deepak mohanty : perspectives on lending rates in india speech by mr deepak mohanty, executive director of the reserve bank of india, at the bankers ’ club, kolkata, 11 june 2010. the assistance provided by dr. himanshu joshi, shri s. gangadharan and shri dhirendra gajbhiye is acknowledged. * * * 1. shri dua, shri sen and friends. i thank the bankers ’ club, kolkata and shri j. p. dua, chairman, allahabad bank for providing me the opportunity to speak to you this evening. as you know, banks will be switching over to a “ base rate ” system of loan pricing from 1st july 2010. besides the announcement of base rate, what is of greater significance is that it brings to fruition complete deregulation of rupee lending rates of banks, a process that began two decades ago. this is also a testimony to the maturity of the indian banking system considering that earlier attempts at interest rate deregulation were not very successful. 2. what i propose to do is to briefly trace the process of lending rate deregulation and address a few issues that have arisen in the context of the base rate system. i will conclude with some observation about the relationship between inflation - adjusted real lending rate and credit growth and its implication for overall economic growth. i. deregulation of lending rates 3. 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. furthermore, there were a number of sector - specific, programmespecific and purpose - specific credit stipulations. with the initiation of financial sector reforms in the early 1990s, various steps were taken to deregulate the lending rates of commercial banks. first, the credit limit size classes of scheduled commercial banks, on which administered rates were prescribed, were compressed into three slabs in april 1993. second, 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 ) ( table 1 ). 4. another important development during this time was the introduction of a “ loan system ” of delivery of bank credit in april 1995. the objective was to bring about greater discipline

average wpi inflation declined from 8. 1 per cent in the 1990s to 5. 3 per cent in the 2000s. similarly cpi inflation declined from 9. 5 per cent to 5. 5 per cent. 13. while the lending rates of various categories of borrowers depend on the risk and reward perceptions, the rates have declined for most categories of borrowers over time. at a disaggregated level, the weighted average lending rate for personal loans was higher while it was the lower for housing loans ( chart 2 ). iv. real lending rates 14. from the perspective of borrowers as also from the point of view of sustainability of debt, what matters is the real interest rate. the fisher equation gives the relationship between the real and nominal interest rates 23. in the fisher hypothesis time preferences of the public and technological constraints determining the return on real investment which is assumed to be constant 24. so the nominal rate moves with inflation. the fisher equation can be used in either ex ante ( before ) or ex post ( after ) sense. as ex ante inflation is not observable, one could compute the “ expectations augmented fisher equation ” given the desired real rate of return and an expected rate of inflation over the period of a loan. while there is no unique way to compute expected inflation, the real interest rate ex post can be computed as nominal interest rate minus realized inflation rate. 15. as investment decisions are made over a medium - term horizon, it is important to consider real lending rates in a medium - term perspective. borrowers tend to view the nominal lending rate in terms of a desired real rate of return and expected inflation. although several methods, including surveys, are employed to calculate expected inflation, it is difficult to assign expected values with a reasonable degree of precision given the uncertainty surrounding the future outcomes. this is more pertinent to developing economies like ours which are subject to structural economic factors and unanticipated supply shocks. 16. another useful way to address this issue is to derive expectations by smoothing the inflation series. this presupposes that expectations are adaptive 25 which is often the case in economies and markets with asymmetric information. furthermore, given monetary policy credibility, the underlying inflation expectations are generally stable but for the deviations caused by short term volatility due to transitory factors 26. i = r + ; where “ i ” is nominal interest rate, “ r ” is real interest rate and “ ” is the inflation rate. fisher