Finance minister P Chidambaram wants public sector banks to cut their interest rates so that people borrow and spend more, and consumer demand improves.
The trouble is that the credit deposit ratio of banks is at extremely high levels. Latest data from the Reserve Bank of India (RBI) shows that as on September 6, 2013, for every Rs 100 that banks borrowed as deposits, they had lent out Rs 78.52.
Banks need to maintain a cash reserve ratio of Rs 4 for every Rs 100 that they borrow as a deposit. This money is deposited with the RBI. They need to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 for every Rs 100 they borrow as deposit in government bonds.
This means that Rs 27 out of Rs 100 that is borrowed as a deposit goes out of the equation straight away. Only the remaining Rs 73 can be lent. But banks are lending Rs 78.52 for every Rs 100 that they raise as deposit. This means they are borrowing from other sources in the market to lend.
This is happening primarily because banks have been unable to raise enough money as deposits. The deposit growth in one year (between September 7, 2012 and September 6, 2013) was at 13.5%. In comparison the loan growth has been at 18.2%.
Given that loan growth has been happening at a much faster rate than deposit growth, banks cannot cut interest rates. To cut interest rates on loans, banks will have to first cut interest rates on deposits. And if they do that they will find it even more difficult to raise deposits.
But Chidambaram seems to have found a way to get around this problem. A finance ministry press release pointed out on Thursday that “it may be recalled that in the Budget for 2013-14, a sum of Rs 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently. The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two-wheelers, consumer durables etc, at lower rates in order to stimulate demand.”
There are multiple problems with this plan. Where will the government get the money for the extra capital it is planning to offer to banks? It will borrow money by selling bonds, which will be bought by banks and other financial institutions. And where will the banks get this extra money to lend to the government? By trying to raise more deposits. And how will they do that? By offering higher interest rates.
The bigger problem with the argument is that the size of loans for two-wheelers, consumer durables etc is too small, for a fall in interest rates to make any difference. Let’s assume an individual takes a two-year two-wheeler loan of Rs 50,000 from the State Bank of India at 18.05% per annum. The EMI for this comes to Rs 2,497.4. If the interest rate falls to 17.05% per annum, the EMI will fall by Rs 24 to Rs 2,473.3. If the interest rate falls to 16.05% per annum, the EMI will fall by Rs 48 to Rs 2,449.35.
Of course, no one is going to buy a two-wheeler because his EMIs have come down by Rs 24-48. When it comes to these kind of purchases, interest rates don’t really matter. What matters is how people feel about their economic future. Questions like whether they will get a raise this year or whether they will keep their job in time to come are more important.
So, fat chance Chidambaram’s plan will work.
Kaul is the author of the soon-to-be-published Easy Money.
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