A turning point

In his speech at the annual day function of the National Institute of Bank Management, the Reserve Bank of India Governor warned banks on two factors "" their very low deposit rates, and the non-availability of credit at reasonable interest rates to small-scale units, the rural sector and government-backed enterprises.

The warning marks a turning point in the Reserve Bank's thinking. So far, the emphasis was always on the need to reduce administered interest rates to bring them in line with market rates.

Seen from that perspective, the pressure was on the government to reduce these rates. Now the RBI seems to be signalling that deposit rates are too low and they need to be revised upwards to match administered interest rates.

To be sure, perhaps that is not exactly what Dr Reddy had in mind, but if the Governor's warning about savers deserting banks for the small savings schemes is to be taken literally, the assumption seems to be that interest rates on small savings schemes are at the 'right' level.

This is strange, because it implies that rates set by the market "" the deposit rate "" should align themselves to the administered rate, and not the other way around. But then it fits in with the recent retrograde announcements which also move away from the principle of the market setting interest rates "" the maximum lending rate of nine per cent fixed for loans to agriculture being a case in point, and the attempt to set up a so-called benchmark Prime Lending Rate being another.

The Reserve Bank has long advocated for more lending to the second-rung corporates and it is certainly true that many of these firms have not really benefited from the sharp drop in interest rates.

There could be several reasons for this risk aversion. One of them is the lack of progress on the foreclosure law, which is stuck in the Supreme Court "" banks would feel far more comfortable in lending to smaller companies if they could recover their loans speedily. The disincentives for loan growth in public sector banks are well-known.

The government's borrowing programme has been one of the biggest disincentives for banks to lend to the marginal borrower. If bankers can make good profits merely by parking their funds in government securities and reaping the benefit of capital gains as bonds appreciate in an environment of interest rates coming down, where is the need for banks to lend?

Moreover, despite continuously falling deposit rates, banks continue to be flush with funds. For the six months to mid-December 2003, incremental term deposits with banks were higher by almost 18 per cent, which shows that real growth in term deposits was substantial, despite the stock market going up sharply, and despite returns on instruments such as RBI Relief bonds being much higher than those on bank deposits.

Growth in bank deposits has proved to be rather inelastic so far. The RBI Governor has also signalled that interest rates have bottomed out. There has been some improvement in credit growth in recent months, and inflation is higher on the back of rising commodity and crude oil prices.

And if interest rates bottom out, that would mean that windfall capital gains for banks on their bond portfolio would no longer be available. Perhaps that would push banks into lending.