If it ain't broke

BS OPINION

However, in not changing either the cash reserve ratio or the bank rate, he belied the hopes of people who wanted a further stimulus of liquidity to the already overflowing coffers of the banking system.

The justification for inaction at this point is that, even as the economy is in recovery mode, its demand for bank finance does not seem likely to put any strain on currently available resources.

If, at some point in the future, the strain starts showing, the Reserve Bank of India (RBI) will simply respond to the situation.

Inaction does not mean zero impact. In breaking the long chain of interest rate cuts, the governor is simultaneously achieving two things. First, the RBI seems to be a little concerned about the impact that growth at this rate will have on inflation.

The announcement itself is relatively reassuring on any potential build-up of price pressures, but its forecast for the end of the year, at 4.5 per cent, appears somewhat higher than many mid-year predictions have suggested.

If there is concern that excessive liquidity may add its own bit to the process, it was clearly prudent not to jump the gun. The absence of any rate cuts now is clearly not going to hurt the recovery in any way.

Second, the banking system has benefited hugely from the steep decline in interest rates because of the impact that this has had on the valuations of government securities held by banks. However, a sudden reversal will have the opposite effect, forcing banks to write down their assets.

Banks have to channel some funds into a reserve fund to hedge against this possibility, but at best this offers only limited protection. Had interest rates been pushed down further, the likelihood of a reversal would have increased, particularly in the current domestic and global economic scenario.

Besides the domestic buoyancy, the US economy is showing a faster than expected recovery and interest rates have started moving up as a consequence. By waiting and watching, the RBI is also providing a measure of protection to bank portfolios overstuffed with government securities.

Two initiatives have been launched, to address credit delivery problems in agriculture and small industries. Given the long-standing complaints about the adequacy of the mechanisms in these areas, it can only be hoped that these do not simply end up as shelved reports. But one area that is crying for attention needs to be quickly addressed by the RBI.

Even as services are the largest and fastest growing segment of the economy, the ability of much of the banking system to finance this growth is limited by the asset-based lending practices of the system, which is geared towards traditional manufacturing activity.

It requires both regulatory change and financial innovation to bridge this gap, and it is time for the central bank to start thinking about this.