Mumbai: The government is comfortable with the Reserve Bank of India’s (RBI’s) suggested target of anchoring inflation at 4% in the medium term, within a band of 2%, said RBI governor Raghuram Rajan in a post-policy interaction with print media journalists. Rajan acknowledged that while some transmission of easier liquidity conditions has taken place in the markets, banks are still to bring down lending rates. Competitive pressure will goad banks to lower rates, he said. Rajan added RBI is looking at ways to give banks more leeway to convert loans into equity at the time of loan restructuring. Edited excerpts:

Was there pressure from the finance ministry to cut interest rates?

The word pressure is perhaps misused. I think there is a healthy dialogue that goes on and obviously the finance ministry internalizes the concerns about inflation and recognizes that we are entrusted with the task of controlling inflation and creating sustainable growth. So we are not combatants. We are on the same side. Sometimes they have different views and we try and persuade each other of those views. I think the finance minister has said publicly that ‘these are my views but ultimately the decision is the RBI’s’. We are very respectful of the views of the government and we try and accommodate the views to the extent we can, and then explain where we can’t and why we can’t. Its a very cordial relation on every facet.

Has the government accepted the 4% (+/-2%) inflation target?

The government is as much on the same page as far as the desirable levels of inflation as we are. We picked the 8% and 6% targets when the previous government hadn’t developed a view. This government has essentially reflected on that and there is a sense that 4% (+/-2%) is comfortable. The i’s have to be dotted and the t’s have to be crossed. But that then allows you to go from the glide path to that framework. My personal view of that 4% (+/-2%) range is that, if you take 4% inflation and you see that the industrial countries are at close to 2% and out productivity growth is about 2%. There is a famous theorem called the Balassa-Samuelson theorem which says that the real effective exchange rate should appreciate at the productivity differential between you and the rest of the world. So if we have 4% inflation, then our real effective exchange rate is appreciating at the rate consistent with the Balassa-Samuelson theory.

So if we don’t want a constantly depreciating rupee, 4% is about where we should be relative to the rest of the world. And then because we are entering a new process, the 2% band gives us room to deal with uncertainties.

In past cycles, we have seen that as interest rates start to come down and growth starts to pick up, inflation picks up relatively quickly. Given that, what kind of headroom do you think we have and what’s RBI’s assessment of a sustainable non-inflationary rate of growth?

There are two things here—one is the potential growth rate relative to the actual growth rate, the other is the potential level of production relative to the actual level of production. So if you have a sequence of periods with growth below potential, the level of actual production falls significantly below the potential. Neither is static. Potential can fall off if you have low growth for a sustained period because unused capacity can become unusable. So our sense is that at least for the next year, there is some spare capacity available as capacity utilization is low. But that doesn’t mean that we don’t have areas where if growth picks up quite quickly we could see price rises. But our sense at this stage is that we don’t think it will be across the board. As growth reaches the 7% levels, it comes closer to or above our current potential. At that point, we will need to be a little careful because the output gap will narrow. Then we need to worry about whether it starts feeding into inflation. But I think we have some time before that.

Do you expect banks to take the signal and cut rates?

I think over time if banks find that deposit flows are higher and the outflow on credit is not, there is pressure on them to cut lending rates.

Thus far we have not seen a substantial pass-through of softening of interest rates into bank lending rates. I saw the SBI (State Bank of India) chairman say that some transmission has taken place, but in conversation with bankers, including the SBI chairman, our sense is that there hasn’t been substantial transmission.

Isn’t that a problem? The pace of adjustment of bank lending rates when rates are coming down has been slow—both under the prime lending rate system and the new base rate system.

The real point is that as they find that, demand for loans is not picking up, because corporates are preferring to go to the market because of cheaper rates, banks will have to cut rates. So whether they reduce the base rate or they do selective adjustments, they will have to figure out. It’s cleaner to adjust the base rate.

We can certainly take a look at whether the base rate system is being adhered to, I would like them to feel the competitive forces. We can’t micromanage the lending process too much. That doesn’t mean we won’t look at whether the process is being followed and we are doing that.

Will the fact that banks have not cut rates also impact credit growth?

I think the sequence will not be driven by lower interest rates, it will be helped by lower interest rates. What is keeping corporates from investing today is not the short-term cost of money. Really investment intentions will change when people are confident for the longer term. If inflation starts to come down, most corporates will have the view that interest rates will come down. I don’t think anyone believes that the RBI wants to hold up interest rates just for the sake of holding up interest rates. So I think there is confidence that rates will come down. The real issue is whether there is confidence of investment prospects and that they will make substantial progress on those investments. That requires two things—confidence on the nature of demand and that policies will be business-friendly and the new government has assured that policies will be investor-friendly.

So at this point in time, I don’t want to rule out the cost of money as one of the factors in determining investment, but it’s not the primary factor. Where interest costs bite more is for the highly leveraged firms. For them, an immediate reduction in interest rates would reduce their outflow.

You have mentioned that there will be some relaxation in banks being allowed to convert loans to equity. What are the relaxations you are planning?

In May of last year, because of concerns over the price at which some of these loans were converted, we had limited the extent of the conversion to equity to about 10% of the shares of the company. Given arguments by banks that this limits the upside if the project turns around, we have looked at this argument a little more sympathetically. The key issue is can we agree on a price range that can make the RBI feel comfortable that it is protecting the banks, while also giving Sebi (Securities and Exchange Board of India) comfort that it’s protecting the minority investors. That’s where the discussion is and something will be announced shortly.

You have highlighted the issue of wilful defaulters a number of times. Does RBI have a clear sense of what proportion of loans fall under the ‘wilful default’ category?

I don’t think that the number, if you put together the frauds and the wilful defaulters, will be huge. It’s big, depending on what you call big, but I would doubt that it would extend into the lakhs of crore. I think it would be more in the tens of thousands of crore. That in itself is a big number, but it’s not the central number that’s responsible for the weakness in the banking sector in terms of stressed assets. The real stress is coming from economically stressed assets rather than wilful default.

The reason I stress wilful default is that it delegitimizes the system when wilful defaulters can get away, frauds can get away without being pursued. So we need to pursue those and ensure that nobody is above the law.

In a recent speech, you had said the slow judicial process is one of the reasons why recoveries of bad loans are low. Going forward, what would you like to see? An entirely different bankruptcy law?

I do believe that in a situation where we are collecting 13% of the outstanding in a year, we are not collecting enough. The loss-given returns that banks have to internalize are considerable, which is why they may do deals outside the DRT (debt recovery tribunal) process and suffer losses which they otherwise may not if there were better processes. The government has said they will set up more DRTs and give them more facilities. That’s something we are fully supportive of. I am not sure we need a different law. The current law, if it’s made to work faster without frequent stays and many appeals, I think we could be quite effective. We don’t need a more draconian law than the Sarfaesi (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest) Act, which is quite a tough act, if implemented.

We do need an overall bankruptcy court to ensure we have a more orderly resolution system. What the corporate debt restructuring process is doing for the banks, we need to have something for claims of all the creditors including bond holders. A bankruptcy law would be very good for the bond markets. The government has a committee looking at a new bankruptcy law. I hope we do get a bankruptcy law quickly but in the meantime, improving the functioning of the DRTs and speeding them up, is the single most important thing.

A number of global currencies have fallen sharply but the Indian rupee has been steady. What is your view?

To some extent, we are more stable because people perceive India as a good destination now and we have had substantial capital flows. Our view is that we cannot substantially affect the long-term value of the rupee through intervention but we have some ability to reduce volatility. But we have to be careful. Too much stability also creates a feeling within corporates that we don’t need to hedge and the RBI will get their back when push comes to shove. But our main focus is to ensure that we don’t have too much short-term volatility while allowing the adjustment in directions consistent with the fundamentals. So what does that mean? When substantial flows come over short periods and we are not confident that those flows are longer term, we buy dollars in the market so that we have some reserves for when those flows go out. But if it’s coming in steadily over a period of time, we are more comfortable.

Why was the 20:80 rule for gold imports eased?

I think we have said in the past that over time when the currency volatility that we experienced last summer eases, some of these restrictions will be withdrawn. So for example we eased the rules under the liberalized remittance scheme. On the issue of gold, there was a healthy debate which is why it took time. One of the opinions was that we are in a much better position, the current account deficit is much lower now and that there were some distortions being created because of these restrictions. Some parties were taking advantage of it while others were obeying the rules of the game. We have always seen that with any quantitative restriction, non-transparent practices emerge. There was one school which said let’s do away with it. There was another school which was more cautious, which said this seems to have worked, let us gain more confidence. Final decision was let’s do it now.

Do you see the fall in oil prices as a transient phenomenon?

Depends on what framework you are looking at. If you look at it on a three-five year framework, it is transient. Because ultimately demand will start picking up once again and supply will get stretched, specially if supply goes out. If part of what is going in is predatory pricing, you want to lock some investors out of the office. If we are talking about 10-15 year investment horizons, we have to see how effective will that predatory pricing be or will the shale gas producers say—this will also pass?

I think in the foreseeable future, we will have some moderation but eventually it will turn. So as far as policy goes, absent geopolitical shocks which are hard to specify, I think we will see some moderation in oil prices over the next year or so.

What are the risks that you see on the external front?

I would say that a few months ago the biggest external risk was on capital flows. Now I would say the biggest risk is that the weak growth in industrial economies is having a dampening effect on export growth. That said, latest PMI (Purchasing Managers Index) data showed that orders are holding up. So it’s too early to get overly worried but the trend in exports has been easing downward. Slow growth will imply that monetary policy outside will stay easy for a longer period. Also the uneven growth implies that the United States may be a little hesitant to start raising interest rates given the effect on the dollar. That’s why I think the emphasis has shifted from capital flows which would have reacted to policy tightening outside to growth.

There is a divergence between what the US is doing and what Europe and Japan are doing. How does that impact policy here?

The divergence may not be entirely bad for us. To the extent it reflects differential growth, yes, it would be great if everyone was growing. But if we are to exit, then exiting in a steady way where first one country exits and then the next, may be an easier way to exit compared to everyone exiting at the same time. So given the massive quantitative easing that has already happened in Japan and the likelihood of some action by the ECB (European Central Bank), as and when the US does raise rates, there will still be plenty of capital looking for a home. And that’s why my sense is that after a period of initial volatility, after that interest rate hike eventually happens, investors will start discriminating among economies. And if all goes well and we continue on the path we are on, India should look relatively good compared to other economies, and we will see some stabilization of flows.

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