fall any further? And, could RBI have done anything to push them down? RBI can ensure liquidity that can reduce interest rates. But, it cannot do much more than that. If lending rates do not fall in spite of ample liquidity, then the problem is elsewhere.

The problem is largely in the sharp increase in the risk in lending. Post the September 2008 crisis, risks and risk perceptions have changed dramatically. In April-June 2008, 4.5 per cent of the ratings assigned by the credit rating agencies were classified by them as below investment grade. In the same quarter of 2009 this ratio had shot up to 27.4 per cent. The ratio had peaked to 31.5 per cent in April.

Under these conditions, no matter how hard RBI pushes the banks, they are unlikely to lend at lower interest rates. Lending rates were expected to rise in line with the increase in risk. They did not partly because RBI intervened to help reduce interest rates. The combined effect of the two forces?rising risk and falling policy rates?led to a slower fall in lending rates.

Partial data for July 2009 indicates that this risk perception continues to remain high as 28.1% of the ratings announced by the rating agencies in the month were below investment grade. Thus, it is quite likely that if RBI had further reduced the policy rates or the CRR, banks would continue to remain sluggish in reducing lending rates.

Lending itself slowed down dramatically in the first quarter of 2009-10. Outstanding bank credit fell from Rs 27.8 trillion as of March 2009 to Rs 27.7 trillion as of 20 June 2009. There has been some pick-up in credit since then. It rose to nearly Rs 28 trillion by 3 July 2009. Nevertheless, the increase in credit during the current year is nearly half of the increase seen in the corresponding period of the previous year.

This poor offtake of credit in spite of greater liquidity and lower interest rates reflects the greater risk and the lower economic activity during the period.

Perceptions regarding the overall risks have climbed down and the liquidity conditions continue to remain good. Banks are in a better position now to discern between risky and not-so risky lending propositions compared to the conditions prevailing 3-6 months ago. Further, RBI?s stance is stated as ?…to meet the challenge of spurring private credit demand by maintaining policy rates and liquidity conditions conducive for revival of private credit demand.?

These conditions look apt for a revival of fresh investment proposals. Fresh investment proposals as seen in CMIE?s CapEx database fell sharply in the April-June 2009 quarter. New proposals fell to investments worth only Rs 1.4 trillion. In the preceding five quarters new investments were always greater than Rs 4.5 trillion.

The fall in fresh investment proposals in April-June 2009 does not imply slowing investments in the immediate or medium term. It is wrong to interpret the fall in fresh investments or the growth in gross fixed capital formation as a cyclical downturn. RBI correctly sees this fall as a challenge to address rather than an inevitable outcome of business cycles.

The fall in fresh investment proposals is interestingly juxtaposed with the highest ever commissioning of projects in a year. Investments worth Rs 5.6 trillion are expected to be commissioned during 2009-10. As these record capacities get commissioned, supplies of goods and services will increase and these will demand greater credit. RBI?s accommodative monetary policy under these conditions will be conducive to growth emanating from these new capacities in 2009-10 and 2010-11.

The author heads the Centre for Monitoring Indian Economy