After Bimal Jalan, in his first credit policy, slipped in the Trojan horse of structural macroeconomics into the sanctum sanctorum of monetary orthodoxy by raising doubts about the stability of the money demand function, he has systematically been pursuing his policy agenda.
It, therefore, came as a no surprise that Jalan resisted the temptation to be the knight in shining armour by not succumbing to the pressure to help recovery by "reducing" interest rates. The limits of monetary policy to manage aggregate demand and its composition, especially in the context of specific supply rigidities, is a well accepted structuralist axiom.
This said, there should be no doubt that in the present economic regime where it is not possible to use pump-priming to further recovery, monetary policy has to play an interventionist role. The real issue is what that role can that be.
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If there were a single market with a perfectly flexible rate of interest, an increase in the supply of funds relative to demand would reduce the rate. This is clearly not the case. Instead, the setup is one of multiple markets for bank finance with divergent trends in short-term interest rates.
For instance, today, the problem is really at the short end of the market. While the AAA rated corporates can borrow at 9 per cent; the second rung can only borrow at around 16-17 per cent. Clearly, such a wide spread is unsustainable.
In a mature market, the trend is for the interest spread on government paper and corporate to narrow. In India, this trend has been limited to AAA corporates and gilts. The spread, if anything, has widened between AAA and the lower-rated corporate paper. And herein lies the real interest rate problem; the spread needs to be squeezed.
The need to redress this skewed distribution in the bank finance market assumes urgency in view of the corporate results for the first half of 1999-2000 which show a clear pattern that big-sized corporates, with sales of over Rs 1,000 crore, haven't performed well. The recovery in the sector is actually based on medium-sized corporates. The simple fact is that the biggest have not been the best performers. This in spite of the fact that the growth in interest burden was lower for these corporates while for the smaller ones it was much higher than the average.
Once a bank decides to lend to the less than AAA-rated corporates, it implicitly acknowledges their creditworthiness. With that not in doubt, and given that they are taking only a short-term exposure, there is no justification to create such deep segmentation. In fact it is counterproductive as it compounds the problem for those corporates who are fundamentally strong but have been caught in the cyclical downswing.
The whole point should be to move towards an interest rate system where the interest rates become counter-cyclical with the government exercising control on it through the rate on small savings.
When the cycle is in the downswing, the interest rates should be lowered and when the cycle is the up, the rates can be indexed upwards. This will be in the long