Mumbai: The Reserve Bank of India's (RBI) prime function as a central bank is to control the monetary situation of the country and to ensure that bank credit is delivered to the various sectors of the economy at the appropriate quantum and price.

This is done through the mechanism of an annual monetary and credit policy, which is announced in April every year. The policy for the year 2003-04 was announced on 29 April and one needs to look at the policy to see what it forbears for the economy.

There have been two major announcements in the policy - a 0.25-per cent cut in the bank rate to bring it to 6 per cent and a 0.25-per cent cut in the cash reserve ratio (CRR) to bring it to 4 per cent. These two announcements, along with various other measures, are meant to ensure that the gross domestic product (GDP) growth attained will be 6 per cent and that inflation will be contained at the level of 5-5.5 per cent.

The bank rate is the interest rate at which commercial banks borrow from the RBI - a lender of the last resort. Based on this bank rate, commercial banks decide the rate at which they will lend to their borrowers. A cut in the bank rate, therefore, will spur commercial banks to reduce their lending rates - although it is not mandatory for the commercial banks to reduce their rates.

With the reduction in the lending rates, the cost of production or service comes down and more businesses will approach banks for credit leading to economic growth.

The CRR is the cash balance all banks maintain with the RBI. This balance is maintained to ensure that banks have a minimum amount of cash in hand to cater to its withdrawing customers. On a reduction of the CRR, banks have more funds in their kitty to lend to the customers.

These are the positive aspects of the cuts. The negative aspects are that a rate cut may result in lower deposit rates and a CRR cut could trigger inflationary pressures. Depositors, particularly senior citizens, are mainly dependent on fixed income instruments on their livelihood and a rate cut will find their income eroding.

Inflation remains an issue
Inflation, which was fairly under control until recently, appeared to be raising its ugly head in the last year and particularly in the recent weeks when the inflation rate crossed 6 per cent. RBI Governor Dr Bimal Jalan has admitted that inflation is a matter of concern. However, he said there is no cause for worry if we look at the composition of inflation, and if we take out petroleum, edible oils and mineral oils, the core inflation will be around 2.5 per cent.

His words can be assuring as with the end of war, oil prices are expected to dip and the central government had announced tax concessions to the edible oil industry a day after the policy was announced.

Another significant policy announcement was on the fixing of the prime-lending rate (PLR). Banks today quote multiple PLRs depending on the tenure of the loan, which depends on whether the loan is short-, medium- or long-term. This does not appear transparent to the borrower and also does not help when comparing the rates of one bank with another.

Banks have now been asked to fix a single benchmark PLR. While fixing PLR, banks have to take into account their actual cost of funds, operating expenses and a minimum margin to cover regulatory requirement of provisioning or capital charge and a profit margin. The PLRs should also have the approval of the banks' boards.

On the credit side, the RBI has raised the financing limits for agriculture and small-scale industries, which are in the priority sector. A welcome step is the classification of housing loans. From now on, housing loans up to Rs 10 lakh will come under the purview of priority sector lending.

Recognising the contribution of services in the economy and the potential for their future growth, the RBI has now permitted banks to increase in their composition of unsecured loans. This means that the services industry can now have access to bank funds, a facility they could not avail earlier.

Forex looks rosy
On the foreign exchange front, the RBI has noted that India's forex at present is more than comfortable. To stem the sudden outflow of foreign exchange, the minimum tenure of non-resident external accounts has been raised from six months to one year. The bank has also warned corporates holding foreign exchange that their holdings are unhedged.

The unhedged positions are due to the expectation that the rupee will keep on appreciating against the dollar. The RBI added that movements in respect of market rates may not be unidirectional and the corporates may run into disadvantage due to their unhedged positions.

While announcing the policy, Jalan had at the outset declared that the policy was framed keeping in view the present uncertain ground realities. The governor has approached the issues with cautious optimism and is clearly looking at a six-month timeline after which the policy will be reviewed. He has said that the policy stance may have to be reviewed even earlier should demand pressures emerge and the inflationary situation worsen.

A bank has tqo constantly hedge its bets. This time the central bank is hedging its bets against, using the governor's words, "the spatial distribution of the monsoons and the geopolitical situation." In other words, the bank is hedging its bets against the rain gods, the Sars virus and the George Bush virus.