This loss of the fiscal lever was seen as a small price to pay for the greater autonomy the new regime affords the central bank and the greater ability provided by that regime to the central bank to use monetary levers to stabilise the economy. This view held by the advocates of reform was strengthened by the rather early success achieved after the 1990-91 crisis in reducing inflation and the deficit on the balance of payments. What is unclear is whether this success was attributable primarily to monetary policy effort to rein in the growth of money supply and increase the cost of credit. Fiscal compression combined with a fall with in the unit value indices or prices of imports could have also delivered these results. In fact, circumstantial evidence suggests that both these factors did play an important role.
 
The ambiguity regarding the factors responsible for stabilisation is of significance because success on this front diverted attention away from an analysis of the efficacy o monetary policy, which was being made the principal means for macroeconomic regulation of the economy. There are two ways in which monetary policy can seek to affect real variables: it can affect the level of potential liquidity in the system, rendering the access to credit of investors and consumers easier or more difficult; it can alter the cost of credit, making it cheaper or more expensive for investors and consumers to borrow to finance their expenditures. A regime which privileges monetary policy would see enhanced access to liquidity at cheaper interest rates as the means to revive flagging economic growth. Exploiting the availability of cheap credit investors would undertake capital expenditures and consumers would increase their consumption spending, triggering a recovery.
 
In India, long before the onset of recessionary trends in the economy, the central bank had made a transition from a tight money policy aimed at stabilising the system and dampening inflation to an easy money policy aimed at stimulating investment and growth. As a result, for quite some time now the banks have been awash with funds and in search of creditworthy borrowers. They were helped in the search by the presence of a government, shunned by the central bank, as a major borrower in the market.
 
The difficulty was that despite this recourse to a liquidity enhancing strategy, interest rates proved to be quite sticky. They fell in nominal terms, but not enough to make much of a difference to real interest rates since inflation too was on the decline. This led up to the view that the problem of reducing the level of interest rates in India was no purely a monetary one, but structural in nature. To quote the RBI, "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."
 
Unfortunately for the RBI and the government, even while it recognises the rigidities that constrain the ability of monetary policies to bring down interest rates, they have few other levers available in their arsenal to deal with the growth slowdown the economy is experiencing. Hence, as elsewhere in the world the current deflationary trends are being confronted not with a fiscal stimulus but with renewed efforts at reducing interest rates and increasing liquidity in the system. That is what the mid-term monetary policy statement sets out to do. However, once again , as elsewhere in the world, the evidence is now overwhelming that both investment and consumption spending do not respond adequately, if at all, to the availability of cheap credit. Consumers spend when incomes are rising, incomes rise when investment is buoyant, and investment tends to be buoyant when there are adequate "inducements" to invest. In India, exports have never provided the inducement to investment. In any case, with the world economy sluggish exports cannot provide the stimulus now. The inducement must come from an expansion in the home market, which seems clearly dependent on a fiscal stimulus. So long as the government retains its obsession with capping and regulating the deficit, irrespective of the state of supply in the economy, growth is bound to be a casualty. Attempts to tinker with or even dramatically alter monetary policy, as reflected in the mid-year credit policy statement, would not change this scenario.

 

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