Stance of Monetary Policy for
the Second Half of 2001-02
33. The annual policy Statement of April 2001 had indicated that under normal circumstances and barring emergence of any adverse and unexpected developments in domestic or external sectors, the overall stance of monetary policy for 2001-02 will be:
Provision of adequate liquidity to meet credit growth and support revival of investment demand while continuing a vigil on movements in the price level.
Within the overall framework of imparting greater flexibility to the interest rate regime in the medium-term, to continue the present stable interest rate environment with a preference for softening to the extent the evolving situation warrants.
34. During the first half of the year, as pointed out in the previous section, in the conduct of monetary policy, it was feasible to maintain adequate liquidity in the market, primarily through flexible operation of repos and reverse repos under LAF combined with OMO, when necessary. Notwithstanding a high level of market borrowing by the Government, it was also feasible to maintain a stable interest rate environment, with further softening of interest rates.
35. At the short end of the market, the average call money rate came down sharply from 8.6 per cent in early-April to 7.0 per cent in mid-October 2001. During this period, the LAF repo rate also came down from 7.0 per cent to 6.5 per cent. The CRR was reduced by 50 basis points to 7.5 per cent, effective May 19, 2001, augmenting lendable resources of the banking system by Rs.4,500 crore. Responding to these operations, the interest rates in other money market instruments also showed a declining trend. For example, the primary yield on 91-day Treasury Bills declined by 150 basis points from 8.5 per cent to 7.0 per cent between April and mid-October 2001. During the same period, primary yield on 364-day Treasury Bills fell by 168 basis points from 8.85 per cent to 7.17 per cent. The discount rates on CP also showed a similar trend. At the long end of the market, the secondary market yields on government paper in the range of 10-20 years have softened from 10.08-10.70 per cent in April to 9.12-9.92 per cent by mid-October 2001.
36. The decline in inflation rate since the mid-1990s, despite occasional supply and external shocks has had a positive impact on inflation expectations. Because of this, it has been possible to reduce nominal interest rates on a sustained basis despite a high level of fiscal deficit and other structural rigidities. While the risks of inflation are relatively low, as of now, in the context of ample liquidity already available in the system, RBI will continue to carefully manage the liquidity with a judicious mix of the range of instruments available with it.
37. Despite several uncertainties, the fundamentals of the economy as reflected in moderate inflation, stable and low interest rates, high foreign exchange reserves, large foodgrain stocks and competitive advantage of information technology related industries, are still strong. The prospects for agricultural growth during this year remain positive. Global and domestic inflationary outlook currently continues to be favourable. It is, therefore, proposed to continue with the overall stance of monetary policy announced in the April Statement for the remaining half of the current year and ensure that all legitimate requirements for credit are met consistent with price stability. Unless circumstances change unexpectedly, RBI will also endeavour to maintain the current interest rate environment.
38. The Bank Rate will continue to remain the principal signaling instrument in so far as RBI is concerned, providing directional guidance to the extent feasible, to general level of interest rates. The LAF rates would operate around the Bank Rate, with a flexible corridor, as more active operating instruments for day-to-day liquidity management and steering short-term interest rates.
39. While all efforts will be made to maintain the current stance of monetary policy, two caveats are necessary in order to ensure that banks and market participants do not take too complacent a view on the current monetary and interest rate environment. First, in their portfolio management, banks, primary dealers (PDs) and other market participants must explicitly take into account that the interest rate environment can change quite dramatically within a very short period of time. The substantial decline in interest rates in the last couple of years has resulted in large gains, realised and unrealised, to holders of medium and long-term securities. It is of utmost importance that these gains are not frittered away or used for illiquid market operations. The time when market conditions are favourable is also the time to build adequate reserves to guard against any possible reversal of the interest rate environment in future due to unexpected developments. Difficulties faced by banks, PDs and other market operators in the first quarter of the last fiscal year, i.e., 2000-01, when interest rates had to be increased by RBI (in order to check volatility in the foreign exchange market consequent upon sharp and frequent increases in the international interest rates) provides a valuable lesson in this regard.
40. Second, it needs to be recognised that in view of certain structural characteristics of our financial system, the scope for further softening in lending rates by banks and other financial intermediaries is limited. Following are some of the factors which reduce downward flexibility in the interest rate structure in India:
Banks, particularly public sector banks, continue to be the primary mobilisers of domestic financial savings (in addition to Provident Funds, Small Saving Schemes, and Life Insurance Corporation). Holders of term deposits in banks generally belong to fixed income groups and expect a reasonable nominal interest rate, in excess of the long-term rate of inflation. The recent reductions in deposit rates and return on small savings have caused widespread concern among depositors because of lack of other risk-free avenues for financial savings. This constrains the ability of banks to effect further reduction in their lending rates without affecting their deposit mobilisation and the growth of financial savings over the medium-term.
Banks have been given the freedom to offer "variable" interest rates on longer-term deposits. However, for various reasons, the preference of depositors as well as the traditional practice with banks tended to favour fixed interest rates on term deposits. This practice has effectively reduced the flexibility that banks have in lowering their lending rates in the short run, since the rates on the existing stock of deposits cannot be lowered.
For public sector banks, the average cost of funds is over 7.0 per cent, and for many private sector banks, the average cost is even higher. The non-interest operating expenses generally work out to 2.5 to 3.0 per cent of total assets, putting pressure on the required spread over cost of funds. Relatively high overhang of Non-Performing Assets (NPAs) pushes up further the lending rates.
There is a persistent and large volume of market borrowing requirements of the Government giving an upward bias to the interest rate structure.
In view of the above rigidities in cost, spread, and tenor of deposits, the link between variation in the RBI’s Bank Rate and the actual lending rates of banks, particularly at lower levels, is not as strong in India as in industrialised countries. PLRs of banks for commercial credit are entirely within the purview of the banks, and are not set by the Reserve Bank. Decisions in regard to interest rates, therefore, have to be taken by banks themselves in the light of various factors, including their own cost of funds, their transaction costs, interest rates ruling in the non-banking sector, etc.
41. It is necessary to continue with the on-going efforts to reduce the impact of the above structural constraints on the flexibility of our interest rate structure. Recently, the Government has taken important steps to reduce the prevailing interest rates on contractual savings like Provident Funds and National Saving Schemes. A more sustainable and flexible interest rate regime for contractual savings has also been recommended by the Expert Committee set up by the Government (Chairman: Dr. Y.V. Reddy). It will also be highly desirable for banks to move over to a variable interest rate structure on longer-term deposits as early as possible. Since interest rates could vary in both directions, depending on the phase of the business cycle and inflationary outlook, a variable interest rate regime on long-term deposits does not necessarily imply lowering of the average interest rate earned by depositors over a period of time (compared with a fixed rate regime, which favours old deposits over new deposits when interest rates are coming down, and vice versa when rates are moving in the opposite direction). In addition, banks have to put in their best efforts to reduce their operating costs over time by improving productivity and increasing their volume of lending.