Thursday, May 7, 2009

RBI: A Call To Action

The public can only wish banks would provide more credit and at lower rates; the RBI, however, can and must ensure that they do.

Shyam Ponappa / New Delhi May 7, 2009

Consider this:

a) In the fourth quarter of 2008-09, interest costs to companies were 41 per cent higher than for the same period in 2007-08. Prime lending rates were between 11.5 and 16.75 per cent, while inflation dropped considerably. This indicates how exorbitant lending rates have been. Corporate net profits were down to 11.7 per cent of revenues for the quarter, compared with 12.7 per cent for the previous year. Imagine what those fourth quarter profits could have been if loan rates were 4 to 5 percentage points lower, ie, at least a third less, with the concomitant effects on demand and revenues.

b) Credit growth slowed from 23 per cent in the third quarter to 17 per cent in the fourth quarter.

c) Small and Medium Enterprises pay interest at an unsustainable rate of 16 per cent. Banks play out this vicious downward spiral by withholding loans, or lending at higher rates to ‘compensate for higher risk’. A totally fallacious rationale: Higher rates do not reduce risk, they increase it; all they do is provide higher compensation for the exposure (ie, they pay more but the risk remains unchanged).

d) The IMF said in April: “Policy rates remain high in real terms in India, and further rate cuts would help bolster credit growth.”*

e) While anecdotal evidence suggests slowing investments, the CMIE reports a steady rise. However, CMIE’s conclusion is based on only two-thirds of investments citing no data available on the rest, so it is possible that fully one-third comprising 40 per cent of projects have been shelved.** This is the opportunity cost — the one-third-empty glass missed out — as is the difference between potential and realised GDP growth (ie, between 5 and 9 per cent).

It’s a simple matter of numbers. Surely the RBI knows this, as also that the proportion of term deposits has been growing in public sector banks, increasing lending costs. The RBI must be aware that reduced cash reserves lower average lending costs, as also of its charter to ensure the availability of credit for economic growth.*** Let’s see if we have it right, spelling it all out:

The Problem

Despite the cuts in the CRR and the apparent excess liquidity evidenced by large bank deposits with the RBI (up to Rs 1,50,000 crore a day at the reverse-repo rate), the problem is that banks continue to be wary of lending. The reasons for this, apart from their being stung by the financial crisis, are that:

  • Demand has fallen, thereby reducing project/enterprise revenues, and

  • Some costs — particularly the cost of money — are staying high.

    Therefore, when banks do lend, the interest rates are very high. As a result, demand is constrained, while growth in sales and profits is also declining.

  • The solution: Policy Rate CutsBank Rate CutsHigher Demand +

    Better Project EconomicsHigher Production + Profits

    The logic is as shown in the header. The RBI apparently thinks it has taken adequate policy measures. However, if we accept that India’s growth potential is 8-9 per cent as in recent years (or higher than at present), there should be no doubt about the need for higher growth, and further steps to achieve this. Higher growth also provides more employment. If production and profits grow faster, so does the economy. Sectors like construction, engineering, and services, including travel and leisure services, can provide considerable employment opportunities to capitalise on India’s demographics.

    (A separate and orthogonal issue is the need for education-and-training initiatives to build the skills of the employment pool, as also to improve work processes and practices. We can only hope this will happen when a government provides direct subsidies to end-users, and the money saved from the PDS and other misguided schemes can be channelled to effective education and training. However, that is unrelated to the pressing need for credit at low interest rates.)

    For both employment and growth, the RBI must act quickly. There is no use pontificating about poor monetary transmission when the actions taken are inadequate, like the recent 0.25 per cent cuts in the repo and reverse-repo. Talk about reducing India’s policy rate to zero is also irrelevant, diverting attention from the fact that policy rates can be cut significantly and still not be near zero.

    Banks’ cost of funds: The CRR and savings rate

    In the last several months, public sector banks experienced a surge in deposits with higher growth in term deposits. This has added to the problem of deposits taken in a higher interest rate environment. Meanwhile, many private banks have lost their cheaper savings deposits.

    This makes it all the more necessary to cut the CRR further. Why? Because when the CRR is cut, loanable funds increase without any increase in costs. In other words, the average cost of funds is reduced, because the same costs are spread over a larger amount of loanable funds.

    Banks might still park these additional funds with the RBI or in government bonds, unless constrained to do otherwise by a lower reverse-repo rate and limits on investment. Action is also needed to improve project economics for sound activities by (a) reducing interest costs to enterprises, and (b) increasing their revenues by providing cheaper finance to increase demand. In addition, initiatives are needed — eg, to revive construction — so that stalled projects start moving again. Equally, the RBI needs to devise disincentives to discourage excess investment in government bonds.

    Finally, the savings rate needs to be lowered in line with lower lending rates. It is necessary for sustained growth and employment to achieve a lower interest rate environment. The gains from a 3 to 4 per cent increase in the GDP would greatly outweigh small depositors’ notional loss from a reduction in interest income. This is why the RBI needs to take immediate action on these issues.

    * ‘IMF: interest rates remain high in real terms in India’, Reuters, Apr 22, 2009:

    ** BS April 27, 2009:

    *** Banking Regulation Act, 1949, includes ‘sound economic growth’ among the RBI’s responsibilities in banking policy: