A reduction in bank lending interest rates is to be devoutly wished for. But the logic leading to the desired outcome is not flawless. The EAC strategy should inspire banks to go the whole hog in cutting costs. But, thereafter, will the banks woo business with lower lending interest?

The question could have attracted a positive answer, without any reservation, if banks had no option but to lend their deposits to commercial borrowers. However, banks can also lend to government. Thus, during the current fiscal year to December 29, 2000, banks expanded non-food credit by Rs 48,802 crore and investments in government securities by Rs 44,000 crore; in the corresponding period of the previous year, banks increased non-food credit by Rs 37,069 crore and SLR investments by Rs 49,870 crore.

Note the sizable deployment of bank funds in SLR investments: the outstanding level of these is about 13 percentage points above the statutory 25 per cent. So, are banks deploying funds in government securities because there are not enough takers of commercial credit at current interest rates? Or do banks prefer to invest in nil-risk SLR securities because the returns they offer are more attractive than on commercial loans which attract provisioning for risk?

If banks prefer SLR investments, they will be in no hurry to expand commercial loans requiring risk-provisioning. (That is to say, the prospective marginal decline in interest rates will not be accompanied by a rise in banks' willingness to lend). The supply of government securities at attractive yields is assured. (If this could be controlled, banks would be forced to significantly explore the commercial lending option).

Deprived of ad hocs (cheap non-repayable loans from RBI), the Centre must borrow from the market (mainly the banks) to cover the large fiscal deficit. This is supported by the RBI's sterilisation policy (sucking out counterpart rupees stemming from foreign currency inflow). It is estimated that during the 30 months ended September 2000, net forex assets rose by Rs 46,953 crore (equivalent); and the RBI sucked out through open market operations Rs 74,274 crore in the same period.

The on-going pre-emption of resources by government has held up interest on government borrowings; this is the floor interest rate attached to risk-free assets; risky commercial loans have to pay above the floor rate. Cutting down the interest on small savings ducks the core issue of pre-emption of resources by government which gives an upward bias to interest rates. In sum, the government must substantially cut-back pre-emption to bring down its cost of market borrowing and create a large commercial lending surplus. An isolated cut in interest on small savings will be a perfunctory measure. However, contraction of market borrowing, based on a fresh squeeze on public investment, will sharply slacken aggregate investment demand: the consequent softening of interest rates will then be pyrrhic.