Credit Policy: Bimal Jalan's dream policy - Views on News from Equitymaster

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Credit Policy: Bimal Jalan's dream policy

Oct 22, 2001

Let's get into the gut of the just announced busy period monetary policy that has sent all banking stocks sky rocketing and has much of the ingredients to be termed as a dream policy.For starters, the Central Bank has reduced the cash reserves ratio (CRR) to be maintained by the banking sector by a whopping 2% over a two-phase schedule. The CRR will be reduced to 5.5% from the current 7.5% with the first cut coming into effect the fortnight beginning November 3, 2001. The second cut of 0.25% will be effective the fortnight ending December 29, 2001. CRR is maintained with the Reserve Bank on Net Demand & Time Liabilities (NDTL) of the bank. These two cuts are expected to increase money supply in the banking system by Rs 60 bn and Rs 20 bn respectively.

Banks are likely to be flush with funds, not only removing any lending constraints but also putting pressure on banks to increase fund based activity. This announcement has raised hopes of turning around a moribund capital investment environment, which could lead to enhanced economic growth in the second half of the current fiscal.

However, the twin effect of the banking sector investing in Government securities (G-Secs) to keep non-performing asset (NPA) levels under check and the Central Government expected to increase market borrowing to fund a higher deficit could crowd out private investments, as has occurred in the past. Commercial bank investments in G-Secs are currently ruling at 36.3% of NDTL. As per the statutory liquidity ratio (SLR) stipulations, commercial banks are expected to park 25% of their NDTL in SLR approved securities. Scaling down of G-Sec investments to SLR stipulated levels would unlock an additional Rs 403 bn in the banking system. As of August '01, the Government has exhausted 50% of its budgeted borrowing programme. Assuming the borrowing programme is uniform across the year, the Government is likely to exceed the borrowing target by 8.3%.

At the same time all other liabilities that were exempted for the purpose of calculating CRR levels will be withdrawn except for inter-bank liabilities with effect from November 3, 2001. This move, to a certain extent, will compensate for the reduced CRR rates. The RBI expects these moves to facilitate the development of a short-term yield curve, money markets (short-term fixed income markets), increase lending resources with banks and enhance the functionality of open market operations for controlling monetary policy.

Between the annual policy of FY02 and the mid-term policy, the RBI had cut bank rate by 50 basis points to 7%. The bank rate has been further brought down to 6.5%. Bank rate is the rate at which commercial banks can borrow from RBI. Another booster is the interest paid on CRR balance maintained with the RBI. In the annual policy the Central Bank had increased the interest rate on these cash balances by 200 basis points from 4%. These cash balance will now attract the bank rate of interest (6.5%).

As part of the open market operations the Central Bank is likely to extend the repo facility to 14 days. This is on the back of the successful introduction of the liquidity adjustment facility (LAF) in June 2000 as a flexible and effective tool for equilibrating liquidity in the banking system.

Other highlights to follow…

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