"It's true that the real interest rate is on the higher side at the moment but the lower year-on-year inflation rate does not call for a rate cut immediately as in the Indian context there is no correlation between interest and inflation rates. Despite the low inflation level, there is no drastic change in the bank deposit rates and hence logically lending rates cannot go down," sources close to the north block said.

"Corporates would always like to borrow money cheap. There is nothing wrong in their demand. But the point is: Has the banks' spread gone up because of low inflation rate? Moreover, last year when the inflation rate touched double-digit--triggered by the onion price rise--did the banks hike their lending rates? The answer is an emphatic no in both the cases as lending rates are related to deposit rates and not inflation (rate)," sources point out.

In India, the difference between lending rates and banks' cost of deposits is around 2.5 per cent. Banks are not in a position to cut lending rates because of the high intermediation cost and hence the lending rates can only be brought down if the deposit rates are slashed.

However, deposit rates cannot be slashed in isolation when both public provident fund (PPF) and provident fund (PF) continue to offer 12 per cent interest rates and other instruments like Relief Bond and National Savings Certificates offer tax-free high returns.

The only way interest rates can be brought down, industry experts argue, is by cutting bank rate and cash reserve ratio (CRR) which will release fresh funds into the system. At present, bank rate is pegged at 8 per cent and CRR 9.5 per cent. However, the RBI may not be comfortable with the idea of a CRR cut at this point of time with the system flush with liquidity and money supply (M3) hovering over 18 per cent level.

"The RBI is not expected to change bank rate if inflation rate rules low (or high) for a few weeks. It can only take appropriate measures after taking a medium-term view. If y-o-y inflation contues to rule low over the next few months and the signs of credit offtake are clear, the central bank may opt for bank rate and CRR cut in its October credit policy," a senior banker said.

The Reserve Bank had effected its last bank rate cut in March immediately after the presentation of the Union budget. Post elections, a stable government at the centre and rising demand for credit on the back of industrial recovery will pave the path of a rate cut, bankers expect.

Industry captains have been lobbying hard for a cut in lending rates after inflation fell to a historic 17-year low of 1.83 per cent on July 3, 1999. But analysts feel the fall in the rate of inflation should not prompt another cut in lending rates by banks as the two-year compounded annual growth rate (CAGR) for inflation is still quite high at 4.97 per cent.

Anlaysts argue that since inflation is computed on a year-on-year (YoY) basis, the wholesale price index (WPI)-based inflation will continue to fall over the next few months. Prices of fuel group items, which are still largely administered, are unlikely to be hiked ahead of general elections. With the trend in primary articles and manufactured products likely to continue, the WPI inflation rate could drop to one per cent, but one has to keep in mind the two-year CAGR which would be about 5 per cent.

Centre should cut borrowings

The policymakers seem to have got hold of the wrong end of the stick. The purpose of policy is not to find reasons why interest rates cannot be reduced, such as high PPF rates, or banks' need for a high spread. Rather, measures need to be formulated which will ensure that interest rates come down to rates prevailing in the rest of the world, so that the competitiveness of our industries is enhanced. The ultimate solution lies in reducing the appetite of the government, the largest borrower.

--Manas Chakravarty