Green signal to interest rates - Views on News from Equitymaster

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Green signal to interest rates

Feb 28, 2001

Finally, the FM has announced an interest rate cut on small saving deposits by 100 to 150 basis points as expected by the finance sector. Interest rates in the economy are market determined. However, their downward movement is constrained by the rigidity inherent in the interest rates offered by provident fund and small saving schemes. Interest rates offered in PPF and other related schemes have seldom exceeded consumer price inflation by more than 3% between 1980 and 1998. Since then, this difference has risen to 6 to 8%. These high real interest rates have put an unsustainable burden on both central and state governments. It has also resulted in high cost of capital to the government impacting overall economic growth of the country.

Reduction in the small saving rates indicates a softening of interest rates for the banking system as a whole. Rate cut in small savings is positive for banks as they normally maintain a high rate of interest on deposits in order to match the returns offered by the government to the small savers. Also, relatively high interest rates on NSC and on PPF prevented banks from lowering term deposit rates. They can now lower the deposit rates and re-price lending rates. This could boost the credit growth of the banking sector. Cost of borrowing for the companies could not only reduce with lower interest rates but it could also boost capital investment by a company.

With an interest rate cut bond prices increase and their yield declines. Investors will now shift from fixed deposits, which offer comparatively lower interest rates to investment in bonds. Banks are required to invest 25% of their liabilities into government securities. The balance they can invest in mutual funds, debt markets and equity. Most of the banks have more than 60% of their investments in government securities. Banks will take opportunity to book profits on their investment portfolio held for trading. This is likely to result in significant gains to banks in terms of higher investment income, which currently contributes more than 30% to their operating income.

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