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Why higher interest rates are needed

February 09, 2005

From December 1997 to Jan 2004, the average bank rate fell from 12 per cent to 6 per cent. The prime-lending rate of banks fell from a peak of 15 per cent to 11 per cent. The interest rates were substantially brought down with the objective of boosting business activity.

Ironically, lending by banks to industrial clients did not really pick up. But what happened as a result was the treasury department of banks made huge profits.

Between July 1997 and October 2003, as interest rates fell, the yield on 10-year government bonds (a barometer for domestic interest rates) fell from 13 per cent to 4.9 per cent.

With this banks made huge profits on their bond portfolios. The falling interest rates gave very little incentive to banks to lend to industrial clients, as the returns were not high enough to compensate for the risk involved.

Instead, low interest rates encouraged banks to concentrate on the retail segment. Cheap credit was used to finance expenditure which did not help in capital formation. It encouraged a spendthrift culture among the citizens of India to a certain extent.

The phenomenal rise in the number of credit cards explains this.

So who really benefited from lower interest rate environment, which prevailed for the last few years?

First and foremost, the Government of India. The huge fiscal deficit that it has been running was financed at lower interest rates.

The second main beneficiaries were large corporates. They could replace their earlier high-cost loans with cheaper loans.

The people who lost out were charitable trusts, poor pensioners, senior citizens and widows who saw the value of their savings come down considerably. The fact that India does not have a social security system in place made it even more difficult for this section of the population.

With the yields going up, the bond party over and the interest rates likely to go up, the banks have gradually come back to their bread and butter business of giving loans.

The incremental credit deposit ratio for the past one-year has been greater than one. What this means in simple terms is that for every Rs 100 worth of deposit coming into the system more than Rs 100 is being disbursed as credit.

The growth in credit has primarily been coming from retail, oil and the infrastructure sectors. This growth of credit has been the highest in the last ten years.

The growth of credit offtake though has not been matched with a growth in deposits. The reasons for this can be more than one. The high inflation (vis-a-vis the interest rates being offered on bank deposits) has led to a situation where the real rate of return on depositing money with banks is negative.

So savers have been looking for alternative sources of investment. Savers have been investing their money into the Public Provident Fund and other small saving schemes which give out higher returns vis-a-vis bank deposits. Also the recent Bull Run in the stock markets has seen some amount of savings being diverted to the stock markets.

So the next question that arises is, with the deposit inflow being less than the credit outflow, how are the banks funding this increased credit offtake?

Banks essentially have been selling their investments in government securities. By selling their investments, the banks have been able to cater to the credit boom. They have also been able to pare down their exposure to government securities in a scenario where the bond yields have been going up.

Also the exposure of the banking sector to government paper has been coming down with banks selling government paper to entities outside the banking system.

This form of funding credit growth cannot continue forever, primarily because banks have to maintain an investment to the tune of 25 per cent of the net bank deposits in Statutory Liquidity Ratio (SLR) instruments.

The fact that they have been selling government paper to fund credit offtake means that their investment in government paper has been declining. Once the banks reach this level of 25 per cent, they cannot sell any more government securities to generate liquidity.

And given the pace of credit offtake, some banks could reach this level very fast. So banks, in order to keep giving credit, need to ensure that more deposits keep coming in. Banks as of now are competing for capital with other forms of investment, which give a greater amount of return than what banks have to offer.

So in the current situation of high inflation (vis-a-vis interest rates), rapid credit growth and lower deposit growth, the only way of ensuring an increase in bank deposits is to increase interest rates.


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Number of User Comments: 1

Sub: Good article

I have been reading your articles and they are very good indeed. However, you forgot to mention that most credit being offered by banks today ...

Posted by Rishi


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