To be fair, the Governor has been consistent. In fact, many parts of the statement are a repetition of what was stated in the past. The cut in the rank bate is also not new the bank rate has been reduced, in steps, from 11 per cent, five years ago. Dr Bimal Jalan, has on many occasions in the past, made known his stance on monetary policy and that consists of three elements: adequate liquidity, soft interest rates and a flexible interest rate structure. It is a good policy stance and it has received widespread acceptance. What is slightly troubling is the Governors inclination to be consistent rather than flexible.
Lets look at the evidence before the Governor. According to him, the annual rate of inflation remained below 4 per cent up to mid-January 2003 and rose thereafter to 6.2 per cent by end-March. The components of the wholesale price index are (i) manufactured products, (ii) primary articles, and (iii) fuel, power, light and lubricants. They have a weightage of 63.7, 22.0 and 14.2 per cent respectively. Of these, the sharpest increase during 2002-03 was in the fuel, power, light and lubricants group prices increased by 10.8 per cent. In the primary articles group, there were steep price increases in oilseeds, sugarcane and cotton. Manufactured products registered a price increase of only 4.8 per cent, but this must be compared with no increase during the previous year.
Further, during 2002-03, non-food credit of scheduled commercial banks recorded a growth of 26.2 per cent. Demand deposits also registered a strong 10.3 per cent growth. According to the statement, both are indicative of the fact that a substantial part of lendable resources of banks has been deployed for productive purposes. At a disaggregated level, credit flows increased to iron and steel, metal and metal products, cotton and jute textiles, electricity, paper and paper products, fertilisers, drugs and pharmaceuticals, cement, gems & jewellery, construction, food processing, computer software, power and roads and ports. So far so good. But the other side of the story is that there is obviously a spurt in demand which has stimulated a spurt in production. What happens when demand increases At least in the case of manufactured products, the tendency of manufacturers is to raise prices.
The statement admits that there is adequate liquidity in the market. Interest rates are soft. The call money rate, discounted rate of commercial paper and cut-off yields on Treasury Bills have converged to a narrow band of 5.5-6 per cent. The yield on G-secs with one-year residual maturity is 5.5 per cent and on securities with 10-year residual maturity is 6.21 per cent. Yields on non-government bonds have witnessed a sharper reduction.
Term-deposit rates have also moved down. On maturities up to one year, the rate is between 4 and 6 per cent. In the case of long-term deposits, the rates are in the range of 7.25-8.75 per cent. Consequently, lending rates have also declined. The PLR of public sector banks have declined and are now in the range of 9-12.25 per cent.
Given this evidence, there was a strong case for a standstill on the bank rate. Nevertheless, the Governor has announced a bank rate cut by 0.25 percentage point from 6.25 to 6 per cent, and has indicated his intention to keep it unchanged until October. He has also announced his intention to cut the CRR from 4.75 to 4.50 per cent with effect from June 14. Together, these two measures will trigger lower interest rates and enhanced liquidity. If demand picks up, as the Governor expects it to, there will be pressure on prices. Added to this, if the monsoon is less than normal there will be an upward pressure on the prices of primary articles.
Industry usually complains of high real interest rates. That complaint is no longer heard because of the reduction in lending rates and the rise in the rate of inflation. But there is a flip side to lower interest rates. Perhaps for the first time in recent years, depositors, that is savers, will be rewarded with a negative real interest rate. This is so because, again, perhaps for the first time in recent years, the rate of inflation is higher than the rate of return on time deposits from one year to three years.
There is some concern that this development will impact savings. There is, of course, the counter-intuitive argument that those who wish or need to save will, whatever be the consequences, save and that a negative real interest rate may not encourage them to consume rather than save. May be so, but in my view, there is something fundamentally wrong if a saver will get a negative real return on his savings. It is the savings of the household sector that keeps this country afloat. Household savings accounts for 22.5 per cent in the overall gross domestic savings ratio of 24 per cent (2001-2002). Besides, in a country with virtually no social security for the vast majority, anything that may discourage the public to save or will harm them when they save - is not acceptable.
The Governor expects that inflation will remain benign around 5-5.5 per cent. Some years ago, the policy stance was that inflation should be kept, at all costs, below 4 per cent. Be that as it may, an inflation rate of even 5 per cent will hurt the small depositor who will get only 4 per cent on a term-deposit with maturity up to one year. If inflation goes beyond 5.5 per cent, the Governor will have little choice but to raise the rank rate. There was a strong case for the Governor to have taken a standstill position and not cut the rank rate. High inflation and a negative return for the depositors/savers make for an explosive combination, especially when key elections are round the corner.