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Jalan's real message: don't ask for more

If there is one message coming through in Dr Bimal Jalan's credit policy, it is this: the interest rate party is coming to a close.

Most media commentators have drawn the opposite conclusion from the 0.25 per cent cuts in the bank rate, the repo rate and Cash Reserve Ratio. This triple bonanza seems to suggest that interest rates will continue to remain benign.

Macroeconomic realities could, of course, take interest rates either way. It all depends on whether the mild industrial recovery will sustain or stumble, whether the drought's deleterious effects turn out to be better or worse than estimated, whether the world economy will react negatively or neutrally to an all-out Iraq war, and whether inflation nudges up or down as a net result of all these factors playing themselves out.

What the Reserve Bank of India's Governor is clearly saying is that the central bank has gone as far out on a limb as it was possible to cut interest rates despite excess liquidity in the system.

The most significant phrase in the Credit Policy statement is the observation that there is a "sizeable gap" between the bank rate and money market rates and the average lending rates of banks.

Therefore, "no useful purpose is likely to be served by a further reduction in the bank rate in the near future. Under the circumstances, the policy bias in regard to the bank rate is to keep it stable..." In other words, no further cuts.

Implied in that statement is a surprising number of admissions. One, it seems obvious that the RBI would not have cut the bank rate on Tuesday but for the fact that the markets continued to expect significant rate reductions. To change expectations, Jalan has thrown the market a few bones to chew on even while signalling that the good times may have come to an end.

Two, the statement also carries in it a tacit admission that the RBI has gone far enough to appease the lobbies in favour of lower interest rates. Three, it does not buy any more the faulty logic that economic revival depends on lower real interest rates alone. Four, the RBI seems to be saying that it has done enough to help banks with easy profits.

This means that in future, interest rate cuts will depend more on what the banks do to improve their ability to lend profitably at lower spreads. This message comes through better when one reads the Credit Policy in its entirety and observes what the RBI has said, and what it has left unsaid.

Let's start with what the RBI hasn't done. Beyond the token rate cuts of 25 basis points, Jalan has pointedly stayed clear of lowering the savings deposit rate, currently at 4 per cent. When asked why he hadn't done this bit of deregulation, Jalan said that savers needed some level of assured return.

Quite right, too. Thanks to the way banks calculate interest on savings accounts, the average cost of savings deposits is only 3.4 per cent. Banks would have liked Jalan to lower the 4 per cent administered rate even further, but by not obliging them Jalan has made it clear that he is not in the business of squeezing savers just to make life easier for banks.

In the past, Jalan has bent over backwards to help banks, even by directly putting money in their pockets. Take the decision to pay interest on CRR funds. At 6.5 per cent (the rate payable on CRR before the recent bank rate cut), the RBI was asking banks to lend it idle money at rates that were only marginally lower than what they could have earned by investing in sovereign debt. Thus, CRR above the statutory minimum of 3 per cent had effectively become something like the statutory liquidity ratio in terms of yield levels. Money for jam.

The RBI also substantially insulated banks from interest rate risks by allowing them to segregate their securities into three categories. They were asked to provide for depreciation only in those categories that were meant for trading or sale. The rest (up to 25 per cent) could be put in the permanent category, on which no depreciation need to be provided.

That relaxation came in the busy season Credit Policy of 2000, after the RBI - unexpectedly - raised interest rates in July to ease pressures on the rupee and prevent undue speculation. The rate increase suddenly brought banks face to face with the possibility of a large hole in their balance-sheets following the fall in the values of their securities portfolios.

The reason Jalan has sounded a warning note on interest rates now is simple: he knows that banks are even more vulnerable on this front.

Far from pulling themselves out of trouble, banks have got themselves deeper into interest-rate risk. Between July 2000 and today, they have had no one to lend to but the government.

Of the Rs 500,000-odd crore that banks hold in the form of SLR securities, one-third represents an excess holding of such investments. Even if 25 per cent of this money can be held in the permanent category where depreciation does not have to be provided for, banks will be in a mess if interest rates rise.

In the April credit policy, Jalan had asked banks to create an investment fluctuation reserve of at least 5 per cent of the value of securities that are for sale or trading over five years.

Barely half the banks have managed to achieve even 1 per cent IFR. It hasn't mattered so far because interest rates have continued falling. But this credit policy is a belated wake-up call. Jalan is telling banks that they have to start looking to a future where things may not be so benign.

Jalan has also removed the ceiling on pre- and post-shipment export credit beyond 180 and 90 days respectively (which was PLR plus 0.5 per cent), but not the ceiling on credit for shorter periods (PLR minus 2.5 per cent).

Thus, if banks lower their PLRs, they will automatically have to cut export credit rates for shorter durations, but competition will ensure that they will have to cut rates at the deregulated end as well. The clear message is: cut your spreads by improved efficiency.

Banks must build greater flexibility into asset-liability systems by moving more customers to floating rates. This can only be done if they invest more in automation and are able to reset rates more often.

Doing a VRS here and a branch closure there is not enough. Indian banks have to reinvent themselves by building themselves into nimble organisations that are able to quickly adapt to changing interest rates and business opportunities and threats.

By indicating the limits to central bank-dictated interest rate cuts, governor Jalan is telling banks, the government and the markets that future cuts in interest rates depend substantially on how banks make themselves more efficient.

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