Solution 2Q. 1 What is selective credit control? How RBI has used this tool in the recent past
In India, selective credit control means control over advances against the security of "sensitive commodities'' such as foodgrains, oilseeds and sugar. There has been considerable misunderstanding about the purpose of SCC, whose objective is not to fight inflation. The RBI should not hesitate to wield the instrument, unconstrained by wrong notions that direct control is inherently bad, says A. Seshan.
SOME attribute the current inflation trend to cost-push factors, mainly a result of the rise in oil prices. There is the implied suggestion that monetary policy cannot do much about the problem. One has to reckon with all factors before devising a strategy.
The country has been swimming in liquidity for quite some time as indicated by the large amounts of the central bank's repo transactions. This is despite the massive open market operations employed by the Reserve Bank of India (RBI) to sterilise forex inflows.
Studies show that, in India, money supply makes an impact on prices after 15-18 months. The current situation is further aggravated by the revival of demand for bank credit by the manufacturing sector. It has resulted in a fall in the amount of repo transactions and also a part of government borrowing devolving on the central bank.
In the recent years, the central bank has shifted its emphasis to the interest rate instrument from money supply.
It has largely left the exchange rate to the market forces except for occasional forays to check volatility. It has also realised that it is conceptually impossible to try to determine interest rate, money supply and exchange rate at the same time.
Only one of them could be manipulated at one time, the remaining two being its corollaries. Trying to administratively fix two or three variables will make the system over-determined and, hence, the result will be indeterminate. It is like trying to stand on three stools.
A rise in interest rates is quite appropriate under the circumstances. Besides, its usefulness in curbing excess demand, especially under inflationary conditions marked by a rise in commodity prices, it would also provide the much-needed relief to fixed-income savers who have been hit severely hard in the last two years.
Another weapon is selective credit control (SCC) on advances by banks against the hypothecation or mortgage of sensitive commodities such as rice, wheat, oilseeds, etc. It is out of fashion now. But it is really not dead if one uses the term in the internationally-accepted sense.
Throughout the world it is understood to mean the central bank trying to promote credit flow through desired channels or prevent its flow in undesirable channels. In the US, it is mainly used to control stock advances to curb speculation in the market.
In the correct sense, we still have SCC in India in the form of stipulation on priority advances and numerous other directives bearing on the directions through which credit is either encouraged or discouraged to flow.
But, historically, SCC has come to mean in India, control on advances against the security of what are identified as "sensitive commodities'' such as foodgrains, oilseeds, sugar, etc. They are sensitive because of their substantial weights in the index of wholesale or consumer prices.
The SCC directives are issued under the powers vested in the RBI in the Banking Regulation Act unlike other monetary instruments mentioned in the Reserve Bank of India Act. There has been considerable misunderstanding about the purpose of SCC.
The objective is not to fight inflation. Unfortunately, the latest edition of the Functions and Working of the Reserve Bank of India, published by the central bank, contains a factual error perpetuating this myth.
The correct position is stated in the Bank's Handbook on Selective Credit Control published in the late 1970s. (Incidentally, it was a sell-out. Forty thousand copies were sold in two editions mainly to banks — a record for any RBI publication.
Earlier, the record was held by the Tandon Committee Report selling 10,000 copies.) There are direct and indirect instruments other than SCC in the armoury of the central bank for dealing with inflation.
SCC is limited to the aim of curbing the use of bank credit for the speculative holding of commodities. Before the advent of social control and the subsequent nationalisation of banks, advances to traders against the security of commodities constituted the bulk of bank credit.
In fact, the concepts of busy and slack seasons in banking transactions had their origin at a time when the ebb and flow of agricultural seasons determined those of bank credit and deposits.
It was easy for the bank manager to issue credit to traders as it did not call for any sophisticated approach such as project appraisal, cash flow statements, etc., as in the case of agricultural and manufacturing production credit.
Thanks to the social reorientation of commercial banking policies and substantial training facilities, bankers have come to realise the importance of the new concepts and the credit flow to traders has come down as a percentage of the total, even as agricultural, manufacturing and other advances has gone up.
However, in the recent period, the banking system has had a problem of inadequate demand for credit either because of non-performing assets or the direct approach of the manufacturers to the market with a consequent disintermediation.
In such a situation, the banker can deploy his funds in government securities as he has done.
The bank investments in government securities are far above the stipulated minimum of 25 per cent of net demand and time liabilities. The other option is to utilise the funds in financing trade, a familiar field. There is nothing wrong in this practice. Trade — wholesale or retail — also needs credit to facilitate the smooth functioning of the economy and the oiling of the transactions, adding value in terms of time and space. In fact, retail trade is part of the priority sectors.
However, any large-scale access to bank credit by wholesale traders or processors of agricultural commodities (rice mills, oil mills, etc.) out of sync with earlier trends should raise a cautionary signal for the central bank.
From this writer's experience with the SCC policy desk, he can cite the example, inter alia, of the vegetable oil mills in Gujarat closing rather early in the season, despite the availability of stocks for crushing, if there is a failure of monsoon in Saurashtra, which accounts for one-third of groundnut production in the country.
The idea is clear. It is to hoard the nuts for a more propitious time to crush when edible oil prices would rise. Bank credit being less expensive, especially in a regime of low interest rates, than private sources for borrowing, the average trader would turn to it first. SCC could deal with such a situation.
It is not as if the trader does not have other sources of finance, either his own or of moneylenders. But the easy route was closed when the minimum margin was kept as high as 75 per cent at the height of edible oil crisis in the mid-1970s. To that extent, there was some curb on speculative tendencies as the traders had to expect prices to rise even more in the absence of bank credit for making a tidy profit.
The RBI will do well to look at the most recent data collected on commodity advances in Basic Statistical Return 3 and look for any signs of accelerated lendings. Thanks to the media, traders are well acquainted with the economics of demand and supply, geographical distribution of rainfall and its impact on different commodities, the level of foodgrain reserves, etc., to make their own calculations on speculative gains.
The RBI should not hesitate to wield SCC unconstrained by wrong notions popularised by Western economists that direct control is inherently bad. No one hears in the US of any trader hoarding agricultural commodities with the help of bank credit. But we do.