Need for a Benchmark Rate of Interest

Need For A Bench Mark Rate of Interest for entire economy


What is the real rate of interest? and what is the average cost of funds in our economy? Is it the whole sale price index or the consumer price index to be reckoned to assess the real rate of interest by investors and savers ? What is the central rate which influence various other rates? These are some of the questions lingering in the minds of many associated with the economy and finance.

The major problem faced by Indian Financial System is that there is nothing called Bench Mark Rate of Interest/Prime rate which can influence liquidity in various markets like Money Market, Forex Market, Securities Market, Credit Market, etc. Like wise, it is also difficult to identify the average cost of funds in the economy which basically determines investments, production, exports, imports, supply and demand for goods and services. The cost of funds in any economy has to be necessarily linked to inflation index whether it is WPI or CPI so that one can assess the real rate of interest and take investment decisions. At present there are several rates operating in the economy without having much of relevance to inflation, real rate of interest and any sort of alignment to each other. Banks offer uniform savings rate at 3.5% fixed decades back without having any link to inflation rates i.e. -1.3% or their own cost of funds ranging between 5% and 6%. The rates offered by the Government on PPFs or savings deposits with post offices or rates offered by banks on their fixed deposits or the yield on government securities have no relationship with each other and are not linked to any benchmark rate. Similarly there are other interest rates like Bank Rate, different Prime Lending Rates of various commercial banks, Treasury bill Rates, Government of India Securities Rate, General Provident Fund Rate, Repo and Reverse Repo Rate, Call Money Rates, Commercial Paper and Certificate of Deposits rates, Mumbai Inter-bank Offered Rates, Corporate Bonds and Debentures Rates etc; operating in the system. In the absence of a central rate to which other rates can hover around depending on the dynamics of various markets, there is some ambiguity in arriving at the cost of funds in the economy in general and banks’ inability to arrive at their own cost of funds and lending rates on a scientific basis in particular.

In a growing economy, particularly where fiscal deficit and revenue deficit are on the high side and Government resorts to heavy market borrowings at market determined rates of interest crowding out private investments, the interest rates are bound to increase and the cost of funds will naturally be high. This year, the fiscal deficit is projected to be at 6.8% of GDP and the borrowings are estimated to be at Rs 4, 51000 crores.

Rate of interest in an economy has to necessarily influence savings and encourage investment in the productive sector. From this point of view, the rates of interest prevalent at present cannot be said to be doing justice both to savings and investment. Very fact that despite inflation at an unimaginably low level and a very large bout of stimulus packages both from Fiscal and Monetary segments, the lending rates, borrowings and investments have not moved favorably should vouch for this. Comparatively, Rate of Savings particularly in banks continues to be high for want of better alternatives. However, there seems to be an inherent weakness other than the recessionary trend influencing savings and investments. Real rate of interest has never been real is a fact which cannot be ignored for long, and the existence of parallel economy which inhibits smooth transmission of monetary policy has to be recognized fast.

The following table would indicate the rate of inflation and various rates in the financial system.

INFLATION: _1.55% as of June 2009.

Interest Rates in the Financial System
(Per cent per annum)Week ended June 12, 2009
Bank Rate 6.00
I.D.B.I.(1) 10.25
Prime Lending Rate(2) 11.00 – 12.25
Deposit Rate(3) 6.50 - 8.25
Call Money Rate (Low/High)(4)
- Borrowings 2.20 – 3.30
- Lendings 2.20 – 3.30

Savings Bank Rate 3.50
Public Provident Fund 8.00
Employees Provident Fund 8.50
Certificate of Deposit 3.75 – 11.50 in 2009
Commercial Paper 2.83 - 14.00 in 2009
Repo Rate 4.75
Reverse Repo Rate 3.25

(1) Minimum Term Lending Rate (MTLR)
(2) Prime Lending Rate relates to five major banks.
(3) Deposit Rate relates to major Banks for term deposits of more than one year
maturity.
(4) Data cover 90-95 per cent of total transactions reported by participants.

Source: Reserve Bank of India Bulletin- Weekly Statistical Statement, June 26, 2009

It may be observed from the table that interest rates both on savings and lendings have no bearing with inflation rate. There should be some relationship among the interest rates and inflation rate although rates may vary based on competition and market dynamics. Average cost of funds in an economy and average cost of funds of intermediaries should move around Savings rate, Real rate of interest i.e. after adjustment for inflation and average lending rate. Banks’ lending at rates below their cost of funds and very much above the cost of funds is something fishy. Herein lies the need for having a bench market rate of interest to which all rates whether it is average cost of funds, savings rate, borrowing rate and lending rate should be linked. The Bench Mark Rate of Interest has to be arrived at on a scientific basis reflecting on the threshold rate of inflation, GDP growth, Fiscal deficit, Borrowings, and Current Account Deficit. This rate should be evolved as a reference rate for all purposes and different rates presently operating in the economy should necessarily be linked to this rate of interest. Such an arrangement will facilitate smooth transmission of monetary policies and prove to be a boon to the economy in understanding the dynamics of interest rates and arriving at appropriate macro level policy decisions. The fact that interest rates in the system have apparently no alignment whatsoever and operate in a disjointed manner can affect the cost of funds and distort the whole gamut of funds related assessments in the economy. Ignoring this fact does not change the fact has to be recognized?

Bank rate which has been inactive or ineffective in influencing various other rates prevalent in the market can perhaps be developed as a reference and benchmark rate of interest. Such a rate if evolved may turn out to be beneficial to the economy in the long run in implementing both monetary and fiscal policy. There will be better coordination in framing fiscal and monetary policies and taming inflation both WPI and CPI apart from influencing liquidity, investment and production. The real strength of the economy lies in lowering the average cost of funds and making it affordable and available for investments. This is possible only if there is a Bench Mark Rate of Interest for the entire economy.


Dr.T.V.Gopalakrishnan