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The final bolt

The 2nd stimulus package highlight the opportunities and constraints that confront policy-makers

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The “final” package of measures announced by the Reserve Bank of India (RBI) and the government on Friday highlight both the opportunities and the constraints that confront policy-makers as they deal with the economic slowdown. On the monetary front, the benchmark repo rate, at which the RBI lends to the banking system, is even now at 5.5 per cent. Since the rate can be taken down to zero, there is still significant room to lower the cost of funds. Simultaneously, the RBI also brought down the reverse repo rate, which it pays to banks on short-term funds parked with it, from 5 per cent to 4 per cent; this should induce banks to lend more commercially, as their cost of funds averages nearly 7 per cent and placing money with RBI leaves them with a big loss. Combined with the reduction in the cash reserve ratio from 5.5 to 5 per cent, which releases an additional Rs 20,000 crore for banks to lend after mid-January, the pressure is mounting on banks to find ways of increasing credit flows, rather than just investing in government securities, which they have been doing rather a lot lately. Expect deposit rates to drop, even as it would appear that the constraint on lending now is not the absence of liquidity that prevailed till a month or two ago, but confidence in client creditworthiness.

Presumably conscious of this, the government on Friday raised the credit growth targets for public sector banks, thus putting yet more pressure on them to lend. The authorities have also taken specific measures to address credit availability where it pinches the most—for projects, for non-banking finance companies (NBFCs, which are active in the vehicle loan market), and exports. The most significant component of the package is the expansion of the fund-raising programme of India Infrastructure Finance Company, which will now raise Rs 30,000 crore by way of tax-free bonds in addition to the Rs 10,000 crore proposed in the December package. The assumption is that there are projects to which IIFC can lend (which its chairman says is not the case). As for NBFCs, the government has given up expecting banks to lend to them (for which a no-SLR inducement had been given); it will now create a special purpose vehicle which will issue government-guaranteed bonds to the RBI, and use the money to finance NBFCs. This will work if the assumption is that there is no serious credit risk involved—which cannot be assumed when the banks have been wary. Despite such doubts, the package increases the likelihood of more credit.

All these are supply-side responses, whereas the problem is now more on the demand side. But there is little extra that the government can do when the fiscal deficit has climbed as high as it has. The big stimulus came in October, with the approval of the supplementary budgetary grants of over Rs 230,000 crore. Compared to this, the December package offered only the Rs 8,700 crore reduction in Cenvat taxes as a direct stimulus, while last week’s package had no direct element at all.

Could this entire package have been announced earlier? The RBI has preferred to cross the river “by feeling the stones”, not take a big leap. Its preferred course gives it the capacity to respond to an evolving situation, thus boosting confidence. On the other hand, using up all the capacity to reduce rates as quickly as possible — as some other central banks have done — makes sure that investment and consumption decisions are not delayed by expectations of further monetary easing.

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