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What the Credit Policy really said

By Abheek Barua
April 27, 2009 17:51 IST
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It might be a little late in the day to comment on the recent credit policy but I thought there were a couple of things in it that deserved much more attention that they got. I want to focus on them in this article.

For one, last Tuesday's monetary policy document seems to finally recognise the fact that the so-called monetary transmission mechanism actually works in India far more efficiently than is generally assumed. Monetary policy action over the past few months has borne fruit much quicker than the conventional discourse would have us believe.

The way the credit policy review does this is simple: it shifts its focus from a discussion of prime lending rates (PLRs) as a measure of the cost of funds in the system to actual effective lending rates. While the former have remained somewhat sticky (particularly for the non-public sector banks), actual effective lending rates have dropped sharply on the back of a sharp decline in sub-PLR lending rates.

Since the bulk of lending happens at rates that are below the prime rate, any discussion or analyses based on gauging changes in PLRs is fundamentally flawed. Let me quote an excerpt from the policy statement that should make my point clear.

The RBI says 'the changes in BPLR do not fully reflect the changes in the effective lending rates. Banks pointed out that lending rates should not be assessed only in terms of reduction in BPLRs since as much as three-quarters of lending is at rates below BPLR which includes lending to agriculture, export sector, and well-rated companies, including PSUs.

The weighted average lending rate, which was 11.9 per cent in 2006-07, increased to 12.3 per cent (provisional) in 2007-08... the average yield on advances, a proxy measure of effective lending rate, in 2008-09 was around 10.9 per cent.  As most of the commercial banks have cut their BPLRs in the second half of 2008-09, the effective lending rate towards the end of 2008-09 could be even lower than 10.9 per cent.'

In short, the complaint that despite aggressive action from the RBI, the transmission to lending rates has somehow failed is misplaced because it doesn't consider the right lending rates.

The cost of funds for a number of companies and consumers has dropped dramatically since the peak of October. Intense competition among banks and the threat of disintermediation (companies are raising funds directly from the market through commercial paper and other instruments) has driven this fall.

The economic slowdown has also meant a decline in the overall demand for credit. Companies are putting off capex plans, their working capital needs are lower and consumers are thinking twice before borrowing. The logic of demand and supply in the market for loans has entailed a fall in interest rates. This is not adequately reflected in the PLR.

This, however, does not mean that all companies that want money are getting it at the right price. The business environment has become extremely risky and banks are being extra careful in lending to sectors that are perceived to be badly affected by the business cycles.

These 'sub-prime' (from a risk perspective) borrowers are those that are being charged the higher and sticky prime rates while 'prime' customers can raise money at 'sub-prime' rates (an irony that this paper commented on in an editorial). In certain cases, banks are simply not willing to lend to some sectors.

Do banks need a rap on the knuckles then? Anyone who has learnt a lesson from the financial turmoil of the past two years would agree that banks are right in being conservative and the pressure on them to grow their balance sheets could lead to serious consequences in the long term.

The fact that the RBI did not go overboard in exhorting banks to lend suggests that the RBI too recognises and appreciates this risk.

Can the RBI do much else about this then? Unfortunately, the absence of a deep corporate bond market stands in the way of the monetary authority being able to do much for riskier borrowers.

A quick review of what the US and British central banks are doing in this regard is perhaps useful here. As part of their 'quantitative easing' programme, they are buying back riskier corporate bonds and releasing liquidity in exchange. As they do this, yields on these risky bonds drops and thus sets a lower benchmark for the rates that riskier companies can borrow at.

The shallowness of the corporate bond market in India precludes this kind of direct monetary intervention in risk-pricing. The only alternative, then, is to offer government guarantees for riskier loans. This is fiscal action and outside the RBI's and monetary policy's remit. The case for deepening the local bond market just keeps growing. 

Should the entire concept of PLRs be recast to make them more representative? I turn again to the problem of a shallow corporate bond market.

In the absence of actively traded debt paper for different risk categories, there is virtually no way to gauge the cost of borrowing for different borrower profiles. If PLRs were to actually reflect the borrowing cost of the 'prime borrowers' and banks were asked to disclose the average risk premium they add to these benchmark rates, the transparency of our credit markets would go up sharply.

It would also put to rest some of the needless controversy that has grown about banks profiteering from the economic crisis.

Why are banks unwilling to lower their PLRs? The answer lies in the fact that a number of the mandated 'concessional' rates for loans to the export and agriculture sector are linked to the PLR.

Thus a cut in PLR would automatically translate into a cut in these rates. Given their risk assessment of these sectors, banks might not however be interested in lowering rates. The only way to address this is by de-linking concessional rates to the PLR.

This, I hope, will figure right at the top of the list of priorities of the committee set up by the central bank that is trying to revamp the PLR.

The author is chief economist, HDFC Bank. The views here are personal.

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