EASY MONEY, BAD LOANS

The deterioration in the overall asset quality of banks — gross non-performing assets (NPAs) are reportedly 27% higher at the end of December 2009 than at the end of December 2008 — is not surprising. Any slowdown in growth is bound to trigger a rise in NPAs as more and more companies default on loan repayments.


The effect would be pronounced when the slowdown coincides with a severe global recession. But for the restructuring of loans permitted by the Reserve Bank of India (RBI) on fairly generous terms, NPAs would have been still higher. Prudent banks that took care while sanctioning loans and then monitored the post-sanction disbursement diligently should be able to weather the crisis .


But it is one thing to have NPAs rise because of a cyclical downturn, it is quite another to have NPAs rise because of policy errors that are entirely within the realm of policymakers. And this is what we need to guard against. Excessively low interest rates skew the risk-reward equation by making projects that are actually not viable appear viable — till interest rates reverse and the same projects cease to be viable!


It is now well established that long periods of unduly low interest rates encourage banks to take more risks. A low interest rate regime driven by an easy money policy rather than macroeconomic fundamentals leads to excessive expansion of credit. It incentivises banks to take on more risk in search of higher returns and to misprice risk.

 

Central banks everywhere need to be on guard against this. The People's Bank of China has woken up to this danger and begun reversing its excessively-accommodating stance. The RBI has not. Its challenge is to try and separate cyclical accommodation, which is needed, from interest rates that are lower than what macroeconomic fundamentals warrant.


Analytically, this separation is easy; not so in policy articulation. Its challenge will be to continue with cyclical accommodation while making it amply clear that interest rates will not stay lower than warranted, once the cycle turns.