Patel warns against steep interest rate subvention

He was speaking at Gandhinagar, Gujarat, at an event to commemorate GIFT

Reserve Bank of India (RBI) Governor Urjit Patel on Wednesday cautioned that credit guarantees and interest rate subventions reduced the incentive to guard against risk when people were protected from its consequences.

Patel was speaking at Gandhinagar, Gujarat, at an event to commemorate GIFT, India’s first International Financial Services Centre (IFSC).

On the New Year’s eve, Prime Minister Narendra Modi raised the ceiling for credit guarantees on loans to small businesses from Rs 1 crore to Rs 2 crore and offered interest rate relief of 4 per cent on housing loans up to Rs 9 lakh and 3 per cent on loans up to Rs 12 lakh.

“While some government guarantees and limited subventions can help, steep interest rate subventions and large credit guarantees impede optimal allocation of financial resources and increase moral hazard,” Patel said.

Credit guarantees “have limited utility in solving important sector issues. For small-scale enterprises, perhaps non-pecuniary and transaction costs related to clearances, inspections and the taxation bureaucracy are more important,” he said.

Such guarantees should be used judiciously, Patel argued, otherwise a government guarantee ended up costing the government through higher risk premiums while borrowing money from the market.

High borrowing by the Centre and the states was limiting India’s ability to improve its credit rating and “pre-empting resources from future generations by governments cannot be a short cut to long-lasting higher growth”, Patel said.

He cited International Monetary Fund data that India’s general deficit, combining state and central borrowing, was the highest among G20 nations.

“We have to take cognisance of these comparisons. Specifically, this will help us to better manage risks for ourselves, and thereby mitigate financial volatility,” he added.

Patel’s speech was delivered amid criticism directed at the RBI for hardships caused by demonetisation, which the government has said was based on its recommendation. The RBI, however, has clarified the government had suggested the recall of high denomination currency notes.

On regulation of international financial centres, Patel said, “While individual regulators can supervise entities initially when the size of the business is small, a unified regulator will be necessary to pay undivided attention to the IFSC.” He added work on the design of a framework for an unified financial regulator should begin soon.

“Existing laws governing financial contracts in India should be reviewed and gaps addressed. Based on the review, a world-class legal framework for financial contracts in GIFT could be enabled, either by appropriately amending the existing laws governing financial contracts or enacting a fresh law,” he added.