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Part II

Trends in the Real Interest Rate

The real interest rates based on the actual inflation rate computed from the Wholesale Price Index (average of weeks) show that, in the government security market the real rate varied between 5.95 per cent to 7.25 per cent for maturities ranging from 3 year to 10 year in 1997-98 compared to 7 per cent to 7.25 per cent in 1996-97 and 5.85 per cent to 6.2 per cent in 1995-96. Based on the weighted average yield, the real interest rate was placed at 6.92 per cent in 1997-98 as against 7.29 per cent in 1996-97 and 5.95 per cent in 1995-96. On the whole, the real interest rate on government bonds has been around 6 to 7 per cent during the last three years. The real rate has declined to below 6 per cent in the more recent months. An important aspect for us to note is that the sharp increase in the real interest rate in 1997-98 and 1996-97 is not due to the hardening of the nominal interest rate, but rather due to a steady decline in the inflation rate in these two years. The inflation rate in 1996-97 at 6.4 per cent declined by 1.4 percentage points over 1995-96 whereas the weighted average nominal interest rate on dated government securities in that year declined by only 0.06 percentage points. So, almost the entire improvement in inflation rate in 1996-97 was reflected on the real interest rate which rose by 1.34 percentage points in that year. In 1997-98, inflation rate has shown a significant decline to 4.9 per cent. Despite a 1.87 percentage point decline in the weighted average interest rate on government bonds in 1997-98, the real rate declined marginally by 0.36 percentage point.

We need to add an important caveat here, that calculations of real rates of interest should take into account the distributed lagged effect. Illustratively, the nominal interest rate in year t needs to be adjusted by taking into account a five-year moving average of the inflation rates in year t, t-1, t-2, t-3, t-4, with weights of say 5, 4, 3, 2, 1. In other words the present inflation rate has a larger impact than the inflation rate in the year t-4.

This has an important policy implication in that as long as the current decline in the inflation rate is not fully captured in expected inflation and reflected in the corresponding decline in the nominal interest rate, the real interest rate would appear to have a tendency to rise, particularly in the long-end of the market. The nature of inflation expectation in an economy then has a significant impact on the real interest rate. If the inflation expectation is forward looking, a credible inflation control policy backed by the achievement of a low inflation rate can quickly alter the long-term inflation expectation and bring down the level of nominal interest rate in the economy. On the other hand, if investors are guided by the past inflation achievements and are backward looking in forming their inflation expectation, the adjustment between the expected and actual inflation can be slow.

In the context of the Indian economy the evidence points to backward-looking expectation behaviour among investors given the wide divergence between the decline in inflation rate and the real interest rate. The expected inflation in Indian economy has been estimated by an internal RBI study to be at around 8 per cent in 1997-98. The ex-ante real interest rate on government bonds based on the expected inflation and weighted average yield on dated securities therefore works out to around 4 per cent in 1997-98 as against 5 per cent in 1996-97.

In the banking sector the movement of real deposit and lending rates are, more or less in tune with the developments in the government security market. Based on the actual inflation the real deposit rate and the real lending rate (based on PLR) were placed at 7.6 per cent and 9.1 per cent, respectively in 1997-98. These are higher than those in 1996-97 at 6.6 per cent and 8.6 per cent, respectively. Based on expected inflation, however, the real interest rate for term deposits of maximum maturity is estimated at a little over 4 per cent in 1997-98 and the real lending rate at about 6 per cent. The spread between the median term deposit rate and lending rate at PLR is placed at around 3 per cent in 1997-98, a little higher than that in 1996-97, but substantially lower than 4.5 per cent in 1994-95 and 1995-96. There could be a decline in the spread between the deposit and lending rate in the recent years, partly due to the competitive rates offered by banks on deposits after the deregulation of deposit rates and the decline in the prime lending rate. It is, however, important to note that the spread calculated on the basis of the PLR and median deposit rate has certain limitations since the average deposit rate and lending rate can vary significantly from these rates. An idea of the actual spread of the banking sector can be had from the net interest income spread of the public sector banks, which as a percentage of total assets has increased from around 2.4 per cent in 1992-93 and 1993-94 to 2.9 per cent in 1994-95 and, over 3 per cent in 1995-96 and 1996-97.

Explanatory Factors

The above trends in the real interest rate raise an important question: Is the current level of real interest rate high in India? This question has been of particular relevance, in the context of the significant increase in the real lending rate of the commercial banks and, a large increase in the real interest rate on government papers. It should be noted that much of the recent increase in the real lending rate is due to decline in the inflation rate. To the extent that, there is a wide difference between the expected and actual inflation rate, the current level of real interest rate does not reveal the true magnitude of expected real interest rate in the economy. As the estimates of expected inflation show, about 3 percentage points in real interest rate is accounted for by the high-expected inflation. Therefore, the expected real lending rate was around 6 per cent in 1997-98, which can be consistent with the recent trends in the saving (22.1% to 26.1% of GDP during 1992-93 to 1996-97); investment (23.3 per cent to 27.3 per cent of GDP during 1992-93 to 1996-97) and growth rates (5.0 per cent to 7.8 per cent during 1992-93 to 1997-98) in the Indian economy.

The real deposit rate and the real lending rate based on the expected inflation (range of 2.2 per cent to 4.4 per cent and 6.0 per cent to 7.8 per cent, respectively) appear to be more or less within the bounds of the GDP growth rate since 1994-95. The strengthening of the real deposit rate has occurred alongside a steady growth in the saving and investment rate in the recent years. It is important to recognise that the growth in broad money has kept a reasonable pace creating an appropriate liquidity condition in the economy. Except for 1994-95 and 1995-96, when the large M3 growth at 22.3 per cent in the former year was deliberately compensated by a modest growth of 13.7 per cent in the latter year, growth rate of M3 was in the range of 15.7 per cent to 18.4 per cent during 1992-93 to 1997-98.

Reasons for Pressure on Real Interest Rate

What are the major factors that could have caused pressure on the real interest rate in India?

• First, a significant part of the recent increase in real interest rate has perhaps stemmed from a relatively high long-term inflation expectation. The current level of expected inflation seems to be significantly higher than the actual inflation rate in the economy during the past two years. For example, the real interest rate has strengthened by about 3 percentage points in 1997-98 almost solely due to the decline in actual inflation 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.
• Secondly, the recent strengthening of real interest rate has a major of part of its origin in the government finances also. Although the ratio of the combined government sector fiscal deficit to GDP has by and large come down in recent years, the high absolute size of fiscal deficit has exerted pressure on the real interest rate in the government security market. With markets getting increasingly integrated, the demand pressure in the government security market has repercussions on the entire gamut of interest rates in the economy.
• Thirdly, a major reason for the lack of sufficient downward flexibility in the real lending rates stems from the stickiness of spread in the banking sector. The spread in the banking sector is influenced by two sets of factors, the efficiency factors and the policy factors. An increase in efficiency in financial intermediation is reflected on the low operating cost and hence in a low spread maintained between the deposit and lending rate. Reducing the real interest rate would therefore require a significant reduction in the operating cost of the banking sector. There are, no doubt, a number of policy factors also which influence interest income and the spread in banking sector but the strongest influence on the spread comes from the operating cost.
• Fourthly, there is an interest tax at the rate of 2 per cent, which the banks load on to the borrowers in addition to the rate of interest charged. This goes on to add to the cost of borrowing, while increasing the difference between deposit rate and cost of funds to borrowers.
• Fifthly, the high effective rate of return offered on some of the non-marketable borrowings of government such as small savings, relief bonds and provident funds has provided a competitive pressure on the real interest rate on bank deposits. The effective rate of return on small savings after taking into account tax rebates on investment is substantially higher than the nominal interest rate on bank deposits. Consequently, the real effective interest rate on small savings is far higher than the real bank deposit rate. To the extent that investment in both these assets are mostly concentrated in the household sector, and there is a significant substitution between them, a high post-tax real interest rate on small savings creates a competitive pressure on the real interest rate on bank deposits.

Policy Issues

This analysis of real interest rates points very clearly to certain major areas that need attention. In fact, many of these areas have already been subjected to substantial policy initiatives though, more needs to be done.

(a) Government Borrowing Programme

A relatively large borrowing programme by government, as we had seen, is not conducive to moderation in real interest rates, especially in the light of persisting revenue deficits. In the current year, the fiscal deficit is being brought down from 6.1 per cent of GDP in 1997-98 to 5.6 percent in 1998-99. Similarly, revenue deficit is also sought to be reduced marginally from 3.1 percent of GDP in 1997-98 to 3.0 per cent of GDP in 1998-99. However, substantial progress is needed to eliminate revenue deficit and achieve a much lower sustainable fiscal deficit.

(b) Bank Spreads

The spread between deposit rate and lending rate can be reduced through policy measures, efficiency measures, and other measures.

• Firstly, the SLR stipulations have been brought down to a statutory minimum of 25 per cent of NDTL. Some reductions in CRR have already taken place, and CRR needs to be reduced further gradually to reach statutory minimum of 3 per cent, from the existing 10 per cent.
• Secondly, interest rate or other stipulations implying cross subsidy or inadequate scope for factoring in credit risk in spreads have a tendency to add to the interest costs to many investors. With substantial deregulation, most, if not all of the inefficiencies on this account have been taken care of.
• Thirdly, in regard to non-performing assets, substantial progress has been made in transparency, awareness and actual reduction. Announcement by the Finance Minister in the recent budget on expanding and strengthening debt recovery systems/tribunals as also comprehensive legal reforms should in due course aid the process of reduction in NPA, and thus cost of intermediation, further. Perhaps, determined and vigorous follow-up on these proposals is to be ensured, keeping in view the recommendations of the latest Narasimham Committee.
• Fourthly, the operating costs can be reduced only by a whole range of measures that would enhance competitive efficiency particularly of public sector banks, which account for a large part of financial intermediation. Here, the skills, the working environment and incentive structures for officers and staff of banks are at least as important as the systems. Progress has been made in terms of some autonomy, and a large degree of awareness but a lot more ground needs to be covered to increase operational efficiency in these banks. Some indicative approaches are available in the latest Narasimham Committee Report.
• Fifthly, as already mentioned, interest tax adds to the cost of borrowing apart from making intermediation through banking channels more expensive than other channels. In fact, the need to dispense with this was accepted and some progress was made in the budget for 1997-98, when an interest-tax which was levied at the rate of 3 per cent on the interest income of lending institutions, including banks and NBFCs was reduced to 2 per cent. This has to be eliminated to keep down the cost of borrowing.

Concluded.

Source: The Net