Administered Interest Rates in India

Administered Interest Rates in India
Author(s): L. M. Bhole
Source: Economic and Political Weekly , Jun. 22-29, 1985, Vol. 20, No. 25/26 (Jun. 22-29,
1985), pp. 1089-1104
Published by: Economic and Political Weekly
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Administered Interest Rates in India
L M Bhole
The rate of interest is an important price in any ecqjiomy. If it is determined mainly by the market f
may hetp in taking appropriate decisions about saving, investment, allocation of resources, financial and m
policy, etc. However, the level and structure of interest rates in India have remained very closely regulated by
the authorities. The present study examines the working of this administered system of interest rates, and discusses
the issues and considerations which need to form the basis of future interest rate and monetary policies for the
Indian economy.
THE plan of the study is as follows: In concerned about the high and increasing neea to establish their appropriate level
Section I, after stating the background capital-output and capital-labour ratios, which at present would be much higher
and the content of the present system, wewidespread low rates of utilisation of the than what it has been so far. It is not a
briefly refer to the nature, criteria, and already existing production capacities, un- case for usurious or exhorbitantly high in-
feasibility of an alternative system of in- duly long lags between investment expen- terest rates, but for 'appropriately' or 'cor-
terest rates which, according to us, would ditures and flows of output, and the rectly' high rates of interest. In doing this,
be appropriate for India. Section II misuse of capital in other ways. we are sharing the perspective developed
discusses the features and rationale of the It is in this context that we have under- in this respect by Myrdal, Shaw, Mckin-
present system by reconstructing its scope, non, and Brahmananda,I and restating
taken a comprehensive review of the work-
techniques, authority, timing, and its ef- ing of the present interest rates policy in the case for free and higher interest rates.
fects on interest rates and credit control This restatement may be regarded as valu-
India in all its major aspects. Over the
mechanism. The reasoning and empirical able and useful because it is far more com-
period of time, more and more interest
evidence in support of the case for an rates have been brought under more and prehensive, up-t-o-date, and based on em-
alternative system are presented in Section more detailed administrative and discre- pirical evidence from the Indian economy
III. The lessons from experiences of some as never before.
tionary controls. As a result, the system
countries in operating the similar systems with the following characteristics has The system of administered interest
of controlled interest rates are mentioned
evolved during the past many years: rates is a special case of the wider system
in Section IV. Summary and conclusions
(i) The rates of interest have been kept at of prices and physical controls which have
are presented in Section V.
unnaturally low levels. (ii) The regulation come to pervade most of the developing
of one interest rate has led to the regula- economies. It is hoped that our analysis
I
tion of another rate. In other words, a ceil- would be useful in re-evaluating the utility
The Background and Anticipatory ing on one interest rate has begotten and advisability of the continuation of
Remarks another ceiling. For example, the regula- these other controls also.
tion of banks' lending rates has necessitat-
The performance of the Indian Before we proceed to explain our posi-
ed the regulation of their deposit rates;
economy during the past three decades of tion, it is necessary to refer briefly to the
and the latter, in turn, has forced the regu-
economic planning has been far below the criteria which can help to determine the
lation of interest rates on deposits with
needs and expectations. There has been appropriateness or otherwise of a given
non-banking companies. (iii) Because the
ratcheting upwards of inflation and un- system of interest rates, what are the alter-
interest rates have been controlled and
employment accompanied by near stagna- native systems which can take the place
kept low, the need has arisen for the im-
tion in the rate of growth. It has been of the present system, and the feasibility
position of widespread and detailed
characteristic of the Indian economy that of the system chosen from them.
quantitative ceilings or restrictions as a
instead of experiencing 'trade offs' bet- In a wider sense, the objectives of eco-
means of allocation or distribution of
ween different economic objectives, there nomic planning should serve as good
finance and fighting inflationary pres-
has been a deterioration on all fronts. All criteria for judging the suitability of any
sures. Thus, the system of administered
this has happened in spite of the adop- given sub-system in the economy. How-
interest rates comprises the presence of
tion of economic planning, and a fairly ever, from the point of view of the im-
discretionary controls on the level and
high rise in the rates of saving and capital mediate relevance and concern, given the
variations of interest rates, the mainte-
formation. Such a poor outcome of our capital scarcity, interest rates policy should
nance of these rates at lower levels than
tryst with destiny is naturally making be such (a) that savings are adequate, and
what they would otherwise have been, and
many a people restless and compelling they are held in forms which are conducive
the existence of the quantitative restric-
them to seek solutions to the predicament for both their use in the growth process
tions on the disbursements of credit.
just described., and control by monetary authorities for
To the extent the monetary and finan- We have attempted to establish in this the purpose of economic stabilisation;
cial factors are relevant in economic deve- study a -connection between this sytem (b) that available savings capacity is
lopment, efforts are being made to under- and the financial and real performance of harnessed for investment in essential and
stand better the working of the Indian the Indian economy. It has been argued, productive purposes, and the efficiency of
monetary system so that appropriate poli- with some empirical evidence, that it has investment is maintained consistently at
cies can be devised for maximising its con-resulted in an inappropriate saving and in- a high level. Interest rates should induce
tribution to the development process, vestment behaviour, maldistribution of socially desirable allocation of resources
Among other things, a clear consensus isfinancial resources, the accentuation of and pattern of investment.
now energing in favour of the urgent need the problems of inflation, unemployment, Stated slightly differently, interest rates
for an increase in the productivity of in- etc, and the weakening of the effectivenesssystem should be such as to help the
vestment in place of the earlier emphasis of monetary policy. Therefore, a case has financial system to adapt flexibly to the
on the increase in merely the quantum of been made for freeing interest rates from evolution of the requirements upon it, and
investment. Everybody now appears to bethe administrative controls, and for the to meet these requirements adequatel and
Economic and Political Weekly

Vol XX, Nos 25 and 26, June 22-29, 1985 1089

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June 22-29, 1985 ECONOMIC AND POLITICAL WEEKLY
automatism, i e, people's
equitably so that individual groups behaviourof
is market forces.
bor-
rowers and lenders are not arbitrarily mostly guided by relative rates of cost and Under the administered interest rates
discriminated and disadvantaged, all the returns rather than administrative discre- system the interest rates are fixed or made
possible economnies in administrative and tions. However, price mechanism is first to, rule at a given level through fiat or
other costs are realised, antd the oppor- adjusted, again mostly through changes discretionary administrative controls with
tunities for corruption and arbitrariness in price signals under the control of almost no reference to the factors em-
are absolutely minimised.2 The system authorities, so that now it provides the bodied in the supply of and demand for
should be simple and open also. specific inducements and inhibitions funds. Such a system has now come to
It is possible to thihk of at least three which are 'correct' with reference to the prevail in India, through gradual evolu-
types of system of free interest rates: goals and targets of economic policy.3 tion over the period of time. Till about
(i) a completely laissez-faire, (ii) a system Such a system is quite feasible and in 1958, all the interest rates were more or
in which the quantity of money is closely tune with the philosophy of economic less free; in the month of October of that
controlled by the authorities and interest planning. As, Oscar Lange has pointed year, however, a ceiling on the deposit
rates are left to find their own levels as ad-out, the price system, including interest rates of commercial banks was introduced
vocated by the 'monetarists', and (iii) a rates, is an important incentive serving to through the voluntary agreement between
system of 'indicative' regulation of interestinduce the private sector to do things re- some lIfdian and foreign banks. Under
rates accompanied by the minimum of quired of it in the plan. But also in the this agreement, a separate maximum rate
discretionary controls. It is this last type public sector, the need for incentives ex- was fixed for deposits of different maturi-
which we have in mind when we argue for ists which again requires a proper price ties. Even then, there was a great deal of
free and flexible interest rates system for system.4 It may also be reminded that in flexibility and variations in the deposit
India. the initial years of planning in our coun- rates paid by different banks which were
I A completely laissez-faire system of try, there was a clear preference for and party to the agreement; the rates paid by
freely floating interest rates, without any emphasis on maximum reliance on the other banks naturally differed from one
t;ype of government intervention in finan- price mechanism and the minimum use of another, and from the banks bound by the
cial markets, is obviously unrealistic for physical controls for implementing econo- agreement. This system lasted for six
India where formal economic planning mic plans. It is, therefore, a misconception years.
has been of much higher degree and that planned or socialistic countries need In September 1964, it was replaced by
serious hue. At the same time, it is to be to keep interest rates low and operate the regulation of deposit rates by the RBI
through a maze of discretionary controls.
firmly grasped that it is equally unrealistic in terms of the Banking Regulation Act,
to expect that direct, discretionary, all- The over-reliance on the present system of 1949. With this change, the system of
pervasive state intervention would help to interest rates is an aberration which defini- regulation became more general and it in-
deal with the imperfections in financial tely needs to be corrected sooner than volved, unlike previously, the fixation of
markets. A policy of discretionary con- later. both the minimum and maximum rates.
trols to deal with market imperfections is Under this system which continues to
II
a logical contradiction, it is a sure way of prevail now also, while the maximum rate
perpetuating imperfections, albiet from aThe Reconstruction of the Present is prescribed on deposits of maturities
different source. System-Its Features and upto 90 days, the minimum rate is pres-
cribed on deposits of maturities beyond
The monetarists have been recommen- Rationale
90 days. In practice, the minimum and
ding that interest rates should be allowed
EVOLUTION, SCOPE, TECHNIQUES, ETC maximum rates have mostly turned out to
to float freely in the markets, and the task
be the fixed rates actually paid by the
of regulation should be performed by the A large variety of interest rates exists
banks on regpective maturities, i e, no
Central Bank by fixing a monetary rule. in any economy at any given time. For ex-
bank pays less than the maximum or more
It will be shown later how such a system ample, in India, there are deposit rates of
than the minimum rates stipulated by the
is beset with certain practical operational commercial banks, co-operative banks,
RBI'5
difficulties because of which, apart from postal savings organisation, non-banking
The deposit rates of co-operative banks
other weaknesses of the monetarist ap- companies, then there are lending rates of
came under the perview of these regula-
proach, the acceptance of such a system these and term-lending financial institu-
tory measures not until 1974. Since then,
is also inadvisable. tions; further, there are rates on industrial
co-operative banks also have been paying
Our plea, therefore, is for a esystem and government securities. All these rates
on their deposits interest rates prescribed
wherein, instead of fLxing almost each andcan be classified as loan rates and rates
by the RBI. They are now allowed to pay
every interest rate, the authorities operate of return on savings (in case of 'direct
interest rates which are higher by certain
more through the instruments of mone- securities', loan and savings rate are the
percentage point(s) (normally, one-half of
tary control-not this or that technique same) or as short-term and long-term
one per cent) over the rates prescribed for
but a whole set of them used in a mutually rates. Under perfect competition, the
the respective maturity of deposits of
reinforcing manner-such as the bank respective levels of all these rates, and the
commercial banks. As a result of this
rate, open market operations, changes in interrelationships between them (i e, their
policy interest rates of commercial and co-
the quantity of money, etc, to determine structure) would be determined on the
operative banks have come to be linked,
the market rates of interest and flows of basis of market forces reflecting produc-
and changes in them have been effected
money and credit. Such a system works tivity of borrowed capital, risk and uncer-
simultaneously since 1974.
through automatically functioning opera- tainty, premium for abstinence and li-
tional controls, and changes in interest quidity preference, maturity, time prefe- The lending rates of commercial banks
rates therein are induced rather than ad- rence, etc. The various degrees of im- have also been controlled by the RBI in
ministratively fixed There is, as Myrdal perfections in the money and capital terms of the Banking Regulation Act,
has pointed out, a far greater use of price markets would modify the rates but they1949 since 1960 in the form of prescrib-
mechanism and a very high degree of would still be determined mainly by the ing minimum, maximum, dual, and dif-
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ECONOMIC AND POLITICAL WEEKLY June 22-29, 1985
ferential interest rates. It prescribes dif- pear to be free from any formal and direct
to pay any interest rate upto the ceiling ir-
ferent minimum and maximum rates respective of the maturity of deposits. Ascontrol of the authorities in India.
depending upon the size of banks, the size a result, the companies have a greater Thus, almost every interest rate in India
and purpose of advance, the type of bor- degree of flexibility than the banks in is now very closely administered in the
rower, the nature of security, etc. Similarly, respect of the mobilisation of deposits. form of fixation of either the specific, or
there are separate minimum rates for the Secondly, while the cost of deposit- minimum or maximum (ceiling) or dual
general credit and the advances under the resources of non-banking financial com- or differential level by the government or
selective credit controls, respectively. panies is regulated,' their lending rates, RBI or Controller of Capital Issues or the
The lending rates of co-operative banks unlike banks, are not subject to regula- Indian Banks' Association, etc, through
were regulated indirectly or through 'sua- tion. This also puts such companie$ in a the exercise of statutory powers or volun-
sion' till 1980. As co-operative banks, at favourable position vis-a-vis banks., tary agreements or suasion. While the ef-
all levels of their three-tier structure, de- There is a ceiling on the level of call rate fect of such a policy on the behaviour of
pend on the RBI for concessional finan- also which is imposed by the Indian interest rates themselves is discussed in the
cial resources, while they were always 'ex- Banks' Association since 1973. Interest following subsection, its wider effects on
pected' to charge only the 'reasonable' rates on post-office saving bank, time, and the economic activity as a whole will be
rates to the borrowers from the agriculture other deposits, other small savings media,analysed subsequently.
and allied activities, in case of finance for Theasury bills and government dated
EFFECTS ON INTEREST RATES AND CREDIT
production and marketing activities of the securities are all directly fixed by the
Government of India. Interest rates on in- CONTROL MECHANISM
cottage and small-scale industries, the
terms of concessional refinance stipulated dustrial debentures and dividends on Statistical series over a long period of
certain conditions about the rates to be preference shares are subject to a ceiling time are available in India only for a few
charged by them to these borrowers. In prescribed by the Controller of, Capital interest rates, although the situation here
1980, the loan rates of co-operative banks Issues. The.loan rates of the statutory is probably not as bad as in many other
also came to be statutorily regulated and financial institutions, although not sub- developing countries. It may be mentioned
now all the lending rates of these banks ject to any direct control, also can be said here that the RBI used to publish only a few
are under the direct statutory control of to be regulated through 'suasion' To the money rates of interest in its Annual
the RBI. extent that these institutions supply creditReport on Currency and Finance till
Interest rates on deposits accepted by to the public sector, small scale units, units1972-73; this practice underwent a wel-
non-banking non-financial companies, in the backward regions, and for other come change with effect from 1974-73
and non-banking financial and miscella- priority purposes, their interest rates are when it started publishing data on many
neous companies, which were completely bound to be influenced by the thinking short-term and long-term interest rates in
free till recently, have become subject to of the authorities about the 'appropriate the 'Structure of Interest Rates in India'
a ceiling fixed by the Government of India cost of finance; and this influence must Thble. But even now, this Table does not
and the RBI, respectively with effect from be strong because of the government include information about interest rates
the beginning of the financial year, 1981- ownership of these institutions, Similarly, on the post-office and other small savings
82. There are certain notable points about institutions like IDBI impose ceilings on media including provident fund, interest
this regulation. Firstly, unlike in the case rates to be charged by the primary lenders rates in the co-operative banking and
of bank deposits, in place of different ceil- who obtain refinance and rediscounting credit structure, commercial banks' sav-
ing rates for deposits of different maturi- facilities 'from them. It is only the ratesing deposit rate, interest rate which the
ties, there is only one ceiling rate which of return on ordinary shares and units, RBI pays on excess reserves, etc. This
is stipulated, and the companies are free bazar bill rate, and hundi rate which ap- short-coming needs to be corrected. The
TABLE 1: INTEREST DIFFERENTIALS IN INDIA
Rates year
on 51-52 55-56 60-61 65-66 70-71 75-76 80-81 81-82
1) TB-call money 0.17 -0.23 -1.59 -2.76 -2.88 - 5.95 -2.52 -4.36
2) Bank rate (1 year) deposit 1.46 0.95 0.56 0.0 -0.38 1.0 1.0 1.5
3) SBI Advances (1 year)
deposit 2.27 1.45 1.56 1.50 2.87 6.0 8.5 8.0
4) Bank deposit:
i) (3-year)-(l-year) - - 0.25 0.25 0.50 1.0 2.0 1.5

ii) (5-year)-(1-year) - - 0.75 1.0 1.25 2.0 2.0 2.5
iii) (5-year)-(3-year) - - 0.50 0.75 0.75 1.0 0.0 1.0
5) Debenture coupon (5-year)
deposit - - 3.0 0.0 0.75 -0.5 3.5 4.0
6) 5 to 15 years government
bonds (5-year) deposit - _ -0.62 -1.74 -2.67 -4.25 - 3.73 -4.59
7) Government bonds:
i) Medium term/shortterm - - 0.24 0.11 0.48 0.12 0.9 0.54
ii) Long term/medium term - - 0.2 -0.19 0.57 0.0 0.69 0.81
8) IDBI loans-SBI advances - - - 0.50 0.0 -3.0 -3.58 -2.5
9) IDBI loans-Debenture
*coupon - - 0 to -0.5 1.0 0.5 0.5 to 1.0 0.5 -1.0

Notes: Deposits refer to commercial banks' fixed deposits; IDBI loa
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behaviour of a few selected weightage given to them, which

nominal andunderlie from year to year. The post-office
real rates of interest over their 'mark-up'
thedecisions.
period. It appears
of that rates have been mostly higher than the
more than a hundred decisions years in respect of changes in interest
(1870-1983) is bank deposits rates, and their difference
depicted in Figures 1 and 2. rates are mostly being taken quite hapha- has varied between zero to 2.0, and -0.5
(i) It would be observed from Figure 1 zardly, in an ad hoc manner, and to 2.75 percentage points in case of one
that there has been quite a bit of increaseinadequately. Consequently, the levels of to three-year, and five-year deposits,
in interest rates during the sub-period interest rates, differences in different rates, respectively during 1969-70 and 1981-82.
1950-83, but the major part of this in- and changes in both of these have usually Similarly, interest rates on small savings
crease has occurred after 1974.6 Inciden- not been related to the, considerations of media have been higher than those on the
tally, it may also be noted that there have risk, liquidity, maturity, demand for and government securities of comparable
been very few marked fluctuations in supply of funds, commodity prices, etc. maturities. There is no reason why the
interest rates during this period. The The concept of adja.cei^cy of different coupon rates on the bonds of IDBI, IFC,
American experience,7 and our own in financial assets in the sense of the ex- EXIM Bank, etc, should be higher than
the past show that when interest rates are istence of well-defined differentials in those on government securities. While the
free, they tend to fluctuate much more in interest rates (returns) on them when they lending rates of the EXIM Bank have
upward and downward directions., are arranged in the descending or ascen- ranged between 9 to 12 per cent, those of
An increase in interest rates just men- ding order on the basis of their major at- commercial banks have ranged between 4
tioned has been the result of periodic tributes does not appear to have much to 18 per cent. The phenomenon of short-
'mark-ups' but we do not know how the meaning in India (see Table 1). For exam- term interest rates exceeding the long-term
authorities have, from time to time, decid- ple, it is difficult to understand why in- rates unrelated to the cyclical swings in
ed upon the extent, frequency, timing, etc, terest rates on time deposits of the same business activity is also to be explained in
of these 'mark-ups'. We do not have any maturity with the post-offices and banksterms of the discretionary controls in this
enunciation from the authorities about should differ much, and why such a diffe- context.
the principles or considerations and the rence, if it exists, should fluctuate greatly (ii) In spite of some increase, interest
rates during the era of regulation can be
TABLE 2: INTEREST RATES IN INDIA AND OTHER COUNTRIES
said to have been artificially maintained
1977 1981
at lower levels than what they otherwise
would have been and what they should
Country DR MMR GBY DR MMR GBY
have been. The following theoretical and
1) India 9.0 10.18- 6.32 10.0 8.61 7.15 empirical evidence supports this view-
2) US 6.0 5.54, 7.67 12.0 .16.38 13.72 point:
3) UK 7.0 8.06 12.73 14.0 13.29 14.74 (a) The very objective of imposing dis-
4) Germany 3.0 4.37 6.20 7.50 12.11 10.38 cretionary controls has explicitly been to
5) France 9.5 9.22 9.61 9.5 15.26 15.66 keep interest rates at lower levels as in the
6) Canada 7.50 7.33 8.70 14.66 17.72 15.22 cases of deposit rates, rates on finance for
7) Sweden 8.0 9.96 9.74 11.0 14.35 13.49 fixed investment, rates on government
8) Italy 11.50 14.03 14.62 19.0 19.60 20.58 debt and loans to the priority sectors, etc.
9) Japan 4.25 - 7.33 5.5 7.69 8.66 (b) Sometimes controls were introduced
10) New Zealand 10.0 - 9.23 13.0 - 12.83 precisely when interest rates determined
11) South Africa 9.0 7.87 10.96 13.50 9.80 12.56 by the market forces reached the levels
12) Pakistan 10.0 10.87 9.27 10.0 9.27 9.40 which were 'regarded' as 'unduly' high by
the concerned authorities. In such cases,
Notation: DR = Discount Rate of the Central Bank; interest rates have been definitely kept at
MMR = Money Market Rate; lower levels through the imposition of ceil-
GBY = Government Bond Yield. ings. For example, the call money rate. The
Source: International Monetary Fund, International Financial Statistics, various issues. in other countries such as UK
experience
and US shows that whenever the policy of
TABLE 3: FEATURES OF SAV,INGS BEHAVIOUR. IN INDIA (ANNUAL AVERAGES)
pegging of interest rates was abandoned,
there was a sharp increase in those rates.
Period 1951-52 1955-56 1960-61 1965-66 1970-71 1975-76
Feature to 54-55 to 59-60 to 64-65 to 69-70 to 74-75 to 79-80 (c) The rates which have not been sub-
ject or amenable to regulations have been
1) Net savings as percentage
consistently higher than the controlled
of NDP- 5.82 8.34 10.3 11.80 14.28 19.48
rates. For example, the bazar bill rate, SBI
2) Corporate saving
hundi rate, and other rates in the un-
a) as percentage of total
organised sector of the financial markets.
saving 7.91 5.98 8.09 3.17 6.24 3.26
b) as percentage of NDP 0.46 0.49 0.81 0.37 0.91 0.64
(d) While judging whether interest rates
3) Houshold saving
in a given period are high or low. they have
been very often compared with their histo-
a) in financial assets
as percentage of NDP 1.16 3.17 3.65 3.37 4.96 7.48
rical level. The application of the idea of
b) in physical assets as
historicism to interest rates has given rise
percentage of NDP 2.96 3.31 2.78 6.14 6.23 7.47
to notions such as the 'band of feasible
c) in currency as percentage
rates'8 or the 'gears of interest rates'. It
of total household saving 7.17 20.49 26.20 25.36 19.66 17.74
is argued that there is some 'normal' level
of and changes in interest rates the idea
about
Source: Rao, V K R V, "'India's National Income, 1950-80", Sage which can beNew
Publications. obtained from
Delhi, the
1983.
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level of and changes asin banks'interest

deposits rates, government
ratesbond determinant of variations in the nominal
which
occur in quiet times and which are consis- yield, etc. These rates can justifiably be interest rates so that the real interest rates
tent with the maintenance of organised deemed to have been effectively still lowermaintain appropriate positive levels. As it
markets. The rates of interest cannot rise (than what data show) if we take into would be seen in Figure 2,12 the real rates
or fall in any given period very far from account, as we must, the fact that the of interest in India during the post-1950
this 'normal' level, except for a brief expected or planned rates of economic period have been mostly negative; and
period. Some people in India have conve- growth and capital formation have been whenever they were positive, they were
niently and successfully made a case for far higher after 1950 than in the historical mostly around the low level of 2 to 4 per
lower interest rates on the basis of such period. While the rate of gross capital for- cent per annum.13
notions. They have argued that interest mation during 1861 to 1929 was about 5
It is likely to be pointed out that the real
rates in the post-independence period have to 7 per cent,"I it was about 12 to 20 per
rates of interest were negative in the earlier
been higher than their historical level, and, cent during 1951-75. If the relevant factors
period also when the rates were not con-
therefore, they should be (further) such as the relative demand for credit and
t-rolled. It has to be accepted that
reduced. finance, the size of government borrowing whenever the rate of inflation has been
programme, deficit financing, balance of
The current interest rates policy cannot very high (around 25 per cent and above),
payments difficulties, the rate of inflation,
be determined mainly on the basis of a it has not been possible for the nominal
historical approach because it is a static etc, were freely allowed to influence in- interest rates to keep pace with such price
terest rates, the latter would have been
one. But even by historical standards, changes even though there were no con-
much higher than their historical as well
interest rates in India have been held at trols on their movements. This long-term
lower levels after 1950. It would be clearly as current levels. Further, if the history of
experience in India suggests that the
interest rates is important, how can we
observed from Figure 1 that excepting the Fisher effect may not be observed in the
period of 1933-50,10 banks' advances forget the history of interest ratds in the
period of hyper-inflation, and the princi-
rate, for example, has been lower during unorganised and semi-unorganised sectors
ple stated in the previous'paragraph may
1951-70 and only slightly higher during of the economy?
be valid only in periods of normal mild
1970-75 than its own level during (e) If the interest rates are not admini- inflation. Having accepted this, it may still
1870-1933. The same thing is also more stered, the secular and cyclical changes in be noted that before 1951, real interest
or less true of other controlled rates such the commodity prices act as a major rates were negative only during war-years;
FIGURtE 1: NOMINAL INTEREST RATES IN- INDIA, 1870-1983
16W BANKERS ADVANCE RATE - X r

YIELD ON GOVT BONDS T
15 WHOLE'SALE PRICES -.-*- 1 300
COMMERCIAL BANKERS | 290

14 DEPOSIT RATE | [ - f 280
POSTAL SAVING BANK _ / ( f /270
13 DEPOSIT RATE I . ! | 260
BAZAR BILL RATE 2 5 0 / 250

12 // 240
11F (eve /V I ! 230
/ / ~~~~~~~~~~~~~~~ (/~~~~~~~~160210l<
/ ~~~~~~~~~~~~~~~~~~~~~~150~
Z 7 ~ C ~ ~140
/ J
6 ~~~~~~~~~~;4 /7120
11iz
910
4 41 X ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~80
70
3 60
50
2 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~40
30
1 20
10
1870 1910 1915 1920., 1925 1930 1935 1940. .1945 1950 1955 1960 1965 1970 1975 1980 1983
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they were positive and directly

at fixed by the authorities.
quite high The in-
levels movements of interest rates? Before we
(after 10 to 18 per cent) in many other terest rates structure has consequently discuss the considerations which prompt
years. Thus, it is possible to explain, at assumed an exceedingly complex and un- such an action, let it be noted that uswally
least partly, negative or low-positive levelsmanageable character-the fact which has it is the result of a fear that otherwise
of real interest rates in the planning era now been admitted by the RBI itself. The interest rates would be much higher than
in terms of discretionary controls on their so-called simplification which it introduc- 'desirable'. In other words, the direct regu-
movements. ed in March 1981 is nothing more than lation of interest rates is mostly resorted
(f) The interest rates in India have tend-tinkering with the existing system'4 with a view to maintain them at low levels
ed to be lower than in many other coun- because it has completely retained the which, in turn, are regarded necessary for
tries. Subject to the imperfections of in- principle of direct fixation of almost every certain reasons. In such cases, the reasons
ternational comparison of interest rates onsingle interest rate in the economy. for keeping interest rates low and for
account of differences in the nature of (iv) The direct administration of interest administering them tend to coincide.;
financial assets, definition, financial rates has been progenitive of a complex The present day policy of controlled
organisation, etc, it is clear from Table system
2 of quantitative credit controls or interest rates can be said to have been
that interest rates in India have often been ceilings as a means of monetary policy historically preceded by the anti-usury
maintained at mnuch lower levels than inand distribution of available finance laws which either completely prohibited
capital-abundant countries such as US, among different borrowers, sectors, uses, the charging of any interest or which
UK, Canada, France, Germany, Sweden etc. The controls on the price of finance sought to control it to a particular level.
or countries with similar inflationary ex- have begotten controls on the quantity of Such a policy was largely based on. the
perience, viz, Italy or countries with finance also. From the point of view of moral and other extra-economic conside-
similar controlled interest rates systems, the monetary policy, the system has been rations, while the present day policy has
viz, New Zealand and South Africa. In the caught in a vicious circle-the discre- come to depend upon quite a complex set
light of this evidence, the argument some- tionary controls on interest rates have led of arguments for its introduction and
times heard in certain quarters that India to the need for imposing quantitative continued existence.
is a country with the highest interest rates credit ceilings or targets which, in turn, (i) In many developing countries inclu-
can be said to be politically motivated. have resulted in the atrophy of those ding India, low interest rates have been
(iii) Apart fromn maintaining interest techniques of monetary control which are regarded desirable in order to induce a
rates at low levels and haphazardly deter- appropriate for and consistent with the higher rate of capital formation, parti-
mined differentials, the present policy has competitive, efficient, and dynamic finan- cularly fixed capital formation. This ex-
resulted in the sacrifice of the simplicity cial organisation, and this 'has further plains why the long-term interest rates
in the working of interest rate mechanism. perpetuated the dependence on the quan- have-been kept. at such low levels. The
The authorities have had to administra- titative or physical or selective or discre- belief in the theories of economic develop-
tively announce the fixation of an un- tionary techniques of monetary control. ment which give paramount importance
believably large number and vast range of to the high rate of capital formation as
THE RATIONALE OF THE PRESENT SYSTEM
interest rates. We have not one but a band the most critical development factor has
of bank rates, we also have a large number Why have the authorities here and else-shaped such a policy.
of bank deposits and advances rates where imposed controls on the level and It is curious that while one view has
24 FIGURE 2: REAL INTEREST RATES I IN INIDA, 1870-1983

22_
20 20 BANKERS DEPOSIT RATE

18 j GOVT BOND YIELD'_
16
141
12I
26
24
187P0 1910 1915 1920 1925 1930 1935 1940 1945 1950 19SS .1960 1965 1970 1975 1980 1983
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argued for lQw interest the costrates

of public debt
for would be low, and
encourag- terms of finarzce. In order to remove such
ing investmont (which there would be a stability oninterest-
implies the govern- discrimination against and disability, of
sensitivity of investment), ment securities market which is conducive
another view certain borrowers, the discretionary con-
has argued for the same policy because for debt placement. Further, the Indian trol of not ony the cost but also the
demand for investment and bank credit experience shows that under the present availability of finance becomes necessary.
is said to be inelastic to changes in interest system, the government is in a position to In a wider sense, such a policy is said to
rates. In more general terms, it has been manipulate rates in such a way as to in- help to improve the distribution of income
argued that in developing countries, price duce the flow of funds in the media it in favour of low-income and 4isadvantag-
incentives are weak and few people there desires to promote more. In the past few ed groups of society. The policies such as
calculate and take decisions in terms of years, the Government of India has been 'differential interest rates' have been
cost and return. In such a situation, high paying higher interest rates on small sav- adopted specifically for such a purpose.
interest rates merely lead to an increase in ings than on comparable long-term (iv) Many reasons-sometimes quite
transactions, velocity of money, increase marketable debt because thereby it can contradictory to each other-have been
in difficulties of the productive sectors, reduce the amount to be floated on the advanced for controlling interest rates on
particularly more vulnerable sectors such market which has certain inconveniences bank deposits and advances. It is felt that
as small-scale industries, small borrowers, as compared with the non-marketable if deposit rates are free, there may be
exports, etc, and increase in cost inflation. debt. unduly keen competition among banks
All this happens without curbing invest- (iii) It is also argued that in a planned for resource mobilisation which would in-
ment because, in sheltered markets, in- economy, the priorities and objectives of crease their cost, reduce their profitability,
creased interest costs would be passed on development are detrmined by the autho- and, in certain cases, lead to bank failures.
to consumers in the form of higher prices. rities. For example, they may desire to Inter-bank agreement in India, Regulation
(ii) The exigencies of government encourage exports, setting up of iddustries Q in US, and inter-bank cartel in UK have
finance have perhaps constituted the most in backward or zero-industry areas, etc. been the result of such a reasoning.
weighty consideration behind the actual If the course of development is to be in However, there has also been an another
adoption of the system of administered keeping with such priorities, the provision view that deposit rates of banks need to
interest rates. In planned economies and of credit with certainty and at low cost to be regulated because otherwise they would
welfare states, since the government and the priority areas becomes necessary. This reap exhorbitant profits by not raising
public sector are expected to play a very is achieved through the systemi of adminis- these rates pari passu with an increase in
big role in economic activities, the finan- tered interest rates. their lending rates. The regulation Q also
cing needs of the government turn out to A related argument is that money and had the objective of limiting the expan-
be on a huge scale. The government raises capital markets in economies like India's sion of bank credit which banks could
funds inter alia through the sale of are characterised by varieties of imperfec- bring about by the vigorous mobilisation
government securities and small savings tions. As a result, certain types of bor- of deposits by offering higher rates of
media. It is argued that if the interest rates rowers are discriminated against with interest.
are kept low and stable through controls, regard to the availability, cost, and other In India, some of the reasons behind
TABLE 4: THE EFFECT OF INTEREST RATE ON INVESTMENT DECISIONS IN INDIA
Sr Independent Variables
No Intercept AV R AC PE FE TX R-2 D W Functional Sector
Form
1) -2755.5 0.139* 434.8 - - 0.686* - 0.995 1.53 Nominal EE

(173.18) (20.17) (25.82)
2) 1859.2 0.114* 47.15 - - -1.21 - 0.585 1.25 Real EE
(21.53) (2.18) (8.12)
3) -191.2 0.328* 109.74 - - 0.559* - 0.973 1.20 Nominal PS
(21.03) (6.75) (0.82)
4) 1160.6 0.266* -13.85 - - 0.726* - 0.761 1.28 Real PS
(21.1) (1.4) (3.97)
5) -17.87 0.032 -0.45 684.5 - - 0.32** 0.90 1.45 Nominal PCS
(1.88) (0.15) (2.76) (4.1)
6) -1277.7 Eliminated 284.34 - 6.05 - - 0.766 0.87 Nominal EE
(83.23) (0.22)
7) 144.94 0.021** -10.26 - 6.68 - - 0.12 1.74 Real EE
(4.28) (0.57) - (0.21)
8) -1863.5 -0.18 393.3 - Eliminated - - 0.6 1.33 Nominal PC
(4.3) (10;84)
9) 217.8 0.11* -13.26 - -17.64 - - 0.09 1.33 Real PC
(4.4) (0.68) (1.22)
10) 5.09 -0.02 -0.14 16.41 0.73* - - 0.44 1.74 Real PCS
(0.13) (0.85) (0.01) (16.49)
Notes: Functions I to 5 and 6 to 10 are for total fixed investment and inventory
by Gross Domestic Product or Gross Public Sector Product or Sales; R = The l
of Credit; PE = Price expectations measured by. one-year lagged inflatio
Figures in brackets are F-ratios; EE is Entire Economy; PS is Public Sector; PCS is Private Corporate Sector.
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the control of deposit and lending rates undesirable movements in the market study, it would be useful to state here for
of commercial and co-operative banks rates. It is pointed out that the authdritiesready reference the gist of this model, and
which have been officially mentioned"5 lack empirical evidence about the extent the hypotheses to be tested by us.
are: (a) lb avoid unhealthy competition and direction of changes in market rates It has been argued that savings at a
for both borrowing and deposit accounts. when the traditional techniques of mone- given level of income are a function of the
(b) To maintain a kind of uniformity oftary control are employed. In other words,real rate of interest, and administratively
the effectiveness and predictability of
interest rates on these accounts of all types determined nominal interest rate holds the
of banks. (c) lb keep deposit r&tes in monetary measures are very limited whenreal rate below its equilibrium level. This
alignment with the lending rates of banks interest rates are free. On the other hand,holds saving and investment below what
and with other market rates of interest. if the market rates are changed directly they would be at high real rate of interest.
(d) To aid deposit mobilisation. (e) To with or without changes in the bank rate, The ceiling on interest rates also results
lengthen the maturity structures of depo- etc, the effect of such a policy on the in non-price rationing of investible funds.
sits by widening the spread between the economic activity would be greater and The xaising of nominal interest rates in-
long-term and short-term rates of fixing more certain. In short, the administered creases saving, investment, and the
the minimum rate(s) for long-term system of interest rates allegedly enhances average efficiency of investment. This
maturities and ceiling rate(sl for short- the predictability and efficacy of mone- leads to increase in income and further
term maturities. (f) 'b impinge upon tary bothpolicy. increase in saving. The impacts of such
the demand for and supply of bank credit. We shall examine the foregoing argu- a policy on growth are multiplicative.
While the prescription of minimum len- ments and discuss our case for free and Accordingly, we shall test the following
ding rates was meant to ensure that in- higher rates of interest in the next section.hypotheses:
creases in RBI refinance/rediscount rates It may only be noted here that these argu- (i) The rate of saving is expected to be
were transmitted to the ultimate bor- ments suffer from a lack of consistency, positively related to the rate of interest.
rowers, the ceiling rates were expected tg and they largely arise from beliefs in cer- If this is empirically validated, the case foi
discourage banks from borrowing more tain theories of economic development higher interest rates becomes strong pro-
from the RBI because now they would not which are quite questionable, profession vided the objective of economic policy is
be in a position to transfer higher of the philosophy of planning and socia- to increase the rate of saving.
refinance cost to the borrowers. (g) To lism, distrust of market forces due to the
(ii) Normally, the rate of interest is
enable the authorities to avoid frequent alleged existence of imperfections and low
expected to be negatively related to invest-
changes in the bank rate and to achieve price elasticities, presence pf multiple
ment. When this happens, investment
the results of changes in the bank rate by vested interests, and simply myopia.
decisions are taken on the basis of rational
changing deposit and lending rates
cost considerations and the efficiency of
directly. III
investment is high. But on the economy
It may bear repetition to say that the The Case fox an Alternative System with the system of administered interest
case for regulation of rates being con-
The reconstruction of the system of rates, since interest rates are kept low,
sidered here involves contradictions. The
administered interest rates-designated by they may be positively related to invest-
deposit rates are to be allegedly regulated
some as the system of "financial repres- ment. If this is found to be true, it would
because the free rates would both reduce
sion" or the one lacking "financial mean that investment activity and the
and increase banks' profitability; the
deepening"-has highlighted some of allocation
its of capital are not being con-
regulation would both increase and
defects and has indirectly shown the need ducted in an efficiency manner.
decrease the deposit resources of banks;
the regulation of lending rates would bothfor "financial reform" by replacing it with (iii) It follows from (ii) that the capital
ensure and hamper the transmission of the system of free and higher interest rates. formation in low interest economies
higher refinance cost to the ultimate We now develop this subject further by would be found to be playing an insignifi-
borrowers. discussing directly the beneficial effects of cant role in the determination of national
(v) It has been argued that when interest the alternative system on various spheres income.
rates are free, changes in monetary techni- of economic activity such as the volume
(iv) The low rates of interest result in
ques such as discount rate, open markel and pattern of savings, efficiency of the low rates of economic growth.
operations, etc, might not bring about anyfinancial system, efficiency of investment
Empirical results of the testing of these
material changes in the entire interest rates and allocation of resources, efficacy of
hypotheses would be reported at the ap-
structure or they may be accompanied by monetary policy, and by showing the
weaknesses of some of the arguments propriate points in the discussion of our
TABLE 5: CAPITAL-OUTPUT RATIOS IN INDIA AT case to which we now return.
which have been advanced in support of
CONSTANT (1960-61 = 100) PRICES
the existing system. While doing this, in
PROMOTION OF SAVINGS
Period Average Incremental addition to presenting qualitative
C/O Ratio C/O Ratio arguments, we have attempted to furnish In developing countries, there is
econometric evidence on a few majordefinitelyrela- a case for higher interest rates
1950-54 2.50 3.51 tionships or propositions posited in becauseShaw they play an important role in
1955-59 2.71 4.85 and Mckinnon model referred to earlier. raising the rate of savings, and in the in-
1960-64 2.92 3.28 However, given the nature of the subject- stitutionalisation or financialisation or
1965-69 3.43 5.41 matter, the discussion has to be primarily activisation of those savings. The strength
1970-74 3.88 11.48 qualitative. This has been shown by the of this argument depends upon the magni-
1975-77 4.20 6.42 lack of success of the attempts of Fry'6 tude of interest elasticity of savings. We,
and Galbis17 to estimate this model for therefore, estimated a few savings func-
Note: The Figures are averages for the
the Asian and Latin American countres, tions for the entire Indian economy for
respective periods.
respectively.'8 In order to indicate the the period 1951-52 to 1979-80 the two of
Source: Rao, V K R V, op cit, p 154. rel'vance of the econometric part of our which are reported below:
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GSR = 5.61 + 0.0671 GDP + 0.0048 two five-year periods, respectively. Thus, Companies (equation 3) and Medium and
if we exclude the last ten years of the Large Private Limited Companies (equa-
(1.696) (7.28)
period under discussion, particularly the tion 4) shows that, given the profits after
PCGDP* + 0.7987 R*- 0.155 last five years which experienced a sub- tax or cash flow, while the companies have
stantial increase in ihterest rates, the rate disregarded interest rate (which has the
(6.52) (4.67)
of growth in saving in India has been very wrong sign) as a relevant factor, they have
PE* + 0.187 GSR1 (1) small indeed. changed their retention policy in the light
The two other major factors, apart of the availability of external funds.22
(0.834)
from an increase in interest rates, which
-2 RR = 33.99 + 2.65 PAT* + 0.07 FWI
R = 0.89008; D W = 2.13469 have contributed to a substantial increase
(27.84) (0.931)' R
in the saving rate during 1970s have been
GSR = 5.11 + 0.0042 PCGDP'
the phenomenal increase in the number - 0.06 ES - 0.68
(5.78) of bank branches and the amount of
(0.23) (0.10)
+ 0.7576 R - 0.1129 foreign remittances. From the point of
(5.749) (3.022) view of the future, while the contribution - 0.14 P + 46.57 T
of one of them is subject to a high degree (0.64) (0.34)
PE** + 0.2868 GSR,. (2) of uncertainty and fluctuations, that of
(2.218) the other has almost reached its limit. R = 0.9645 ... (3)
Therefore, it has been rightly pointed out
R = 0.88689; D W = 2.11339 that we cannot take for granted the con- RR = 82.52 + 11.98 CF' - 1.10 FWI
tinuing increase in the rate of saving in the (14.5) (4.16)
Where, GSR is the gross saving rate;
GDP is the growth rate in gross domestic last quinquennial period and the establish- - 3.77 ES* - 0.77 R
product; PCGDP is the per capita GDP; ment of a trend rate of growth which in- (10.82) (0.03)
R is the one-year deposit rate of interest; cludes this period.20 In such a situation,
the offering of an attractive rate of return + 0.23 P' + 2.21 T
PE is the measure of price expectations;
retains a crucial importance in the policy (5.98) (4.53)
GSR_, is the one-year lagged dependent
variable; figures in brackets are F-ratios; of promotion of savings. R2 = 0.8977 ... (4)
all variables are in nominal terms; the Secondly, deposits with commercial and
functions are in non-logarithmic form; * co-operative banks account for about half Where, RR is the retention ratio; PAT
and ** indicate the level of significance of total household sector savings in finan- is profits after tax; CF is the cash flow;
at I to 5 and 10 per cent, respectively.19 cial assets. Further, current account FWI is the investment in fixed and work-
It would be seen that these fits are very deposits constitute about 20 to 30 per cent ing capital; ES is the external sources of
good and the rate of interest has quite of total bank deposits. Now, to the extent funds, R is the debenture yield; P is the
high and significant coefficient; it may bethat a part2l of the current account price level; T is the time variable; figures
noted that the performance of rate of in- deposits is the result of created credit in brackets are F-ratios; functions are in
terest is better than that of income. Thisrather than genuine saving, the figures nominal non-logarithmic form; and the
on
and the fact that the price expectations aresaving ratio in India need to be adjusted period of study is 1961-62 to 1974-75.
shown to discourage savings strongly sug- downward to obtain a realistic estimate of Finally, in spite of a substantial in-
gest the need for a higher interest rates the level of genuine savings in the country. crease, can we say that the rate of saving
policy in India. Thirdly, in spite of good progress in the in India has been at the required level? If
It may be counter-argued that this is institutionalisation of savings so far, there it was so, there would not have been the
unnecessary in view of the good savings is still a great scope for further progress need for so heavy and increasing depen-
performance of the Indian economy in the in this respect. The proportion of house- dence on foreign capital, credit creation,
past 30 years. The rate of gross savings hashold saving in the form of currency is still deficit financing, and the credit rationing
increased substantially over this period quite high; it has been around 18 to 26 per on a continuous basis. It is true that a
from about 10 per cent in 1951-52 to aboutcent of total Jhousehold saving. Similarly,greater efficiency in the use of financial
21 per cent in 1979-80. It may be argued the physical assets still account for about resources and physical capital would have
that if interest rates in India are regarded half of total household saving. If this pre- reduced this dependence. However, as we
to have been low, they have apparently not ference for idle saving is to be reduced, shall show, the level of efficiency just
discouraged people from saving. We feel the return on financial assets must referred to also has been low partly on ac-
that this is an euphoric view of the matter, become attractive both in nominal and count of lower interest rates. Thus, higher
and it would be harmful if interest rates real terms. interest rates become necessary both to in-
are continued to be kept low on the basis Fourthly, the contribution of the cor- crease (or to maintain) the rate of saving
of such a reasoning. There are many other porate sector in this context has been and to improve the efficiency of invest-
important features of savings behaviour extremely poor. Its saving rate has been ment. If the former alone occurs unac-
in India which show the need for an in- about 0.5 per cent, and its contribution companied by the latter, it involves a per-
crease in the reward for savings in future. to total saving has declined from 7.91 per manent sacrifice for the consumers
Table 3 contains an useful information on cent to 3.26 per cent over the period under because savings then do not contribute to
some of these aspects of savings in India. study. The easy availability of cheap credit the acceleration of the growth of income.
Firstly, it is necessary to note the time from banks and term lending financial in-
EFFICIENCY OF THE FINANCIAL SYSTEM
profile of an increase in the saving ratio. stitutions has definitely been one of the
While it took as many as 20 years to in- important causes for this poor savings The present system has been promotive
crease by merely six percentage points dur- performance of the corporate sector. Theof inefficiency because the interest rate
ing 1950-51 to 1969-70, it increased by 2.48estimation of the determinants of saving mechanism as an impersonal, neutral, and
and 5.20 percentage points during the next of the Medium and Large Public Limited anonymous allocator of finance has been
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replaced by the arbitrary deposit rates hasand

adversely affected the
discretionary financial institutions, and all the users of
means of doing the same. The command growth of bank deposits. If there was no finance.24
over financial resources now depends large-scale expansion of bank branches,
EFFICIENCY OF INVESTMENT
upon the ability to offer security, political it is doubtful whether banks would have
pressure, the bigness of size and ability to experienced the rate of growth of deposits Interest rates policy has a very imme-
outmanoeuvre both other seekers of credit which they actually did (between 16 to 24 diate and decisive influence on the volume
and credit controls, benefits to the loan per cent per year) after nationalisation. and efficiency of capital formation and
officers, etc. The resources allocated in On the other hand, deposits with the non-on economic growth via the former., It is
such a manner are very often used for banking companies have grown at compa- natural that in an inefficient financial
either low-yield safe investments or for rable or even higher rates in many years; system like India's promoted by the system
socially less useful or even detrimental these deposits have grown at the annual of administered interest rates, the process
purposes. There is also very often dn over-rate of 20 to 78 per cent during 1978-82; of capital formation should have been
capitalisation of units. The reality of this this rate perhaps would have been still greatly wasteful. There is much incontro-
point is so well-established in India that higher if there was no ceiling on the vertible evidence which establishes this
we need not further belabour it here. The amount of deposits which each company point.
evidence accumulated by, among others, could accept. This along with the fact that Firstly, investment decisions in India
the Dutt Committee, Dehejia Committee, the authorities had to impose a ceiling on have not been affected by interest rates in
Tandon Committee, etc, is enough to em- interest rates on company deposits also the theoretically expected manner;
phasise the need to change the present shows that the policy of regulating bank because of the low level of interest rates,
system. deposit rates has been wrong. The new they have beep positively related to invest-
It is high time to realise that imperfec- development in.the making, i e, the entry ment. Our unprecedentedly comprehen-
tions in markets cannot be corrected by of banks into a more complex and risky sive study25 of the interest elasticity of
imposing a set of other imperfections business of lease finance within the ex- different components of fixed and inven-
merely because the latter emanate from isting set-up or by setting up subsidiaries tory investments in seventeen industries,
the authorities. The misuse of the dif- reflect banks' desire to bypass the cxisting the private corporate and public sectors,
ferential interest scheme, the appropria- regulations on them to provide funds to and the entire economy, during the period
tion of credit meant for a variety of smallthe corporate sector, and to benefit from 1950-51 to 1977-7826 and its sub-periods
borrowers by the big borrowers through the opportunities to lend at higher rates has proved this beyond doubt. A few of
devices such as creating fictitious or linked of interest. a large number of investment functions
(captive) small units, etc, point to the The foregoing suggests that non-price estimated by us which have been presented
dangers of non-price rationing of credit. credit ratiQning and ceiling on interest for ready reference in TIble 4 clearly show
It is acceptable that some kind of action rates result in sub-optimal allocation of that interest rate is mostly positively
was necessary to help farmers, small funds, the growth of financial institutionsrelated to investment, and it has been
village and cottage industries, other small or arrangements which tend to divert the mostly insignificant statistically whenever
borrowers in the face of market imperfec- flows of funds from channels which are it had the negative sign.
tions. But it could have been done within directly amenable to the supervision and Secondly, it can be shown in different
the ambit of the usual legal powers of the influence of the Central Bank, reduction ways that an increase in capital formation
government, through 'suasion', and in the profitability of banks,23 negation has contributed little to fostering appro-
through creating certain 'counterrailing' of the intentions of the atithorities with priate techniques of production and in-
institutions which functioned on the basis regard to the sectoral distribution of creasing labour employment; and that the
of normal economic and cost considera- credit, etc. The experience in the UK in creation of capital on a massive scale has
tions. this context has been very much similar. not resulted in the commensurate growth
The entire array of interventions by theAs pointed out by Johnson also, it is, of output. This is firstly reflected in the
authorities has led to the development of therefore, necessary to reinstate price com-high and increasing capital-output and
an inefficient financial system in an petition and high rates of interest on both capital-labour ratibs which prominently
another way also. The ceiling on the bank sides of the balance sheets of banks, other characterise the Indian economy. Accor-
TABLE 6: THE ROLE OF INVESTMENT IN THE GROWTH OF OUTPUT IN INDIA
Independent Variables
Sr No Dependent Intercept I MS Time Pop -2 R D W Functional
Variable Form
1) NDP 4.41 Eliminated -0.071 0.009* - 0.9911 2.13 Log-nominal

(2.72) (128.4)
2) PSP 4.22 -0.021 -0.092 0.006* - 0.8838 1.65 Log-nominal
(0.05) (0.94) (12.69)
3) SSP 4.08 0.04 -0.21 0.01* - 0.9836 0.69 Log-nominal
(2.62) (4.56) (56.24)
4) GDP -24.59 1.155* -0.322 - 8.27 0.27197 2.40 Non-log-
(8.26) (2.22) (1.93) nominal
5) GDP 1.74 -0.418 -0.011 - 4.15 -0.016 2.19 Non-log-
(1.62) (0.006) (0.799) real
Notes :The functions 1 to 3 and 4 to 5 are for the period 1950-51 to 1975-76 and 1951-52 to 1979-80, respectively. NDP = Net Domestic Product;
PSP = Pritiary Sector Product; SSP = Secondary Sector Product; GDP = Gross Domestic Product; I = Investment; MS = Money
Supply narrowly defined; Pop - Population; Time = Trend variable; Figures in brackets are F-ratios.
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ding to one estimate, the capital-labour adopted through increased investment, tional, ethical and other grounds.
ratio has increased trom Rs 3,185 in Interest rates have a role to play in p:o t"he monetary authorities in India have
1950-51 to Rs 8,542 in 1980-81; the index moting employment and appropriate been using bank credit, money supply,
of this ratio has increased from 100.0 to technology by discouraging premature bank borrowings from the RBI, seasonal
268.0 during the same period.27 Similarly, modernisation or mechanisation not only return flows of funds, the growth of
while the average capital-output r-atio has in the industrial but also in the agricpl- resources of banks and their being in
increased from 2.5 during 1950-54 to 4.2 tuiral sector. In this context, while tbe 'liquidity blind', etc, as targets/indicators
during 1975-77, the incremental capital- adverse effects of low initerest rates in the of monetary policy. They have not been
output ratio has increased from 3.51 to industrial sector are well-received, their in a position to make a conscious and
6.42 during the same period (see Thble 5).similar consequences in the agricultural active use of interest rates as targets/
The second way of showing the wastefulsector tend to be overlooked. It is to be indicators because of the policy of admi-
use of capital in India is to study changesnoted that just as there is a need to wean nistered rates. This has been inconsistent
in its productivity and that of other fac- savers and investors in rural areas from with their theoretical belief with regard to
tors of production. Brahmananda has assets such as gold, currency, etc, there is the transmission mechanism of monetary
estimated that the index of net output also pro-a need to wean the farmers who are policy,3' and it has severely undermined
ductivity of capital has declined from already well to do and also whose cash the effectiveness of monetary policy in
100.0 in 1950-51 to 68 in 1980-81. Further, flows are improving as a result of the India.
on the basis of his study of rates of growthadoption of new seeds and fertiliser It may be possible to discard the use of
in total factor quantity, net domestic pro- technology away from the mechanisation interest rates as targets/indicators and
duct, and total factor productivity in the of agriculture which positively displaces instruments of monetary policy if one be-
Indian economy as a whole and in its hired labour exacerbating the problems of lieves in the exogeneity of money supply,
various sectors during the planning era, unemployment and underemployment, i e and if the money supply is, in fact, exoge-
he has shown that " . . . the contribution which increases the social cost. Now, neous. The monetarists do not, for exam-
of improvements in total factor produc- higher interest rates on financial assets ple, bother about interest rates because
tivity to sectoral growth seems to have would help here because the farmers tney hold that the Central Bank can, by
become less and less as we move from the would then finid high-yielding alternatives itself, completely control changes in
first decade to the third decade ... both from outside their own ernterprises. money supply. In India, both the condi-
traditional and modern activities seem to The importance of the role of higher tions Just mentioned are not fulfilled. The
be losing the productivity growth momen- interest rates in allocating resources moiietary authorities here do not believe,
tum. The most distressing finding is that economically and using them more effi- and rightly so, that in the conduct of
- registered manufacturing and mining, ciently or productively can be guaged or monetary policy, money supply alone
the two sectors on which huge amounts appreciated from the changing attitude of matters and they can fully control its
of capital have been invested, indicate a the authorities in communist cotutries to variations. Further, our empirical study of
negative contribution from total factor the relevance of interest rate poiicy there. the process of money supply determina-
productivity growth'28 On the basis of his study of the working tion during the period fo 1950-51 to
In order to clinch this issue, we have of monetary systems in these countries, 1979-80 has clearly shown that money
estimated the sectoral and aggregate out-Wilczynski has evidenced that in the supply in India is not at all exogeneous.32
put functions to study the contribution of beginning, interest rates were virtually It has, therefore, been both logically in-
capital formation to changes in output. ignored in these countries as a weapon of consistent and wrong on the part of
They are reported in Thble 6. Investment economic policy. Budgetary all-cations ofmonetary authorities to have rendered in-
is showrn, except in one equation, to be an finance to enterprises were made without terest rates useless as targets/indicators
insignificant or irrelevant determirnant ofany charge and where interest rate was and instruments of monetary policy, and
output. It is the trend element which charged, it used to be very low. This led thereby paved the way for the inefficacy
seems to explain variations in output into extravagant demands for capital, wide- of their own policy.
India. Incidentally, it may be noted that spread hoarding, and underutilisation and Under the present system, while main-
changes in money supply also are irrele- a wasteful neglect of capital assets. How- taining that it does not believe in the
vant in this context. eve?, the adoption of the intensive growthmonetarist approach to monetary policy,
In short, investment activity in India -trategy (as distinct from the extensive in practice, the RBI perforce has been pay-
has been taking place irresFpective of onie) which heavily depends upon in- ing almost exclusive attention to money
changes in interest rates. The capital aloca- creases in productivity of capital forced supply and bank credit as targets/indi-
tion and labour employment decisions do these economies to make interest rate an cators of monetary policy. There are
not seem to have been governed at all bvindispensable instrument of sound eco- reasons why this system ought to be
the criterion of optimality for production, nomic management. Accordingly, in the changed if the monetary policy is to be
employment, etc.29 The productivity of early 1960s, they introduced capital more effective than it has been so far. Not-
capital has been- low in spite of a very charges on enterprises and appreciably withstanding its importance in the Indian
young capital stock in the economy bar- increased interest rates on saving bank monetary system, the concentration of ef-
ring traditional industries. The present deposits, consumer credit, bank credit to forts to regulate mainly the bank credit
interest rate policy must share the blame enterprises, and foreigin credits.30 has unnecessarily narrowed the ambit of
for this state of 'iffairs in our country. monetary policy: The technique of discre-
The high and free rates of interest EFFICIENCY OF MONETARY CONTROL
tionary quantitative ceilings has further
would contribute in bringing about a From the point of view of the working narrowed down this scope because these
change in this picture. They would lead of monetary policy, the case for th; aban- ceilings are applEcable only to certain
to an efficient diffusion of modern donment of the present svstem and the typeS of bank credit to the private sector;
technology in the sense that the extent replacement of interest rates as targets/ they exclude bank credit provided for
relative factor abundance would be taken indicators and instruments in its place public food procurement, fertilisers and
into account when new techniques are res_s on the following theoretical, opera- exports credit, and the 6-edit for all pur-
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poses by banks other the resuilt of

than statistical 'noise'.33 com-
scheduled pend upon indirect response-mech,anism
rnercial banks. Under the alternative The question of monetary control but are directly effected through fiat), the
system, the policy would be more effec- through administered versus free interest effectiveness of monetary policy is not
tive bpcause changes in interest rates have rate system has engaged attention of the increased because the stipulated interest
a more general relevance and pervasive concerned people in UK since long. A rates do not adequately reflect changes/
influence; and such changes when brought careful study of the debate on this issue differences in relevant economic and other
about through changes in the bank rate, in that country of the mother of central determinants of interest rates; and, in
open market operations, etc, would be banking brings out a consensus against addition, changes in interest rates are
accompanied by changes in other crucial the system of discretionary regulation of accompanied by discretionary directives
intermediate variables such as money interest rates and credit ceilings. In 195O, about credit disbursements which also, as
supply, size and composition of the the Radcliffe Committee was of the opi- shown earlier, are often determined by
government debt, etc. nion that in normal circumstances credit extra-economic considerations. If interest
Operationally, it is difficult to turn rationing
off should be avoided because it is rates are freed and an active use of more
and on the flows of bank credit (and subject to substantial slippages, and it than one technique of monetary control
money) instantaneously as a result of would lead to the loss of efficiency in the is made, the effect of changes in monetary
which there may be an undeterred growth capital market. Recently, a number of policy would be greater because it would
of bank credit for sometime even afterauthors34 the have argued against such a spread to the entire economic system.
tight money policy is announced. This is system because it is a conspicuous but It may be argued that although this is
particularly so when the cash credit/over- uncertain way of reducing aggregate effec- theoretically true, are there reasons to
draft system of bank credit characterises tive demand; it reduces the scope of believe that the suggested mechanism of
the monetary system predominantly. monetary control; it does not guarantee monetary control would actually work in
Under such circumstances, there is a need that the rationed out units are the ones India in this manner? There are two parts
for more rapid and larger increases in which are the least productive; and it is of this mechanism, the effect of changes
interest rates for the effectiveness of always likely that rationed out units wouldin monetary policy instruments on market
monetary policy. If the interest rates are find their way around loan ceilings. It interest rates and other intermediate
also held down artificially in these circum- should be emphasised here with full force variables; and the effect of the latter on
stances, the monetary policy is bound to that the Bank of England also has always real variables or economic activity. Would
be ineffective as it has happened in India. been against such a system. In its both of these effectws actually occur in
Another operational reason for freeing testimony to the Radcliffe Committee, Indianit conditions? How widespread
interest rates is that, as opposed to the had made clear its distaste for and dis- would they be? Would they not 'remain
quantity of bank credit (and money sup- inclination against the use of such a confined to the small segment of the
ply), the information about them is in- system, and it has maintained this posi- monetary system, say the organised
stantaneously available, and it is far more tion since then. The following quotation sector?
accurate. They, therefore, serve as excellent from the then Governor of the Bank of These are undoubtedly weighty issues
indicators of goings-on in the monetary England ought to persuade Indian mone- and the strength of the case for the system
system. The effective conduct of monetary tary authorities to review their policy of of free interest rates depends upon their
policy requires that the authorities receiveadministered interest rates: appropriate resolution. However, a
information on various indicators on number of considerations and much evi-
44 . .. quantitative restnrctions should be used
week to week basis but at present, banking dence in this regard do point towards a
only when severe restraint is necessary. We
data are available to the authorities in the great potential for the success of an alter-
are far from happy that we have had to use
final accurate form after quite a signifi- native monetary policy at the present stage
them so severely and so long not only
cant time-lag. It is well known that these of development of the Indian monetary
because of their inherent disadvantages but
data are substantially revised 'even after system. We have accumulated consider-
also because of the strain which thtit pro-
two years or more after their first publica- able experience in the use of bank rate
longed use places upon the very happy co-
tion. With the reaching out of bank bran- technique, and we do not have evidence
operative as distinct from legalistic relation-
ches and the working of other financial to show that market rates would not res-
ship which exists between Central Bank and
institutions in the-remote areas and given pond to its changes if they are as bold and
commercial banks. It is not an economical
the slow communication and information frequent as necessary. The government
and efficient system in which one side is con-
processing arrangements, it has become securities market in India has become
tinually looking for loopholes in the control
impossible to lay hands on the relevant quite well-developed in terms of its size,
and the other side continually trying to plug
information with the speed required. It is, diversity of maturity structure, etc, and the
them. For all that, the longer ceiling restric-
therefore, necessary to use interest rates Central Bank possesses enough legal
tions are in force, thWa greater the strain on
as targets/indicators of monetary policy powers to operate in this market. The
the system"35
and to free them if they are to perform stock of BTeasury bills also happens to be
this role accurately. The experienced cen- The foregoing discussion should also significantly large. The potential for the
tral bankers even in the economy such as show that the argument in support of the effective conduct of OMO also, therefore,
US have made a strong plea for making present system that it improves the predic- does exist provided the objectives of debt
a judicious use of interest rates in the tability of the response of banks and other management policy are changed which, as
conduct of monetary policy because while components of financial markets in it will be shown shortly, is quite possible
they are easily and acc rptely available, respect of volume and terms of finance The experience in the recent past few years
there are a number of andomn forces and supplied by them in the event of changes of the use of Cash Reserve Ratio (CRR)
estimating errors pr serit in most short- in Central Bank policy does not stand technique has shown that it can be an
period adjusted dat . o.i money and credit;scrutiny. As far as only interest rates are effective tool of monetary policy. In short,
and there are few seeks, even months, in concerned, although it is true that they unlike in the past when the RBI has tend-
which the repot 4d movements in tnone- surely change when monetary policy is ed to rely very heavily on any one techni-
tary and credit -gregates are not primarilychanged (because such changes do not de- que of monetary control in a given period,
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if more than one technique cient becauseis

the harnessed
decisions at all different mical and efficient use of resources, and
in a well co-ordinated manner, the RBI stages of the transmission process have would also have a higher income effect.
would be in a position to influence the now become amenable to the influence of
PRIORITY SECTORS' NEEDS
behaviour of intermediate variables such policy changes.
as market rates of interest, money supply, The provision of finance to priority
EFFICIENCY AND IQUITY IN GOVERNMENT
bank reserves, central bank refinance, etc. sector borrowers is a sensitive and ticklish
FINANCES
Similarly, our study of the behaviour problem. There is no doubt that the in-
of different variables related to the aggre- iWo major motivations for administer- terests of these essential but disadvantaged
gate effective demand has demonstrated ing interest rates have been to ensure economic units ought to be served well by
that there is potential for transmitting the cheap availability of funds to the govern- the financial system. But are higher in-
effect of monetary policy changes to eco- ment, and to the 'priority sectors' and terest rates really unsuitable for and
nomic activity also. We have already stated 'economically weaker and small' bor- against the interests of these borrowers?
earlier that if the investment has not been rowers. The ideological form of the latter Has their disadvantage consisted in cost
restricted so far by changes in interest has been to state that the present system or availability of credit? Do they have
rates, it has been so because of the low helps in bringing about equality and social capacity to pay higher interest rates? A
level of the latter. Consumption and sav- justice. We deal with these aspects in this dispassionate and non-ideological review
ing have been found to be responsive to and the following sections. of these issues would lead one to conclude
changes in interest rates. It is often feared The provision of cheap finance to the that the case for higher interest rates is
that the expenditure of the public sector government is a totally unjustifiable argu- defensible even in this respect.
is not responsive to monetary management for the continuation of the present It appears to us that banks and finan-
ment. That this fear is exaggerated is system. To ensure availability of cheap cial institutions had been guilty of not
indicated by the discovered - negative, credit to the government or to dny bor- making adequate credit available to these
although statistically insignificant, rela- rower for that matter cannot be made theunits rather than of charging higher in-
tionship between interest rates on the one central objective or function of the Cen- terest rates to them. The objective of in-
hand, and government consumption ex- tral banking policy. Further, the objective creasing the availability of funds to them,
penditure and government borrowings on of debt raising activity of the government therefore, has been right. But, as pointed
the other. Further, the demand by public has to be to increase employment and out- out earlier, there is really no need to adopt
sector enterprises to help them to reduce put with stable prices and not to obtain the measure of prescribing quantitative
their debt/equity ratios, and the recent command over resources at cheap cost ir- credit ceilings and targets to do this. The
action by certain public sector trading cor- respective of the consequences of such a existing legal framework, moral suasion,
porations, viz, Cotton Corporation of policy. Since it is by now well-established and the minimum of directives can achieve
India to reduce inventories because inter that government finances in general and this. This increased flow of credit, how-
alia mounting interest costs have increased debt management in particular have been ever, should be made at appropriate and
their operating losses certainly reflect the the important sources of instability in the not subsidised rates of interest. The
possibility of responsiveness of even economy, and conflict with the working higher interest rates themselves would
public sector spending decisions to mone- of monetary policy, it would be wise if the augment the supply of funds to these bor-
tary variables.36 goal of holding down interest cost is not rowers via increase in the resources of the
Let it be emphasised that since the allowed to take a precedence over the financial system and greater willingness
Indian monetary system has become fairly other goals mentioned above. An addi- of banks, etc, to lend to them. The expe-
well-matured and well-integrated,37 the tional reason for doing this is that the rience in Indonesia of increasing interest
spread effects of the bold monetary policygovernment with socialistic persuasion rates during 1960s and 1970s has been that
changes are xnow going to be really wideshould not exploit its monopolistic or it led to an increase in the resources of
and quick. This is true of both the 'orga-statutory position to appropriate, as it banks which, in turn, led to their search
nised' and 'unorganised' sectors. In fact, now does, large amount of funds at an for borrowers in the small-scale, trading,
it is not really meaningful at this stage of unnaturally low cost. and other sectors.38
the development of Indian economy to Once interest rates on public debt are As to the capacity of these borrowers,
talk of the dichotomy of the 'organised' competitively raised, giVen its other invest- the rates in the 'unorganised' sector ad-
and 'unorganised' sectors of the money ment characteristics such as safety, liquidi- mittedly do not reflect such capacity; they
market; this traditional bugbear of Indianty, etc, the government would be able to have been certainly exploitative, but is
monetary policy is now only of a historicalraise the major part of its financial re- there really a need to go to the other ex-
value. The constituents of the so-called quirements without compulsion. There treme and supply funds at excessively sub-
'unorganised' sector namely, agriculture, would also be an increase in efficiency not sidised rates? We deem such a policy to
small scale and cottage industries, other only within the public sector but also in be unnecessary and unwise. It is to be
rural activities, retail trade, etc, have now the economy as a whole because of chain noted that the capacity to pay higher rates
become quite well-linked with the 'orga- effects of such a measure. The resultant is to be decided with reference to the rate
nised' sector through the spread of com- increase in the debt-servicing burden of return not on current methods of pro-
mercial and co-operative banking, opera- should not frighten and, therefore, duction and cultivation but on the im-
tions of special financial institutions such dissuade the government from doing this proved ones. Just as the high rates in the
as SFCs, SIICs/SIDCs, etc, creation of because since government debt is held 'unorganised' sector have resuited in low
industrial estates, growth of agricultural mainly by government institutions, it investment because no worthwhile project
marketing organisations such as FCI, would mean only an accounting change. can be implemented at such a high cost
CCI, State Marketing Federations, Mono- Further, the government is in a position of credit,39 the deleterious effects of low
poly Cotton Procurement, etc. to meet this burden from borrowing everrates in the form of unproductive use of
In summary, the alternative system pro- more from the public without facing the funds, encouragement of inappropriate
posed here would make monetary mana- risk of bankruptcy. But in the process, theand conspicuous technology, etc, also
gement in India more effective and effi- higher rates would compel a more econo- should not be overlooked. The best policy
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would be to charge interest rates between over, to the extent that such a policy would the performance of the economy with
the exorbitant rates in the 'unorganised' be instrumental in curbing inflation, the regard to saving, investment, price stabili-
sector and currently prevailing highly sub- lower and fixed income groups would be ty, and growth. While South Korea and
sidised rates on institutional credit. benefited. Taiwan have achieved quite good results
There are also very crucial practical The Indian economy is characterised by with the flexible and high interest policy,
cornsiderations for abandoning t'he present a plethora of price and distribution con- Malaysia and Singapore performed well
system. FixIstiy, the cheap credit is being trols, the systems of industrial and import with the low interest rate strategy.40
appropriated on a large scale by the un- licensing, etc. These institutional arnange- Similarly, Japan has performed excep-
targeted groups of borrowers because of ments have been very much loaded in tionally well although it has been pursuing
the existence of various loopholes in the favour of the well-to-do, well-connected, the low interest rates poliCy.4' In the
system, corruption, imprecise nature of and the elite. Now, the possession of a Commonwealth, New Zealand, Australia
definition of small-scale units, bogus licence, a quota, a permit,. opens the doors and UK with controls have probably done
registration of small uni.3S, creation of of banks and financial institutions. There- as well as the free system of Canada.42
captive small units by large units, ingenui- fore, it is the already rich and economi- But there has been unmistakably a high
ty and influence of big units and rich cally powerful people who benefit from d.egree of dissatisfaction with the working
farmers to obtain benefits not meant for the lower interest rates. Under the present of mne administered rates system wherever
them, etc. Secondly, in spite of the low set-up, they reap double benefits-they it has been practised. Except in Japan, the
official rates, the effective or implicit cost appropriate high yielding investment op- good performance in such systems men-
of credit to these borrowers in many cases portunities. maniy of which are of specula-tioned above has not been good enough
actually works out tc be very high indeed tive charactrc, and they are also in a posi- when compared to the potential which
because they have to make underhand tion to appi-opriate directly or indirectly existed in those economies. Therefore,
payments to obtain loans and the prices cheap credit to finance those opportuni- they have either abandoned or consider-
of goods to be purchased with sanctioned ties. In the inflationary situation, their ably modified the administered interest
credit are 'marked up' to benefit certain gains have mtnultiplied because they have
rates system. The changes in the philo-
functionaries and vested interests. benefited both as debtors and investors. sophy and policy in this regard which have
In contradistinction, the poor, the low, occurred in the socialistic countries have
INCOME DISTRIBUTION AND SOCIAL
and the middle income people have been already been referred to. Among the non-
JUSTICE impoverished both because of the decline communist world, the US abandoned
This is a far more complex and wider in their purchasing power and low and the policy of supporting the government
issue but we cannot completely slur over fixed interest rates on the media of savingsborrowing operations at fixed interest
it because the administered system of in- which are within their reach and which rates in 1951 through the Treasury-Federal
terest rates has been prominently pro- they prefer to hold. Thus, the case for the Reserve Accord in that year; and there has
jected as one of the means of delivering higher interest rates is strong from the been a widespread criticism of the Regula-
social justice. While, the discussion in the point of view of social justice also. tion Q in that country. Similarly, the
previous section (6) partly serves to indi- policy of interest rates cartel, and ceilings
cate the weakness of this argument, the IV on bank credit in UK has been under
other major points are briefly discussed The Experiences of Other severe criticism (the dissatisfaction with
below. it of the Bank of England itself has been
Countries
The interest rates policy is hardly the shown earlier), and it was finally discon-
right policy for tackling the problem of The adoption of the policy of low and tinued in 1971 under what has come to be
income distribution. The government controlled interest rates appears to be known as the 'new approach' to monetary
budgetary policy would prove more potent quite common in other countries also. management propounded by the Bank of
in this context. Even in its supplementary Such a policy has existed in US, UK, England in its document 'Competition
role, it is the higher rather than lower Japan, Australia, New Zealand, South and Credit Control'.
interest rates which would serve the ob- Africa, Malaysia, Indonesia, South Korea, Japan could achieve excellent results in
jective of income distribution better. The Taiwan, and Latin American countries in spite of low interest rates because of
higher interest rates on bank deposits, one period or other and in one part of the higher saving ratio and higher produc-
small savings, provident funds, etc, would financial system or other. It has taken its tivity which, in turn, were mainly due to
directly benefit the lower and middle extreme form in the communist nations. socio-economic forces, absence of deficit
income groups. In the ultimate analysis, In the non-communiist world, however, thefinancing, etc.43 What is, however, to be
these groups are 'surplus-spending units' controls in India have been probably noted is that the Bank of Japan has been
to a greater extent than 'deeficit-spending much more pervasive and direct than in in favour of abandoning the administered
units' as a result of which their position other countries. The knowledge of experi- rates system although it has not been able
is bettered more by the higher interest ratesences in these countries, despite the limita-
to do so because of government opposi-
on financial savings than by the lQwer tions to wuiich inter-country comparisons tion to it on the basis of considerations
lending rates. are subject, would definitely prove instruc-which can easily be expected to have had
To the extent that the higher interest tive in formulating appropriate policy in a 'political' content. It has been pointed
rates would encourage the adoption of this regard. We have, therefore, already out by Patrick that the Bank of Japan
labour intensive techniques, and since the referred to some of these experiences at preferred to have a more flexible market-
elasticity of substitution of labour for the relevant junctures. Some of the other determined interest rates structure, which
capital is most likely to be high in develop-major lessons which emerge from the would have resulted in raising of interest
ing countries, the higher interest rates study of these experiences are briefly rates to a higher level than in the past. But
policy would serve the cause of social discussed below. the government insisted upon a policy of
justice better via the greater employment There does not appear to be any fixed- relatively low rates in order to maintain
generation and consequent increase ineither the positive or negative-correlation cost of exports low and to develop the
share of wages in national income. More- between the system of interest rates and long-term capital market. In spite of
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overall good results, such a policy has economic activity. The alleged justifica- Brookings Institution, Washington, 1973;
been regarded as highly misguided one tion that the vast needs of government Myrdal, Gunnar, "Asian Drama", Vol II and
because it has actually led to worsening finance, and the fulfilment of planning III, Appendix 5 and 8, Allen Lane, The
of the balance of payments and the need objectives such as meeting the financial Penguin Press, London, 1968; Shaw, E S,
for progressively tighter monetary policy requirements of the priority sectors and "Financial Deepening in Economic
during'the post-war years.44 promoting equitable distribution of in- Development", Oxford University Press,
Among the Commonwealth countries, come require the present system of admi- 1973.
in New Zealand, the system is shown to nistered interest rates has been shown to 2 National Board for Prices and Incomes,
have inexorably led to an increasingly be altogether unconvincing. The experi- 'Borrowing and Lending', in Johnson, H G
complex and pervasive constraints on the ences of countries in the socialistic block, (ed), "Readings in British Monetary
financial system, and to a stifling'of com-Commonwealth, Latin America, and Asia Economics", Clarendon Press, Oxford,
petition as a result of which the country also support the,case for the alternative 1972.
suffered from the ineffective and heavilysystem. There are: no reasons why its 3 Myrdal, G, op cit, pp 904-905.
lagged responsiveness to real needs, and adoption cannot be feasible in India. 4 Quoted by Myrdal, G, op cit, p 909.
from the failure to curb effective demand. Notes 5 The description by the RBI of its own policy
The situation in Australia was more or less in this respect is confusing. Sometimes it
[This study has been prepared for the Commit-
similar till 1963-64 when the system was states that it stipulated the maximum rate,
tee to Review the Working of the Monetary
liberalised in the sense that interest rates at other times it states that it stipulated the
System. The author is thankful to the Commit-
were raised to a much more appropriate minimum rate on a deposit of a given
tee for giving him an opportunity for working
level and a greater use of OMO was maturity. See Reserve Bank of India, "Func-
on this topic. The views expressed herein are
resorted to. On the basis of a comparative tions and Working", Bombay, 1983,
those of.the author.]
study of the economies of New Zealand, pp 87-91.
Australia, South Africa and Canada, it I Brahmananda, P R, "Interest Policy in 6 For further discussion of this point and
has been recommended that New Zealand India!" S K Muranjan Memorial Lecture, general features of the behaviour of interest
and Australia should emulnte the example mimeo, 1982; Mckinnon, R I, "Money and rates in India, see, Bhole L M, "Financial
of Canada and eliminate the use of direct Capital in Economic Development", The Markets and Institutions", Tata McGraw-
controls on interest rates.45
The Latin American countries also have
APPOINTMENTS
found that ceilings on interest rates, etc,
became more and more repressive in an
inflationary period; inflation required
upward movement of the ceiling rate but RESEARCH AND INFORMATION SYSTEM FOR THE
the administratively determined increases
in rates proved to be ad hoc and inade- NON-ALIGNED AND OTHER DEVELOPING COUNTRIE
quate. The indexation of interest rates did
not help for a variety of reasons. There- Invites applications from eligible candidates for the following po
fore, many countries opted for the strategy
of free interest rates at one point of time 1. SENIOR FELLOW: A High Second Class M.A. in Economics/Stat
or the other. For example, while Uruguay Operations Research. Ph.D. Degree with research experienc
and Nicaragua freed the rates in 1976, at least 15 years in the field of International Economic Relati
Argentina, Brazil, and Chile did so during and publications of high quality. Senior Fellow may be put in any o
1967-76.46 following scales: Rs 1500-1800/1800-2000/2000-2250.
V 2. FELLOW: A High Second Class M.A. in Economics/Statistics/Oper
Summary and Conclusions Research. Ph.D. Degree and Post-Doctoral research work/experienc
at least five years in the field of applied economics.
We have discussed in this study the
Pay Scale: Rs 1100-1600.
evolution of the system of low and admi-
nistratively fixed interest rates and the 3. RESEARCH ASSOCIATE: No. of Posts-Two: A High Second Class M.A. in
discretionary ceilings of credit allocation, Economics/Statistics/Operations Research with knowledge of quantitative
the alleged justification for the adoption methods of analysis. Research experience for two years or M.Phil. degree.
of such a system, and its effects on the
Working experience of Computer/Micro-processor desirable.
behaviour of interest rates, the working Pay Scale: Rs 7001300.
of monetary control, and the economic
activity in India. We have shown that this Except the posts of Senior Fellow and one Research Associate, all other
system has been harmful and, therefore, posts are to be on ad hoc-basis for two years only for project work.
it should be replaced by the alternative All the.above pay scales carry usual allowances permissible. Reservations
system of high and free interest rates with to SC/STs applicable as per Government Rules. Sefection Committee has the
the dependence on more than one techni-
pover to relax the eligibility criteria in suitable cases. Candidates for the above
que of monetary control used in a well
posts may also be considered for appointments for fixed period on
co-ordinated manner. Such an alternative
contractual/deputation basis.
system would be very much conducive to
increasing the rate of saving, efficiency of Application giving full bio-data should reach within 15 days from the date
investment, efficiency of the financial of advertisement, to Administrative Officer, Research and Information System,
system, efficiency of monetary control, 40-B, Lodhi Estate, New Delhi-110 003.
and, as a result, efficiency of overall
1103

202.41.10.108 on Sat, 25 Nov 2023 07:12:00 +00:00
Hill Publishing Co, New Delhi, 1982, account-holders, it may not be wrong to 38 Mckinnon, R I, op cit.
Chapter 20. assume that they arise largely out of created 39 Bhatt, V V, 'Some Aspects of Financial
7 Homer, S, 'Factors Determining the Secular credit. Policies and Central Banking in Develop-
Trend of American Interest Rates, in Pro- 22 For further discussion in this regard, see ing Countries% in Coats, Jr, W L, and
chnow, H V, "The Five-Year Outlook for In- Khatkhate, D R, op cit.
Bhole, L M, 'Retained Earnings, Dividends,
terest Rates", Rand Mcnally and Co, and Share Prices of Indian Joint-Stock
40 Chandavarkar, A G, 'Some Aspects of
Chicago, 1968. Interest Rate Policies in Less Developed
Companies', Economic and Political Week-
8 Homer, S, op cit. Countries: The Experience of Selected
ly, Review of Management, August 1980.
9 Hicks, J R, "Value and. Capital", Oxford Asian Countries', in Coats, Jr, W L, and
23 It is sometimes argued that where banks are
University Press, Oxford, 1939, p 262. Khatkhate, D R, op cit, pp 505-530.
a predominant financial intermediary, in-
10 The period of 1933-50 happens to be the 41 Bolotho, A, "Japan: An Economic Survey,
terest rates ceilings are justifiable because
phase of lowest interest rates in India which 1953-1973", Oxford University Press,
the competitive bidding of interest rates
could be due to the general depression and Oxford, 1975.
would raise the cost for all banks without
exigencies of war finance. In the case of the 42 Tew, J B H, and Artis, M J, 'Monetary
significantly impog their resource-
banks' advances rate, there is a statistical Policy, Part I and Part 11', in Blackaby, F T
position vis-a-vis each other. This is a very
explanation also. During 1935-50, this rate (ed), "British Economic Policy, 1960-74",
weak argument because it neglects the
has been represented by the bank rate which Cambridge University Press, Cambridge,
potential for the growth of other inter-
is not strictly comparable with the bank rate 1978; Perkins, J O N, "Macro-Economic
mediaries and also the interests of savers.
of the Imperial Bank before 1935, and SBI Policy: A Comparative Study". George
24 Johnson, H 0i, 'Problems of Efficiency in
advances rate after 1950. Allen and Unwin, London, 1972.,
Monetary Management', in Johnson, H G
11 Goldsmith, R W, "The Financial Develop- 43 Bolotho, A, op cit, and Lockwood, W W
(ed), op cit.
ment of India, 1860-1977", Oxford Univer- (ed), "The State and Economic Enterprise
sity Press, Delhi, 1983. 25 Bhole, L M, "Responsiveness of Imvestment in Japan"' Princeton University Press, New
and Other Expenditures to Changes in Jersey, 1965.
12 See also, Bhole, L M, op cit, Chapter 20.
Techniques of Monetary Control", Research
44 Patrick, H T, "Cyclical Instability and
13 The real interest rates have been calculated
Project Report submitted to the Indian Fiscal-Monetary Policy in Post-War Japan'
as the nominal rate + the three-year mov-
Council of Social Science Research, New in Lockwood, W W (ed), op cit, pp 605-606.
ing average of rates of change in wholesale
Delhi, July 1983.
prices (1913 = 100 for the period 1870-1946, 45 Perkins, J 0 N, op cit, pp 116-205.
26 The period of study for the public sector
and 1970-71 = 100 for the period 1949-83). 46 Galbis, V, "Inflation and Interest Rate
was 1960-61 to 1977-78.
14 Reserve Bank of India, "Report on Cur- Policies in Latin America, 1967-76", Inter-
27 Brahmananda, P R, "Productivity in the national Monetary Fund Staff Papers, June
rency and Finance, 1980-81", Vol I, p 106.
15 Reserve Bank of India, "Functions and
Indian Economy", Himalaya Publishing 1979; and Jud, G D, "Inflation and the Use
House, Bombay, 1982, p 213.
Working", Bombay, 1983, pp. 87-91. of Indexing in Developing Countries",
28 Brahmananda, P R, op cit, p 125, and p 143. Praeger Publishers, New York, 1978.
16 Fry, M J, 'Money and Capital or Financial
29 Brahmananda, P R, op cit, p 215.
Deepening in Economic Developments?' in
30 Wilczynski, J "Comparative Monetary
Coats, Jr, W L, and Khatkhate, D R (eds),
Economics", Macmillan, London, 1978, Roche Productg
"Money and Monetary Policy in Less
pp 130-133. ROCHE PRODUCTS is going ahead
Developed Countries"' Pergamon Press,
31 For a discussion on the theory of monetarywith modernisation of both its plants at
New York, 1980.
policy in India, see, Bhole L M, Research a cost of about Rs three crore. Meanwbile,
17 Galbis, V, 'Money, Investment and Growth
Project Report, op cit, Chapter 2. the company's production of vitamin A
in Latin America, 1961-73', Economic
Development and Cultural Change, April
32 Bhole, L M, ibid, Chapter 9. has been affected due to shortage of raw
.1979.
33 Holmes, A R, 'Operational Constraints on materials. The overall sales in the current
the Stabilisation of Money Supply Growth', year have been about. 10 per cent higher
18 Somne of the equations estimated by Fry are
and Maisel, S J, 'Controlling Monetary Ag- compared to the corwesponding period list
too simplistic to be taken seriously; some
gregates', both in Federal Reserve Bank of year, according to R Setlur, Chairman.-
of the relationships estimated by him and
Boston, "Controlling Monetary Ag- The company has obtained a price in-
Galbis are not really relevant in settling the
gregates", Boston, Massachussets, 1969, crease in vitamin A, but its applications
controversy of high versus low interest rates,
p 71, and p 152. for increases in prices of formulations are
viz, hypotheses of eomplementarity between
34 Bain, A D, 'Monetary Control Methods in still pending with the government. Setlur
demand for money and investment, and the
the United Kingdom', in Clayton, G, and told shareholders at the first annual
effect of inflation on economic growth; and
others (eds), "Monetary Theory and Policy general meeting after.dilution of foreign
notwithstanding elaborate specifications,
in the 1970s", Oxford University Press, Ox- equity that price fixation continued to be
the estimated equations by Galbis do not
ford, 1971; Karken, J, 'Appraisal of the most difficult problem facing the com-
contain the interest rate variable which
Monetary Management', in Johnson, H R pany and the industry. The subject had
drastically reduces the utility of his study
(ed), op cit; Harrington, R L, 'The Impor- been considered at length by the Working
in this context.
tance of Competition for Credit Control', Group and Steering Committee of the
19 This notation is followed in all regression
in Johnson, H G, and Nobay, A R (eds), Pharmaceutical Development Council
results in this study.
"Issues in Monetary Economics", Oxford and the government was presently seized
20 Rao, V K R V, "India's National Income, University Press, Oxford, 1974. of the problem. There seemed to be a
1950-80", Sage Publications, New Delhi, 35 Bank of England, 'Monetary Management general concensus that the price control
1983, p 136.
in the United Kingdom', in Johnson, H G should be at a minimum level. He hoped
21 We do not know what part of current (ed), op cit, pp 580-81. in the new regulations steps would be
account deposits arise out of created credit 36 Bhole, L M, Research Project Report, op cit.taken to ensure automatic re&ision of
but, given the fact that these deposits are 37 Bhole, L M, "Financial Markets and Institu- prices necessitated by increases in input
mainly held by the business and industrial tions", op cit, Chapter 2. costs.
1104

202.41.10.108 on Sat, 25 Nov 2023 07:12:00 +00:00

Administered Interest Rates in India

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Administered Interest Rates in India

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Administered Interest Rates in India

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TABLE 1: INTEREST DIFFERENTIALS IN INDIA

on 51-52 55-56 60-61 65-66 70-71 75-76 80-81 81-82

i) (3-year)-(l-year) - - 0.25 0.25 0.50 1.0 2.0 1.5

*coupon - - 0 to -0.5 1.0 0.5 0.5 to 1.0 0.5 -1.0

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behaviour of a few selected weightage given to them, which

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level of and changes asin banks'interest

FIGURtE 1: NOMINAL INTEREST RATES IN- INDIA, 1870-1983

16W BANKERS ADVANCE RATE - X r

15 WHOLE'SALE PRICES -.-*- 1 300

COMMERCIAL BANKERS | 290

BAZAR BILL RATE 2 5 0 / 250

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they were positive and directly

24 FIGURE 2: REAL INTEREST RATES I IN INIDA, 1870-1983

20 20 BANKERS DEPOSIT RATE

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argued for lQw interest the costrates

1) -2755.5 0.139* 434.8 - - 0.686* - 0.995 1.53 Nominal EE

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replaced by the arbitrary deposit rates hasand

1) NDP 4.41 Eliminated -0.071 0.009* - 0.9911 2.13 Log-nominal

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poses by banks other the resuilt of

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if more than one technique cient becauseis

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