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Lower interest rates maybe around the corner

Mar 15, 2000

The Reserve Bank of India (RBI) is reported to be considering a 1% cut in the bank rate along with a reduction in the cash reserve ratio (CRR). The moves are aimed at improving credit availability and the attractiveness of government bonds. Let’s tackle the first issue. During the year to January, non-food credit has grown by 10.4% as compared to 6.6% in the corresponding period last year. This clearly highlights the surge in demand for credit. However, during last year, inflation had been much higher (due to the hike in prices of essential commodities) as compared to current levels. Despite the marginal reduction in interest rates over the last one-year, there has been a sharp rise in the real rates on interest (as inflation has declined much more rapidly). Thus borrowers actually have to borrow funds at higher real rates of interest, implying higher costs.

In view of the nascent recovery in economic activity and the slow growth in investment activity the RBI needs to make credit available at reasonable cost. The proposed measure will take care of both these demands. Just to moderate the demand for more credit, it must be stated that inflation is on the rise (oil prices have jumped 200% over the last year or so) and any abrupt rise in money supply may directly add to it.

The second argument that such a measure would make the market for government securities more attractive however is not as convincing. The RBI is implying that the excess liquidity in the markets created by a cut in the CRR could flow into government bonds (what about the corporate?!!). Also, the reduction in rates meanwhile will make investment in government securities more attractive. With the government scheduled to borrow in excess of Rs 1.16 trillion, interest rates are unlikely stay low (or decline) for some time, making existing government yields unattractive…once again.

The RBI's measures are nevertheless desirable, as existing real interest rates are prohibitive for companies considering new investment opportunities. Moreover, with the government likely to jump in to the debt market early next month, the decision to increase liquidity will be more than welcome.

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