Here we go again

The uneasy relationship between the Reserve Bank of India (RBI) and the ministry of finance in the conduct of monetary policy was in evidence again last week. On Friday, speaking to a gathering of bankers and industry representatives, Mr Chidambaram asked banks to find ways of lowering their cost of funds so that lending rates could be kept down. He was responding to the news of a slowdown in some industries, particularly the automobile sector, which has been attributed to the rising cost of car and truck loans. Over the course of the past couple of years, during which the RBI has been steadily increasing interest rates and trying to curb liquidity with a view to reining in inflation, the finance minister has on occasion asked the public sector banks to in effect ignore these signals and not raise their lending rates in order to avoid disrupting the growth momentum.

The problem is that this stands macro-economic management on its head; the whole point of the central bank raising interest rates is to reduce the growth rate, which, in turn, leads to a moderation of inflationary pressures. The RBI's rationale for its interest rate policy has been precisely that the economy has been growing at an unsustainable rate, which carries the risk of kicking off an inflationary spiral. Obviously, the RBI's actions require an appropriate response from the banking system; it is expected to raise its lending rates. If this does not happen, the policy will be ineffective.

Of course, monetary policy always comes with the risk of over-correction; in today's context, this means that interest rates have been raised to levels higher than warranted by the underlying inflationary trends. If this has indeed happened, GDP growth would decline to below its sustainable rate. The RBI's macro-economic assessments have consistently indicated its assessment that the sustainable growth rate is in the region of 8.5 per cent. As of now, there are very few forecasts that the growth rate for this year will drop below this level; in fact, the Prime Minister's Economic Advisory Council recently forecast that the economy would grow by 9 per cent in the current year. From the RBI's perspective, this would imply that inflationary pressures still persist. The country will have to wait until the next monetary policy announcement on October 30 to know the RBI's mind, but, meanwhile, there is hardly enough evidence available to suggest that the slowdown in specific sectors is out of line with the overall objective of attaining a sustainable balance between growth and inflation.

Given this, from a simple analytical perspective, the finance minister's message to banks appears unwarranted. But, beyond this, the statement raises questions about who exactly is conducting monetary policy and why one arm of the economic policy establishment wants to subvert the other's objectives. It also reinforces doubts about the autonomy and the quality of corporate governance of banks. Do they have the freedom to make decisions in the overall interests of their stakeholders or does the majority shareholder call the shots with apparent disregard for other interests? It is, of course, entirely to be expected that the RBI and the finance ministry may occasionally disagree on the state of the economy. Indeed, with some banks softening their lending rates in recent weeks in the wake of a fresh surge in liquidity, it could be argued that the RBI needs to re-visit its assumptions "" especially if it wants to avoid a situation where high domestic interest rates attract dollar inflows even as rates soften in the US. However, North Block and Mint Road need to find more appropriate ways of resolving these differences internally and avoid sending conflicting signals to the banking system.