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Business Commentary/ R C Murthy

RBI must ensure rate cut benefit reaches the customer

The Reserve Bank of India announced on Saturday the long-awaited cut in the bank rate, the rate at which the central banking authority provides money to banks as the lender of last resort.

The bank rate cut was announced on All Fools' Day, incidentally the day on which the new fiscal begins, taking one by surprise.

The bank rate has been lowered by one percentage point to seven per cent. The cash-deposit ratio (the cash commercial banks have to deposit with RBI as a proportion to their deposits) is down to 8 per cent from 9 per cent, releasing Rs 72 billion of banks' cash for lending.

RBI Governor Bimal Jalan wanted an element of surprise, though the rate cut as such had been in the air for some time.

The big day was advanced from April 27, when the six-month slack season Credit Policy would be enunciated. Jalan is on record saying that he wants to make the half-yearly Credit Policy announcement a "non-event".

The Budget was announced on February 29 and on the same day Finance Minister Yashwant Sinha said he has created the right atmosphere for rate cuts and that it is up to the RBI to do the needful. Jalan cut the rates on March 31. So, he kept Sinha, the business community and the public at large in suspense for 31 days. Thus, he was asserting the independence of the central bank.

In the past, the RBI used to coordinate with the government and any changes in monetary policy were synchronised with the Budget. With the financial sector reforms in place, independence of the central bank is an important ingredient of the emerging institutional structure.

But the suspense could not last long. Jalan finally wilted under pressure as Commerce Minister Murasoli Maran followed up Sinha's pleas for the interest rate cut.

The government and the business community are focussed on the interest rate changes. The public at large is keen to know only the interest their cash with banks will fetch. Competition has brought down the interest they pay on consumer durables loans. Markets are deciding the lending rates of consumer durables and even housing loans.

The Union Budget seems to have increased pressure on Jalan to act. Sinha scrapped banks' earnings tax from April 1 and banks are obliged to lower their lending rate, which is inclusive of a little over 0.5 per cent tax element, to bank borrowers. The State Bank of India has already cut its prime lending rate today.

Jalan should aim at every bank passing on the entire 1.5 percentage point reduction to the customer. Since it cannot be achieved through official fiat as in the past, the governor seems to be creating conditions for it to happen.

Although the six months from May are considered traditionally slack for banks, Jalan decided to ease liquidity by cutting the CRR in two stages in April by a combined one percentage point. That will enhance liquidity by Rs 72 billion.

Will banks pass on the entire 1.5 percentage point benefit to customers? Bankers are already arguing that they cannot afford to do so. The savings deposit rate is cut by 0.5 percentage point to 4 per cent.

The new rates will apply to fresh fixed deposits and will not apply to existing ones. Since deposit is a contractual obligation, banks have to pay pre-April rates unless the contract includes a clause for revision in case of bank rate change.

But this argument is specious. The banking system and the money market have already discounted the rate cut. Several banks and financial institutions have already lowered their deposit interest rates. Even the government has re-adjusted downwards the provident fund interest rate.

The ICICI and IDBI, the two major financial institutions, have cut interest rates for their recent bond floatations, anticipating the bank rate cut. If others have not seen the writing on the wall or are not alert enough, they should pay for the lapse.

Will the market become really competitive? Several other issues must have been on Jalan's mind when he cut the CRR on April 1. New Delhi has programmed a record Rs l.17 trillion gross market borrowings this fiscal and the RBI will have to see it through. Also, additional liquidity is required to oil the nascent industrial revival.

But there is the danger of massive central and state loans skewing the long and medium-term interest rates. It certainly calls for skill to manage the loan floatations without upsetting the applecart. In a dynamic society, one has to put up with the short-term shifts. The RBI should be alert to take corrective action whenever the need arises.

Especially, one has to keep a watch on inflation trends. The Wholesale Price Index jumped to 3.76 per cent mid-March reflecting the budgetary imposts and reduction of food, LPG and kerosene subsidies. The next six months should be tough from the point of view of supply-demand management.

Having triggered the inflationary spiral by eliminating subsidies and levying new budgetary imports, the monetary policy should not fuel inflationary pressures. Supply management is the key.

The liberalised Exim Policy should help in holding the priceline. But the government should be alert to tackle the kinks in the supply side and effect timely imports if necessary to maintain a balance.

Two issues that arise out of the bank rate cut are economic growth versus holding the priceline and the impact of the rate cut on the banking system.

The Indian economy is prone to lags and leads and it is difficult to arrive at the exact liquidity requirements of expanding industrial production and overall growth. The money supply has of course expanded by a whopping 17 per cent last year without side-effects. The rate cut will certainly boost money supply.

The economy can absorb enhanced money supply without unduly affecting the priceline, provided supply management is effective.

The key for banks to get over the problem is to narrow the spread -- the difference betweeen the average deposit interest rate and lending rate. Presently, it is more than 3 per cent. Banks will have to cut the spread if they have to keep their head above water.

R C Murthy

Business