Sir Geoffrey Howe was Mrs Thatcher's first Chancellor of the Exchequer. When the Thatcher team assumed office they were all monetarists. While Mrs Thatcher remained so, Sir Geoffrey in his autobiography confessed that in a short while after assuming office, his faith in monetary alpha-numerics started getting shaken. The Ms started behaving in different ways and nobody knew which of them was the more important and its exact correlation with inflation. In short order, Sir Geoffrey fell back to targeting interest rates through control of the base rate.
Our monetary authorities, however, continue to put their faith in monetary aggregates, the favoured number being M3 for which a target of 15 - 15.5 per cent growth has been announced for the current fiscal year. It is worth pondering on the facade of precision this target creates.
The central bank with the most monetarist approach has for long been the German Bundesbank. As it happens, quite possibly 1998 would be the last year in which the Bundesbank will have control over monetary policy (the euro would be in operation by next year). The announced target for M3 growth in 1998 is 4 to 7 per cent. This means that the most religiously monetarist central bank accepts a 75 per cent gap between the minimum necessary and maximum tolerable growth in money supply. In our case the gap is 3 per cent. Do our authorities have better data and monetary management systems than the Bundesbank, to operate within a far narrower range?
More From This Section
Again, the basis for the M3 growth target is the expected nominal GDP growth. The assumption seems to be that this is the sole determinant of the genuine demand for rupees for productive purposes. Such is hardly the case.
For a given level of nominal GDP, industry's demand for rupee credit can fluctuate widely with the way imports and exports are financed: in foreign currency (six month suppliers'/buyers' credits, and bill rediscounting); or in rupees (sight imports, rupee pre- and post-shipment credits). The choice depends on interest differentials and the outlook for the exchange rate. The theoretical swing in demand for rupee credit arising from the preference between forex and rupee trade financing will be of the order of Rs 150,000 crore! To add to this, foreign currency loans from, say, FCNR(B) deposits, could also be used for working capital. Thus, a far wider band for tolerable growth in the M3 seems to be called for.
Having said this, it also needs to be admitted that there are some pointers in the policy statement that the central bank would be looking at "a multiple indicator approach". Paragraphs 20 and 21 in the policy statement lead one to believe that the central bank is in the process of evaluating a more complex model to determine future policy. If so, this will be all to the good. One other point it may like to ponder about is the ratios of M3 and bank credit to nominal GDP. In our case the two are approximately 30 per cent and 20 per cent, far below the corresponding numbers in many other developing countries. At the other extreme, just before the crisis in Thailand, bank credit in that country had crossed 150 per cent of GDP! While no one would like to follow Thailand, surely there is a case for a review of why our ratios are so low and what impact they can have on economic growth.
The hope that the central bank would look at a number of variables apart from the favourite monetary aggregate, is also bolstered by the stated objectives: "the need to accelerate industrial investment and output" is taking precedence over "maintenance of low rates of inflation". Or am I reading too much in what could be an accident of sequencing? There are, however, grounds to believe that the answer to the question is in the negative. In his interview published in this paper, the Governor has emphasised that "credit won't be a constraint" on growth.
One other general impression I get is that the authorities are putting a lot of faith in their ability to fine-tune quick and timely responses to the changing environment. While one remains an agnostic on the effectiveness of continuous tinkering, the authorities' confidence in their own ability would surely have been bolstered by what happened in the exchange markets. Immediately after the January 16 measures, volatility came down dramatically. The measures seemingly worked but this may not always be the case. Again, the measures have merely stabilised the exchange rate at a level significantly above what is needed for the competitiveness of domestic industry.
In order to encourage longer term FCNR(B) deposits, the ceiling rate has been increased by 0.5 per cent for longer maturities, and reduced by 0.25 per cent for deposits below one year. The assumption seems to be that the RBI prescribed ceiling is the only relevant factor for banks to fix their interest rates. This is a wrong assumption. Any bank desiring to determine interest rates on FCNR(B) deposits will have to do so on the basis of market rates, the assumption being that the funds will have to be deployed in interbank market abroad. Thus, the changes in ceiling would at best be ineffective and at worst misguide commercial banks.
The freedom to banks to quote different interest rates for identical maturities and on premature withdrawals has been widely welcomed. For what it is worth, one adds one's vote to the welcome "" except for the use for the word "penal interest". One reason for the reservation is that it is indicative of a mindset where one of the duties of the banking system is to "discipline" and penalise customers. This apart, if interest rates have come down after the fixed deposit was taken, the premature withdrawal could well be at the same rate at which the deposit was taken or, indeed, at a higher rate than originally contracted! Logically, the interest given on premature withdrawals would be a function of the current cost of refinancing the withdrawal for the remaining maturity.