The Soup Is As Expected, And Looks Fine, But The Fly In It Is Not!

Updated: Apr 30 2002, 05:30am hrs
The Monetary and Credit Policy Statement for 2002-03 did not surprise. Which of course is a measure of the increasing maturity of both market players and the regulatory establishment. The hallmark of good Policy-making is its predictability - a necessary pre-condition for maturity in an evolving financial structure. Most people bet on a 50 basis point (bps) cut in cash reserve ratio (CRR) and there was one. A clear majority bet on no change in the Bank Rate - there was none; several expected the wish list on flexible deposit rates articulated in last October’s Statement, to take more concrete shape - and it has. As it also has, in the case of continued tightening of prudential norms and provisioning norms. The enhanced appetite for modest initiatives towards capital account integration that was evident in Budget 2002 has been taken a couple of steps further in the Credit Policy. So that is good. The greatest success of the policy-maker is to sensitise his audience to the continuing logic of his perspective, so that people can know what to expect and plan accordingly. One must not forget that in India we have lived too long under a dispensation where opacity has been the preferred characteristic of policy-making.

Before one comes to the thing floating in the soup, there are other issues that require comment. The desire of the RBI to encourage variable rate deposit taking, and the use of price-based incentives to move people away from fixed rate deposits is commendable. As is facilitating corporate debt restructuring (para 125-h). Of considerable significance is the permission now granted to banks to “borrow up to 25 per cent of their unimpaired Tier-I capital from overseas market”, and raising of the limit from 15 per cent “to 25 per cent of unimpaired Tier-I capital for investment in overseas market instruments” (para 73). This is a logical step forward from the Budget provisions that allowed Indian mutual funds to invest part of their funds in rated instruments overseas.

In regard of the stance, there is a problem however. “Unless circumstances change unexpectedly” the RBI proposes to “maintain ... a bias towards softer interest rate regime in the medium term” (para 43.). At the outset, the 287 bps decline in 10-year G-Sec, has been put down to “flight to quality” (para 14.). Surely the cut in administered interest rates by the Government had something to do with it As also the shortage of demand from good quality credit. For it is axiomatic that loan assets are more profitable than investment assets, especially G-Secs. Of course the axiom falls apart when more loans than is expected, go dud, or when underlying securities cannot be enforced, or when prices do not reflect the risks and profit margins get squeezed beyond the limits of discomfort. And/or when there isn’t plain enough demand from borrowers of acceptable credit quality.

Now to interest rate policy. In para.53, the RBI states that “it is evident that the real interest rates on long-term paper, the Bank Rate and short-term rates are now fairly reasonable”. This is the flattest yield curve that we have had for many, many years now. Short-term rates (T-bills) at 6 per cent and 10-year paper at 7.3 per cent; does the spread capture the interest rate and market risks of the asset portfolio of the banking system Remember that the RBI also wants banks to extend the tenor of their liabilities, which means more risks from this quarter, an outcome that needs to be supported by a steeper yield curve. Surely there is a deficit in the assertion of “reasonableness”. Now, about the caveat attached to the ‘softening bias’ of ‘unexpected changes in circumstances’. What is the expected change in circumstances

US Fed Chairman, Mr Greenspan has been talking about a “tightening bias” ever since February 2002; the 5.8 per cent growth in GDP for first quarter of 2002, released on April 26, 2002, makes the tightening a near certainty. Especially so, since an important source of growth has for the fist time in several quarters come from a sharp reversal in the direction of business investment in equipment and software. The market is factoring in anything up to a 225 bps rise in the Fed Fund rate by the end of calendar 2002, which will bring the short-term differential between Indian and US interest rates from the present 425 bps down to under 200 bps. How does the RBI propose to maintain its “softening bias” under these expected conditions - leave alone the unexpected - like a war in say, Iraq

Finally, to the bumptious fly in the soup. The RBI has over the past several years urged banks to price their risks and cease looking to the central bank or the government for periodic blood transfusion.

Public sector banks have responded by internalising the process of risk management, including both credit decisions and risk pricing. Why therefore should the RBI insert itself into the argument by postulating that “in the present interest rate environment, it is not reasonable to keep very high spreads over PLR. Banks are, therefore, urged to review the present maximum spreads over PLR and reduce them wherever they are unreasonably high” (para 58). Again, there “is also some evidence that the spread between the interest rates generally charged by banks to different borrowers has also tended to widen” . Surely, it is only “reasonable” to expect that price (interest rates) will vary in the same proportion as the underlying credit quality

Does anybody advocate that the fees surgeons and lawyers charge should not vary overmuch across practitioners of surgery or law After all, matters of life and death, or jail and freedom are undeniably of far greater social import than the humdrum one of dealing in lucre In any event the wholesale cornering of the funds market by the excess of Government’s unproductive expenditure over its revenues, surely causes far greater distortions on the financial market, pre-empting for one thing fund flow. The intrusion of the antiquated attempt to directly control both price and quantity is an unwelcome development in this Credit Policy. Bank shares took a beating yesterday. Much of it is was no doubt caused by concern at such intrusion and of its potentially open-ended character.