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Interest rates have not fallen despite continually low inflation and repeated government assurances

By V. Shankar Aiyar

The desire is universal. The mood is right. The environment is conducive. Yet the action is missing. Both the Ministry of Finance (MoF) and the Reserve Bank of India (RBI) have been saying that interest rates should "and could" come down. But even these two most potent power centres of India's economic decision making have failed to talk down the interest rates. On the contrary, the real interest rates have actually been on the rise. Over the past decade the rate of inflation has come down from over 13 per cent to barely 2 per cent but real interest rates -- the differential between the rate of inflation and the banks' prime lending rate (PLR) -- which were at 2.7 per cent (see chart) have actually risen to over 9 per cent.

It is not that the Government has not tried. The Government has cut interest rates on small savings and provident fund and made a start on structural adjustments. The RBI too has tried. It has slashed the bank rate -- the reference rate or rate at which RBI lends monies to banks -- to 8 per cent despite the high borrowings of the Government. In fact, over the past 12 months banks have stuck to a PLR of 12.5 per cent. This, when WPI has dropped from 5.3 to 2.08 per cent.

In fact, the overwhelming evidence is in favour of a cut. Mohan Lal Mittal, chairman, Ispat Industries, argues for a "one-time quantum cut of 5 per cent or at least a 3 per cent cut to bring interest rates in line with expected inflation". Videocon Chairman Venugopal Dhoot echoes Mittal's views. "There is a strong case to cut rates by at least 2 per cent. But for this to happen the MoF will have to wield the stick. It is in the interest of not just corporates and borrowers but also the real economy and the Government."

Ponder over the impact on the economy of, say, a 3 percentage point cut in interest rates:

• The Government's interest payment for the current year is Rs 108,000 crore. Assuming an average interest cost of 11 per cent, the cut would reduce the interest burden by more than Rs 30,000 crore over a period. This would also bring down the Government's overall debt.
• In 1998-99, state governments borrowed Rs 10,679 crore at a rate of about 11 per cent from the market. The cut would enable them to reduce interest costs by as much as Rs 400 crore. Costs on their borrowings of Rs 33,000 crore from the Centre would have also come down.
• Currently, the Government allows refinance for exporters at 9 per cent. The slash in rates could either make them more competitive or, better still, obviate the need for export subsidy.
• A sample of 820 corporates reported half yearly sales of Rs 1,54,940 crore. The annual sales are expected to touch Rs 3,09,880 crore. A 3 per cent cut (assuming a four-month working capital cycle) would save costs by 1 per cent (3 per cent of 12.5 per cent prime lending rate). In other words, the profitability of these companies would go up by 1 per cent or Rs 3,098 crore. This would either be reinvested, in which case investment would go up, or translate into additional taxes (of about Rs 900 crore) for the Government.
• A fall in interest rates would also spur investment in the infrastructure sector. It would make infrastructure costs affordable. For instance, in the power sector it would bring tariff down by 40 paise per unit/KWHR. But as Rajeev Chandrashekar, chairman, BPL Telecom, enters the caveat -- this would happen provided policy glitches are cleared.
• The cut would also spur consumer demand. For starters, housing loans, which are at 13.5 per cent, would be down to 10 per cent. This would trigger a recovery in the core sectors of steel and cement. Overall consumer spending would increase, company sales will perk up and revenue collections will be higher.
• Lastly, the reduction would add lustre to the stock markets, bring in mutual funds more forcefully into the savings market and boost chances of better realisation in PSU divestment.

Given such a strong case for interest rate cut, what is holding it? Primarily the Government's fiscal deficit, its high and rising borrowings. In fact, M.R. Madhavan, debt analyst with I-Sec, states, "The case for lower interest rates is not too strong if you look at the large government borrowings and expected borrowings for the next few years as well as real interest rates (nominal 'expected' inflation)." Vikram Goyal, regional economist for Morgan Stanley Dean Witter, strikes the middle ground. "Given the structural changes, the fall in inflation and the buoyancy in the external sector (thanks to the it sector), there is a case for a cut in interest rates. However, there is a concern about the Government's high borrowings and the ability to manage inflation." Deepak Parekh, chairman HDFC, agrees. "While a cut in interest rates is desirable, it can't be over a per cent. It has to be gradual and the Government has to manage not just the present but the profligacy of the past."

Surjit Bhalla of Oxus Fund Management disagrees vigorously. "At 8 per cent, real interest rates are out of whack and the highest in the world. Fiscal deficit and borrowings are an excuse trotted by apologists. It is high real interest rates that are the primary cause of the high fiscal deficit. Our research of 100 countries spread over 30 years shows that a dip of 1 per cent in interest rates results in a rise of 0.5 per cent in GDP. A cut in interest rates will bring down deficit and a per cent's fall in gross fiscal deficit brings in a rise of 0.3 per cent in GDP. The obvious thing to do is to bring down interest rate by cutting the real deposit rates which are around 9.5 per cent."

Jalan agrees that the cause lies with deposit rates but couches it in Jalan-speak. "The RBI has already said that its policy preference is for a lower interest rates given the fall in inflation. However there are structural factors that constrain the ability of banks to lower rates." Very simply the constraints are high wage costs (banks recently agreed to a 12.5 per cent wage hike for all banks regardless of profitability), the "insoluble" NPA (non-performing assets) issue and inefficiencies that account for 3.5 per cent of the 12.5 per cent PLR. Ergo, the RBI -- which does not fix rates any more -- can't do much. Jalan though is hopeful: "The Government has certainly made some positive moves and we hope over a period of time all these changes will have a favourable impact in the interest rate environment. There is really no quick-fix."

Bhalla, however, believes otherwise. "It is not the RBI but the Government which has to make this happen by targeting the high small savings rate which is the real cause." Bhalla warns if rates are not cut the 8 per cent GDP growth will not happen. "Worse, non-ice (information, communication and entertainment) stocks will crash leading to a crisis in the stock market. Yashwant Sinha could either achieve greatness by intervening now or have greatness thrust upon him when the crisis happens."

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