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Home > Business > Budget 2003-2004 > Special

The many faces of the finance ministry

Tamal Bandyopadhyay | March 06, 2003

Paring the public provident fund and small savings rates by one percentage point in an election-year Budget is certainly a bold step.

But the indifference was shown by merely cutting the savings bank rate and not freeing it (of course, the savings rate cut was announced by the Reserve Bank of India but this is one area where the central bank cannot do anything without the finance ministry's nod).

The finance ministry has also introduced a new set of administered rates for small-scale industry and agriculture loans. This is irrational in a liberalised regime.

Let's take a close look at each of the steps, all of them related to lowering interest rates -- the new-found panacea for all economic ills ranging from low growth to high fiscal deficit.

The cut in small savings and PPF rates was not a surprise but the depth of the cut was. What puzzled the market most was the Reserve Bank of India's lightning response.

Sure the RBI had been talking of a 'soft' interest rate regime but it suddenly changed direction towards 'softer' interest rates.

It is possible that it was arm-twisted to do so. Bankers did not attach much importance to Finance Minister Jaswant Singh's announcement of a one percentage point cut in the small savings rate, which was largely perceived as a corrective move.

After all, the deposit and lending rates in the banking system are already low. But the sentiment changed the moment Singh, in a post-Budget interview with Star TV, said it was indeed a signal to the central bank.

The RBI lost no time in announcing a 50 basis point cut in the short-term repo rate (the rate at which the central bank repurchases securities from banks) as well as the administered rate of savings bank.

The bond market applauded the move but bankers vetoed a lending rate cut for the time being.

Perhaps they are waiting for an RBI signal in the form of a bank rate cut. Nonetheless, the finance ministry's master stroke changed sentiments overnight.

Those who thought that the low interest rate party was over have started talking about a new wave of downward movements.

But with inflation inching up, will the RBI be able to sustain the low rates? Unless there is a dramatic change in the macro-economic scenario, it will be able to do so in the medium term.

One can expect a cut in bank rate as well as banks' cash reserve ratio in the April Credit Policy.

The bank rate is now pegged at 6.25 per cent -- 125 basis points higher than the repo rate.

The RBI may bring down the bank rate to 6 per cent or even 5.75 per cent. This, combined with a CRR cut, will prompt banks to cut their lending and deposit rates.

The CRR, currently 4.75 per cent, may be cut to pump more liquidity into the system since the RBI needs to ensure that the government's huge borrowing programme for the next fiscal goes through smoothly.

As for the savings bank rate, instead of being cut by half a percentage point to 3.5 per cent, it could have been freed.

The savings bank rate is one of the last relics of the administered rate regime (the other being the small loan rate up to Rs 2 lakh (Rs 200,000) which is capped at the prime lending rate).

Since there was political backing, RBI could have at least capped the savings bank rate at the old rate of 4 per cent or even 3.5 per cent and given the banks freedom to fix the savings bank rate within the cap.

Why should the savings bank rate be administered when all other deposit rates are free? Anyway, for most banks -- particularly, the foreign and new private banks -- the savings bank account has lost its relevance.

Many of them now offer flexi-deposit schemes where the savings bank account money automatically flows into fixed deposits (above a certain level) and a higher interest rate.

For depositors, the yield on savings bank accounts is much less than the actual rate because the interest is paid on the minimum balance kept between the 10th and last day of the month.

However, the cost of savings bank money is high for the banks since they are required to load overheads on the overall cost structure.

Once the savings bank account rate is free, the more efficient banks will be able to offer depositors a higher rate.

If the RBI is worried that banks will jack up the rates in a scramble to mop up huge funds through the savings bank account route as a result, and end up raising the cost of funds substantially, it could cap the maximum rate and give the banks freedom to fix the rate within the cap.

This will infuse a semblance of competition. At the second stage, it can be completely freed.

If the refusal to partially free savings rate is indifference, the introduction of an administered rate structure for small loans and agriculture loans is irrational.

The benefit of the low interest regime has not been passed on to small borrowers and hence the Budget has suggested that banks must not charge beyond 2 per cent over the prime lending rate (PLR) to small scale industry (SSI) and farm loans.

On the lower side, the rates can go down as much as 2 per cent below the PLR. In a way, this is a new administered rate for small loans.

Nobody is denying the fact that the small and medium entrepreneurs and farmers should be charged less but there could have been different ways of tackling this issue.

In the US, a government-sponsored association called Small Business Association offers guarantee to small loans, thereby enhancing their credit-worthiness.

The SBA charges a commission for the guarantee it offers and in case of any default by a borrower it clears the dues to the bank. A similar experiment could have been implemented here.

Alternately, the government could have encouraged the venture funds to pick up long-term equity in small projects by offering them tax breaks.

By introducing administered rates for small loans, the government has ended up forcing the good SSIs to subsidise the bad SSIs.

No bank will dare to violate the government-dictated band on small loans but they may stop disbursing small loans at below or even at PLR and peg all loans at 2 per cent above PLR.

In other words, the few SSIs that were getting cheap loans at below or at PLR will not get loans at those rates any more. Banks will jack up their rates to 2 per cent above PLR to subside the weaker SSIs. This is subsidisation at its worst.

Just before the Budget, the RBI allowed banks to book non-existent interest income on certain borrowers. It has allowed banks to recognise income on an 'accrual basis' in respect of some categories of projects under implementation which had a time overrun and were classified as a 'standard' asset.

In other words, banks will be able to book interest income in cases where borrowers are required to pay interest but are actually not paying it. This is not only irrational but retrograde.

Essentially, this means that banks will be able to book interest income on projects like Dhabol and Essar Oil even though borrowers are not making interest payments.

Banks have been doing this but in May last year, the RBI barred this practice.

Under tremendous pressure from the industry the regulator has relented and allowed them to continue with the old practice, even though it is imprudent. It seems that the central bank's concerns over bank bottom lines are greater than the need to follow prudential norms.

By doing this, the regulator has put the reform process in reverse gear.

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