III
 
Let us take bank credit first. In any situation where banks hold a larger amount of government securities than required under the SLR obligation, they can always off- load a portion of these securities to the RBI, if not directly then at any rate at the margin by not picking up fresh government debt (which ipso facto would then devolve upon the RBI in its role as the underwriter of this debt). It follows that whenever banks hold excess government securities, since these can be traded for reserve money but are not, the credit market must be a buyers' market, i.e. there must be a shortage of demand for credit from worthwhile borrowers. Credit cannot be supply-constrained in such a situation.
 
This is precisely the case in India today. Indeed the Economic Survey 2000-01 states this quite clearly: "The position changed with the inflows under IMDs in November 2000, which led to a sharp increase in the RBI's net foreign currency assets. The resultant generation of liquidity facilitated a sharp reduction in RBI's net domestic assets by enabling the RBI to off-load from its portfolio a significant portion of Central government dated securities to the market" (p.55). If credit had been supply-constrained in the economy, then the "market" which includes the banking system would never have moved into government securities.
 
One remark of the PMEAC may be construed as a counter-argument to what has just been said, but that remark itself constitutes yet another logical contradiction in the PMEAC's argument. The PMEAC report says: "In recent years the government has been borrowing at around 11 percent when inflation averaged around 5 percent. This implies real interest rates of 6 percent for government borrowing, which means that private sector financing has to be at real interest rates of 8 percent or so for the best corporates and correspondingly higher for others. With such high real interest rates, private investment is bound to be choked off, which is exactly what has happened." This argument would appear to contradict my argument that "excess holding" of government securities by banks can occur only when credit is demand-constrained, since it believes that this "excess holding" is because of the attractiveness of government securities.
 
This argument of the PMEAC however is logically faulty for two reasons: first, a 6 percent real rate of interest on government securities can correspondingly increase the interest rate on private securities only under certain circumstances. An obvious one is if the supply of government securities is infinitely elastic at this rate. If the supply is only a finite amount, then after this amount has been picked up, banks having additional resources will start picking up private securities at 6 percent or even lower real rates (as long as they cover "marginal cost").  A 8 percent floor real rate for private securities can operate only if banks' resources are limited relative to the supply of government securities. But if that were the case then the Reserve Bank (whose Governor is a member of the PMEAC) should be deemed to have committed a great disservice to the nation by offloading "from its portfolio a significant portion of Central government dated securities to the market." The RBI cannot gratuitously increase the stock of government securities in the market and then complain that there are too many government securities in the market! Attributing sense to the RBI must therefore lead to the conclusion that it offloaded securities because banks had extra resources owing to insufficient demand for credit from worthwhile borrowers. In other words, banks' holding of excess government securities suggests that credit is not supply-constrained.
 
Secondly, the interest rate comparison in the PMEAC report is wrong, as the following example will show. Suppose for simplicity that banks have only three assets, cash, government securities, and loans to commercial enterprises, and suppose they are required to maintain 10 percent of their assets as cash and 25 percent as government securities. Suppose also, to start with, that they hold Rs.10 of cash reserves, Rs.29 of government securities, and Rs.61 of credit, i.e. they are maintaining the cash-reserve ratio but have "excess holding" of government securities. Then by selling Re.1 of government securities to the RBI, they can, collectively, expand their assets to Rs.11 of cash, Rs.28 of government securities, and Rs.71 of credit, provided there is plentiful demand for credit. If the number of banks is small and profit prospects significant, they would indeed be expected to co-operate to realise these prospects. Hence if  r denotes the real interest rate on government securities and  r'  the rate on credit, then banks in the above example would get rid of excess holding of securities if 10 times r' exceeds r. More generally, if the cash-reserve ratio is denoted by c, banks would never hold excess government securities as long as r'/c exceeds r. The real comparison to make in other words is not between r' and r, as the PMEAC does, but between r'/c and r, where the former must win. It follows then that "excess holding" of government securities will never be resorted to if adequate credit demand is forthcoming.
 
The fact that the banking system in India has been holding excess government securities implies then that credit has not been supply-constrained, in which case one of the assumptions underlying the PMEAC argument collapses. The other assumption, namely that the real economy is supply-constrained, is even more palpably wrong. When the country has 45 million tonnes of foodgrain stocks, when industrial growth is slowing down, when the existence of a demand constraint over vast sectors of Indian industry is recognised even by the Economic Survey, it is indeed sad to see that the group of highly distinguished economists which constitutes the PMEAC has put forward an argument which assumes Keynesian full employment!
 
Since our system is demand-constrained both in credit and commodity markets, the basic assumptions of the PMEAC report break down. Thus, no matter which of its alternative versions we consider, the proposition that the real interest rate is high because of the high levels of fiscal deficits is erroneous: the theory it invokes for itself is in each case untenable; and the conditions under which it might hold empirically, if inserted within a tenable theory, are far removed from those that are actually obtaining.

 
 

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