In the last few weeks, the RBI finally forced the banking sector to recognise the piles of nonperforming assets (NPAs) on its balance-sheets — an important first step towards cleaning up the system and stopping blatant misbehaviour by rogue entrepreneurs.

Nonetheless, there is a danger that the financial system may gridlock while this operation is being carried out. The central government and the RBI need to urgently coordinate policy to avoid a potentially dangerous downward spiral.

The cleaning up of the banking system has long been governor Raghuram Rajan’s crusade and he should be supported in this. However, the economy is an interlinked ecosystem and, with investment and lending already weak, it is likely that many well-managed companies will also be hurt by the resulting squeeze.

Capital the Lifeblood
In turn, this could further slow investment and the circulation of money. Broad money supply and credit growth are currently running at a moderate 11% year-on-year. But a disruption of the transmission mechanism could cause it to drop sharply.

In such a situation, the NPAs would keep rising and the government’s attempts to recapitalise banks would always be inadequate and behind the curve. Japan and much of the West have discovered what happens once the transmission mechanism stalls. Even an interest rate of zero may not reinflate a gridlocked system. So what needs to be done?

The first thing that needs to be done is to proactively make capital cheaper and easily available so that the rest of the economy keeps running even as NPAs are identified and processed. One cannot shut off blood supply to the brain while carrying out surgery on the liver.

At the very least, this means that the central bank needs to drastically reduce interest rates, say, by another 100-150 bps. The RBI governor has remained cautious about monetary easing on grounds that consumer price inflation is still running at 5.7%.

But this is being driven by food prices even as wholesale price inflation has been in negative territory for months. Surely, the central bank does not believe that interest rates are an effective way to control food prices.

Meanwhile, industrial production declined for the second consecutive month in December. Capital goods production fell 20% year-on-year. There are several additional things that the RBI can do in order to ease liquidity conditions.

The yield on 10-year government bonds has barely declined by 10 bps over the last year despite a 100-bps reduction in the policy rate. The RBI effectively sets this yield through its open-market operations and has inexplicably decided to undo the transmission of its own monetary policy decisions.

If the yields on government bonds were allowed to decline, it would have two important benefits. First, it would give banks breathing space by triggering an appreciation of their bond portfolios. Second, it would provide space for fiscal expansion.

Interest costs consume about half of the Centre’s net tax receipts and a lower cost of borrowing is essential for faster public investment in infrastructure. Given the sheer scale of borrowing, even a small reduction in interest rates is equivalent to a major reform in some other area.

It must be stated that the government is not blameless. It administers interest rates on small savings schemes and provident funds. By refusing to cut rates on these schemes, it distorts deposit rates in the banking system and gets in the way of an overall lowering of the cost of capital.

Provident, But Prudent
Far from lowering it, the government recently increased the rate on the Employees’ Provident Fund to 8.8%. The government should, instead, link the rates on these schemes to the RBI’s policy benchmark, so that it goes up and down along with the overall monetary stance.

The government may think that it would be politically unpopular to reduce the returns on the schemes. My response would be: first, there is a trade-off here between creating more employment for future savers and providing higher returns to existing savers. Given India’s demographics, the former should be the priority. Second, the provident funds are so user-unfriendly that many people think of them as taxes rather than savings. (This is why there are so many inoperative and unclaimed accounts.)

From personal experience, I can say that the average citizen would not mind a somewhat lower rate if the system is made more flexible and user-friendly. To be fair, this government has been trying to clean up procedures but it is not yet clear how far it has succeeded.

Latest readings of economic indicators suggest that the world is at the risk of entering another recession, or at least a period of very anaemic growth. This is already hurting our exports. But India also has the opportunity to take advantage of cheap capital and commodities.

A jammed domestic financial system, however, will not be able to tap or allocate cheap global capital. Moreover, as other countries are discovering, it is very difficult to get things moving once the financial system is already gridlocked.