Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 6 Monetary Transmission Mechanism

Administered Interest Rates

As noted above, one of the factors imparting upward rigidity to the interest rate structure in India is the administered nature of interest rates on small savings instruments. In order to provide flexibility to the interest rates on small savings and other administered instruments, the Report of the Expert Committee to Review the System of Administered Interest Rates and Other Related Issues (Chairman: Dr. Y.V. Reddy) (RBI, 2001) recommended that the interest rates on these instruments could be benchmarked to the secondary.

Between June 2002 and June 2004, the lending rates of the banks (the rates at which at least 60 per cent of lending takes place) have declined further. The sharpest decline is witnessed in the case of private sector banks. Similarly, interest rates on deposits have seen a further softening since March 2001. In particular, deposits above one-year maturity have exhibited a significant reduction which suggests an enhanced flexibility to the banks in pricing their loans in the future. Empirical evidence confirms that pass-through in India is less than unity although there are signs of an increase in pass-through over time (Box VII.4).

Real Interest Rates

It is the real rate of interest that matters for investment and consumption decisions of firms and households in an economy. Although there has been some moderation of nominal interest rates since mid-1990s, inflation rates in India underwent an even more conspicuous decline. Illustratively, wholesale price inflation has averaged around five per cent per annum in the period since 1997 as compared with an average of 8-9 per cent per annum in the prior two decades (see Module 4). Moreover, the moderation in respect of manufactured goods inflation was even more pronounced than that in the overall inflation rate. Accordingly, real interest rates for borrowers exhibited a distinctive hardening in the second half of the 1990s with adverse implications for investment demand in the economy. The key issue, in terms of the growth objective, is the impact of the structure of real interest rates, especially as the interest cost as a proportion of sales of corporates is much higher in India as compared with many emerging market economies.

Apart from a degree of stickiness in banks' lending rates, the increase in real rates could also be attributed to relatively high long-term inflation expectations, at least in the second half of the 1990s. "What is more relevant from the policy point of view is the expected or ex ante real interest rate which is measured by the difference between the nominal market interest rate and the expected inflation. An ex post high real interest rate may reveal the difference between the expected and actual inflation rate, rather than the factors which determine the real rate. To the extent that the mind-set regarding the historical inflation rate in the Indian economy can be addressed, by credible policy measures, the nominal interest rate should decline, in tune with the decline in current inflation rate, thus bringing down the pressure on real interest rate". With consistently low and stable inflation since 1997-98 onwards, inflation expectations appear to have stabilised and this has enabled a moderation in nominal and hence, ex post real rates for both Government and non-government borrowers during 2000-04 compared to the second half of the 1990s. Real deposit rates, on the other hand, remained positive and, on average, exhibited a marginal increase. In the recent couple of years, however, there has been some moderation in the real deposit rates, concomitant with a moderation in nominal deposit rates.

In this context, the appropriate level of real interest rates remains a topic of continuous debate. The Report of the Committee to Review the Working of the Monetary System (Chairman: S. Chakravarty) (RBI, 1985) felt that 'reasonably high positive real rate of interest' was needed on savings to deter 'leakages' of financial saving in the form of gold, real estate and physical assets. The Committee, therefore, recommended real rates of up to three per cent to depositors depending upon maturity, issuer and instrument: a marginally positive real return on 91-day Treasury Bills; a positive real return of 2 per cent per annum for bank deposits of maturity of 5 years or more; and, a positive real return of 3 per cent per annum on 15-year Government dated securities. Ex post real deposit rates in the period since the mid-1990s have been close to the benchmarks suggested by the Committee.

A more generalised approach on the level of real interest rates has been elaborated by Reddy (1998) with focus on long-term growth as a key determinant. "In the context of the economy as a whole, or in macroeconomic policy, the sustainability of the real interest rate is critical. Ideally, the expected real interest rate in the economy should reflect the potential rate of return on the capital stock. If an economy is operating on the maximum attainable efficiency, the rate of return on capital or the growth rate of real GDP should provide an indicator of the real interest rate in the economy. In the case of advanced economies, which are more or less operating on the best attainable efficiency level, the real growth rate sets the limit for the real interest rate in the economy. It is interesting, therefore, to observe that the typical real interest rates on Government paper in some of the advanced economies vary from 3 to 4 per cent, which is close to their growth rate of GDP. In the case of developing economies, the typical real interest rates are higher than those of the developed economies which is perhaps explained by the higher rates of growth in these economies. It is possible that for a fast growing and high performing economy, the real rate of interest may in fact stay higher than the real growth rate, if the potential growth rate is higher than the actual growth rate and if expectation regarding the future growth rate is strong".

High real interest rates are a cause of concern since these have an adverse impact on investment demand and output growth. Evidence for the G-7 countries suggests that a 100 basis points increase in real interest rate leads to a decline in output of 6-17 basis points in the short-run while the long-run impact is a decline of 25-69 basis points. To analyse the impact of real interest rates on output for India, aggregate demand curve specification on the same lines as Goodhart and Hofmann (op cit.) is employed, i.e., output gap is regressed on its lags and real interest rates. As supply shocks can have an adverse effect on output, fuel prices and agricultural sector output are also included in the equation. Estimates of this equation over the period 1970-2003 using annual data suggest that a 100 basis point rise in real interest rates in India depresses real GDP and hence widens the output gap (actual less trend output) by five basis points in the short-run . The impact increases over time and the long-run impact is almost 40 basis points.