RBI policy: Cautious but far-reaching

Tuesday was Reserve Bank of India Governor D Subbarao's third scheduled monetary and credit policy announcement.

In the previous two, last October and January, he chose to maintain the then status quo. Of course, there was plenty of action on both rates and the cash reserve ratio in between the scheduled announcements.

This time, the RBI has chosen to go by the book and used the scheduled date to reduce both the repo rate (at which the RBI lends money to banks) and the reverse repo rate (which it pays them for their deposits with it).

The RBI's assessment of the economy, presented as a prelude to the policy announcement, was relatively downbeat. Conceding the persistence of a hostile global environment and domestic weakness, the RBI expects GDP growth during 2009-10 to be 6 per cent. This is slightly higher than the 5.7 per cent that reflects the median of its external forecasters' survey.

This is in sharp contrast to the outlook presented by the Prime Minister's Economic Advisory Council, which expects growth to be 7 per cent, but the Council has been shown to be excessively optimistic in its forecasts since mid-2008.

Be that as it may, the RBI's policy should be consistent with its own assessment. This is where the 25 basis point cut appears to be somewhat inconsistent.

If the outlook is so grim and the current state of affairs as reflected in both growth and inflation so amenable to strong policy action, the action itself could have been more assertive, by way of a 50 basis point or even a 100 basis point cut in the benchmark rates.

Perhaps Dr Subbarao's penchant for unscheduled moves will come back into play and further cuts will be made in response to new macro-economic data. But there is concern that this cautious approach may end up once again being a case of too little, too late.

An important banking issue addressed on Monday is the problem with the benchmark prime lending rate.

This is supposed to reflect the rate that the banks charge their most creditworthy borrowers. In reality, it is kept at an unjustifiably high level, with much lending (almost two-thirds, by some estimates) taking place at below the prime rate.

In a way, this practice allows banks to discriminate between more and less creditworthy borrowers. In effect, the 'prime; lending rate is actually charged to 'sub-prime' borrowers! Unfortunately, the differentiation is opaque, which can lead to arbitrariness and a mis-alignment between actual risks and rates charged.

The RBI has set up a committee to make recommendations on this issue. The goal will be to restore the prime rate to its appropriate status, with risk-based pricing being done in the form of add-ons to the prime.

Of course, this cannot be applied to existing loan contracts that are formally priced off the prime; a sharp lowering of the prime would cause these contracts to be re-priced without any change in the risk profiles of the borrowers.

The recommended change would have to be implemented for new contracts only. But, assuming a proper transition process is put in place, this will be a significant and welcome change in banking practice.

Similarly, the policy also contains a number of references to issues such as financial inclusion, a critical item on a long-term financial sector reform agenda.

The one unsurprising announcement was the maintenance of the status quo on foreign banks, which are nobody's favourite category in these trying times.