The RBI has been making a group of stimulus measures ever since the appearance of financial stringency in our economy in mid September 2008. The CRR has been reduced by four hundred basis points from the high nine percent in September 2008 to five percent. Another key policy rate- the repo has been reduced by 350 bps to 5.5%. Both these measures means that the economy is operating in a relatively easy liquidity- soft interest rate regime akin to that existed five years back.

Further, there is always complementarity between interest rate and the level of inflation. The inflation rate is now brought down to comfortable levels.  Hence the overall interest rate in the economy has also to be brought back to moderate levels.

The RBI’s monetary policy stimuli are aimed to facilitate lending and thus to create credit fed demand in the economy to counter the expected slow down. But its is the financial system which is carrying out lending operations in accordance with the monetary policy signals. Or in other words, the success of monetary policy depends upon the behavior of financial intermediaries and the financial market and macroeconomic environments.  

Whether the financial intermediaries especially the commercial banks redesigned their operations in tune with the RBI’s expected pattern is to be analysed in detail. This helps us to assess the extent of the success of monetary policy (stimuli) to overcome the economic slowdown.

The commercial banks always craft their lending operations in accordance with the phase of the credit cycle. For instance during 2007-08, when the economy was experiencing credit boom, the commercial banks resorted to excess fund mobilisation and even used the Certificate of Deposit route to procure short term loans at high interest rate to meet the booming credit demand. Amidst high CRR, the commercial banks issued financial instruments in the money market for additional fund mobilisation.

Simultaneously, their holding of government securities reached a historic low of 25 % towards the end of 2008. Given the then existing high interest rate and amidst prosperity in the economy, the commercial bank’s lending to the business and other private sector operations reached the plateau. The abysmal holding of government securities by commercial banks curtailed the open market operations of the RBI.  The RBI, during 2008, adopted the policy of high interest rate regime to accommodate the high rate of inflation.

Now we are in the opposite end of the credit cycle. Another notable development is that the economy has returned to the low interest rate easy liquidity regime. Besides, the gap between the returns on G-secs and loans has been reduced in the wake of low interest rates. And now, because of the slow down, it is more risky and less rewarding for the commercial banks to give loans to the non-government.

The banks are now more sensitive to credit risks more than ever in the aftermath of the financial crisis. No financial institution can forget the stringent liquidity period during September-October 2008 that existed in our money market. The lessons of illiquidity and insolvency that destroyed the financial institutions abroad have developed extreme degree of risk aversion in the behavioral pattern of our commercial banks.  Now, the banks find it more convenient to give loans to the government than to the non- government sector. Otherwise known as narrow banking, the commercial bank’s holding of government securities will increase further resulting in diversion of resources from the private sector to the government sector. In the current phase of the credit cycle, it is the right strategy both from the perspective of risk and return. Hence, whatever may be the monetary policy stimuli from the RBI to expand lending to the business and households, they may not be successful in realizing the objectives. 

Tags : monetary-policy,rbi