A cut that may not heal

T T RAM MOHAN

ET, JANUARY 24

India’s fiscal deficit is falling faster than expected. That makes fiscal policy contractionary — as is appropriate in an economic expansion. The monetary authorities evidently think this is not enough. So, monetary policy is tending to be contractionary as well. The Reserve Bank of India (RBI) has responded to what it believes are signs of ‘overheating’ in the economy. With the inflation rate surging past 6%, the RBI may well think it necessary to press the brakes even harder. The decline in the fiscal deficit introduces an added compulsion. As banks have been big providers of savings to government, the decline in the deficit should reduce the government’s demand on banks and free more of their resources for lending. The RBI recognises this. That is why we have the planned ordinance that will give the RBI flexibility to lower the statutory liquidity ratio (SLR) below the current floor of 25%. However, with credit growing at 30%, the RBI would not like to abet such growth in any way. In reconciling the two requirements, the RBI has a challenge on its hands. The improvement in the finances of the Centre and the states promises to exceed expectations. There is every indication that the combined fiscal deficit of the Centre and the states for 2006-07 will end up much lower than the budgeted figure of 6.5%. The booming economy has made nonsense of the dire warnings of the fiscal pessimists. A falling deficit implies lower supply of government securities. At the same time, the savings rate seems to be rising. A lower government deficit itself implies a higher savings rate. Another sign is that the current account deficit for the year is now projected at 1.5% of GDP, lower than the earlier estimate of 2.5-3%. Given that investment in the economy appears to be going up, this also points to a rise in the savings rate. The two factors together — a lower supply of government securities and a larger pool of savings — will accentuate a trend seen in the last two years: a greatly diminished reliance on the banking system to finance government borrowings. That is the rationale for the proposed SLR cut. From the late nineties onwards, banks’ holdings of government securities increased way beyond the SLR — at its peak in April 2004, it was 42.7%. However, from 2005-06, banks have been liquidating their holdings of SLR securities in order to finance credit. This, of course, means that incremental credit/deposit ratio in the system has been 100%. The SLR in the banking system is now 29%. Going by the reduction in SLR achieved between FY 2005 and FY 2006, the SLR could touch 25% by March 2007. If the RBI cuts the SLR below 25% at that point or earlier, the incremental credit/deposit ratio at banks will continue to be 100%. But the RBI is uncomfortable with the rate of credit growth. So it could opt to retain SLR at 25% for some time. For the reasons mentioned above, this will spell excess demand for G-secs and depress yields on G-secs. Whenever the SLR cut is effected, yields will rise and expose banks to marked-to-market losses. This is hardly a desirable state of affairs. So, the SLR must be cut before long but this must not mean continuation of the present rate of credit growth. The two requirements can be reconciled only through a rise in interest rates — and indeed that is what many expect in the coming credit policy. If that happens, an SLR cut will not bring banks the promised relief.

Is it desirable at all to rein in credit growth in the present buoyant conditions? Yes, if we believe that there is systematic mis-pricing of credit risk. Mis-pricing of every kind of risk is a universal phenomenon today and it is the result of the global surge in liquidity. But the answer to under-pricing of credit risk is not to make credit more expensive across the board. That will adversely affect investment and lead to supply constraints down the road. The answer is to focus on segments of the banking system where credit risk is under-priced. If home loans are being under-priced, then measures specific to that segment (such as higher risk weights) are in order, not a generalised rate hike. The best way to ensure proper pricing of risk, as this column has long argued, is to ask banks to put in place systems to measure risk-adjusted return on capital for every borrower. If this return is lower than the threshold return on equity, the regulator knows that risk is being under-priced. In other words, the response to runaway credit growth must be microeconomic. It must be selective and it must not penalise those who are pricing risk correctly. Pushing and pulling macro-economic levers in the belief that there is ‘overheating’ in the economy will cost us dearly by derailing growth.

The author is professor, IIM Ahmedabad