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Interest and exchange rates: limits to intervention
Clearly, there are limits beyond which the Government or the RBI
cannot dictate on interest rates or exchange rate. Educating a
wide section of the community therefore becomes imperative.
By C. R. L. Narasimhan
The subject of interest rate movements fascinates lay people and
policymakers alike. No other macro variable with the exception
perhaps of the rupee-dollar exchange rate is so often referred to
in everyday conversation as well as in serious discussions.
Again, in common with the exchange scenario, lobbyists,
exporters, industry associations and chambers of commerce
constantly clamour for a lower interest rate level just as they
ask for a depreciated rupee. At different points in time, each of
these ``demands'' is made out as the one point agenda that would
cure the economy of specific ills. For them, a low interest rate
structure will make the economy competitive. A depreciated rupee
will boost exports. Such arguments have been heard before and
will be heard many times over in future too.
There are fallacies in these arguments. Most importantly, they
are not workable. Even if the Reserve Bank of India or the
Government ordains, a lower interest rate structure (or a
depreciated rupee) will not automatically follow. In the kind of
market-based financial system that is evolving in the country, a
certain level of interest rate or a particular level for the
rupee against the dollar or any other major foreign currency
cannot be pre-determined. These are no longer administrative
decisions: neither do we have a fixed exchange rate system nor
are the interest rates, save a few minor exceptions,
administered.
As the RBI's recent monetary policy statement explains, the day-
to-day movements in exchange rates are market determined. The
bank's primary objective in the exchange arena continues to be
the maintenance of orderly conditions in the market. For which
purpose it corrects temporary demand-supply gaps and generally
keeps a watch on speculative activities. The central bank cannot
devalue its currency, it can only manage a progressive
depreciation.
A similar articulation of its interest rate policy is found in
the latest monetary policy. Once again the RBI shows that it can
at best only signal a downward movement. Currently there is a
debate whether nominal interest rates can be brought down
sharply. The implication is that the decline in nominal rates has
not kept pace with the decline in the rate of inflation. So any
sharp reduction here will similar impact the real interest rates
(interest rates adjusted for inflation). In that context the RBI
takes stock of the several structural factors that inhibit a
downward movement in interest rates.
Over the recent past the central bank has reduced some of the
remaining administered rates such as those on the PPF and the
savings schemes of the National Savings Organisation.
Significantly, the interest tax (whose incidence is on the
borrowers) has been abolished. The bank rate - restored to its
traditional role as a signalling mechanism - has been freely used
by the RBI during the past 2 1/2 years. It is now at a low 7 per
cent. Used in conjunction with the other parameters (cash reserve
ratio, repo rate) as well as with open market operations, the
central bank has indicated that it wants a lower the interest
rate structure. Indeed, there has been a general softening over
the past 13 months.
But there are limits beyond which even the RBI cannot act. (1)
The prime lending rates (PLRs) which benchmark the cost of bank
credit are within the purview of individual commercial banks, not
the RBI. The few rates that are still administered (for example,
on savings bank accounts and export credit) as well the key rates
such as the Bank Rate and repos are currently almost around
international levels.
(2) Banks alone can decide the rates they will charge their
borrowers. The several variables they have to reckon with in this
context include their own cost of funds, their transaction costs
and the interest rates ruling in the non-banking sector. Despite
the recent reduction, some Post Office schemes can still compete
with banks in the matter of yields.
(3) Banks can now offer variable yield on their long term
deposits. Yet maybe because of strong consumer preference, a
significant percentage of the banking system's term deposits are
on a fixed rate basis. This naturally means that banks cannot
lower their lending rates that easily.
(4) The high level of non-interest operating expenses of public
sector banks, working out to 2.5 to 3 per cent of their total
assets is another inhibiting factor. The high transaction costs
which generally mean high staff costs combined with relatively
high levels of non-performing assets (NPAs) further constrain the
banks' manoeuvrability to reduce lending rates.
The obvious solution is of course through financial sector
reform. That again cannot happen immediately. The recent monetary
policy statement enunciates certain financial sector reform
measures, but none of these have the effect of immediately
transforming the banking system and the financial sector.
Even assuming for argument's sake that the RBI or any one else
can ``order'', a certain desired level of interest or exchange
rate, should the consequences be welcomed uniformly? No lobbyist,
for instance, shows even the remotest concern for those affected.
In an interest rate argument, for example, nobody has a word of
sympathy for the saving class. The pensioners and other
vulnerable sections have valid reasons to complain - against
policy makers who do not see the collapse of the institutional
savings mechanism - NBFCs and all as a cause for worry. For those
affected classes, the argument that lower interest rate is good
for the economy is some macabre joke. The exporting class, which
has received ample concessions in the past keeps wishing for a
cheaper rupee. Here again many others including exporters who
depend on imported inputs may not buy that line. The problem in
India is that only those who lobby more seem to be heard.
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