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Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans

May 15, 2017

28

"Lower interest rates lead to higher lending," is something that most economists firmly believe in. The beliefs of Arvind Subramanian, the chief economic adviser to the ministry of finance, are not an exception to this rule.

Hence, not surprisingly in a lecture a few days back he came out all guns blazing against the Reserve Bank of India(RBI) for not cutting the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loan. We say sort of a benchmark here because there are other factors which go into deciding what rate of interest that banks charge on their loans.

Subramanian wants the RBI to cut the repo rate further from its current level of 6.25 per cent. As he said: "Inflation pressures are easing considerably... the inflation outlook is benign because of a number of economic developments... Against this background, most reasonable economists would say that the economy needs all the macroeconomic policy support it can get: instead, both fiscal policy and monetary policy remain tight."

The point here being that current inflation is under control and from the looks of it, future inflation should also be under control. And given this, the RBI must cut its repo rate. The RBI last cut the repo rate in October 2016. And as and when it cuts the rate further, the hope is that the banks will cut their lending rates. Only then will people and industries both borrow and spend more. This will give a flip to the economy. QED.

Subramanian's point is well taken. Nevertheless, does it make sense? We will deviate a little here before we arrive at the answer.

The RBI Monetary Policy Report released in early April 2017 points out that the decline in the one-year marginal cost of funds based lending rates (MCLRs) of banks between April and October 2016 was just 15 basis points. This when the repo rate was cut by 50 basis points. Hence, even though the RBI cut its repo rate by 50 basis points, the banks cut their lending rates by just 15 basis points, a little under a one-third. One basis point is one hundredth of a percentage.

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Post demonetisation "27 public sector banks have reduced their one-year median MCLR in the range of 50 to 105 bps, and 19 private sector banks have done so in the range of 25 to 148 bps." This when the repo rate has not been cut at all. On an average the one year MCLRs of banks fell by 70 basis points to 8.6 per cent.

What has happened here? A cut in the repo rate barely makes any difference to the cost at which banks have already borrowed money to fund their loans. But demonetisation did. The share of the "low cost current account and savings account (CASA) deposits in aggregate deposits with the SCBs went up to 39.2 per cent (as on March 17, 2017) - an increase of 4.0 percentage points relative to the predemonetisation period". This is because people deposited the demonetised notes into the banks and this money was credited against their accounts.

This basically meant that banks suddenly had access to cheaper deposits because of demonetisation. And this in turn led them to cut interest rates on their loans, despite no cut in the repo rate. The RBI's repo rate continued to be at 6.25 per cent during the period. A cut in lending rates is only one part of the equation. The bigger question has it led to higher borrowings? Are people and businesses borrowing more because lending rates are now lower than they were in the past? And this is where things become interesting. The total deposits of banks between October 28, 2016 (before demonetisation) and December 30, 2016 (the last date to deposit demonetised currency into banks) went up by 6.41 per cent to Rs 10,568,17 crore. This was a huge jump during a period of two months. This sudden increase in liquidity led to banks cutting their deposit rates and then their lending rates.

Interestingly, the total deposits of banks have continued to remain stable and as of April 30, 2017, were at Rs 10,509,337 crore. This is a minor fall of 0.6 per cent since December 2016. Between end October 2016 and end April 2017, only around 36 per cent of the incremental deposits raised by banks were loaned out. (We are looking at non-food credit here. The total bank loans that remain after we adjust for the loans that have been given to the Food Corporation of India and other state procurement agencies for the procurement of rice and wheat produced by farmers).

This means for every new deposit worth Rs 100, the bank loaned out just Rs 36, despite a cut in interest rates.

If we were to look the same ratio between end October 2015 and end April 2016, it projects a totally different picture. 116 per cent of the incremental deposits during the period were lent out. This means for every new deposit worth Rs 100, the bank loaned out Rs 116. This means that deposits raised before the start of this period were also lent out.

Hence, a greater amount of lending happened at higher interest rates between October 2015 and April 2016. And this goes totally against Subramanian's idea of the RBI needing to cut the repo rate. It also goes against the idea of banks lending more at lower interest rates. Given this, low interest rates are only a part of the story. If that is not leading to higher lending, it doesn't help in anyway. Lending isn't happening due to various reasons, which we keep discussing. Demonetisation has only added to this issue.

Also, a fall in interest rates hurts those who depend on a regular income from fixed deposits to meet their expenditure. It also hurts those who are saving for their long-term goals. In both the cases, expenditure has to be cut down. In one case because enough regular income is not being generated and in another case in order to be able to save more to reach the investment goal. And this cut in spending hurts the overall economy. Interest rates are also about the saver and depositor.

We are yet to see a professional economist talk from this angle. To them it is always a case of garbage in garbage out i.e. lower interest rates lead to increased lending. This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people.

But that doesn't necessarily work in India. It is a totally different proposition.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. He is the author of the Easy Money trilogy. The books were bestsellers on Amazon. His latest book is India's Big Government - The Intrusive State and How It is Hurting Us.

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6 Responses to "Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans"

kamalakanta

May 16, 2017

First of all in the footnote all articles there is option "Like" but no option for "Dislike" This itself explain what is India and Indian media serving whom

Arvind Subramanian, the chief economic adviser to the ministry of finance is well educated a rational man probably he himself understand what Vivek kaul and agree with it , but he is in Government by the public, of the public! for the public!

Like (1)

Amit

May 15, 2017

Please stop publishing these extremely negative articles by Kaul.

Like (1)

PURWAR

May 15, 2017

We disagree with you partly.There is no single reason for reducing /increasing loan.We have very high rate of interest in India .Our product are not competitive globally and indigenous cost is also high.There is argument in your point that fixed income group/retiree hurt badly as their interest income goes down.But it is otherwise as consumption remains low due to younger demographic.Economy benefited more with higher consumption boosting employment & assets creation,because industry/individual will have some money left for consumption even after buying homes/cars/appliances etc.As far as senior citizens are concerned,Government is already protecting them keeping interest rate higher in PF/Post office/Sr citizen deposit.Trader/businessman ,there is no retirement age,till they die in India.As they grow old ,they accumulate more & spend less.There are 30% people ,who are below poverty line ,do not have money .Rather they die in debt as local bania/marwari/gujrati do not charge 10-12% but whopping 18-24% interest even today So where they have saving to make deposit.
Then our old generation is very conservative,They believe in saving for hard days and in the process they do not spend on good food & on health.
To prove your point you have compared deposit & loan from 1/10/16 to 30/4/17 with same period of previous year is totally wrong.When 8/11/16 to 31/12/16 people were forced to deposit high denomination note to the bank and bank were busy in demonetization ,how you expect the same growth.Both situations are not comparable as business environment were different & deposit rates were abnormal as being people were asked to deposit higher denomination note. There is time lag between repo rate cut & actual reduction which takes time as bank to adjust borrowing cost.So if RBI changes Repo-rate in monetary policy meet,bank will not change the interest rate immediately or may reduce token 10-15 basis point.By reduction in Repo-rate by RBI ,it gives signal to bank that you can take action for reduction in deposit as well as borrowing rate.So first bank will reduce the deposit rate & then revise the interest lower.

Like (1)

KPL

May 15, 2017

"This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people."

But then even the US seems to be reaching its limits. These silly economists with their warped theories have simply made living beyond your means and substituting borrowings for savings as the way of life over the last three decades, since 1987, when Alan Greenspan started the interventionist policies. This system has made those living within one's means and saving so outdated that it now appears so silly to be like this. This music would have stopped playing in 2008 but for the biggest money printing exercise undertaken by the central bankers. But then the ending of the movie is still nowhere in sight. With growth at a standstill, this policy of lowering interest rates to induce growth is on its last legs.

Like (1)

minesh bhimani

May 15, 2017

Sir,
as a small enterprise we are still not comfortable with lending rates offered by banks, in-spite of having flushed with funds banks are holding lending rates high to cover their NPA's , which is visible from lending growth figures.
if industry does not get fund at competitive rates new investment is a question and new jobs are also hard to come and hence no consumer spending.
because in India pension is a privilege to a few most of the seniors are dependent on interest income but for that growth can not be sacrificed.
for growth low rates can work as catalyst.

Like (1)

Mani

May 15, 2017

Dear Equitymaster,

You will do the readers a great service if you would avoid publishing these useless articles by this Modi-baiter. This article reeks of non-professionalism. Mr Kaul is desperate to stop progress in the country and is disillusioned that progress takes place despite the presence of him and his ilk.

Like (1)
  
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