Why Interest Rate Reforms Are The Need Of The Hour 

Anyone who’s interested in financial markets would have explored the question of the importance of interest rates. While there may be disagreement with respect to the extent of their impact on investment or on growth, nobody can deny that they do matter even if a statistical causality cannot be explicitly established.

The State Bank of India (SBI) recently reduced its deposit rates by 25 basis points and the lending rates by 10 basis points. A very simple analysis would be to argue that they make an additional 15 basis points (0.15 per cent).

But banking is never linear. Nevertheless, the difference between lending and borrowing rates is known as the spread and the spread has indeed increased as they slashed lending rates by a lower amount than the borrowing rates.

The fact that we’ve had a transmission problem is well known and there are many factors that influence the decision of banks to cut either deposits or lending rates. Once such factor is the provisioning for NPAs — but this factor could be addressed, more so now as the government has front-loaded recapitalisation of banks.

The other lacuna is to do with the small savings rates which act as an effective competition for deposits to banks. It is, therefore, important to introduce reforms that would link all these deposit rates — irrespective of whether small or large with external benchmarks.

Merely linking lending rates with external benchmarks will be successful only when even the deposits rates whether administered by banks or different government savings schemes are linked with these benchmarks.

It is also important to remind ourselves that with low inflation, we are, perhaps, looking at lower nominal growth rates. This makes it more important to understand the dynamics of the current lending rates.

In many cases, our nominal lending rates are higher than our nominal growth rate which was at around 8 per cent for the first quarter. This is true even for some of the relatively safe sectors of our economy and it stresses how India continues to have one of the highest real interest rates in the world.

Regular readers are aware of my views on the monetary policy and the way it has been conducted off-late, so I will avoid getting into it at this juncture.

At the moment, we know that credit is choked in the sense that we’ve seen a contraction in the extension of domestic credit to major sectors. But, at the same time, Indian firms have raised $1.14 billion through External Commercial Borrowings (ECBs) between April to August against $0.13 billion during the same period last year.

This shows that Indians are indeed borrowing to finance their working capital needs or in some instances, investments. But they’re borrowing from other countries instead of borrowing from our domestic banks.

The reason why more firms are looking to raise money from foreign investors through debt-based instruments is because of the low cost of capital that prevails across the world. Both nominal and real interest rates are lower and, therefore, companies save up on a lot of interest costs by borrowing at these low rates.

There are exchange rate risks with such external borrowings but the fact that we’ve seen a 10-fold increase only illustrates that even after accounting or hedging for the exchange rate risks, it must indeed be cheaper to borrow from abroad than for India.

Indian banking must acknowledge the fact that we’re looking at lower levels of lending rates and consequently, they must adapt to modern banking practices and swiftly implement tech-interventions that can make them leaner and efficient.

There will be tremendous pressure on the spreads should this trend persist, and banks may be left with low ticket loans which often have lower margins due to the high processing costs.

We do need both interest rate reforms and leaner banks to bring down our cost of capital. We would also need a more predictable and coherent monetary policy that acknowledges these changes and looks at real interest rates, but nobody knows when the MPC would finally be in a mood for doing ‘whatever it takes’. So far, it has done too little and too late.

One is reminded of a Corporate Finance 101 lesson in graduate school with respect to the relationship between higher risk and higher return.

The low cost of capital may make most of our Indian firms with good and viable business projects look at foreign banks and investors for debt-based funds. Since the projects have little risk, they will give lower returns and, therefore, at a low cost of capital, firms can still find these projects viable.

A consequence of this is that all risky projects that can generate higher returns for promoters over and above our real rates will be available for Indian banks to finance. In the event they are to finance them and there’s a negative business cycle in a few years, we may, perhaps, see most of such projects yet again become a problem for our banks.

Increasing the spreads may, therefore, not be in the best interests of our banks at the moment. The world has changed — MPC and banks would be better off if they recognise this change as they will have to confront it either sooner or later.