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II. Stance of Monetary Policy for 2000-2001

28. Against the background of the developments in the economy last year and economic prospects during 2000-2001 an important objective of monetary policy in the current year is to provide sufficient credit for growth while ensuring that there is no emergence of inflationary pressures on this account. On current assessment, the prospects for achieving these objectives look reasonably promising. Notwithstanding the sharp increase in oil prices, the international inflationary environment continues to be reasonably benign. A freer trade regime, combined with a high level of food stocks and a high level of foreign exchange reserves, should provide sufficient scope for effective supply management during the year. On the demand side, the budget stance of reining in the overall fiscal deficit is welcome. Some allowance, however, has to be made for the fact that there has been considerable delayin the adjustment of important administered prices, including prices of petroleum products. However, such adjustments cannot be avoided if fiscal deficit has to be kept under reasonable control in order to keep potential inflationary pressures under check and future expectations favourable. 29. Keeping the above considerations in view, the Reserve Bank proposes to continue the current stance of monetary policy and ensure that all legitimate requirements for bank credit are met while guarding against any emergence of inflationary pressures due to excess demand. Towards this objective, the Reserve Bank will continue its policy of active management of liquidity through OMO, including two-way sale/purchase of treasury bills, and reduction in cash reserve ratio as and when required.

30. In line with the continuing overall stance of policy, at the beginning of the new financial year on April 1, 2000, the RBI announced a number of measures to enhance liquidity and reduce the cost of funds to banks. These measures were :

(i) A reduction in the Bank Rate by 1.0 percentage point;

(ii) A reduction in CRR by 1.0 percentage point in two stages;

(iii) A reduction in Repo Rate by 1.0 percentage point; and

(iv) A reduction in savings deposit rate of scheduled commercial

banks from 4.5 per cent to 4.0 per cent.

Following the above measures most public sector banks have also announced a reduction in their lending and deposit rates. For major banks, deposit rates have been reduced by 0.50 to 1.00 percentage point depending on maturity and prime lending rates have been reduced by 0.50 to 0.75 percentage point. In March 1999 also, banks had effected similar reductions in the PLR. Taking these changes in the PLR into account, the prime lending rate of the largest bank (i.e., the State Bank of India) was lower by 1.75 percentage point on April 3, 2000 compared with end-February, 1999. 31. For purposes of monetary policy formulation on the basis of current trends, growth in real GDP may be placed at 6.5 to 7.0 per cent in 2000-2001, assuming a normal agricultural crop and continued improvement in industrial performance. Assuming the rate of inflation to be around 4.5 per cent (i.e., close to the average of last two years), the projected expansion in M3 for 2000-2001 is about 15.0 per cent. This order of growth in M3 should lead to an increase in aggregate deposits of scheduled commercial banks by about 15.5 per cent (or Rs.1,25,000 crore). Non-food bank credit adjusted for investments in commercial paper, shares/debentures/bonds to PSUs and private corporate sector is projected to increase by around 16.0 per cent. This is expected to be adequate to meet the credit needs of the productive sectors of the economy.

32. However, it cannot be over-emphasised that the above outlook can change dramatically within a relatively short period of time in the event of unanticipated domestic or international events. Several unfavourable events that affected the outlook for the economy during the years 1997 through 1999 point to the need to respond quickly and to change course, if and when required. In the past 3 weeks, even after eliminating the effect of the change in the base year of the Wholesale Price Index, the inflation rate has been somewhat rising. Some States have also been affected by severe droughts. On the inflation front, therefore, there is need for continuous vigilance and caution. The Reserve Bank will continue to monitor domestic monetary and external developments, and tighten monetary policy through the use of instruments at its disposal, when necessary and unavoidable. Banks and other financial institutions should make adequate allowances for unforeseen contingencies in their business operational plans, and take into account the implications of changes in the monetary and external environment on their operations.

33. Based on the experience of some industrialised countries, there is a view that, in India also, monetary policy, to be transparent and credible, should have an explicit narrowly defined objective like an inflation mandate or target. While technically this appears to be a sound proposition, there are several constraints in the Indian context in pursuing a single objective. First, there is still fiscal dominance and the debt management function gets inextricably linked with the monetary management function while steering the interest rates. If the two functions, (i.e., monetary management and debt management) were to be separated as has also been suggested by some experts, it is almost certain that the prevailing interest rates in the market would be substantially higher than considered desirable from monetary stability and/or growth points of view. The last year’s experience in our ability to maintain a softer interest rate environment, during a period of low inflation, while at the same time meeting large government borrowing requirements, confirms this view. Secondly, in the absence of fully integrated financial markets, which remain still imperfect and segmented, the transmission channel of policy is rather weak and yet to evolve fully. Thirdly, the high frequency data requirements including those on a fully dependable inflation rate for targeting purposes are yet to be met. Under these circumstances, it is necessary to carefully measure and balance between possible outcomes, after taking into account movements in a variety of monetary and other indicators.

34. It may be recalled that during the last 2 years, the Bank Rate, Repo Rate and CRR have been used in conjunction with OMO and other operations bearing on liquidity to meet short-term monetary policy objectives in the light of emerging domestic and external situations. The Bank Rate and short-term repo rate announced by the RBI have been perceived by the markets as signals for direction in market rates of interest, in particular the call money rates. The active debt management, combining private placements and distribution of securities through open market sales at convenient intervals and activating the OMO window for Treasury bills, has helped in keeping the short-term liquidity situation reasonably comfortable during the year without causing undue pressure on security prices. 35. While there has been a significant softening of interest rates in the last 13 months, the decline in nominal interest rates has not kept pace with the decline in the rate of inflation. Under the circumstances, there has been some debate in the country on the need to bring nominal interest rates down sharply so that real interest rates would move down 9

correspondingly. If this happens, it is argued, industrial growth could be accelerated further and India’s competitiveness abroad would improve. At the same time, it has to be recognised that there are several structural factors which constrain downward flexibility in the interest rate structure in India. The mid-term review of the Monetary and Credit Policy in October 1999 had dealt with some of these structural rigidities. In view of the interest in the subject, and also significant decisions taken recently to reduce some of the administered interest rates and abolish the interest tax, it may be useful to revisit this matter again.

36. It needs to be reiterated that the prime lending rates of banks for commercial credit are entirely within the purview of the banks and are not set by the Reserve Bank. The domestic interest rates which are subject to regulation are only the rate of interest on savings accounts and rates of interest on export credit and credit for small and tiny sectors, including DRI schemes, up to an amount of Rs.2 lakh. It is interesting to note that several key rates fixed by RBI, i.e., the Bank Rate, Repo Rate and the rate on savings account have already come down substantially (to 7.0 per cent, 5.0 per cent and 4.0 per cent, respectively). At the present levels, these rates are not too out of line with ruling international rates. 37. Decisions in regard to interest rates on bank credit have to be taken by banks themselves in the light of various factors, including their own cost of funds, their transaction costs, and interest rates ruling in the non-banking sector. It is interesting to note that, even after reduction in several administered rates, the post tax return on deposits being provided by banks is considerably lower than the prevailing rates on contractual savings like Provident Fund, as well as National Savings Scheme. The interest rate, subject to tax, on 3-yearly deposits is currently 9.5 per cent as compared with 11 per cent for National Savings Scheme and Provident Fund (which, of course, have longer maturity and are also less liquid).

38. Banks have been given freedom to offer variable interest rates on longer-term deposits. However, partly due to historical reasons and partly due to strong preference of depositors (for example, fixed-income groups and retirees), banks have continued to offer fixed interest rates on relatively long-term deposits. The effect of this practice is to reduce the flexibility that banks have in lowering their lending rates since the rates on the existing stock of deposits cannot be lowered. (For example, in respect of one of the large public sector banks, it is estimated that 80 per cent of time deposits are longer than 1 year. Even though the rates of interest for maturities of one year and above are currently in the range of 8.00 to 9.50 per cent, the effective rate of interest for the outstanding deposits of maturities above one year is as high as 11 per cent.)

39. Another factor affecting the interest rate structure in India is the high level of non-interest operating expenses of public sector banks. These work out to 2.5 to 3 per cent of total assets. The high transaction costs which generally reflect high staff costs, combined with relatively high levels of Non-Performing Assets (NPAs), further constrain the manoeuvrability in respect of lending rates.

40. Against the above background, it is clear that, while much greater flexibility in the structure of interest rates in tune with changes in the inflationary environment is desirable, there is no "quick fix" solution to engineer a sharp fall in nominal deposit and lending rates of banks. Vigorous action has to be taken by banks to reduce their transaction costs and the volume of NPAs, and improve risk management. This requires action in a number of areas, including legal reforms for recovery of dues and restructuring of weak banks. Concerted action is also required to move forward with financial reforms in a competitive environmentcoupled with a reduction in Government’s fiscal deficit and wider public acceptance of the need for flexibility in administered interest rates. 


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