The Reserve Bank of India in its latest Monetary and Credit Policy cut the bank rate by 0.25 per cent to 6 per cent. The apex bank has also reduced the cash reserve ratio (CRR) by 0.25 per cent to 4.5 per cent beginning from the fortnight of June 14. The Reserve Bank of India’s monetary policy stance thus continues to show “a preference for soft interest rates.” The rationale provided for such a policy action to bring down interest rates is that it will facilitate the revival of industrial growth, align domestic real interest rates with global interest rates and reduce the burden on the fiscal deficit via reducing the cost of the borrowing for the government.

Interest rate cuts have become a common phenomenon in the monetary policy statements of the RBI of late. So why is the Reserve Bank almost regularly reducing the interest rates? One, there is high liquidity in the banking system because demand for credit has been sluggish for the last few years. Two, because investment in the industrial sector has been more or less stagnant and the Reserve Bank feels that by making cheaper money available, entrepreneurs will be encouraged to plan more new projects and build c

The recent Economic Survey however noted a disturbing fact about the Indian banks. Given a choice between credit to the commercial sector where returns were higher but asset quality was doubtful and full provisioning was mandatory, and investment in g-secs with lower returns and risk, Indian banks overwhelmingly prefer the latter. Improved credit demand in the recent time linked to a revival in industrial activity has enabled banks to almost double the aggregate lending levels during the current fiscal. But that has still not satiated their appetite for Government paper.

Table1 indicates that the real interest rates for borrowers have actually increased in the last decade. This is indicative of the widening spreads at banks. While banks have been quick to slash deposit rates as interest rates head south, they have not been as spontaneous in lowering the cost of credit. This means that borrowers are worse off now than they were a decade ago. Lending rates have not fallen at a similar rate compared to the fall in the inflation rate. For a country like India this is a cause of concern.

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