Thursday, August 21, 2008

RBI proposes, Finance ministry disposes?

The RBI wants to bring down growth in banks' commercial credit in a bid to slow down growth in money supply. Money supply has been growing at over 20% against the RBI's target of 16.5-17%. The RBI has raised interest rates but commercial credit has been growing at 24-25%, against the RBI's target growth of 20%.

Many think this is because public sector banks have not been aggressive enough in raising their lending rates, thanks to interference from the finance ministry. The ministry, they say, wants to sustain growth and it wants to keep home loan borrowers happy as elections loom, so it gets PSBs to refrain from raising rates as much as they should.

I am not so sure. I examine this whole issue in my ET column, Is finmin foiling RBI? and find that there isn't a strong enough case for this view.

There are just a couple of points I would like to add. One, the finance minister asking banks not to hike rates on home loans of upto Rs 30 lakh is not such a bad thing. A rise in home loan rates, as I mention in my column, may push many borrowers into default. Also, a sharp drop in home loan demand will affect a whole range of industrial sectors to which banks are exposed. So, in trying to extract better returns on home loans, banks may end up shooting themselves in the foot where corporate borrowers are concerned.

It is in the collective interest of banks not to raise home loans. But no bank on its own has the incentive to maintain home loan rates on its own- some other bank will then try to produce better returns by raising interest rates. In other words, we have what is called a "coordination failure". For the ministry to step in and provide coordination is appropriate.

The second point is that commercial credit growth is one element in high growth of money supply. A more difficult problem is the rise in forex reserves. There isn't much the RBI is able to do about this, so we can't expect a deceleration in commercial credit alone to bring down the inflation rate.

1 comment:

apurv said...

could you please explain how forex reserves affect inflation

regards
apurv