Y V Reddy's first credit policy will be subject to much scrutiny, even though he has, doubtless, written a few of these before. What are the issues and priorities, which should figure in the upcoming policy?
The first issue of concern is the interest rate environment. The most important challenge is that of dealing with capital inflows.
Under the terms of the Reserve Bank of India's existing peg to the US dollar, the RBI has steadily purchased foreign currency in recent years. Normally, this would lead to an increase in money supply.
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However, sterilisation is at best a limited tool, and its problems are now increasingly visible. The most important logical problem is that sterilisation tends to elevate local interest rates and invites further capital inflows.
The sustainable path consists of a reduction in capital flows. If RBI is to stick to its currency policy, then this involves subjugating the interest rate policy.
In other words, it means cutting interest rates, in order to slow down capital inflows. As most currency speculation is focused on short-term interest rates, it is the bank rate and the repo rate that need to be addressed.
While the repo rate was cut by 50 bps, the inflow continues, suggesting that there needs to be a further cut. Also, the bank rate, which also has a signalling value for bank lending rates, needs to be cut.
One impediment to the adjustment of interest rates is the savings deposit rate. In a liberalised economy, there is no case for the RBI to be setting this rate. The argument is sometimes made that such a rate cut would adversely affect 'the middle class'.
However, it is hard to argue that the 'middle class' obtains a significant part of its income from funds held in savings bank accounts.
A grave danger in dealing with the present problems, of the currency regime, is that of engaging in policies, which are a throwback to the 1970s. The RBI has a long tradition of implementing goals of monetary policy using a large number of administrative levers. In the current liberal environment there should not be a move back to administrative controls.
In recent weeks, the RBI has given instructions to banks about what interest rates they can offer on NRE deposits. Proposals for raising the ECB ceiling of $ 1.5 billion have been blocked. Imposing controls on one route can only encourage other, often illegal, routes for capital movements.
This links up to the recent debate about benchmark PLR. The interest rate that a bank charges its borrower is something that should be settled between the borrower and the bank, considering various factors.
When a person takes a car loan, there is a very transparent indicator of the price, which is the EMI. It is easy to shop around and choose the bank with the lowest EMI. There is no role for the RBI to get involved in defining the benchmark rate with respect to which credit takes place.
There have been concerns about the low offtake of bank credit. The steepening of the yield curve, through a lowering of the repo rate and the bank rate, would also address this issue. The weak demand for short-term corporate credit is due to a combination of several factors.
It is partly driven by offshore borrowing and trade credit. It is also driven by efficiency gains. In the 4000 manufacturing firms found in the CMIE Prowess database, working capital as a fraction of sales has dropped from 13 per cent to 3 per cent over a five-year period.
On a base of Rs 9,00,000 crore (Rs 9,000 billion) of sales that these firms have, this improvement in efficiency has dropped demand for working capital by a substantial amount of roughly Rs 90,000 crore.
Bankers may bemoan this efficiency gain of the corporate sector. But it is not something absolute. It is important to also interpret demand for working capital as a price phenomenon.
Current market conditions imply that at existing prices, which banks like to charge corporate customers, the corporate sector is not keen on drawing upon bank credit.
A steepening of the yield curve, with lower interest rates at the short end, would help obtain an equilibrium between deposits and off-take at the short end.
Banks also need to be better prepared for sudden changes in the interest rate environment. One important issue that Dr. Reddy needs to tackle is the long-standing problem of interest rate risk of Indian banks. RBI's existing 'investment fluctuation reserve' (IFR) has many conceptual mistakes.
IFR defines capital requirements for banks in terms of holdings of government bonds. It ignores the extent to which different banks are hedged on the liabilities side. It penalises well-run banks, like SBI and ICICI Bank, who have done a good job of their ALM.
In addition, IFR defines capital requirements that should be met over years, and is silent about the consequences of interest rate volatility today.
The most important tool for assessing the interest rate risk of banks consists of simulating realistic shocks to the yield curve on both assets and liabilities. RBI regulations should require that banks engage in these calculations, and fully disclose these calculations to the market.
This would assist price discovery on the stock market, and improve market discipline. RBI regulations should also require banks to hold equity capital when these calculations reveal vulnerability to interest rate risk (as opposed to IFR, which is blind to the risk management of the bank).
The interest rate futures market is a vital element for interest rate risk management. RBI's existing rules about interest rate futures are riddled with mistakes.
First, the existing rules say that only the interest rate risk of the government securities portfolio of a bank can be hedged using the interest rate futures. This needs to be amended, so that the overall interest rate risk of the bank can be hedged.
Second, the rules allow banks only to sell interest rate futures, based on the assumption that all banks will only lose money when interest rates go up. In fact, many banks are hedged, or have reverse exposures.
Banks can be active participants in the interest rate futures market, through trading and arbitrage activities. By forcing all banks to only sell interest rate futures, the RBI has effectively strangled the market.
The RBI's rules for exchange-traded interest rate futures are a sharp contrast with the RBI's rules for the non-transparent OTC market, where the RBI allows all sorts of activities. From an economic perspective, the opposite should be the case, where a more transparent market should enjoy a more liberal rule set.
The market will, undoubtedly, look expectantly towards Dr Reddy's credit policy. Hopefully, it will address not just the above, but many more issues.
The author is at ICRIER. These are her personal viewsPowered by 
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