Current Economic Statistics and Review For the Week 
Ended November 28, 2008 (48^th Weekly Report of 2008)

Theme of the week:

The global financial distress and its repercussions on the Indian financial markets – current and prospective – have attracted from the authorities mindboggling sets of measures. Never has there been in the history of the Reserve Bank of India (RBI) such concerted attempt to augment liquidity in the financial system on such a large scale and in such quick succession.  The release of about Rs 140,000 crore liquidity through 350 basis points slashing of cash reserve ratio (CRR) within the space of three to four  weeks, as shown in Table 1, the injection within such a short span has nullified the effect of the CRR hikes effected between 2006 and 2008. The simultaneous release of additional liquidity support to the extent of 1.50 per cent of demand and time liabilities (DTL), equivalent to Rs 60,000 crore, to be used exclusively by the banks for funding the requirements of mutual funds (MFs) and non-banking finance companies (NBFCs), and the reductions in repo rate from 9 per cent to 7.50 per cent, are all historic measures befitting the havoc wrought by the financial crisis.   

In response to the depleting foreign exchange reserves, interest rates offered on foreign currency deposits have been raised and the rules regarding external commercial borrowings have been liberalised. With the need for sterilization of foreign exchange inflows disappearing, the government have decided to buyback the securities issued under the market stabilisation scheme (MSS) as a measure of further injection of liquidity and that too on a long-term basis.  Besides, as a counter-cyclical prudential measure, the dynamic provisioning  requirements have been activated and all types of standard assets would now attract a uniform 0.40 per cent provisioning, substantially reduced from 1.0 to 2.0 per cent; the low rate of 0.25 per cent for agriculture and SME sectors will continue..  

1.         The Situation Calls for Some Soul-Searching by RBI 

In the conventional monetary policy framework, the authorities’ response to the crisis and the series of measures taken thereunder cannot be faulted.  But, the greatest drawback lies in believing that the conventional measures will do the trick in the current unprecedented crisis.  In turn, this belief arises from the lack of realisation that the entire economic edifice built on monetarist policy framework combined with a policy of fiscal compression can only be weak and can be unsettled with the slightest of external stocks.       Critically viewed in this light, there can be strong misgivings regarding the objectives set before the measures, their nature and sequencing.  The objective seems to be to inject vast amounts of short-term money market liquidity, without ensuring its end-use. This attitude is in no way different from President George Bush’s assertion at the recently concluded G-20 summit that there is nothing wrong with free market capitalism and minimal regulations. And even the RBI measures have come about not as a studied response on its own volition but based on promptings by the governmental authorities. Instead, the present crisis should give the central banking authority an opportunity – and need – to do some soul-searching.  There are many elements involved in such inward-looking exercise necessary for the RBI.  

First, it is necessary to realise that deep-down the current economic malaise, the crisis of the Indian financial sector is peripheral; the deeper crisis is rather to be found in the rapid deterioration in the real sector growth.    The projected 7 to 8 per cent growth in overall GDP during 2008-09 with support from the services sector, hides the problems of crisis proportions faced by the real sectors.  More specifically, the deterioration in recent industrial growth is to be traced to the RBI’s knee-jerk and sledge-hammer methods of fighting inflation based as they were on the generally-discredited monetarist policies.   In this respect, it is worth recalling that the rate of industrial growth had begun to falter right from the beginning of the current financial year, much before the exacerbation of the global financial crisis manifested in the bankruptcy, sell-out and restructuring of some of the world’s largest financial institutions that occurred in mid-September 2008.  The adverse consequences of such a dear money policy are to be seen concretely in the doubling of interest cost to corporates in the second quarter of 2008-09 and in the largest amount of shelving of planned investment projects estimated at worth Rs 85,500 crore during the first half of the year, almost one and a half times more than such normal shelving a year ago.  

Secondly, it is time the RBI realises that its model of relying only on money market instruments to convey its policy signals has created three noticeable distortions in the working of the credit and monetary system of the country:  layers of money market transactions unrelated to the underlying real sector needs, grossly unequal distribution of bank credit and huge and sudden increases in interest cost for projects.  To begin with, layers of money market transactions indulged in by low-deposit-based foreign and new private sector banks have determined the interest rate structure in the country in the country and thus distorted the rate structure relevant for the real economy, in a manner of the tail wagging the dog.  This distortion in turn has been prompted by the RBI’s policy of non-interference in the much-touted prime-lending rate (PLR) system. After the system was allowed to have a free-play without any lower and upper bounds on interest rates, the scheduled commercial banks have favoured the corporates with large sub-PLR lendings for short-term purposes and kept the rates for the rest at sticky levels.  Even for corporates, the rates of interest on long-term project finance are found to be higher than those for short-term working capital. As shown in Table 2, the interest rate on non-export demand and term loans above Rs. 2 lakh excluding lending rates at the extreme five per cent, shows that the BPLR has shifted significantly upwards from a range of 10.25 – 11.25% in March 2005 to 13.25 – 14.75 % in September 2008 – an increase of more than 300 basis points in more than three years for public sector banks. Similarly, increases have taken place for private sector banks and foreign sector banks.

The sector-wise incremental share in bank credit between March 2002 to March 2007 shows that the share of agriculture has increased from 9.8 per cent to 11.8 per cent. Similarly, the share of personal loans has jumped which includes consumer durables and housing loans and balance personal loans (Table 3)

What is more, as shown in Table 4, the scheduled commercial banks show no compunction in charging the same weighted average of interest rates for artisans and village industries, small-scale industries and agriculture as those for the total bank loans; in many years, the artisans and village industries have attracted higher rates than the average rate for the system as a whole.  However there has been a decline for Industry, Artisans and Village and Tiny Industries and other small scale industries.

A final distortion has come about in banks’ neglect of agriculture small-scale industries and other small borrowers in credit delivery.  As the Report on Trend and Progress of India for 2006-07 writes: “Out of 28 public sector banks (PSBs), only eight banks --- could achieve the agricultural lending target of 18 per cent. In the case of lending to weaker sections, only seven PSBs --- have achieved the sub-target of 10 per cent as on the last reporting Friday of March 2007” (p.72)

The priority sector guidelines have themselves allowed the fulfilment of the priority sector targets without satisfying the sub-targets for agriculture or for weaker sections. Such a system, which overtly excludes a large section of the poor, is patently inequitable and replete with serious social and economic implications.  While demand-side issues are no doubt crucial for increasing the credit absorptive capacity of the poor, the supply-side exclusion is, as it is, indeed massive and therefore there exists vast scope for the credit agencies to reach the vulnerable groups with the help of policy guidelines.  

The neglect of the informal sectors embracing more than 80 per cent of the population with vast social returns in credit supply smacks of insensitivity in the operations of the nation’s credit policy regime which in turn gives rise to socio-political revulsions.  This precisely what happened when the government of India, faced with severe and repetitive incidences of farmer suicides, adopted the policy of doubling of bank credit for agriculture and allied activities within a period of three years (2004-05 to 2007-08).  This has been done despite there being no proper spread of additional branch network in rural areas for proper appraisal of credit needs and delivery.  In fact, the number of rural branches has experienced a steady decline and so has the number of staff posted over there.  Such narrowing of the institutional set up is also the direct result   of the RBI giving up branch licensing policy – a policy which had given an impetus to the spread of branch banking in rural and semi-urban areas in the country.  In a situation of such weak institutional structure, there are serious dangers of varied distortions: the bulk of the agricultural credit going to rich farmers and borrowers located in urban and metropolitan areas, and above all, such politicised loans giving rise to a growing incidence of non-performing assets – a phenomenon which is already getting revealed.  

In such a policy environment, the propagation of ‘financial inclusion’ appears hollow.  The very concept of ‘financial inclusion’ looks to be an escapist device to avoid a genuinely egalitarian credit distribution arrangement.  To cite an example, in the years 2005-06 and 2006-07 when the RBI went to town with the declaration that “as banking services are in the nature of public good, it is essential that availability of banking and payment services to the entire population without discrimination is the prime objective of the public policy (Leeladhar, V “Taking Banking Services to the Common Man – Financial Inclusion.” RBI Bulletin, January 2006)”, the banks hardly observed any of the credit guidelines for the real and neglected sectors including those for opening general credit lines for the weaker sections or the need for expanding branch network in rural areas but instead extended unprecedented levels of bank credit for real estate, capital market and commodity market operators (Table 5). It may appear queer but true that the outstandings of loans of public sector banks against real estate (including housing loans) at the end of March 2007 (at Rs 217,979 crore) have far exceeded their loans against agriculture, both direct and indirect together (Rs 205,091 crore).

The sum total of the contention in this section is that a calibrated set of central bank guidelines with rigorous enforcement are necessary regarding social goals in credit policy prescriptions including the strengthening of banking institutions and a rational interest rate structure. When public pressures are brought to bear on the government to desist from diluting the independence of the central bank. The most egregious example of interference by the Ministry of Finance has been surely the constitution in mid-October of the Liquidity Adjustment and Injection Committee headed by the secretary in the Ministry of Finance. What was the main province of the central bank became the terrain of the ministry. The case against such governmental interference becomes stronger if the central bank ensures the necessary developmental role for institutional credit  and above all, exhibits  a reasonable degree of social concern for an egalitarian pattern of credit distribution and economic development.