Interest rates

Pre liberalization era - A regulated regime

Interest rate is the opportunity cost of money.  Till 91, RBI used to regulate the interest rates in Indian Economy & all the interest rates were used to be fixed by the RBI.  Banks were not allowed to fix rates according to their cost of funds.   The RBI used to fix the PLR of the banks and the banks had to set their interest rates accordingly.  The interest rates of the banks set the floor for interest rates to be paid on corporate borrowings.  So in a way, the RBI used to decide the entire structure of the interest rates.

Post liberalization era - A deregulated one

After liberalization, the RBI started to deregulate the interest rates gradually.  The economy started moving from a regulated to a market determined interest rate regime.  Now, the RBI only give indications to the market through the bank rate, reverse repo rate, CRR, SLR and open market operations.  It only fixes interest rates to be paid on the saving bank deposits.  Now the banks can decide their PLR and other interest rates based on their cost of funds.  This was accompanied by cuts in CRR, SLR and the bank rate which decreased the cost of funds.  

All this was accompanied by liberalization of financial markets.  New players were introduced in the markets.  The RBI took every step necessary to develop a well functioning money market.  The concept of a Primary Dealer came into being for that purpose only.  Certain financial institutions, apart from banks, were also allowed to operate in the money market which increased the funds available and the turnover in the money market.  A well functioning money market provides a basis on which other interest rates of the economy are determined.

The Fall out

And this created wonders for the Economy.  The interest rates (i.e., prime lending rates), which  were as high as 16 - 17% in 92 - 93, came down to as low as 11.75% at present.  What has happened is that the market determined regime has increased the competition in the markets & the operators are ready to operate on thin margins.   Also, the RBI was dead bent on decreasing interest rates in the economy.  So it kept on decreasing CRR, SLR and the bank rate, bringing down the cost of funds for the banks.  Because of all this, the interest rates are on a fall in Indian economy for quite sometime now.

Implications of decrease in Interest rates

The decrease in interest rates had serious implications for the Indian economy.   First of all, it provided a much - needed boost to the industrial activity.   Most of the Corporates, who had outstanding loans, discharged their costly loans financed by new loans at lower interest rates.  The investment activity in the economy increased & provided a big boost to the economic growth.

This decreased any arbitrage opportunities, that were earlier available, & that is always helpful to control volatility in other financial markets.  It also helps the operators to manage their balance sheets in a more efficient manner.

The market determined interest rate regime increase the width & maturity in the financial markets.  In Indian economy, the deregulation was accompanied by liberalization of financial markets.  This introduced new players in the market.

Presently, how are the interest rates determined in Indian Economy?

Call rates
The call rates sets the floor for all the interest rates in the economy.  The call money market is an overnight market and is considered to be the most liquid market in an economy.  The call rates are determined each day on the basis of demand supply situation on that particular rates.  Since the call money market is the most liquid market, the interest rates in other markets have to be more than call rates.

Sovereign securities
Next comes the market for sovereign securities, i.e., T - bills and dated securities.  These securities are sold on the basis of competitive bidding system.   The dealers make their bid on the basis of call rates.  Of all the bids, a cut - off rate is decided as yield to be payable on that particular issue. 

Interest rates charged by banks
Next in line comes the interest rates charged by the banks.  The banks fix their interest rates based on their cost of funds which includes the rates they pay on the deposits they get and their operational expenses.  Prime lending rate (PLR) is the benchmark rate for all other interest rates charged by the banks.  PLR is the rate which the banks charge from their top clients who have the best credit rating.  All the other interest rates charged by the banks includes a risk premium for advancing money to clients who don't have as good a credit rating.

Corporate debt
And finally comes the interest rates paid by the Corporates on their debt.   The interest to be paid on this debt is PLR plus a risk premium because of their business and financial risk.