INTEREST RATES AND INVESTMENT EXPENDITURE PATTERN IN INDIA OVER THE

LAST TWO DECADES

Aditi Ankit Beena Dwijesh Kanishka

What is interest rate?

How it is determined?

What is interest rate?

Simply put, the price of money. Economics describes the interest rate in many ways: as the reward for postponing current consumption the opportunity cost of holding money the price paid for use of money the inverse of the price of bonds

How is the rate determined? The simplest theory is the loan able funds one, that it is the rate that equilibrates the supply of loan able funds in an economy with the demand for such funds. Then there is the classical theory, which defines the interest rate as the point of intersection of the savings and investment curves. Investment represents the demand for investable resources and saving represents the supply, whilst the rate of interest is the “price” at which the two are equated.

Deregulation of Lending Rates

Deregulation of Lending Rates

With the objective of providing credit to the productive sectors of the economy, bank lending rates as well as the allocation of bank credit were closely regulated by the Reserve Bank till the late 1980s. With the initiation of financial sector reforms in the early 1990s, various steps were taken to deregulate the lending rates of commercial banks. A system of prime lending rate (PLR), the rate charged for the prime borrowers of the bank, was introduced in October 1994. The PLR system went through several modifications from a single PLR to multiple PLRs and then to a Benchmark PLR (BPLR).

Phases of Interest Rates Policy

Phases of Interest Rates Policy

The period since 1951 can be divided into the following five phases of interest rates policy (system) in India:i)     1951 – 52 to 1960 – 61          

  Flexible interest rates system.ii)  1961 – 62 to 1985 – 86           

The system of administered, regulated, and repressed or suppressed  (low) interest rates.iii)  1986 – 87 to 1990 – 91           

The beginning of liberalization or the system with inclination or intend towards liberalization and flexibility, or a semi-administered system with the inching up of interest rates.iv) 1991 – 92 to 1996 – 97           

The system of progressive deregulation and flexibility, and a significant increase in and unprecedentedly high interest rates, or the phase of deregulation and dear money.v)  Form 1997 – 98           

The system of managed flexibility with nearly complete deregulation, and one of the lowest levels of interest rates in India, or the phase of cheap money.

Evolution of Lending Rate Structure in India

Evolution of Lending Rate Structure in India

Timeline Description

Sep. 1990 The structure of lending rates was rationalized into six size-wise slabs. Of these, banks were free to set interest rates on loans of over Rs.2 lakh with minimum lending rates prescribed by RBI.

April 1992 Slabs compressed into four.

April 1993 Slabs compressed into three.

Oct. 1994 Lending rates for loans with credit limits of over Rs. 2 lakh deregulated. Banks were required to declare their Prime lending rates (PLRs).

Feb. 1997 Banks allowed to prescribe separate PLRs and spreads over PLRs, both for loan and cash credit components.

Oct.1997 For term loans of 3 years and above, separate Prime Term Lending Rates (PTLRs) were required to be announced by banks.

April 1998 PLR converted as a ceiling rate on loans up to Rs.2 lakh.

Timeline Description

April 1999 Tenor-linked Prime Lending Rates (TPLRs) introduced.

Oct. 1999 Banks were given flexibility to charge interest rates without reference to the PLR in respect of certain categories of loans/credit.

April 2000 Banks allowed to charge fixed/floating rate on their lending for credit limit of over Rs.2 lakh.

April 2001 The PLR ceased to be the floor rate for loans above Rs. 2 lakh.Banks allowed to lend at sub-PLR rate for loans above Rs.2 lakh.

April 2002 Dissemination of range of interest rates through the Reserve Bank’s website was introduced.

April 2003 Benchmark PLR (BPLR) system introduced and tenor-linked PLRs discontinued.

Feb. 2010 Draft circular on Base Rate placed on RBI web site for obtaining comments/suggestions from public/stakeholders.

April 2010 Base Rate system of loan pricing introduced effective July 1, 2010. Rupee lending rate structure completely deregulated

Introduction of Base Rate System

Introduction of Base Rate System

The PLRs turned out to be rigid and inflexible in relation to the overall direction of interest rates in the economy. In order to address these issues, a BPLR system was introduced in April 2003.

The lack of transparency in the BPLR system also hindered transmission of monetary policy signals. On the basis of the recommendations of the Working Group (Chairman: Deepak Mohanty) and after taking into account the views of various stakeholders and discussions with banks final guidelines on the base rate system were announced on April 9, 2010.

Introduction of Base Rate System

The base rate system will replace the BPLR system with effect from 1st July 2010. Base rate shall include all those elements of the lending rates that are common across all categories of borrowers. Banks may choose any benchmark to arrive at the base rate for a specific tenor that may be disclosed transparently. Banks are free to use any other methodology, provided it is consistent, and is made available for supervisory review. Banks will determine their actual lending rates on loans with reference to the base rate and by including such other customer specific charges as considered appropriate.

Since the base rate will be the minimum rate for all loans, the current stipulation of BPLR as the ceiling rate for loans up to Rs.200,000 is withdrawn and banks are not permitted to resort to any lending below the Base Rate.

Lending Rates in India

Lending Rates in India

Source - http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?id=508

The decline in the inflation rate between the 1990s and 2000s contributed to lower nominal lending rates.

Lower inflation volatility in the 2000s reduced the inflation risk premia.

Significant productivity improvement in the banking system lowered the intermediation cost .

The observed decline in weighted average lending rates in the banking system can be attributed to the improvements in pricing of risk due to the increased space provided by progressive deregulation of lending rates.

Credit Growth and Real Lending Rates

Source - http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?id=508

Ideally, the real lending rates should not be too much out of alignment with the real GDP growth rate.

The data for the period 1990-91 to 2008-09 show that real lending rates were higher than real GDP growth particularly during 1997-98 to 2002-03.

This scenario has clearly changed since 2003-04 concurrent with the high growth phase of the Indian economy. The weighted average real lending rate has since remained below the real GDP growth rate .

In terms of real sector activity, approximated by the index of industrial production (IIP), the industrial growth cycles are

also inversely related to the real interest rate cycles

Source - http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?id=508

From 2000 until 2010, India's average interest rate was 5.82 percent reaching an historical high of 14.50 percent in August of 2000 and a

record low of 3.25 percent in April of 2009

Investment expenditure

Investment Expenditure

Investment expenditure refers to the expenditure incurred either by an individual or a firm or the government for the creation of new capital assets like machinery,

building etc.

Types of Investment expenditure:This investment expenditure can be broadly classified into the following types:

Autonomous investment expenditure is the one that does not depend on the current production or the demand for goods. This expenditure is not made with

the profit motive. The government constructs roads, bridges and canals etc. which are regarded as the infrastructure for the country's economic

development.

Induced investment depends upon the current level of production and demand for the product.

Financial investment refers to the investment expenditure made on the purchase of shares, bonds, securities etc.

Gross investment refers to the entire expenditure incurred on acquiring new capital assets like machinery.

Net investment expenditure is calculated by deducting the depreciation charges from the value of existing capital assets.

INVESTMENT EXPENDITURE DETERMINANTS

Interest rates

The cost and productivity of capital goods

Expectations of future profits

Current profits

New techniques and new products

RELATIONSHIP BETWEEN INTEREST RATES AND INVESTMENT EXPENDITURE

There is negative relationship between interest rate and investments.

It means that as interest rate falls investment rises. And the opposite is true when interest rate rises.

When the interest rates are high, investors make less real investment.

On the other hand, if the interest rate is low, more and more investment take place in the economy.

Contd…

A central bank assesses the amount of funds required to oil the economy’s wheels, commensurate with the desirable level of economic activity. It raises rates whenever it feels the economy is over-heating and lowers these when it wishes to spur investment and growth.

The rates are an important determinant of the level of investment in an economy. Broadly, if rates increase across the board, then, other things remaining the same, investment will decrease (as it will no longer be as profitable as before to invest) and so will the growth rate. If interest rates fall, investment will pick up and so will growth.

INVERSE RELATIONSHIP

So should economies like India keep interest rates low?

No, while high rates may dampen ‘animal spirits,’ keeping interest rates artificially low can have far worse consequences over the long-term. This is because any investment decision is a tradeoff between the cost of capital (whether borrowed or own funds) and the rate of expected return from the investment.

So, if interest rates are kept artificially low, many investment decisions that are otherwise unviable may be taken. The result could well be the creation of excess capacity—companies producing more cars, scooters, fridges, TVs and so on, relative to demand— bringing in its wake the inevitable painful adjustment later, when companies downsize and lay off workers.

Changing pattern of credit to industry

Do firms rely heavily on bank finance to meet working capital requirements?

For the last two years and more, the corporate sector has been increasingly dependent on external sources of funding, particularly bank finance, to meet its growing demand for credit. This is borne out by CMIE data which show that the share of corporate borrowings from banks and financial institutions went up sharply from 4.1 per cent in 2004-05 to 22.7 per cent in 2008-09.

This is in sharp contrast to the trend during 2002-03 to 2004-05, when corporate preferred internal sources of finance, particularly retained earnings, rather than bank credit, to meet their demand for funds. In fact, bank credit has emerged as the most preferred funding option for corporate and has even overtaken internal accruals, despite the fact that interest rates have started moving upwards.

One of the reasons for such a trend could be that the last 2-3 years have been difficult for business on account of adverse demand conditions arising from the global financial crisis.

The profitability ratio is down from 14 per cent in 2003-04 to 11.7 per cent in 2008-09. This has eroded internal surpluses and forced firms to borrow from banks. Hence, the share of bank borrowings as a funding option has been slowly rising since 2005-06.

Do banks respond to the funding needs of industry by stepping up credit flows to this sector?

As per CMIE data, is that the largest chunk of lendable resources of banks is still channelled towards industry.

A break-up shows that industry is the major beneficiary as fund allocation to this sector has recorded a growth rate of 22 per cent in 2008-09 and 19 per cent in 2009-10, as against a mere 6 per cent in 2003-04.

However, total bank credit has also notched up 18 per cent growth in 2008-09, which, though lower than the boom period of 2004-07, is still higher than the 15-20 per cent rise at the beginning of the decade.

Despite these positives, it is equally true that the share of industry and manufacturing in total credit has declined since the 1990s. Funds dispersed to industry have come down from a high of 45 per cent of gross bank credit in 1997-98 and 43 per cent in 2001-02 to 38.4 per cent in 2008-09 and at 40 per cent as on May 21, 2010.

The decline in share of bank credit to industry is bad news for companies, especially at a time when their dependence on bank finance is growing to meet their investment needs.

OTHER AVENUES

Corporate also have other funding avenues such as commercial paper, shares, bonds, mutual funds, non-bank domestic sources (comprising 35 per cent) and foreign sources.

However, the impact of the declining share of bank credit to manufacturing is being acutely felt by the small and medium sector. Credit delivery to SMEs has come down from 14.2 per cent in 2001-02 to 10.9 per cent in 2008-09. The best SMEs get credit at interest rates which are at least 175-200 basis points higher than blue-chip companies.

The smaller units have no option but to tap internal savings, approach NBFCs and other non-institutional credit sources where cost of funds is much higher.

...CONCLUSION...

Conclusion There is negative relationship between interest rate and

investments means that as interest rate falls investment rises. And the opposite is true when interest rate rises.

Interest rate helps to determine the trend of investment in an economy. When the interest rates are high, borrowing becomes quite expensive for the investors so they make less real investment. The high interest rates make it difficult to cover their expenditure because their products becomes less competitive in both the domestic and international market.

On the other hand, if the interest rate is low, more and more investment take place in the economy which result in more production, more employment opportunities and increase in the potential GDP. Thus the real interest rate through their effect on investment improves growth and future living standards of a nation.

BIBLIOGRAPHY

rbi.org.in

thehindubusinessline.com

economywatch.com

caclubindia.com

tradingeconomics.com

financialexpress.com