On 13 August, the US Federal Reserve, contrary to expectations, kept the federal fund rate unchanged at 1.75 per cent. Since January 2001, when the 11 rate cuts were initiated in the US, interest rates in India too, especially longer tenor, have fallen sharply. Sagging economic growth and the depressed stock market have inspired loud demands for more aggressive reductions in the interest rate regime at home. The consequences to the Indian banking system apparently count for little.
In 2001-02, most banks booked large profits on sales of government securities, and this put a nice sheen on their profits. Net lending margins, after provisioning, are far less pretty. Advocates of aggressive rate cuts argue that lower key rates will boost credit flow, push up equity prices, help finance investment and thus boost growth.
Let us look at what has happened over the past few years in the US. The federal fund rate has been slashed from 6.5 per cent to 1.75 per cent, with short-term paper following suit. The longer end of the yield curve has proved obstinate. Ten-year treasury yields have dropped only 160 basis points (bps), while Aaa paper has fallen by 110 bps, and Baa yields by even less. Despite the fiscal surplus turning into a deficit, the spread of Aaa paper over treasuries has risen, as has that for Baa bonds over Aaa. Note that in the summer of 2000 the spread of treasury over Aaa was at historical highs, due to the fiscal surplus and the perceived shortage of gilts.
Long-term lending rates by banks have eased by more than corporate bonds, but if commitment and other charges are priced in, effective rates currently are closer to Baa yields. The level of commercial and industrial (C&I) loans have fallen off, with the stock of C&I loans falling from $1.1 trillion in March 2001 to $0.99 trillion in July 2002. The large decline in equity prices is of course a celebrated fact — the Dow down by 20 per cent and the S&P 500 down 37 per cent. Changes in the level of private investment, except residential, are still firmly in negative territory and economic growth in 2002 is unlikely to exceed 2 per cent by much.
So, clearly there have been other impediments at work. Factors which have blunted the edge of the primary monetary tool, despite a relatively robust banking system and fiscal stimulus through a tax cut and higher spending. The US Fed clearly identifies the culprit: “The softening in the growth of aggregate demand that emerged this spring has been prolonged by weakness in financial markets and heightened uncertainty related to problems in corporate reporting and governance.” Closing his testimony to the US Congress last month, Mr Alan Greenspan pinned the prospects of improved economic performance on the “implementation of sound monetary, financial, fiscal and trade policies”, corporate governance included under the generic “financial”. A fairly simple restatement of the obvious: the effectiveness of every policy instrument is contingent on a level of soundness in other policies.
Thus, the expectations that Dr Bimal Jalan can “kick-start”, or whatever tired cliche, the slack Indian economy, is wilful delusion. It conveniently ignores the thoroughly mismanaged state of government finances, the stressed conditions in parts of the financial sector (witness UTI), the pressure on operating profitability of banks, and the huge deficit in standards of governance ?? public and private.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)