Divergence in interest rates

POLICY PRONOUNCEMENTS ON interest rates are at the very core of the Reserve Bank of India's monetary policy statements and are therefore keenly watched. Of all the macroeconomic variables that are influenced by the monetary policy, it is the interest rate policy that links the different segments of the domestic economy with one another and, as is becoming increasingly evident by the day, with the external sector. The exchange rate policy, by itself an important constituent of the monetary policy, is influenced by the interest rate structure within India as well as in the developed markets. The burgeoning external reserves are at least partially attributable to the higher interest rates in India compared to those prevailing in certain other emerging markets. For the domestic economy, the interest structure is critical in moderating inflation and in determining the cost of funds. The recent mid-year review of the monetary policy has kept its traditional stance intact, with a bias towards a softer and flexible interest rate regime.

Last week's review has, however, disappointed a vociferous section of industry that has been favouring a continued downward movement of interest rates. Neither the bank rate nor the CRR was reduced. Those have been the traditional monetary devices signalling an appropriate interest rate structure for commercial banks. Despite the lack of a signal, some leading banks such as the State Bank of India have reduced deposit rates to their lowest levels in living memory. A three-year fixed deposit with the SBI group now fetches just 5.5 per cent, barely covering inflation. Other savings instruments such as capital gains bonds are already yielding negative returns. Lending rates of banks, however, have not been brought down, further reinforcing the prevailing impression that banks are unwilling to reduce their prime lending rates (PLRs), the benchmark rates at which banks lend to their first class customers.

The specific developments in the wake of the monetary policy expose the underlying malaise in the financial sector. If deposits at banks and other intermediaries have been increasing despite the lowered interest rates, the reason is to be found in the absence of any alternative investment avenues. Over time, there will be a serious disincentive to save. Specific segments such as the pensioners are particularly vulnerable in a falling interest rate regime as there are no worthwhile social security schemes. Paradoxically, borrowers too have not benefited as a class. While prime customers of banks are being offered loans at sub-prime rates, a majority of borrowers, especially in the small and medium industries segment, say that they are deprived of their normal credit needs. The problem continues to be in credit delivery. That, rather than just credit availability, has by now come to be recognised as the major challenge for the authorities. Banks continue to invest in safe gilts far in excess of their requirements rather than lend to risky borrowers. As the RBI Governor has said, a lasting solution to overcoming the inhibitions of bankers might well lie in overhauling the existing Government-owned banking set-up and encouraging bankers to take commercial risks. The RBI in its earlier policy statements had forcefully made out a case for furthering financial sector reform as the only means of reducing the interest costs to borrowers. The review too carries forward the reform agenda. The results, however, can be seen only over the long term.

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