New Delhi: The finance ministry is planning to end open-ended interest subsidy schemes and replace them with direct interest subsidies that do not interfere with the monetary policy transmission mechanism, finance secretary Ratan Watal said on Monday.

Speaking at the state finance secretaries conference, Watal said the new system of banks calculating their lending rates based on the marginal cost of funds cannot succeed unless the government removes the distortions that have crept into the system over the years.

“We need to revisit our interest subvention schemes and replace them with back-ended interest subsidies that do not interfere with the marginal lending rates, and yet have the same effect on the loan repayments as the interest subventions have," he added.

Indian banks have started calculating their lending rates based on the marginal cost of funds, or the rate offered on new deposits, from 1 April. The new rules are expected to make loans cheaper for new borrowers. Banks earlier used to set their lending rates based on the average cost of funds on deposits outstanding.

“The moment you start fiddling around with interest rates, it distorts the market, it distorts transmission and that is one thing the RBI (Reserve Bank of India) governor has also been talking about," Watal said.

RBI governor Raghuram Rajan in November 2014 had said that interest subsidy schemes are prone to misuse by borrowers. “To my mind, any broad-based interest subvention distorts the price of credit and leads to misuse. Again and again, we see that distorted prices lead to the wrong kind of investments. If you incentivize short-term loans you don’t get long-term investment, but only short-term credit," Rajan had said.

Watal said interest subsidies should not be open-ended. “Old accounts will be cleared; for the new ones, we will just give a certain amount of money, it could be in the form of a subsidy also, but I need to know how much money has to be given for what period of time," he said.

Ranen Banerjee, partner and leader public finance at PricewaterhouseCoopers India, said interest subvention schemes distort the market mechanism. “The best way to provide such support is through direct benefit transfers like in other subsidies," he said.

Finance secretary Watal also said the medium-term planning framework and financial approval of schemes and projects after the Planning Commission era can be synchronized with the period of the Finance Commission over which both central and state governments have a clarity regarding the flow of resources.

The finance secretary said the central government has proposed a better coordinated and more evenly spaced borrowing schedule for states over 2016-17.

“Post October 2015, one important cause of tight liquidity was too much government securities simultaneously off-loaded by the state governments to meet their normal borrowing requirements. While we will address your concerns, in the true spirit of cooperative federalism, I seek your help in the matter," he added.

Watal said states will be co-opted in the proposed committee announced in the budget to review the implementation of the Fiscal Responsibility and Budget Management Act.

The budget had proposed that the committee may be asked to fix a range instead of a number for fiscal deficit, which will give the necessary policy space to the government to deal with dynamic situations, Watal said.