After pushing PSU oil companies to the sick bed by forcing them to bear part of the rising subsidy burden, notwithstanding the oil bonds, the government now seems all set to do an encore with the PSU banks.

In a clear attempt to achieve its economic growth targets, even at the cost of the financial health of the banking sector, the government has directed PSU banks to seek board approval for all decisions to hike lending rates. The directive issued by the finance ministry asks banks to keep rate hikes in abeyance till the matter is cleared by their respective director boards.

Most PSU banks had announced a hike in their benchmark prime lending rate (BPLR) this week following the end-July rate hike by the RBI. They include top three government banks - SBI, PNB and Bank of Baroda.

It is not yet clear if the banks would be asked to roll back the rate hikes announced this week. Some reports indicate that the missive from the ministry was sent before the banks announced the hikes. However, this is unlikely to be the case as no bank management would have dared to go against the instructions of the ministry.

It is likely that the government would veto any future decision on rate hikes through its nominees on the boards of these banks. Reports have quoted finance ministry officials talking about the need to consider the overall impact of such rate hikes on the economy.

Such a directive from the finance ministry makes sense if the banks are raising lending rates without a corresponding rise in deposit rates. If that was the case, banks could have been accused of profiteering by taking advantage of rising interest rates globally.

However, cost of funds for the banking industry has also been steadily going up. Interest rates on fixed deposits of one year and above are hovering near 8 per cent per annum. Even after raising deposit rates, most banks are still unable to attract enough funds to bring down their incremental credit-deposit ratio to less than one.

The finance minister has defended the initiative by stating that the government - as the majority shareholder - is within its right to ask the bank managements to seek board or in effect government approval on any rate hike decisions. So much for the government's espousal of PSU autonomy and minority shareholder protection.

Forcing banks the oil PSU way
After pushing PSU oil companies to the sick bed by forcing them to bear part of the rising subsidy burden - notwithstanding the oil bonds - the government now seems all set to do an encore with the PSU banks. If government banks are not allowed to raise interest rates to protect their spread, their financial condition would most definitely weaken.

When money is priced at artificially low rates, it would attract a lot of borrowers with low creditworthiness. Banks would be forced to lend to these customers as they have to ensure high credit growth to compensate for lower spread. In future, especially if the economy slows down, such advances may become sticky - adding to the woes of PSU banks.

To make it worse, such directives are coming when the banks need to shore up their capital base to meet Basel II norms. Most PSU banks need to raise long term resources in the form of tier-1 and tier-2 capital to meet the higher capital adequacy requirements coming into place by next year. If the financial performance of PSU banks takes a hit, they would be hard pressed to raise additional resources.

Rendering the RBI ineffective
Another concern is the ministry directive's impact on the effectiveness of RBI's policy measures. If banks are forced to keep lending rates artificially low, credit growth may accelerate and would push up inflation. This would blunt the effectiveness of RBI's own rate hikes in controlling inflation.

If inflationary pressures continue to rise because of easy liquidity, the RBI would be forced to keep increasing interest rates. The central bank may even have to consider accelerated rate hikes instead of small measured increases, if global interest rates also continue to rise. Such jolts can trigger a downswing in investment spending and cause an economic slowdown - something which the finance ministry is trying to avoid.

Newspaper reports mention that the RBI was kept unaware of the ministry directive to banks, for obvious reasons. Dr Reddy would not have been too please to be informed that his political masters have decided to make his life a lot more difficult.

Political pressures
The political pressures which have forced the finance ministry to come out with such a directive are obvious. The government has been at the receiving end, both from the opposition as well as its own allies, on the issue of price rise ever since it came to power. There is criticism even from within the ruling party that the government, which in this case means the finance ministry, is not doing enough to control rising prices.

The recent jump in prices of primary food articles has caused considerable heartburn in the ruling party. For want of a convenient scapegoat, they have blamed everything from the previous government - which lost power more than two years ago - to commodity futures trading.

The ruling party's political managers know quite well that economic management would become a major liability if there is any slowdown in the economy, especially since the government boasts of a dream team headed by the prime minister himself. Moderate price rises may be acceptable to the general population as long as the economic engine chugs along nicely. The finance minister seems to have succumbed to these pressures.