The interest rate wish

By C. R. L. Narasimhan

Maintaining a desired level of interest rate is a perennially favoured topic, more so at budget time even though few seem to know what the correct levels are. At present the topic has come into sharp focus for two reasons: (i) On Friday evening the Reserve Bank of India cut the Bank Rate by 50 basis points to 7.5 per cent from 8 per cent. Simultaneously, a two stage reduction in the cash reserve ratio (CRR) to 8 per cent from 8.5 per cent was announced. (ii) There has been intense speculation over an imminent interest rate cut on Public Provident Fund and deposits of the National Savings Organisation. According to reports, the Prime Minister's economic advisers had recommended that course as part of a comprehensive ``reforms programme''.

The two interest rates fall into different categories. A rate reduction in PPF and the like is basically a lowering of the last of the administered rates. The distinction is important because almost every other interest rate has now been decontrolled meaning that they are now set by the market rather than by administrative fiats.

The RBI action on Friday is a powerful signalling device but tangible news on the interest rate front will start coming in only when banks begin reducing their rates.

As in every major economic decision there will be pluses and minuses and winners and losers.But with barely ten days to go for the Union Budget there has been widespread yearning for an across the board cut in interest rates.

The RBI has set in motion a process. Many were hoping for a stronger signal. For PPF holders and others, the RBI's action may be a precursor of bad news but more than the banking system the connection is tenuous.

The logic is something like this: banks have to maintain a reasonable spread, therefore reduce deposit rates too. But in the process they cannot hope to compete with small savings anymore.

So the rates on the latter will have to be brought down for bringing about a softer interest rate regime. The proposals have won support from many but obviously not from those directly affected.

In support of it is the belief that it will pave the way for all- round interest rate reduction and hence generate a feel good factor, that is conspicuously absent now. The issue is sensitive not necessarily because those who stand to lose the most - the pensioners, the relatively aged and the salaried class (the majority of whom do not have savings besides the PF and the like to fall back upon) - can organise themselves into a constituency, both powerful and articulate enough to at least compel a debate.

The State governments whose finances depend a lot on the quantum of small savings collected in their respective territories will count in any tinkering with the rates. And banks that operate on margins to accommodate extraordinary pressures this year are also not pleased.

Attractive but improbable scenario

For now it has become almost axiomatic to view an interest rate reduction as synonymous with reform and - facile as it may seem - with economic progress. Here is a scenario that is extremely popular: consequent on an interest rate reduction, deposit rates and yields on fixed income securities will fall. Equities will become more attractive. Foreign institutional investors will pump in larger amounts into the stock markets. And because debt is no longer attractive to them, the foreign inflows will be locked in for shorter periods. The Indian rupee will therefore not appreciate. Exporters who have a vested interest in a cheaper rupee benefit doubly.

For they would have benefited by the reduction in interest rates on export finance. Lower interest rates also mean that consumers will spend more, thereby spurring consumption demand, another key ingredient for the feel good factor. Of course, credit will become cheaper and the industrial sector will benefit immensely also because the stock markets would have revived facilitating capital formation.

This is an interesting scenario, something to be wished for but, alas, unlikely to happen. (If even half the expected positive consequences will materialise what prevents the authorities from turning on the switch as it were?). Any such decision does not automatically guarantee a desired set of results. There is the problem of lead and lag.

Even in advanced countries where financial markets are fully integrated with one another the effects of a major move such as an interest rate cut need not always impact in a pre-set manner across the financial system. In India there are imperfections and structural rigidities that can neutralise the expected consequences of any such action.

Follow the FED?

Following other countries' lead - a course suggested by many in the wake of the U.S. Federal Reserve board's action in lowering the discount rate in two stages - is not feasible here. Even the U.K. whose monetary authorities have greater reason to dovetail with the U.S. followed suit only belatedly. In other words, each country should have its own reason to change its monetary stance. In India, now inflation is at a near term high of above 8 per cent. The RBI data say that industrial borrowers are getting their share of credit this year. It is doubtful whether an interest rate reduction will further spur credit offtake.

Also, there is no evidence yet as to whether interest costs are the key ingredient in total production costs. As everyone knows unless the Government reins its expenditure the pressure on interest rates will remain. A consensus on fiscal prudence should precede the one on signalling interest rate downwards. Even more pertinently, there is the practical difficulty of bringing about a reduction in the rate structure across the board.

While PPF and small savings deposits can have their interest reduced administratively, bank deposits and loans are subject to individual bank's discretion. (Savings bank interest rates are still controlled). For instance, the bulk of the lending rates are nowadays linked to the prime lending rates, which for each bank represents the cost of funds plus a reasonable cushion.

For many other reasons too, a reduction in the Bank Rate, the orthodox signalling device will not have the desired results. At the start of this financial year, the RBI cut the Bank Rate. Many banks did not follow suit. By July end faced with the problem of a runaway rupee the RBI restored the Bank Rate cut. That also suggests that the authorities are bound by a number of factors before initiating decisive action. In short, a single line of attack, in this case an interest rate cut, will not do for solving multi-faceted problems.

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