The policy has left the basic bank rate unchanged. It has also left the repo rate unchanged. There is no change in the cash reserve ratio which the commercial banks maintain with the Reserve Bank. In anticipation of the rate cut, the bond market had rallied last week and fell a bit after the announcement. It was in fact surprising that the market did not fall more!
The main reason for the expectation of the rate cut among market men was that the yields on the benchmark 10-year 2013 government bond is around 5 per cent - 5.1 per cent, whereas all bank rates are much higher. So the market wanted bank interest rates to be aligned more towards bond market rates.
It appears as if governor Reddy has decided to be practical rather than charismatic. For one, he must be worried about the inflation rate which today is hovering around 5 per cent. Inspite an excellent monsoon, probably because the new crop is yet to come in, prices of food articles are still ruling firm. Petroleum minister Ram Naik has kept petroleum product prices low even though this has meant a big hit for the government-owned oil companies (no surprise that oil majors have under-performed the other stocks in the current bull run).
This has, to some extent, kept inflation figures depressed. With industrial activity picking up and the economy going from recovery phase to a boom phase, demand for credit is also on the way up. For the first time, the July-September quarter saw a good increase in non-food bank credit. So the governor appears to have seen no great need to reduce interest rates. He must be enjoying the strange phenomenon of real interest of 50 basis points in the Indian economy which has been used to 500-600 basis points in the past.
Another unspoken reason for this reluctance to reduce the interest rate may be the fear of antagonising the middle class. Over the last two years, bank deposit rates have fallen by 3-4 per cent and pensioners who have lived on interest income have been hit hard. The middle-class mostly lives in urban areas and is very articulate. A reduction in the bank rate would have meant a possible reduction in interest rate on deposits which would have been very unpopular indeed.
This does not mean that the RBI will not cut interest rates in the near future. The previous governor, Bimal Jalan, made it a practice to cut bank rate and repo rate outside of the credit policy. His argument was very logical: The interest rate should be changed when the occasion demands it and not as a matter of course. My own prognosis is if the new crop arrival and falling oil prices brings inflation down, we can expect a rate cut in January 2004.
Having disappointed the corporate sector FICCI, CII and co, have been quick to cry foul the RBI should act fast to bring pressure on commercial banks to pass on the lower interest rates to borrowers. It is quite disgusting to note that prime lending rates (PLR) of most banks are 10 per cent and over. Given the fact that banks normally add risk premium of 1-3 per cent over the PLRs, the manufacturing sector is still getting credit at 11-13 per cent. This is a ridiculous situation and the RBI should use all its clout to bring down these rates. The interest spread of 5-8 per cent that banks are getting is just too much.
There is no doubt that the whole interest rate scenario in the country needs a rethink. As the deputy governor Rakesh Mohan said in his usual candid fashion, as long as the central government continues to have a hold on interest rates it is impossible for RBI to have policies that reflect market forces. As it stands today, the central government controls the interest rate on small savings and on provident funds. Both these are much higher than yields on 10-year benchmark treasury.
The government will argue that it needs to protect savers and is forced to introduce this high rate of interest in the larger public good. This argument has large political overtones which may be addressed in the Union budget.
The government can derive satisfaction that the RBI has increased its GDP target from 6 to a higher level of 6.5 per cent to 7 per cent. Central banks generally tend to be cautious about crediting growth rate and this statement should bring satisfaction to North Block which has often been accused of being too optimistic. The credit policy definitely strengthens the feel-good factor in the economy but has fallen a bit short of the high expectations the market had of the new governor.
The author is a Delhi-based investment banker and Convenor of the BJP Central Economic Cell. The views expressed herein are personal. He can be contacted at email@example.com