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One of the favourite predictions of the proponents of financial
liberalisation measures in the 1990s was that the eventual result of such
reforms would be reductions in real interest rates. It was argued that
there would be an initial rise in such rates to redress the excessively
low interest rates created by policies of "financial repression". In fact
this was argued to be both necessary and welcome because it was supposed
to lead to higher rates of domestic saving as well.
But thereafter the greater access to capital, especially from
international markets, was supposed to imply that Indian entrepreneurs
would face lower real rates of interest. This in turn would obviously act
as a spur to investment. Thus financial liberalisation was seen as a means
of generating lower real interest rates and higher real investment rates.
This has not occurred. In fact, neither have investment and savings rates
increased significantly over the 1990s,
nor have real rates of interest
gone down over the course of the decade. Chart 1 show the overall savings
ratio, the household savings rate and the financial savings of households
as proportions of GDP.
Chart 1 >>
This shows that gross domestic savings rose slightly in the mid-1990s (a
period when, interestingly, real interest rates were relatively low) and
have declined slightly thereafter, to levels that are more or less
comparable to those of the beginning of the decade. This decline from the
mid-1990s has also been associated with a decline in household financial
savings.
Meanwhile, nominal interest rates have fallen, but real interest rates
have shown no such tendency and have in fact risen quite sharply from the
middle of the decade, to levels well in excess of 8 per cent. This is
clear from Chart 2, in which the representative nominal interest rate is
taken to be the State Bank of India's Advance Rate. The real interest rate
is that minus the rate of change in the Wholesale Price Index. (The other
nominal interest rates facing entrepreneurs, such as the term lending
rates of the non-bank financial institutions, tend to be substantially
higher.)
Chart 2 >>
Clearly, this is something which requires explanation. Even if the very
optimistic argument of the liberalisers concerning the effect of capital
inflows on domestic real interest rates were not accepted, there would
still have been some expectation that access to more forms of capital
would have meant some decline in real interest rates for domestic
investors. The apparent imperviousness of real interest rates to any such
pressure therefore deserves much closer consideration.
One of the arguments that has recently gained a lot of attention, and is
increasingly cited by a number of proponents of the financial sector
reforms, relates to the fact that small savings by households constitute
an important part of the overall savings in the economy. According to this
argument, the Government, in order to attract small savings in the form of
Public Provident Fund, Post Office deposits, National Savings Schemes and
other such schemes to finance its own expenditure, has kept interest rates
on such schemes relatively high.
In addition, of course, such schemes have the advantage of appearing to be
risk-free besides offering the added incentive of tax benefit up to a
certain limit. For the household sector, this has increasingly become an
attractive alternative to bank deposits. For this reason, banks are forced
to maintain high deposit rates and this is why their lending rates remain
high despite the financial liberalisation measures.
Another explanation that has been offered relates to the supposed
inefficiency of banks, due to "inadequate liberalisation" and the fact of
public ownership, which is supposed to have meant that the spreads between
deposit and lending rates has remained high. According to this position,
the dominance of the nationalised banking sector has meant that the
benefits of lower deposit rates are not passed on the borrowers, and so
investors continue to face high rates.
It is worth considering the validity of these arguments in more detail,
because they are now commonly advanced as likely without careful
assessment of the available evidence. Consider first of all the argument
relating to small savings and the higher returns to households from such
savings.
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