The Hindu Business Line : RBI should look to boost demand, not liquidity

What the RBI needs to undertake is some sector-specific moves towards export promotion and not a general monetary policy initiative. Of course, this is what has been done already, but a review is called for assessing the need for further steps in this direction.

Textiles is among the sectors that has been the worst affected due to a fall in export orders.

A. Seshan

The last few months have seen a sea change in the principles and practices of central banking the world over. What would have been looked askance earlier has become run-of-the-mill policy now under force of circumstances to which even the hard-boiled fundamentalist central banker does not raise any objection.

Look at the US Federal Reserve doing the unthinkable while flooding the economy with liquidity. Under the law, it cannot provide financial assistance without security. But it has found a way to buy commercial paper (CP) through an off-balance-sheet vehicle.

Short of buying CPs or financing the private sector directly, the Reserve Bank of India (RBI) has also done everything in its power to make liquidity available in ample measure. This new-found aggressive or Rambo spirit has partly been encouraged by the bold actions taken by the conventionally conservative central banks in the West. Besides, the political and public pressures in the country are making it imperative that something should not only be done to deal with the ongoing economic crisis but should also be seen to be so.

It is in this context that the nation awaits eagerly the Annual Policy Statement of the RBI to be unveiled on April 21, 2009.

The problem in the West

In the West, the credit channels were clogged due to the sub-prime crisis and increased perception of risk. Not only retail credit shrank but financial institutions were unwilling to lend to each other.

To improve the functioning of credit markets and provide additional support to the economy, the US Federal Reserve has established and expanded a number of liquidity programmes, including direct lending to market participants, and recently initiated a large-scale scheme for asset purchases. Its balance-sheet has more than doubled from about $870 billion before the crisis to roughly $2 trillion now.

But there is some disconnect between the Fed policy and what is happening in the US markets. Credit spreads of triple-A private sector bonds vis-À-vis government securities of same duration have not come down much.

What is even more interesting is that the household sector has started saving, something unheard of in the recent history of the US. As against zero saving and personal debt amounting to 180 per cent of income in the past, the average American saved 4 per cent of his earnings last year due perhaps to a sense of insecurity about the future.

The lack of effective demand is a major problem calling for the classical Keynesian prescription. Pumping money into the economy by the government and the central bank seems to be the only solution to revive demand.

The problem in India

As it is in the treatment of diseases, in economic malaise also the correct diagnosis of the causes is half the battle won. We do not have the sub-prime problems of the US. The exposure of Indian banks to real estate and housing is relatively small, thanks to timely prudential measures initiated by the RBI in the past.

Although non-performing assets (NPAs) are suspected to be on the rise in respect of certain categories of loans they are still within manageable levels. In fact, according to one stress test, even if NPAs were to double, the capital-asset ratios of banks would still be adequate to take care of the problem.

The basic question is whether the country is facing an economy-wide depression of effective demand or is it sector-specific. The former will call for general monetary policy measures relating to the cost and availability of credit across the spectrum. The latter would necessitate only sector-specific steps.

The RBI has admitted that its policy stance in quantitative expansion of resources and reduction in policy rates has not been adequately transmitted to the system. This is understandable.

The problem is basically one of lack of demand, not internally, but for exports of certain goods and services faced by a section of the industrial sector. This is corroborated by the trends in industrial production and exports in the recent period.

Such industries as textiles, gems and jewellery and information technology seem to be the worst affected due to a fall in export orders. There is no problem of a general lack of demand in the rural or agricultural sector.

On the services side, two sub-sectors are to be mentioned as having a difficult time: one is construction and the other is information technology and related fields.

There is no doubt that a fillip to housing activities would be a great demand booster for a number of commodities such as steel, cement, etc. So far as information technology is concerned, the industry can improve its export prospects on the basis of competitive costs helped by the trend of depreciation of the Indian currency in recent times.

Thus, what the RBI needs to undertake is some sector-specific moves towards export promotion and not a general monetary policy initiative. Of course, this is what has been done already both by government and the RBI. But a review is called for assessing the need for further steps in this direction.

Liquidity in the economy

Fiscal stimulus packages amounting to about 3 per cent of GDP, supplemented by primary liquidity released by the RBI to the extent of 7 per cent, came on top of an already announced expanded safety net for rural poor, a farm loan waiver package and salary increases for government staff. All of this should stimulate demand.

The comfortable liquidity position, starting mid-November 2008, is borne out by a number of indicators relating to the money market. However, the utilisation of some of the RBI facilities by the banking system is not measuring up to the available supply. Banks blame the lack of demand for credit for the situation. For the banking system as a whole the excess investment in securities coming under SLR (statutory liquidity ratio) amounted to more than 6 per cent, as on March 27, 2009.

There is increasing evidence of a round-tripping of resources from the RBI to banks to mutual funds to banks and back to the RBI. Although funds are fungible, the release of Rs 1,60,000 crore from CRR (cash reserve ratio), which did not earn any interest and for which there is only partial credit outlet, has led to the flow of money back to the RBI through the reverse repo (RR) operations for quite some time.

The steep decline in the (weighted) average interest rates since the beginning of the current financial year in the collateralised borrowing and lending obligations below the RR rate of 3.5 per cent has provided a good arbitrage opportunity to banks to make use of their surplus SLR securities borrowing at less than 3.5 per cent in money market and depositing the money at the RR window of the RBI at 3.5 per cent.

Reverse repo window

It is a win-win situation for all except the RBI. Should the central bank think of closing the RR window? Under the circumstances, a further cut in CRR would not serve any purpose. It would only mean that banks, which are not getting any interest on their CRR balances, would be earning 3.5 per cent through RRs in respect of funds released.

The repo rate is of no use now since banks are not accessing that facility. However, for the sake of public relations and for a cosmetic effect, the RBI may reduce the repo rate by a percentage point along with the closing of RR window.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India. blfeedback@thehindu.co.in.)

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