India - Only the first step

It was a foregone conclusion that the public sector banks would heed the Finance Minister’s exhortation and lower the interest rates sooner rather than later. On Thursday the country’s biggest bank, State Bank of India, announced a 0.75 percentage point reduction in its prime lending rate, which now stands at 13 per cent. Other government-owned banks are expected to fall in line immediately and the Indian private banks and foreign banks a little later. Lower in terest rates were expected in the wake of a series of massive liquidity infusion measures undertaken by the RBI since mid-September. Domestic liquidity has been enhanced by as much as Rs.260,000 crore. Benchmark interest rates in the United States, Japan, and a few other countries have been brought down to historically low levels as policy makers strive hard to stave off recession. Again, as in India, central banks everywhere are keeping the financial system afloat through massive cash injections. But obviously ensuring liquidity is only one of the key tasks before policy makers. Equally important is to make sure that the funds available are deployed in the productive sectors so as to moderate the slowdown.

India experienced renewed pressures on domestic liquidity and hence on the banking system, as the global financial crisis intensified. To forestall sharp rupee depreciation in the wake of the exit by foreign institutional investors, the RBI has been selling dollars, thereby reducing rupee resources with banks. As pointed out by the SBI Chairman, global avenues for raising resources such as external commercial borrowings and foreign currency convertible bonds have dried up for domestic companies. This and the fact that tapping the capital market is hardly an option now have made them entirely dependent on banks. Despite all this, credit is expected to grow by a robust 30 per cent this year, matching the annual rate of growth over the past three years. Hence the pressure on liquidity, though moderated for now, is bound to increase over the medium term. Public sector banks need to overcome their risk aversion and earmark a portion of their credit to small and medium enterprises, agriculture, and other sectors that are likely to lose out if the overall banking system’s resources are squeezed. All banks will have to reckon with the fact that a slowing economy will spawn bad loans. They need to be given some latitude in providing increased credit — as they are being directed to do — as also in restructuring problem loans.