CHENNAI, FEBRUARY 4: Signals are important; they influence expectations. In promising a bank rate cut (from the prevailing 8 per cent), the Reserve Bank governor issued what appears to be an encouraging signal. Business will feel reassured. True, Dr Bimal Jalan held both the timing (before the budget or after) and the extent of the cut under consideration close to his chest.But he said something far more important: the economy has logged a good rate of growth with low inflation; forex reserves are at a high and the external situation is favourable; thus the ``conditions are favourable for a cut in interest rates''. Jalan's analysis suggests that lower interest rates will boost economic growth and that there is no question of the economy overheating; his implicit point is that the current high real interest rates hurt growth. That is fairly straight talk from a central bank. But how do you get interest rates down?
Ostensibly, a lower bank rate will do the trick. But banks are hardly big borrowers from the Reserve Bank. Cheap central bank accommodation will fall flat. Note that Jalan's intention to cut the bank rate follows the reduction in interest rates the government pays on small savings and the public provident fund. Period.
The point is that the full percentage point reduction in the Bank rate (last April) brought down the banks' prime lending rate by 50 to 75 basis points; the PLR remained above 12 per cent or close to a stiff 8 per cent in real terms. As Jalan points out, two-thirds of bank deposits are locked up at high interest rates.
That is to say, a downward adjustment in deposit interest (in the wake of a bank rate reduction) saves interest costs only on incremental deposits. In the short run, aggregate interest costs of deposits fall but marginally. This is the reason why despite the cut in the bank rate from 11 per cent to 8 per cent in recent years, the PLR remains at a stiff high. Lending interest rates are also sticky because banks have to cover bad loan provisioning.
The proposed bank rate cut will disappoint industry which wants lending interest rates to come down by at least two full percentage points. At best, working capital loans will cost marginally less, unless the commercial banks strive to cut down servicing costs and pass on productivity gains to borrowers. Judging by the fall in gilt-edged yields, following Jalan's loud thinking, the government may issue new loans at pared coupon rates. But this loss might discourage the banks from cutting lending interest rates.
The swings and roundabouts of a bank rate cut are unpredictable. May be a rise in the inflation rate is needed to bring down real interest rates!
Copyright © 2000 Indian Express Newspapers (Bombay) Ltd.