Bending Over Backwards

From an infinite world of negation, said Milton Freidman, I chose only two things to illustrate what monetary policy cannot do. One it cannot keep interest rates lower than warranted in the long term and second, it cannot keep unemployment levels lower than warranted...Monetary policy is like a string which you can pull but cannot push. The monetary policy for the second half of 1997-98 is a brave attempt at pushing the string.

Undaunted by the inefficacy of cuts in the cash reserve ratio (CRR) and bank rate, the Reserve Bank of India (RBI) has propounded more of the same. The two percentage point CRR cut should release another Rs 10,000 crore into the system by end-march 1998, though it shall always remain a mystery why the RBI staggered it over the next six months and in eight installments. A straight cut would have resulted in an immediate and reassuring cut in banks lending rates.

What is debatable, however, is the dynamics of the flow of investible funds. The RBI governor, C Rangarajan, insists that he has forced banks into a position where they have no option but to lend. Rangarajans thesis is based on two factors. One, that the government has completed its targeted borrowing programme. There is going to be no fresh supply of paper, so banks investment opportunities are blocked. Two, that yields have fallen to such levels that commercial lending suddenly looks attractive in comparison to government paper. It is doubtful if the markets or banks will agree on either count.

In the circumstance that banks are flooded with money and there is no fresh supply of paper, banks are only going to chase existing security prices higher and higher. Yields will crash further. This is exactly what has been happening in the last three months. Indeed, banks accumulated more stock in the last six months than was issued by the government. While the latter unloaded Rs 27,099 crore of fresh paper in the system, banks investments in gilts went by Rs 28,299 crore in the period April-September 26, 1997. Given also that provident funds, trusts and others too would have bid significant amounts, the amount of paper collected by banks in fresh auctions will have been much lesser than the paper issued; the rest they picked up in the secondary market, driving yields lower. There is nothing to suggest that the process will be reversed. Indeed it will accelerate in the next three months, as provident funds enter the market with almost Rs 12,000 crore of disposable funds. One should not be surprised if

ten-year paper quotes below 10 per cent.

This leads to the second point: that the sparkle will return to commercial lending once gilt yields fall to low enough levels. Again it is highly unlikely. The two asset prices are closely linked by the risk premium attached to corporate lending. Simply put, if the yield on zero-risk government paper is at 10 per cent, the lowest rate for corporate lending (that is, assuming the very best of Indian corporates) will only factor in the additional cost of capital to be set apart in compliance with prudential accounting norms. Assuming a capital adequacy ratio of eight per cent and cost of capital at 15 per cent, the additional premium would be 1.2 percentage points. Add to that, then, the risk premium attached to corporate lending and we are close to 13 per cent.

In short, the point is that asset yields are neutral: at no time possibly can one asset be deemed more attractive than the other. If that were to happen, theoretically, all resources will flow to the supposedly attractive sector. Market clearing prices ensure that all assets are priced at optimal allocation levels. To suggest, then, that commercial lending at 13 per cent is more attractive then gilts at 10 per cent could be misleading.

We posit a tentative hypothesis that the risk premiums attached to corporate lending increase disproportionately with every unit decrease in lending rates. Simply put, this would mean that bankers see greater risk in lending to corporates when interest rates are lowlower than what they think is a reasonable level. This would mean that the more interest rates fall, the more would be bankers reluctance to lend. Knowing fully well that such low levels of interest will not stay for long, there is no way bankers will commit themselves to the long term at current rates. Perhaps this is what is happening at the moment with credit offtake showing total indifference to the interest rate structure.

Surely each banker has a view on what is a comfortable level of interest rateshis level of comfort being determined by what he perceives to be the course of future inflation and real interest rates. Suppose he were to lend at 13 per cent to a long term project based on the latters financial projections which take into account such low rates and interest rates rise to 15 per cent, say, in the next six months. All the financial cash flows go haywire and so does the quality of the asset in the banks books.

The skewness of risk is determined by bankers expectations of the corporates ability to absorb the cost push arising out of higher interest rates. A company operating in a fiercely competitive markets will be more unlikely to pass on the additional costs into its pricing and therefore, all the more certain to turn into a non-performing asset for the banks.

That said, it is more than likely that bankers would prefer to lend to existing lines of business or activityor perhaps, some business which has survived through at least one business cycle. Lending to startup businesses or line extensions or even diversifications is ruled out in the circumstances. Kickstarting investment demand is the last thing such a policy could possibly achieve, though working capital lines may open up.

One such instance is the RBIs focus on more credit to truck and transport operators, which it says would lead to greater spillover effects. The point is simple: banks are unlikely to fund a first timer perhaps a truck driver who wants to buy his first truck and any banker will confirm that all truck drivers aspire to become fleet owners one day. Why? Because his ability to withstand a shock is much lesser: one accident or an RTO holdup stands between the banker and the asset.

The more fundamental issue is: what is the RBI agenda? By pumping in more and more money, it is ensuring that nominal rates of interest come down. That is because the demand side keeps still and the supply keeps expanding. When the demand side starts picking up, as it surely will at some time when interest rates fall enough, interest rates will start rising. It does not take any great economics to figure that out.

This means the RBI will have to continue to pump in greater amounts of money in each successive tranche to keep rates level. Indeed, some evidence of that is already discernible. When unbridled monetary expansion is ruled out, this means two things.

One, that the RBI is setting itself a short fuse. Interest rates which have fallen by four percentage points over a period of 18 months and five percentage point cut in CRR, may shoot up sharply.

Second, and more importantly, releasing vast sums of money to chase stagnant levels of output means difficulty on the inflation management front. It does not need the brilliance of a Keynes or a Milton Friedman to figure out that a 15 per cent money supply expansion which was supposed to be commensurate with inflation at 6 per cent and GDP growth at 6-7 per cent is far too much when GDP growth is expected lower at 6 per cent. The excess should translate into at least one percentage point increase in inflation.

This is not to suggest that a 6 per cent target is either good, bad or indifferent. The whole point is that rational agents have the habit of seeing through the central banks desperation. Therefore, all effort at inducing them to bite the bait fall flat. Another policy has come and gone, and all thats left to do now is await the ides of April 1998.Kickstarting investment demand is the last thing such a policy could possibly achieve, though working capital lines may open up.