Government bond yields have been rising despite yet another policy rate cut by the Reserve Bank of India (RBI). The banking community, too, is not very enthusiastic about taking the cue from RBI and cutting loan rates. And the central bank has probably reached a stage from where it will find it extremely difficult to lower rates further.
Have interest rates bottomed out? Is there any way to push bankers to lend to companies at cheap rates? Can they be enticed to buy government paper—key to the success of the government’s massive borrowing programme in the next fiscal year?
All these are possible if RBI can cut its policy rates further. Experts have been suggesting deep rate cuts, by as much as a full one percentage point, to prop up sagging economic growth.
Also Read Tamal Bandyopadhyay’s earlier columns
Can RBI do this? Can it be even more bold and bring down the policy rate to zero? Yes, it can, through the back door.
Let’s listen to an imaginary conversation between a banker and a borrower to understand the predicament of different entities in the Indian financial system and how RBI can actually cut its policy rate to zero.
Edited excerpts of the dialogue:
Borrower: RBI has cut both its repo and reverse repo rate by half a percentage point each to 5% and 3.5%, respectively, but why aren’t you still cutting your loan rates?
Banker: We can’t bring down our loan rates because we are not able to bring down our deposit rates.
Borrower: Why can’t you bring down your deposit rates?
Banker: Well, we have brought the rates down from around 9.5% to 8% for one-year deposits, but we won’t be able to bring it down further as the government pays 8% on various small savings plans, offered by post offices. So, if we pay less than 8% to our depositors, they will stop coming to banks and park their savings in post office schemes.
There is yet another hurdle. Our depositors are required to pay income tax on their earnings. In fact, we deduct tax at source while paying interest on deposits. This is not the case with small savings schemes. So, the earnings on bank deposits are lower than what the government’s small saving schemes offer. We cannot bring down the rates further unless the government brings down the small savings rates.
Borrower: Since you are lending to good customers at below your prime rates, what prevents you from bringing down your prime lending rates?
Banker: Again, there is a structural issue. There are quite a few mandated loan rates. For instance, we need to offer loans to exporters at two percentage points below our prime rates. Similarly, farmers and other borrowers too must get loans at below prime rates. Overall, such loans account for about 30% of our total loan book.