PPF rate cut: Nobbling the wrong culprit

The cut in the interest rates payable on small savings announced in the Budget has been greeted by howls of protest from all but the very affluent. The result, as might be expected in a democracy, is that there are reports now that the government may restore the cuts partially. But whether or not it should do so would depend on determining the validity of the original argument for such a cut. The argument was that the rate on small savings was acting as a floor for the general interest rate structure and that if it was cut there would be a sharp reduction in interest rates. A quick look at the evidence, a month after the Budget was presented, is instructive.

It shows that while there has indeed been a downward movement, the magnitude has not been quite as much as expected. The reason: the structural constraints that prevent a quick softening of rates have not been properly addressed. Banks still have very high administrative costs which means that their lending rates have to be considerably higher than deposit rates. Further, as long as the fiscal deficit remains high, government siphons off a huge volume of financial resources of the system. Its assets are often preferred by banks because they are risk free and at least do not entail the risk of increasing non-performing assets (NPAs) of banks. Large NPAs of commercial banks imply that to remain profitable banks have to increase spreads on all loans to recover the money lost on account of bad loans.

The stage for the rate cut had been set by a cut in the bank rate. Earlier statements from the RBI that the core inflation rate was low and the fact that the rupee was generally stable had suggested that the RBI was open to the idea of a rate cut. The market had, as a result, been expecting a cut. This expectation was strengthened by the cut in interest rate by the Federal Reserve Bank of the US which had widened the interest differential.

The sequence of events was as follows. On February 16, 2001 the RBI cut the bank rate and CRR by 0.5 percentage points. This had followed a cut in the Fed rate. Some banks, notably the State Bank of India then cut their PLR. Next, a cut in the small savings rate of 1-1.5 per cent was proposed in the Budget. This was followed immediately by another cut in the bank rate by half a percentage point on March 1, 2001. Following this a number of interest rates were reduced. Smaller banks such as Bank of Baroda, Corporate Bank and Indian Overseas Bank cut their PLR by 100 basis points. The SBI cut its short term lending rate -- but the medium term lending rate was left unchanged.

The question now is will there be a further cut in rates and if so after how long. This is where the structural constraints become critical because reducing lending rates without cutting deposit rates is not very feasible for banks. Their intermediation costs are simply too huge. The only way banks can reduce PLRs is if they reduce deposit rates as well. But this doesn't look very probable in the short term or even the medium term. The deposit rates face competition from mutual funds and other instruments.

They are also subject to expectations about price rise, which have risen, rather than declined. So the point is simple: with higher expected rates of inflation, interest rates on deposits cannot be cut too much as that would reduce the attractiveness of bank deposits. The banks will obviously resist that. In order to reduce their costs the banks have been trying to reduce their labour costs. While this is the way to go in the long run, in the short run their chronic problem has been worsened by the VRS schemes. This has reduced their room for manoeuvre as far as quick rate cuts are concerned. They simply cannot afford it.

Only a rough estimate of the additional costs on account of the voluntary retirement schemes can be made because the exact figures are not yet available. SBI, for instance, is expected to pay out about Rs 1,200 crore on account of the VRS as cash payment to employees. Four other public sector banks -- Punjab National Bank, Bank of India, Syndicate Bank and Bank of Maharashtra -- have compensated about 21,700 employees. If the total number of employees who are given voluntary retirement compensation in the banking sector adds up to 1,00,000 with a cost of Rs 5,00,000 each it places an approximate burden of Rs 5,000 crore on the banking sector. This too will act as a dampener on whatever enthusiasm there might be for cutting rates.

Then there is also the problem of non-performing assets (NPAs) or bad loans. At the beginning of this year the gross non-performing assets of the Scheduled Commercial Banks stood at Rs. 60,841 crore. The proportion of NPAs is reported to have improved but new regulations about NPA norms have raised NPAs for some banks, such as the SBI. A third structural constraint is public sector dis-saving which would require a substantial reduction before overall rates come down significantly. The size of its borrowing programme has not really seen a cut. In 1999-2000 the central government borrowed Rs 1,04,717 crores, in 2000-01 Rs 1,11,972 crores and in 2001-02 it proposes to borrow Rs 1,16,314 crore. Little has been done to address the overall size of the deficit. Thus the main cause of the high interest rate regime is the government's huge borrowing programme to finance its fiscal deficit. This remains to be addressed and so interest rates cannot be expected to move downwards with the speed that the finance minister and the RBI had suggested. Indeed, unless the essential task of reducing the fiscal deficits is addressed, it is quite unlikely that there can be a very significant softening of interest rates. The moral is clear: if government demand for funds remains high, cuts in administered rates may create the environment for a general movement towards lower rates. But they will not ensure that rates come down. This is what we are witnessing now. And, unless the physician heals himself, this is what may well go on happening.