Why arenít interest rates declining? - Views on News from Equitymaster

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Why arenít interest rates declining?

Jul 14, 2000

According to the Reserve Bank of India (RBI) publications, interest rates over the last one-year have declined only marginally. This is despite incessant efforts to affect a significant decline in rates. What is causing this Ďstickinessí in interest rates? Well, a large part of this has got to do with the government and its prodigal ways. Consider the following statistics:

  • The central government's fiscal deficit increased from a low of 4% of GDP in FY97 to 5.6% in FY00. The deficit is projected at 5.1% of GDP in FY01. (These figures exclude the deficit of the state governments and other off balance sheet items like the oil pool account and losses of public sector units.) This has forced the government to raise resources from various sources like banks, individuals and market borrowings among others.

  • The central government, which financed only 35.7% of its deficit by borrowings from the market in FY97, now finances over 70% from this source. The point is driven home when one sees that between FY97 and FY01BE, the fiscal deficit has increased by 95% in absolute terms.

Fact sheet on the Central Government's financial position

Both these factors have ensured that the demand for funds in the market continues to remain high. The government has become the largest borrower in the market, who is perpetually waiting to pounce on liquidity, the moment it is spotted. This continuously exerts an upward pressure on interest rates, negating the other efforts to bring down rates.

Letís take the example of banks, which are the primary providers of credit. The RBI imposes an SLR (statutory liquidity ratio) requirement on banks. The aim of the SLR is to ensure that banks have adequate liquidity at all points of time. However they serve another purpose Ė that of financing the deficit. This is so because of the very few investments that qualify under the SLR requirements, government securities are one of them. The returns offered on these securities are not completely reflective of market rates (till a decade back it was fixed at 4.6% per annum!) resulting in sub optimal results for the banks. The high rates of CRR (cash reserve ratio, which is maintained with the RBI) and SLR basically result in an increase in cost of that portion of the funds, which are to be lent out. Banks thus try to make up by charging higher rates from borrowers.

The most important step towards a lower interest rate regime would be a decline in the deficit of the public sector as a whole (currently estimated at over 10% of GDP). Such a development would reduce demand for funds by the government, in effect freeing up resources in the market.

A lower fiscal deficit would serve other purposes too. As the government would limit itís spending in relation to its revenues, the pressure on prices (inflation) would reduce. These factors would also effect favorably the exchange rate environment.

Sadly, such a development, although planned for many years, has failed to materialize.

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