THE ECONOMIC WEEKLY November 7, 1969

Interest Rate Policy M O N E T A R Y pol icy i n I n d i a has

slipped in to a groove: the bank rate has remained between 3 and 4 per cent over a period of 25 years— a period m a r k e d by a w o r l d w a r and the in t roduc t ion o f p l ann ing in the economy. The Reserve B a n k has acquired a va r ie ty of detailed powers fo r interference in the b a n k i n g sphere, w i t h o u t add ing to the na ture or extent of i t s cont ro l over the economy. We have, in­stead of a coherent d i rec t ion of the economy, ad hoc sporadic inter­ferences to meet pa r t i cu la r changes in the s i tua t ion as they occur. ( I n 1957, the Reserve B a n k issued more t h a n ten circulars to banks on the subject of g ran t of credits — ad-vances against various commodities sugar, c loth , foodgrains; the Governor also wrote letters to banks on the same and other subjects; Cf 'Trend and Progress o f B a n k i n g in I n d i a du r ing the Year 1957.' pp 90-116. This was continued dur­ing 1958 and later ; Cf 'Report on Currency and Finance 1958-59/ pp 30-32.)

No fundamenta l t h i n k i n g has been done on the subject at the offi­c ial and the non-official levels, since the Reserve B a n k was set up, ( A t the Fo r ty - f i r s t I n d i a n Economic Conference, the hand l ing of the mone ta ry policy came in for gene­r a l approbat ion: the most revolu­t i ona ry c r i t i c i sm was the sugges­t i o n to raise the bank rate f r o m 4 per cent to 5.) The advent of p lanning , instead of p r o v o k i n g new t h i n k i n g , appears to have led to an abdicat ion of moneta ry policy, i t being assumed t ac i t l y t h a t invest-ment decisions are related to phy­sical needs as l a i d down under the plans and no longer subject to mone ta ry policy. The influence of p l ann ing has been so all-pervasive t h a t i n the f o r m o f directives ( a m o u n t i n g in recent t imes to lay­i n g d o w n by the Reserve B a n k Governor by w h a t exact f igure cre­d i t should be brought down in the Black season!) the concept has also been Incorporated in cen t ra l bank­i n g pol icy. (Cf 'Reserve B a n k o f I n d i a B u l l e t i n , ' June, 1959, p 716; also ' T r e n d and Progress o f B a n k ­i n g in I n d i a d u r i n g the year 1957', pa ra 7.)

P l a n n i n g and M o n e t a r y Pol icy So p l a n n i n g has to pu l l , besides

the w e i g h t of a heavy investment

The interest-rate s t ructure in I n d i a is general ly assumed to be bu i l t round the bank rate w h i c h a t present is 4 per cent. However, w h a t is immedia te ly noticeable f r o m the table is the w i d t h of the range and the clear gap in the middle range The la t te r also marks a qual i ta t ive difference in the money marke t in I n d i a — tha t between the organised sector and the unorganised sector of the eco­nomy . (For an analysis of the factors leading to the emergence of the dual m a r k e t fo r capi ta l , Cf George Rosen, "Capi ta l Marke t s and the Indus t r i a l i sa t ion of Under­developed Economies." I n d i a n Eco­nomic Journal , ' October 1958.) The organised sector comprises banks, stock exchanges, large industries and support ing sections (commerce and t ranspor t ) of the economy, con t r ibu t ing to less than a quarter of the na t ional income; the un­organised sector comprises the rest of the economy, inc lud ing most of agr icul ture (excluding p lan ta t ions) , r u r a l moneylenders, r u r a l crafts and industries and support ing commerce and t ransport . The i n ­terest rate structure in the orga­nised sector is bu i l t a round the bank rate; in the unorganised sec­tor, on the basis of demand and supply in agr icul ture .

The organised sector affords a low rate of r e tu rn to the saver. The re tu rn foregone by not sav ing is smal l and not sufficient to i n ­duce even those who save to i n ­vest, thereby i n h i b i t i n g fu l l mob i l i ­sa t ion of savings. A saver who seeks a higher r e tu rn has to be­come di rec t ly a lender in the un­organised sector— there is no organisat ion enabl ing h i m to do so.

'Reserve B a n k o f I n d i a B u l l e t i n , June 1959.

†Calculated f r o m "Finances o f I n ­d ian Jo in t Stock Companies,"

'Reserve Bank of I n d i a B u l l e t i n . " October 1958. Div idend on prefer­ence shares is no t shown separately.

†Based on recent offers and pros­pectuses.

* *Report of the R u r a l Credit Sur­vey; the Survey also refers to other objectives ( fo r example, acquisi t ion of l and or purchase of produce) in the g r a n t of such loans.

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P B M programme, the burden of a mone­t a r y policy wh ich , by p rov id ing i n ­adequate r eward for saving, prevents mobi l i sa t ion of resources and, by concealing the real cost of different k inds of investment, sub­ver ts decisions on investment pr io­r i t ies . Mone ta ry policy, instead of helping the p l ann ing effort, acts as a d r ag on i t and frustrates i t . The need for r e - t h i n k i n g on the subject, pa r t i cu l a r ly in view of the greater investment effort envisaged under the T h i r d Plan , is therefore urgent .

This paper is concerned w i t h i n ­terest rate policy. A t rea tment of interest rate touches at once mone­t a r y policy and p r i c ing policy. This paper does not deal w i t h the wider issues of monetary policy and pric­i n g policy. In teres t rate, however, is an impor t an t means of monetary cont ro l in an economy. Moreover, i t is a key price, pa r t i cu l a r l y in an economy seeking to accumulate capi ta l . The impact of interest ra te policy is therefore pervasive and its independent t reatment justif ied.

November 7, 1959 THE ECONOMIC WEEKLY

THE ECONOMIC WEEKLY November 7, 1969

Lenders in the unorganised sector therefore have a m a r k e t of the i r own , in w h i c h they enjoy a k i n d of monopoly. At the same t ime, they cannot extr icate themselves f r o m the unorganised m a r k e t w i t h o u t a large loss in re tu rn (equal to the difference between the rate of i n ­terest in the unorganised marke t and t h a t i n the organised m a r k e t ) , The dua l i sm in the money m a r k e t is thus a direct consequence of the a t t empt to m a i n t a i n the bank rate a t i ts ex i s t ing l ow level.

Credit Needs of Rural Sector The credit requirements of the

r u r a l sector ( w h i c h i s the most i m ­p o r t a n t const i tuent of the unorga­nised sector) were placed by the R u r a l Credi t Survey at Rs. 750 crores a n d are placed by the De­pu ty Governor of the Reserve B a n k at Rs 1,000 crores at current prices, equivalent rough ly to about 20 per cent of the value of output in the a g r i c u l t u r a l sector. ('Reserve B a n k of I n d i a B u l l e t i n ; August 1958. p 900.) Of these requirements, pro­fessional moneylenders supplied a l i t t l e less t h a n half, and ag r i cu l tu ra l moneylenders a quarter . The Gov­ernment, the co-operatives and the commercia l banks ( w h i c h m a y be assumed to provide a l i n k between the organised and the unorganised sectors) between them provided on ly 7 per cent of the credit re­quired for agr icul ture .

W h e n the Reserve B a n k was set up, i t was expected to b r i n g the Shroffs (indigenous bankers) under i ts umbrel la , by m a k i n g t h e m con­f o r m to i t s o w n notions o f proper b a n k i n g practices. Recently, i t has t r i ed to offer loans at low rates fo r a g r i c u l t u r a l purposes, w i t h o u t being able to scra tch the surface. The a t t empt to in tegra te the rest of the economy in to the Reserve Bank ' s m o u l d o f t h i n k i n g was, by the very nature of the i n s t i t u t i ona l set-up in Ind i a , doomed to fa i lure — it was l i ke the t a i l t r y i n g t o w a g the dog.

Reserve Bank Control on the Economy

A coro l l a ry of th i s dua l i sm in the money m a r k e t i s l ack of con t ro l o f the Reserve B a n k over the eco­nomy. The Reserve Bank ' s policy ( inc lud ing i ts directives) now affects the organised sector only . I t s actions, f o r example, do no t affect the ho ld ing of ag r i cu l t u r a l produce by farmers , moneylenders a n d agr icul tur is t -moneylenders i n the unorganised sector. The Re­serve B a n k manipulates a steering

wheel wh ich has no l i n k w i t h most of the economy.

Moreover, a low rate of interest i s ineffective in con t ro l l i ng the ho ld ing of goods in an in f l a t ionary s i tua t ion . Even a sma l l expected rise in prices w i l l neutralise the i n ­terest-cost of ho ld ing goods. The exis t ing policy at once increases chances of in f l a t ionary pressures and reduces the efficacy of the Re­serve B a n k in meet ing the s i tuat ion so created.

Incentive to Save The rate of sav ing in the eco­

nomy remains s tagnant a n d has fa i led to keep pace w i t h the g r o w t h in investment , Sma l l savings have fai led to go up despite organised efforts, being a round Rs. 70 crores d u r i n g the last four years

In the F i r s t F l an , the rise in na t ional income was 18 per cent, against 11 per cent planned; how­ever, the m a r g i n a l rate of saving on na t iona l income was on ly 20 per cent as planned. The F i r s t P l an postulated the m a r g i n a l rate of saving f r o m 1956-57 at 50 per cent; the reliance on fore ign assis­tance and the cut in t o t a l invest­ment target w i t h i n the f i r s t three years of the Second P lan imp ly t h a t this has not been achieved. The deficiency in sav ing is met by deficit f inancing, increase in foreign indebtedness and lower ing of in ­vestment targets. The basic factor i n h i b i t i n g saving in the economy the inadequate inducement to save in the organised sector is hard­ly given any a t t en t ion .

Investment and Its Pattern I t is argued t h a t Capi ta l Issues

Con t ro l channels investment in de­sired di rect ion and t h a t physical p lanning sanctions (as under the Industr ies Development and Regu­l a t i on A c t ) cover investment of funds l ike retained profits w h i c h do not pass t h r o u g h the capi ta l mar­ket. Therefore, i t i s impl ied t ha t pr ior i t ies in investment are gov-erned by physiclal p lann ing needs, and not by the ra te of interest in the economy. (Curiously, th is argu­ment can be inver ted to say t ha t a higher interest rate would equally not detract investment f r o m its path!) These pr ior i t ies are often just i f ied by re la t ing the expected r e tu rn to interest cost. A higher i n ­terest rate wou ld in such a case d i rec t ly affect the de te rmina t ion of pr ior i t ies .

Moreover, even w i t h g iven pr ior i -tles, the method of product ion adop­ted would i tself depend upon the interest cost of investment. The exis t ing low rate of interest (a id­ed by a labour policy w h i c h keeps cost of engaging and disengaging labour h igh) favours the adopt ion of capi ta l - intensive methods of product ion. I t leads to the perverse s i tua t ion of subsidising methods of product ion w h i c h use factors of product ion in proport ions unrelated to the i r supply-conditions.

As the interest foregone by misuse of capi ta l is smal l , a low rate of interest leads to low for­m a t i o n of capi ta l and waste of capi tal formed. Such 'waste' arises when revenue is not saved but used. for example, in competi t ive adver­t i s ing ." Fur ther , even when capi­t a l is formed, i t is used in low-pr io­r i t y investments, for example, in the case of the cot ton text i le i n ­dust ry in which capacity is not a l ­lowed to be expanded, in ' f inishing ' processes.

Disparity: Profit-Rate and Interest

The p ro f i t ab i l i ty of investment, as measured by earnings in re la t ion to paid-up capi tal of exis t ing com­panies and by earning-prospects of new companies g iven in prospec­tuses, is far higher t han the yield on corresponding securities in the organised marke t Such a s i tua t ion places a p remium on access to the capi ta l marke t , w i t h the result that an investment tha t is sanctioned gets an unearned bonus represented by the difference between the real p roduc t iv i ty of capi ta l and the mar­ket rate of interest. Such access to cheap capi ta l leads either to ap­preciat ion in the value of shares

The. most fr ivolous instance of such use is the Calico Dome. Other instances are adver t i s ing in the soap indus t ry where the t o t a l product ion of organised producers has remained constant d u r i n g the last five years and the oi l indus t ry where the m a r k e t is d ivided by i n ­te rna t ional cartel agreements and demand is g r o w i n g due to other na tu ra l factors. A h i g h rate of in ­come t axa t i on has also the same effect, A low rate of interest. moreover, leads to waste in the public sector, for example, through "prestige expenditure" of the Gov­ernment and the Reserve Bank, re-fer red to by many economists, among them V K R v Rao and D R Gadgi l .

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November 7, 1959 THE ECONOMIC WEEKLY

or to a d iv is ion of such ex t ra pro­f i ts a m o n g a few t h r o u g h var ious means ( l ike f o r m a t i o n of closely-held buy ing, sel l ing or m a n a g i n g agency companies to wh i ch pay­ments are made f o r 'services' ren­dered). † The reward fo r sav ing is t ranscr ibed in to r ewa rd fo r invest­ment wh i ch is hard ly just i f ied in the present s i tua t ion in I nd ia — a s i tua t ion of cap i ta l scarci ty, guaranteed marke ts w h i c h reduce the r i s k of investment , and the se­pa ra t i on o f sav ing and invest ing classes,

A coro l la ry is the adverse effect of such a d ispar i ty on the impor t and use of fore ign c a p i t a l Fo re ign companies wh i ch are induced to i n ­vest in I n d i a by the h igh rea l pro­f i tab i l i t y o f investment in Ind ia , f ind i t advantageous to employ I n ­d ian cap i ta l wh i ch is ava i lab le a t the same interest cost as in the home country . (Fore ign com­panies are not subject to the same pressure to pad labour employment as the I n d i a n companies and fo l l ow ing 'home' practices, a t tempt to use the same complement of labour f o r g iven output as in 'home' factor ies. Th is f u r t he r adds to the i r p ro f i t -earn ing capaci ty. The h igher pro f i t ra te of fo re ign companies is reflected in the h igher salaries and wage-rates paid by them to the i r staf f and in bonuses to workers wh i ch range f r o m 3 to 6 months ' basic wages against 2 to 3 months ' basic wages paid by I n d i a n com­panies.) The present low ra te of interest in the organised I n d i a n m a r k e t thus lead s to the absurd s i tua t ion where fo re ign companies f i nd i t more advantageous to w o r k w i t h I n d i a n capi ta l (o f ten w i t hou t even g i v i ng i t vo t i ng r igh ts , as when preference shares or deben­tures are issued or loans taken) t h a n to b r i n g in the i r own funds. The most conspicuous example of th is tendency is tha t of F i restone (Cf T a r i f f Commiss ion: 'Report on the T y r e I n d u s t r y ' ) ; the o i l com­panies are other instances. Th is tendency arises not so m u c h f r o m the low ra te of interest in I n d i a as f r o m the rough equal i ty o f the ra te of in terest between the organised

†Cap i ta l issued on the basis of a re tu rn h igher t han the ex is t ing low y ie ld on shares ( re la ted to a low bank ra te) immed ia te ly appre­ciates in va lue, f o r example, as in the case of Guest, Keen, W i l l i ams , Ph i l ips and some other issues in recent t imes.

I n d i a n and fo re ign money marke ts . I t s net effect is to reduce the i m ­por t o f fo re ign capi ta l and to In ­crease the d r a i n on fo re ign exchange as represented by the difference between earnings on i n ­vestment in I n d i a and the rate o f interest in I n d i a (except to the extent t h a t the earnings are siphoned off to labour by way of h igher wages or bonuses).

Why Low Bank Rate?

To go in to the causes fo r the low interest ra te pol icy, one has to go outside the f ield of economic rea­soning proper. A low Interest ra te is assumed to foster investment and in th is Keynes ian era, i t is u n ­fashionable to advocate a h igh ra te wh ich is supposed to discourage investment . A h i g h interest ra te immedia te ly singles out a count ry as less advanced, as les s ent i t led to respect. Moreover, a h i gh in terest rate is equated w i t h usury, and re­vives medieval Ch r i s t i an antago­nism to such a pol icy.

A low bank ra te has a c h a r m of its o w n . A lmos t a l l advanced coun­tr ies have in recent t imes (except f o r shor t periods as in the case of the U K dur ing the seven per cent period) had low bank rates, r ang ing between three and f ive per cent (West Germany being one excep­t ion w h i c h fo l lowed a h i gh bank rate pol icy consistent ly f o r a long t ime du r i ng the post -war per iod) . The Reserve B a n k l ikes to belong to the elite — the club of the low bank ra te countr ies. Appearances are sought to be kept up, and the Reserve B a n k ma in ta ins a low i n ­terest ra te s t ruc ture as an index of advance.

Th is facade of modern i ty , how­ever, can ha rd l y conceal the rea l i t y of the s i tuat ion w i t h i n the count ry , wh ich is one of cap i ta l scarc i ty re­lat ive to labour supply. Abundance of labour is ref lected in the re la­t i ve ly low level wages wh ich , in i ts t u r n , reflects the low level of labour p roduc t i v i t y in the count ry , caused by the lack of complementary cap i ta l investment ( lower mechan i ­sat ion) in the economy. Cap i ta l scarc i ty , however, is not recognised in the price offered fo r cap i ta l : the la t te r bears the same pr ice- tag of f i ­c ia l ly as in advanced countr ies.

I f i t is argued t h a t price is a resul t o f in te r -ac t ion of demand and supply (and no t o f supply a lone) , i t cannot be denied t h a t de­m a n d f o r cap i ta l has r isen m a n i ­f o l d in recent years and supply has

fa i led to respond in the same measure** th is s i tua t ion has been sought to be met not by a change in the pr ice of cap i ta l but by eco­nomica l l y dubious expedients, among t hem defici t f i nanc ing , fo re ign bo r row ing and h igher t axa t i on .

I n t eg ra t i on of the T w o Sectors As in the foreseeable fu tu re , the

rate of interest in the unorganised sector (wh ich is the rea l ra te) is not l i ke ly to f a l l to t ha t in the organised m a r k e t (wh ich t r ies to m a i n t a i n an unrea l facade) , an ad jus tment of the l a t te r wou ld be the on ly possible means of in tegra­t i ng the two sectors. The ma jo r effect of a more real ist ic interest rate policy wou ld be to remove the dua l ism in the economy,

Wou ld th is be an advantage? Such a step m i g h t be construed to be re t rograde—a bending down to­wards the ' backward ' sector of the economy. To reject i t on th is g round would be to give in to fa lse not ions o f prestige. An Ins t i tu t ion l ike the Reserve B a n k should seek to meet, adjust to and solve the s i tuat ion in the count ry as i t exists, instead of adher ing to some fanc i ­f u l concepts of propr ie ty (wh ich , in this case, means on ly w h a t exists in other countr ies wh ich are taken as the model ) . The p r i m a r y objec­t ive of the Reserve B a n k In regard to the unorganised sector should be not to g r a n t credi t to i t at the low rate of interest p reva i l ing in the organised marke t , as is now being a t tempted this is an unat ta inab le objective, as shown by the fa i lu re of the organised sector to sat isfy even one-tenth of the credit require­ments of the r u r a l sector—, i t should ra ther be to b r i n g the unor­ganised sector w i t h i n i ts f o l d and thus make i t more amenable to the influence of the Reserve B a n k . Th is can be done only by a h igh interest rate policy.

(To be Concluded)

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* * " T h e cur rent phase of f inanc ia l s t r ingency does not reflect absolute shortage of money but expanded demand fo r i t . A basic solut ion to the prob lem of s t r ingency is to be sought in increase in savings so as to effect a bet ter balance between the demand fo r funds ( f o r invest­ment ) and the i r supply ( t h r o u g h sav ings ) . " P a r a 32, Reserve B a n k of I nd i a , 'Repor t o f the Cen t ra l Boa rd o f D i rec tors f o r the year ended June 30,1957/