Part I

Friends,

I am happy to be here at the inaugural conference to commemorate the incorporation of Fixed Income Money Market and Derivatives Association of India (FIMMDA). Let me, at the outset, congratulate the organisers who have taken the initiative to incorporate this Self Regulatory Organisation (SRO).

Perhaps, I should explain why a Deputy Governor of the Reserve Bank of India (RBI) is the Chief Guest at the function of an SRO. It is simply because, RBI is taking the initiatives in developing financial markets also and, not merely in regulating them. These initiatives have been quite bold and explicit since April 1997. We, in RBI, are also keen to ensure appropriate technological infrastructure for development of financial markets. RBI is very conscious of the need to ensure efficient transmission of monetary policy, and financial markets, especially money and debt-markets, have a crucial role to play in this. I observe from the objectives of FIMMDA that, it could contribute to the development of efficient, stable and orderly debt markets. Finally, I am here to extend a hearty welcome to the newly born FIMMDA and, earnestly wish that FIMMDA becomes a highly responsible, truly representative and adequately responsive SRO.

I had enquired with the organisers regarding the subject that would be relevant to the occasion. They wanted me to speak on recent initiatives in monetary policy and, interest rates. They are being accommodated halfway, since today's interest rates in India, their status and issues. The latest Economic Survey for 1997-98 released by the Government of India lists issues and priorities in the first chapter. Among the policy measures emphasized in para 70 is "fiscal and monetary policies aimed at moderating real rates of interest." Hence, I believe that there is an explicit and official recognition of the significance of real rates of interest in economic policy at this juncture to revive and accelerate growth. So, let us share our views on real rates of interest.

Concept

Interest is essentially the price people pay to have resources now rather than later and, interest is conventionally expressed as a percentage for one year. The interest rate thus expressed or reported is nominal interest rate, since it is without a correction for the effects of inflation on the resources available for money, between now and later. Real interest rate is the interest rate corrected for the effects of inflation. There is also a need to recognise the expected real rate of return, which is the difference between nominal rate of interest and expected inflation. Incidentally, in all discussions on interest rate, one has to account for other elements such as risks and liquidity or term structure, although we may not state them explicitly.

From a policy point of view, we need to recall some features of real interest rate.

• First, the real interest rate is not an observed phenomenon; it is computed by deducting inflation rate from the nominal interest rate.
• Second, 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.
• Thirdly, the real interest rate refers to return on investment net of various kinds of risk premia.
• Fourthly, taxation of interest income creates a wedge between the interest earned and the post-tax rate of return on investment.

What determines the real interest rates?

Some of the important policy issues in considering real interest rates are:

• First, most markets follow a reference or benchmark rate, which is a risk neutral rate. Government security rates are ideal candidates for the reference rate. An increase in the real interest rate in the government security market therefore transmits to other segments of financial market, no doubt depending on the degree of integration among markets.
• Secondly, 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 rate 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. However, a persistent high real interest rate, which exceeds the real growth rate, is not sustainable in the long run as this implies that the service cost of the capital stock exceeds the rate of return from capital.
• Thirdly, a significant part of the real interest rate is due to the stance of the central bank in the market. If the monetary signalling is substantial, the market real interest rate can considerably diverge from the equilibrium real interest rate. The signalling route of monetary policy, therefore, constitutes a crucial determinant of real interest rate.
• Fourthly, the real interest rate is significantly influenced by the efficiency of the financial system. A well functioning financial market helps reduce the cost of financial intermediation, and thereby brings down the spread between the interest rate on savings and that charged on investment.
• Fifthly, an unsustainable fiscal policy, with a high burden of public debt, provides a downward stickiness to the real interest rate.
• Sixthly, in an open economy, with a high degree of capital mobility, the domestic real interest rate is considerably influenced by the world interest rate. A fully convertible capital account without restrictions on cross-border capital movement implies full convergence of domestic interest rate with the world interest rate and any difference between the domestic and world interest rate is then attributed to the expected exchange rate changes. One can also argue that a certain degree of imperfection in capital mobility can become a desirable policy option for exercising control over the domestic interest rate and to enhance its effectiveness in the economy, but the desirability will depend on the efficiency of policy intervention.

The Relevance of Positive Real Interest Rate

The policy relevance of a positive real interest rate stems from several aspects, although there is no conclusive evidence that a positive real interest rate is essential for promoting economic growth in developing countries.

• First, a positive real interest rate provides incentive for savings and allocates investment more efficiently. This has been the main driving force behind the motivation of financial liberalisation in many economies.
• Secondly, a positive real interest rate across a range of financial instruments ensures greater degree of integration of financial markets and improves the elasticity of substitution among assets.

Trends in Interest Rates in India

In the Indian context, movements in the real interest rates were not a major concern as long as the interest rates were highly regulated and the resource allocation was largely determined by plan framework. With the economic reforms, especially in the monetary and financial sector, which encompassed deregulation of interest rates, there has naturally been heightened concern about interest rate movements. As you are aware, interest rates are now largely market-determined.

In the government securities market the coupon rate on various maturities increased from the range of 10.50 - 11.50 per cent in 1990-91 to 13.25 - 14.00 per cent in 1995-96 but the rates have since declined gradually to the range of 10.85 - 12.15 per cent in 1997-98. In the current financial year so far, the yield of ten-year government security has declined to about 12.0 per cent. The weighted average interest rate on government dated securities increased more than 2 percentage points from 11.41 per cent in 1990-91 to 13.75 per cent in 1995-96, but declined subsequently to 11.82 per cent in 1997-98. At the shorter end, the 91-day Treasury bill rates showed considerable fluctuations, rising from 4.6 per cent in 1991-92 to an average of 12.67 per cent in 1995-96 but coming down sharply in the following two years to 6.83 per cent in 1997-98. Following the freeing of term deposit rate in July 1996, interest rate on bank deposits (public sector banks) of more than one-year maturity increased to a range of 11 to 13 per cent in 1996-97, but softened since then to a range of 9.5 to 12.5 per cent in 1997-98. The wide spreads of rates in a sense reflect market imperfections. After the abolition of minimum lending rate in October 1995, the typical prime lending rate of public sector banks has seen a progressive decline from 16.5 per cent in 1995-96 to 14.0 per cent by March 1998 and further to 13 per cent in the case of major public sector banks by May 1998. The prime lending rates of financial institutions peaked in 1995-96 and declined in the subsequent two years. The interest rates on the taxable public sector bonds were down to a range of 12 to 17 per cent in 1997-98 compared to 13.7 to 17.75 per cent in 1996-97. The typical interest rate on small savings and provident funds have remained at about 12 per cent since 1992-93.

What do the above trends in the nominal interest rate indicate?

• First, the nominal interest rate at the long-end of the market remained fairly strong compared to the rates at the short-end. The difference between the average yield of the 364-day treasury bill and 10 year government bond increased to 3.69 percentage points in 1997-98 from 2.18 percentage points in 1996-97 and 1.13 percentage points in 1995-96. This indicates, to some extent, that the long-term expected inflation and the real interest rate in the economy are higher than those in short-run. We should note that, the prevailing conditions in the secondary markets impose a liquidity premium on government stock in addition to a premium for longer maturities. As markets develop, reduction in liquidity premium will come to a level that will reflect only the premia for the term structure. At that stage, the spreads between the short-term and long-term should narrow and would reflect only premium for maturities. Analytically the long-term rate of interest is the average of the future anticipated short-term rate adjusted for risk and liquidity.
• Secondly, the spread between the interest rate on government security on the one hand, and that on other financial instruments, on the other, has been ruling at a high level. At the short-end, the yield spread between the 91-day treasury bills and typical commercial paper` rate increased from 1.63 to 2.63 percentage points in March 1997 to 6.75 to 8.92 percentage points in March 1998. At a relatively longer end, the difference between the yield on the public sector bond (taxable) and 5 year government security rate ranged between 0.85 to 5.85 percentage points in 1997-98 compared to 0.2 to 4.2 percentage points in 1996-97. The yield differences may imply the changing risk perception of investment in non-government financial assets. The large yield differences may also be explained by virtual absence of secondary markets for PSU bonds, inhibiting stamp duty structures, non-repoable status for bonds that have not been dematerialised, etc. The yield differences could be higher if one considers the front-end discounts and other such features that accompany bond issues.
• Thirdly, the spread between the deposit rate of banks and the government security rate for comparable maturity has declined sharply in recent years. There has been a tendency of both these rates to converge after the ceiling on deposit rate was removed. This is revealed by the fact that the spread between the yield rate on five year Government paper and the maximum deposit rate offered by public sector banks on term deposits has been declining since 1995-96. We should bear in mind the fact that in our market, the yield on government securities appears to be more sensitive to developments in the domestic and international markets than deposit rates. In fact, it has been observed at times that bids in auctions of long-term government paper are unduly influenced by prevailing call market rates. Also, the resource base for large public sector banks includes float funds and saving deposits, and to this extent, the relationships between deposit rates and government security prices are not intimate.

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Source: The Net