Has Dr. Bimal Jalan once again ushered in lower interest rates? If you think that the 1 percent cut in the bank rate and the 1 percent in the CRR will lead to a softening of the interest rates in the economy, think again. There will be no such impact on interest rates. Here is why.

First what does a cut in CRR mean. The cash reserve ratio (CRR) is the liquid balance that the banks are required to maintain out of their deposits with the Reserve Bank of India. This liquidity is necessary to ensure that banks are not short of funds when excess withdrawal requests come up. A cut in CRR has two important implications. Firstly, a cut in CRR will mean more funds with the banks for lending purposes. Secondly, it means that since the supply of funds in the market will go up the interest rates, which is basically the price of money, will come down. Then why are interest rates not falling each time the CRR is cut? The answer lies in the fact that CRR cut will result in falling interest rates if and only if these excess funds are lent to corporates. But unfortunately the banks’ government investments have been rising sharply from 12% increase in 1996 to a whopping 27% in 1999. In simple terms, whatever funds the government is releasing through CRR cuts, it is mopping up through issue of securities to satiate its enormous borrowing appetite. Not surprising then that interest rates have not been falling.

The second reason why interest rates will not fall is that banks are already operating on wafer thin spreads. If interest rates have to fall then banks have to lend at lower rates to corporates. But this the banks cannot afford since their cost of funds is already high and any cut in CRR only has an marginal impact on their cost of funds.

The third reason why interest rates will not fall is the high interest rates that are paid on small savings. After great debate these rates of interest were cut from 12% to 11%. But it is still high by macroeconomic standards. These rates of interest on small savings form a floor below which interest rates in the economy do not fall.

Last but not the least, any cut in CRR or bank rate or repo rate can only impact interest rates at the short end. Medium term and long term interest rates are still largely influenced by inflationary expectations, which is currently quite high.

So the next time you wonder why you are still paying the same interest despite the RBI Governor’s best efforts, here is why. The linkage is not as simple and straight forward as you imagine.

T S Harihar