‘Interest’ is the compensation for one of the most important
resource needed for production, i.e., ‘capital’. The rate of interest in short term mostly
depends on the forces of demand and supply much like for other sources of
production like labor (wages), land (rent) and raw material. However, over a
longer period there are many factors that structurally impact the demand and
supply of capital and therefore influence the rate of interest demanded and
offered for use of such capital.
The benchmark or policy rates established by the regulators or
central bankers theoretically play a critical role in determination of interest
rate structure in an economy under normal economic conditions. However, in
extreme cases policy rates may fail to transmit to the ultimate provider or
user of capital.
Indian economy presently is passing through such extreme
conditions. Therefore, policy rates established by RBI are not as effective as
these should be under normal circumstances.
Banks have not reduced interest rates in past one and a half
year despite RBI easing the policy rates. The reason for this failure in
transmitting the policy rates are varied and multiple. For example:
(a)
The default risk and therefore credit cost for
banks has risen substantially in this period. Most of the credit demand is for
re-financing of existing stressed loans or working capital loans. Thus
increasing the risk premium.
(b)
Fiscal profligacy has kept demand for government
borrowing higher whereas higher inflation and higher administered small savings
rates have led to lower deposits growth (supply of funds).
(c)
Precarious BoP conditions have prevented the
regulator from aggressively enforcing transmission, as lower rate could impact
inflow of much needed foreign capital.
In our view, higher risk, higher demand and lower supply should
keep interest rates in Indian context relatively higher for next couple of
years at the least.
Also read other posts in this series:
Thought for the day
“The more a sensibilitist I am; The more I seem to want my mountains wild.”
- Robert Frost (1874-1963)
Word of the day
Palinode (n):
a poem in which the poet retracts something said in an earlier poem
(Source: Dictionary.com)
Shri Nārada Uvāca
Jayalalithaa’s googly to BJP – AIDMK supports for communist D. Raja for his Rajya Sabha election.
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