In a downturn, companies suffer negative shocks. Sales do not materialise, and output prices are weak. Some firms, therefore, are threatened in a downturn. But in a well-functioning economy, fundamentally well-run firms should obtain that breath of life of an infusion of debt or equity capital, which makes it possible to tide over these bad times. In this downturn, then, the most important story is that of financing going into good companies. External financing must be discriminating: it must not be given out mindlessly to all companies. And external financing must be timely and come in adequate quantities. If these conditions are met, then the financial sector will have done its job in helping the economy cope with the downturn. And that’s why, of course, tomorrow’s monetary policy review is so crucial. One element which determines how external financing will shape up is the central bank. By setting the short-term rate to low levels, RBI can make short-term riskless financing cheap. The short rate, that is the rate for 90-day treasuries, has dropped considerably: from 9% in September 2008 to a little over 4% today. This is a decline of roughly 500 basis points. Such rapid action by RBI was not expected by the private sector, and the RBI has gained new respect in the eyes of the economy for having been able to analyse problems and respond to events rapidly.
But RBI does not directly deliver external financing to corporations. It only gives out wholesale financing to a few financial firms. The real difficulties lie in the corporate sector. RBI is making the raw material cheap. But a properly functioning financial system is required to consume this raw material and turn it into ample and inexpensive financing for corporations (both debt and equity). While the riskless rate dropped by 500 basis points, the best borrowers (the AAA companies) have benefited by only 250 basis points. The story is much worse when we go beyond this handful of AAA corporations. Bank credit growth has distinctly started decelerating. This reflects a combination of supply and demand factors. But a good part of this is surely about the peculiar incentives and compulsions of banks, which do not find it profitable to take money from RBI at 4% and give it out to companies at above 12.25% (the SBI PLR). As has been repeatedly emphasised by this newspaper, the problem lies in the faulty ‘monetary policy transmission’. When we see central banks like the US Federal Reserve or the Bank of England change the policy rate, we are used to a far-reaching impact of these rate changes all across the US and UK economies. But we do wrong to transfer this intuition into India. With a malfunctioning financial system, the good work of dropping the policy rate is not reaching out and alleviating credit constraints across the economy.
So, sure, in the coming credit policy announcement, RBI can and should cut the policy rate further and sharply. Inflationary expectations are very low, and the policy rate should not be above 1% in real terms. But the credit policy must not stop there. The real challenge lies in coming to grips with the financial sector reforms so as to achieve a properly functioning monetary policy transmission in order to convert cheap money at the short end for riskless borrowing into lowered cost of capital for equity and debt capital all across the economy. This requires going after the host of issues that are usually ignored in monetary policy discussions. One immediate element is shifting administered interest rates to floating rates that are automatically linked to the interest rate on 364-day treasury bills. But going beyond that, why are banks so comfortable with where they stand? The lack of competition in banking is surely one important factor that is giving them this comfort. This needs to be addressed by deregulating interest rates on demand deposits, eliminating branch licensing for domestic and foreign banks and giving money market mutual funds access to the cheque clearing system.
Why does the transmission mechanism not work? This requires removing the five artificial restrictions that RBI has put in to hold back the currency futures market, removing the restrictions against currency derivatives arbitrage that have been imposed by RBI, removing the ban against interest rate derivatives trading, removing the ban against trading of credit default swaps on exchanges, removing the biases in banking regulation which favour OTC contracts (such as loans or currency forwards) and disfavour transparent contracts (such as corporate bonds or currency futures), and creating a unified mechanism through which shares, corporate bonds or government bonds can be borrowed for the purpose of short selling. Admittedly, this is a long list of reforms. But it is long because of long periods of inactivity. A start has to be made. What better time than when India needs monetary policy to really work?