Themes > Current Issues

12.09.2001

Why have Real Interest Rates not Come Down?

Jayati Ghosh

One of the favourite predictions of the proponents of financial liberalisation measures in the 1990s was that the eventual result of such reforms would be reductions in real interest rates. It was argued that there would be an initial rise in such rates to redress the excessively low interest rates created by policies of "financial repression". In fact this was argued to be both necessary and welcome because it was supposed to lead to higher rates of domestic saving as well.
 
But thereafter the greater access to capital, especially from international markets, was supposed to imply that Indian entrepreneurs would face lower real rates of interest. This in turn would obviously act as a spur to investment. Thus financial liberalisation was seen as a means of generating lower real interest rates and higher real investment rates.
 
But it turns out that this has not happened. Investment and savings rates have not increased significantly over the 1990s, nor have real rates of interest gone down over the course of the decade. Nominal interest rates have fallen, but real interest rates have shown no such tendency and have in fact risen quite sharply from the middle of the decade, to levels well in excess of 8 per cent. This is clear from Table 1, which shows the movement the State Bank of India's Advance Rate. The real interest rate is that minus the rate of change in the Wholesale Price Index. (The other nominal interest rates facing entrepreneurs, such as the term lending rates of the non-bank financial institutions, tend to be substantially higher.)

Table 1 : Nominal and real rates of interest

Clearly, this is something which requires explanation. Even if the very optimistic argument of the liberalisers concerning the effect of capital inflows on domestic real interest rates were not accepted, there would still have been some expectation that access to more forms of capital would have meant some decline in real interest rates for domestic investors. The apparent imperviousness of real interest rates to any such pressure therefore deserves much closer consideration.
 
One of the arguments that has recently gained a lot of attention, and is increasingly cited by a number of proponents of the financial sector reforms, relates to the fact that small savings by households constitute an important part of the overall savings in the economy. According to this argument, the Government, in order to attract small savings in the form of Public Provident Fund, Post Office deposits, National Savings Schemes and other such schemes to finance its own expenditure, has kept interest rates on such schemes relatively high.

In addition, of course, such schemes have the advantage of appearing to be risk-free besides offering the added incentive of tax benefit up to a certain limit. For the household sector, this has increasingly become an attractive alternative to bank deposits. For this reason, banks are forced to maintain high deposit rates and this is why their lending rates remain high despite the financial liberalisation measures.
 
For this to be accepted, it must be shown that small savings with the government have replaced bank deposits, at least at the margin, in total household savings. But there is no such tendency of bank deposits as a share the total financial assets of households to fall over the 1990s. In fact, on average the share of bank deposits has been substantially higher in the last three years of the decade (at more than 38 per cent) than in the first three years of the decade (at only 32 per cent).
 
It is true that the share of small savings has increased slightly (from 32 to 34 per cent), but much less than the share of bank deposits. And it turns out that the increase in both has been at the expense of the share of household savings held as shares and debentures. This had reached 10 per cent in 1992-93 following the stock market boom immediately after the initial liberalisation,  and has since has declined sharply to only around 2 per cent in 1998-99.
 
So it is mainly the greater uncertainty in the stock market which has driven small investors back to the more secure forms of savings such as Public Provident Fund and so on, and reduced exposure to the riskier forms of saving. It is worth noting that recent fiscal measures, in terms of reduction in interest rates on small savings and tax concessions such as relief in terms of capital gains tax, are designed to cause such investors to turn back to shares and debentures and reduce their holding of public instruments of small savings. The rates of interest on such instruments are now lower than they have ever been in the 1990s.
 
So small savings cannot be see as the culprit for why real interest rates continue to remain high. In fact, commercial banks are actually finding difficulty in identifying desired borrowers at the prevailing rates of interest. That is why bank holding of government securities has increased substantially in recent years, rising from 26 per cent of total deposits at the beginning of the decade to 34 per cent at the end of the decade. And credit deposit ratios have fallen from the already low levels of the early 1990s, to abysmally low levels of just above 50 per cent.
 
This is more than an interesting irony, given the reduction of the Statutory Liquidity Ratio as part of the financial reforms of the early 1990s. This measure was designed to free commercial banks from necessarily holding more than one-third of their assets in the form of government securities, since the SLR was lowered to 26 per cent in 1993. It turns out that the current position is that commercial banks are holding more than Rs. 100,000 crore as government securities. This amounts to 35 per cent of the deposits, which is the same as the level that existed prior to the financial reform measures ! So, while this measure did operate to make borrowing more expensive for the Central Government and therefore increased its interest burden, it has certainly not led to greater access of the private sector to bank credit.
 
In this context, why then have interest rates not declined in real terms ? If banks are hard put to find desirable domestic borrowers in a context of domestic recession, and instead prefer to hold government securities, then why are real interest rates not driven down further ?
 
The answer lies in government policy, in a combination of fiscal policy and financial liberalisation which has put upward pressure on interest rates and affected the structure of government borrowing. Two financial liberalisation measures of the early 1990s have been of special significance in terms of government borrowing.
 
The first was the decision to reduce and eventually to do away with deficit financing as a means of financing the fiscal deficit. It is impossible to justify this in rational economic terms, especially given the widespread recognition that some amount of deficit financing (which is the cheapest form of borrowing available to the government) has no inflationary implications. The second was the reduction of the Statutory Liquidity Ratio, which was already mentioned.
 
Both of these measures had the effect of forcing the government into more expensive open market borrowing, which in turn has been a significant cause of the increase in the interest burden of the Central Government. Meanwhile, the increasing resource crunch faced by the State Governments has also forced them into more market borrowing on even more expensive terms, since they are seen as less preferred borrowers than the Central Government.
 
The problem is that this is not just an issue of fiscal and monetary management. It amounts to a huge burden on present and future taxpayers and potential recipients of public services which are cut because of resource constraints, given the large drain on the public exchequer because of interest payments.
 
This need to maintain high real interest rates in turn becomes necessary because the other aspect of financial liberalisation has meant that the government must necessarily be concerned with the need to attract or maintain capital in the country and prevent capital flight. Thus financial liberalisation, far from reducing real interest rates, has been the major contributory factor to their remaining at high levels.