Wednesday, February 09, 2005

Why higher interest rates are needed

on Rediff

So who really benefited from lower interest rate environment, which prevailed for the last few years?

First and foremost, the Government of India. The huge fiscal deficit that it has been running was financed at lower interest rates.

The second main beneficiaries were large corporates. They could replace their earlier high-cost loans with cheaper loans.

The people who lost out were charitable trusts, poor pensioners, senior citizens and widows who saw the value of their savings come down considerably. The fact that India does not have a social security system in place made it even more difficult for this section of the population.

The fact that they have been selling government paper to fund credit offtake means that their investment in government paper has been declining. Once the banks reach this level of 25 per cent, they cannot sell any more government securities to generate liquidity.

And given the pace of credit offtake, some banks could reach this level very fast. So banks, in order to keep giving credit, need to ensure that more deposits keep coming in. Banks as of now are competing for capital with other forms of investment, which give a greater amount of return than what banks have to offer.

So in the current situation of high inflation (vis-a-vis interest rates), rapid credit growth and lower deposit growth, the only way of ensuring an increase in bank deposits is to increase interest rates.

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