As I write this, the Reserve Bank of India governor, Bimal Jalan, has just released the monetary and credit policy for 2003-04. The policy document contains a number of measures to facilitate the smooth functioning of the entire financial sector. But, the key features that affect the entire economy in a big way relate to policy changes relevant to the flow of credit and the structure of interest rates. Jalan announced two major policy changes of this nature — the bank rate has been lowered from 6.25 per cent to 6 per cent, while the banks’ cash reserve ratio has also been lowered to 4.5 per cent.

The bank rate and the CRR are two major policy instruments through which the RBI tries to influence the volume of credit in the economy. The bank rate is the rate at which commercial banks can borrow from the RBI, while the CRR stipulates the fraction of deposits that the commercial banks have to maintain as minimum reserves with the central bank. A reduction in the bank rate lowers the cost of borrowing for commercial banks and so encourages them to increase the supply of credit to the economy. Often, a lower bank rate also translates to a lower interest structure, with banks reducing both lending and deposit rates. Similarly, a lower CRR also increases the availability of credit in the economy.

One newspaper reported that the RBI has taken these steps in order to ensure that the Central government does not face any major obstacles in fulfilling its borrowing programme. Indeed, if the economy actually moves to a lower interest rate structure, this would also mean that the government’s cost of borrowing would be that much lower. This would be a tremendous boon to the Central government (and to state governments too) since debt servicing is an increasingly heavy burden for them.

However, although the Central government is the most important economic agent in the economy, the actions of the central bank of the country must be justified by how these affect the overall economy, and not just the fortunes of the central bank. After all, that is why it is so important to preserve at least a modicum of autonomy for the central bank — it cannot be a wing of the finance ministry.

Is an increase in the availability of credit and possibly at lower rates of interest, good for the overall economy, given the prevailing conditions today? Obviously, that depends on whether Jalan and the RBI believe that the extra credit availability will stimulate growth. For this to happen, there must be adequate demand for credit in the economy so that the availability of credit in the absence of these policy changes would act as a constraining factor preventing entrepreneurs from carrying out their investment plans, or households from financing spending decisions. On the other hand, if credit is not in short supply, then increases in credit availability cannot have any appreciable impact on rates of growth.

The Central government does seem to have an insatiable demand for credit to finance its deficits, and there is always the danger that government borrowings may “crowd out” private entrepreneurs’ borrowings. In other words, the private sector may find it hard to finance its spending programmes because the government takes up a large fraction of the overall supply of credit. If this is a correct description of the current economic situation, then the policy changes announced by the RBI make sense.

Of course, the demand for credit from the private sector and indeed whether there is any danger of crowding out depends on whether entrepreneurs are eager to carry out new investment projects. During times of sluggish economic activity, entrepreneurs are likely to be unenthusiastic about undertaking new investment projects. Of course, expectations also play a major role. Even if the economy is at a low level of activity perhaps because of some temporary adverse phenomena, entrepreneurs may still feel optimistic about the future, and so be eager to expand capacity or branch out into new activities. This implies that expectations about future rates of growth may be an important determinant of the demand for credit.

There are different projections about the future growth path of the economy. The RBI itself is rather bullish about the short-term prospects of the economy. Roughly a week before releasing the monetary and credit policy, Jalan announced that the economy was likely to grow at 6 per cent during this fiscal year. This is based on the meteorological office’s prediction that the monsoon rains during June-September will be 96 per cent of the normal amount. The RBI seems to believe that a reasonably good monsoon and the consequent revival of agriculture will ensure a satisfactory rate of growth. Other projections are more pessimistic, and contend that much depends on how the global economy adjusts after the United States of America’s invasion of Iraq.

If the more pessimistic projections are correct, then the greater availability of credit will not be of much productive use. Some critics have gone to the other extreme and suggested that the easier availability of credit may actually exacerbate the inflationary pressures in the economy. However, Jalan feels that these dangers have been exaggerated. According to him, the current high rate of inflation is due to the sharp rise in prices of a few items such as edible oils and petroleum products.

Once petroleum prices settle down to levels prevailing before the onset of hostilities in Iraq and if the monsoon brings down edible oil prices, then the level of inflation will cease to be much of an issue. It should also be kept in mind that the economy is far from being overheated, and so easier availability of credit is unlikely to have any significant impact on prices.

The RBI governor also hinted that interest rates were unlikely to fall much further. This is likely to be scant consolation to pensioners and others who are dependent on interest incomes — they feel that deposit rates are already too low. If the rate of inflation cannot be brought down, then these views become more persuasive since real rates of return are dangerously low. But, with elections just round the corner, can government largesse be very far away?