T H E E C O N O M I C W E E K L Y M a y 28, 1960

The Structure of Interest Rates in India

U L T I M A T E L Y for the would-be indust r ia l is t , the various credit

inst i tut ions influence his investment behaviour in its effect upon two variables—the supply of f inance and the pr ice, assuming supply is avail­able at a pr ice. The shape of the supp ly curve may be such that w i th ­in a certain range of prices some f inance w i l l be avai lable, bu t beyond that amount none is available, re­gardless of his wil l ingness to pay. (There may also be no supply avai l ­able at any pr ice . ) The relat ion­ship between the pr ice of finance, or the rate of interest (the rate of re turn he either must forego in alter­nat ive investments i f i t is his own funds or that he must pay if he bor­rows) and the expected re tu rn on the use of that finance, or the mar­ginal rate of prof i t , w i l l determine his wil l ingness to invest his own, and other people's, funds in an i n ­dus t r i a l under tak ing .

RATES C H A R G E D O N B A N K A D V A N C E S We w i l l f irst look at the struc­

ture of interest rates in I n d i a and the rates of re turn on indus t r ia l i n ­vestment. In order to thoroughly compare the rates of re turn w i t h the rates of interest, and their effect on indus t r ia l investment, we should ideally examine the rates in fields of act iv i ty al ternative to indust ry . We cannot do t h i s—i t is un l ike ly , how­ever, that these al ternative rates of re turn ( i n ag r i cu l tu re ,o r t rade) have changed apprec iab ly w i t h i n the past ten years in Ind i a . O u r re turn data w i t h respect to indus t ry is also not marg ina l for there are no separate data w i t h respect to the new invest­ments as compared w i t h the older ones. Fur thermore we know l i t t le , i f anyth ing , about those gains taken by the entrepreneur in the f o r m of capital gains f r o m the sale of in ­dustr ial plant or various w i n d f a l l gains. ( In the longer r u n , however, capital gains by one entrepreneur for the sale of p lant wou ld reflect themselves in the level of returns

The ar t ic le 'is a draf t of a chap­ter of the for thcoming book on Ind ian Capi ta l Markets , the mate­r i a l for w h i c h the author gathered d u r i n g his stay in Ind ia in 1958-59 for the Massachusetts Institute fo r Technology Centre for Inter-nat ional Studies Project in Ind ia .

made by the entrepreneur who buys the plant .) For our r e tu rn data we w i l l rely on the data i n the Reserve Bank studies of company finance.1

We w i l l confine our discussion of these rates to those charged by the organized bank ing system and pa id in the organized capi tal market by the organized indus t r i a l sector.

The main factors affecting the structure of rates of interest charged by banks are the type of security offered, and the borrower 's status. We have rather complete data on I he breakdown of advances by i n ­terest rales and by security fo r one dale - the end of June, 1956 and these data are summarized in the next two tahles.-

RATES VARY WITH SECURITY A N D STATUS

We may consider the higher end of the range of rates as a measure of the character of the security offered—its risk and l i q u i d i t y ; and the lower end as a measure of the client's status. If we assume this, then, the least r i sky and most l i q u i d of the securities offered are govern­ment and trustee securities, go ld and silver bu l l ion , ag r i cu l tu ra l mer­chandise under the bank's lock and key. fa rm land, and fixed deposits w i t h banks; go ld ornaments, shares of joint-slock companies, and non-agr i cu l tu ra l products under the bank's lock and key are considered of me­d i u m risk and l i q u i d i t y ; w h i l e hypo­thecated corn modi ties (not under the bank's lock and k e y ) , and nonagri-cu l tu ra l real estate, are considered about equal to no tangible security at all on this assumption. On the other hand the best credit risks are

the borrowers normal ly a l lowed to hypothecate their security, wh ich wou ld expla in the low m i n i m u m rate against such securities; in the same way those firms allowed "c l ean" advances would normal ly be better r isks. On the other hand go ld orna­ments are l ike ly to be offered as security for personal loans, as dis­t inguished f rom loans for produc­tive purposes and wou ld be charged a higher m i n i m u m rale.

A g a i n , the rates of interest tend to vary inversely wi th the size of the bank, a l though there is some over­l a p p i n g ; the over lapping would re­flect variat ions in the rates charged by any bank due to the vary ing qua­li t ies of its borrowers . However the model rate of interest charged in June, 1956 was somewhere between 4-5 per cent, and almost 90 per cent of the advances were at between 3-6 per cent. The rates hardened somtv what thereafter; in 1958-59 the average rate on scheduled bank ad­vances by major banks was between 5.3 and 5.5 per cent; by medium size banks between 5.7 and 6.1 per cent; and by small banks between 6.4 and 6.9 per cen t ; ' but the range charged against different types of security was probably as wide as in 1956. The larger well-established f irms would have paid at the lower end of the range and the more risky e l ig ible f irms at the higher range. At these rates the total amount of bank credit al lowed a firm varies by the type of output the ownership of the firm, and the l im i t on a bank's absolute capacity to grant a loan to any one would-be borrower. These loans at such rates w o u l d also have

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been granted for short-term, or osten­s ib ly short-term periods, a l though subject to renewal .

LONG-TERM RATES

The rates of interest on long-term credi t are definitely higher than the average rates charged by the major and med ium size scheduled banks. In 1958-59 the m i n i m u m rate of the Indus t r ia l Credit and Investment Cor­pora t ion of I n d i a ( I C I C I ) was 6½ per cent, and its rate for foreign currency loans 7¾ per cent; the I n ­dus! r i a l Finance Corpora t ion charges a rate of 7 per cent w i t h a rebate for prompt payment. The State Finance Corporat ions charge ap­proximate ly the same rates; com­mercia l banks wh ich refinance me­d i u m term loans th rough the Re­finance Corpora t ion charge at least 61 per cent. For the b o r r o w i n g firm there are also addi t ional charges and stamp taxes that raise the effec­tive rate to the borrower by ¼ to 1 per cent, depending upon the size of the loan.6 ( V e r y good firms can borrow for really long-term purposes

w i t h i n certain size l im i t s f r o m their banks and pay short-term rates, by the banks will ingness to renew the ostensibly short-term loans repeated­ly for a long per iod.)

What have been the rates which f irms must pay to raise funds in the open market? The rates earned by Government of I n d i a securities in 1958-59 averaged 3.5-4 per cent depending upon the security, and its matur i ty date (several non-terminable securities were above 4 per cen t ) . The average y ie lds— tax free—7 on outstanding pr ivate debentures in 1957-59 was about 4.1-4.2 per cent; on fixed d iv idend preference shares the yie ld ranged f rom 5.9-6.0 per cent; and on va r i ­able d iv idend securities f rom 6.3-6.9 per cent. In manufac tu r ing industries specifically, the tax-free yield ranged f rom a low of 4.3-5.0 per cent for i r o n and steel shares to a h igh of 6.7-7.6 per cent for paper industry shares, Not sur­pr i s ing ly the yields on securities, l ike the rates charged by banks,

tended to rise f rom 1954-55 u n t i l 1957-58, and there was a sl ight de­cl ine thereafter.8 The yields on new issues—which may he consider­ed as the marginal yields -centered at 6 per cent taxable (or approx i ­mately 4.5 per cent tax-free) for debentures, and 6 per cent tax free for preference shares in 1956; in 1957 the yields on new debentures st i l l centered at about 6 per cent taxable, but on preference shares rose to 6 or 7 per cent tax free." The rates on these securities are roughly equal to the rates firms must pay for medium and long-term loans to the special financial insti tutions and the banks, a l though they would be above the bank rates on short-term loans.

G I L T - E D G E D S A N D D E D E N T U R E S

At this point b r ie f mention might be made of the closeness of the rates on government securities and on pr ivate debentures. This is pro­bably a major reason for the very l i m i t e d demand for pr ivate deben­tures they offer only a s l ight ly higher yield, than (Governments for probably a much higher r isk, A change in the rate structure to raise the yield on pr iva te debentures re­lat ive to government's wou ld pro­bably raise the demand for the fo rmer s igni f icant ly from the L I C (as i t d i d w i t h private insurance companies after the war ! and w i th the increasing number of ind iv idua l savers.

What were the rates of return earned after taxes, on the total ca­p i ta l employed in indus t ry? We shall use a measure of re turn to include profits net of depreciation and taxes, but gross of interest, and managing agents commission; and capital is defined as capi tal used in product ion or sale of pro-ducts net of depreciation ( i . e. ca­pi ta l measured by the sum of net fixed assets, slocks and stores, and receivables; but exclusive of i n ­vestments in securities, income tax advances, cash. e tc ) . The rales of return measured in this fashion, for the Reserve Bank Survey companies average 7.5 per cent f r o m 1950-1958 inclusive1 0 and range f rom lows 5.4 per cent and 6.4 per cent in 1957 and 1952 respectively, to highs of 9.0 per rent in 1951' and 1955. There was l i t t le change over t ime.

C O S T O F C A P I T A L T O I N D U S T R Y

How do these earning rates com­pare to the cost of capi ta l to these

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term purposes. However, the rate was close to 5 per cent for the best risks; for somewhat smaller or r iskier firms it migh t rise to 7-9 per cent. Long-term credit other than this was probably not avail­able other than f r o m the pub l ic market, and this was only available to a few f i rms ; or f r o m the un­organized market in small amounts at very h igh rates.

SUPPLY AND DEMAND M O V I N G UP

W i t h the special credit inst i tu­tions long-term credit became avail­able at rates consistent w i th other long-term rates and yie lds ; simul­taneously a demand for this greater supply of f inance arose, in par t because of the very existence of the credit inst i tutions. Entrepreneurs, attracted by the expected profits ar is ing f rom government expendi­ture^ and the Five Year Plans, were interested in expanding or starting new firms; at the same time the government expenditures created new deposits in banks and thus in tu rn addi t ional supplies of bank credit. Many of these firms could meet part of their financial needs f rom the special insti tutions

and would not have been able to do so unless these insti tutions ex­isted—and they could do so at rates consistent w i th long-term rates for comparable securities. The fact that they were able to gel finance from the special institutions had effects on their demands for other c red i t - - they would require working

capital , and more long-term capital , to make the special finance usable. Banks wi th higher deposits were w i l l i n g to lend to them on short term for work ing capital purposes or subscribe to their security issues, in part because they d i d get the special long-term credi t ; at the same time individuals were attract­ed to these firms, financed in par t by special institutions, and offering securities at yields higher than might be earned on governments, and would subscribe to their issues.

Wi thout the existence of the cre­d i t institutions the additional bank deposits or savings of individuals created by the Plans might either not have been used at all in indus­t r y ; or would more probably have been invested in safe securities— governments and blue chips -and raised their prices, thus forcing the rate of interest down in the orga­nized sector. We can conclude therefore not that the additional special finance led to lower interest rates in this sector; but rather to upward shifts in the supply and demand curves of finance, but at approximately exist ing rates.

This can be summarised by the fo l lowing d iagram showing in the organised financial markets the two supply curves of finance to indus­try and then the two demand cur­ves of industrial finance before and after the special institutions came into operation. Curve S-l is a hy­pothetical supply curve before the

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short-term assets (stocks and stores plus renewables) are somewhat above one-half the net assets includ­ed in our def ini t ion of capital , and that these are financed by these firms f rom banks at about 4-5 per cent; that the long-term capital is financed one-third by reserves at an imputed rate of 4 per cent11 and two-thirds by securities or mort­gage loan at approximate ly 7-8 per cent. T a k i n g a weighted average of these charges we get an overal l cost rate of about 5.5 per cent on capi ta l ; in contrast to an average re turn on capital earned by these companies of 7.5 per cent.12 W h i l e we are unable to measure expected earn­ings this may be higher in the l igh t of government expenditures and policies and the clear industrializ­at ion of the economy.

Wha t has been the effect of the increase in credit facilities over the past five years on the rate of i n ­terest and the supply of capital? The rates of interest charged do not appear to have varied substan­t ia l ly w i t h the increase in finance available du r ing the past 5-10 years. Rather one may say that the effect of the increased activities of the special institutions and the banks has been to make more credit avail­able at the existing rates, and to fill p a r i of the gap i n rates between the organized and unorganized mar­kets. Former ly the banks lent only to the best industr ia l firms for short-term credit purposes, though

firms? We estimate crudely that this might be renewable for longer-

T H E E C O N O M I C W E E K L Y M a y 28 , 1960

special ins t i tu t ions had their effect; curve S-2 a hypothet ica l supply curve after th is effect was felt .

At the lowest interest rates there w o u l d be l i t t l e o r no increase in supply of c r e d i t ; bu t a t the rates at w h i c h most bank credi t is avai l ­able (3-6 per cent) more credi t became available to indus t ry at those rates f r o m the banks than w o u l d have been available p r i o r to the special inst i tut ions since banks w o u l d consider f i rms receiving spe­c i a l f inance good risks.1 3 F o r m e r l y as the rates increased and approach­ed 7-8 per cent the s u p p l y curve o f credi t f r o m organized credi t i n ­st i tut ions became progressively more inelastic and f ina l ly showed no change w i t h h igher rates; now at 7-8 per cent the special ins t i tu t ions stepped in w i t h the i r credi t supplies and so too d i d i n d i v i d u a l investors in to the securi ty market . T h e sup­p l y curve for the organized credi t markets now does not become per­fec t ly inelastic u n t i l about 10 per cent. The hor izonta l difference between curves S- l and S-2 is thus a measure of the supply effects of the special f inancia l ins t i tu t ions at the same rates of interest.

S i m i l a r l y at the highest interest rates demand would remain h i g h l y inelastic a s o r i g i n a l l y ( D - l ) . Bu t after the credi t inst i tut ions are i n ­t roduced (curve D - 2 ) , at about 8 per cent the demand for long-term credi t wou ld increase in p a r t be­cause there is now a s u p p l y of cre­d i t a t this rate and f o r m e r l y there was none a t a l l . 1 4 T h e gran t of th is special credi t increases the de­mand fo r supplementary long-term f inancing at about these same rates; and, as a result of these new or ex­panded firms, there is now a greater demand for short-term credi t fo r w o r k i n g capi ta l purposes f r o m the banks at thei r lower rates. The hor izonta l distance between D - l a n d D-2 is a measure of the in f lu ­ence of the special ins t i tu t ions on demand. However, i t is noted that in th is case the e q u i l i b r i u m pr ice of finance remains the same before and after the ent ry of the special ins t i tu t ions in to the capi ta l market — a n d this is rough ly the si tuat ion i n Ind ia . 1 5

N O T E S We assume that the stated returns

are correct . In fact i t i s possible, t h rough a network of control led raw mater ia l se l l ing agencies and finish­ed product sel l ing agencies fo r an

entrepreneur to manipula te the ret­urns at any stage of the indus t r ia l process to show a level that he may desire, for tax or other purposes. See also Final Report of the National Income Committee, Feb rua ry 1954, p 6 4 .

2 F r o m Reserve Bank of I nd i a , Trend and Progress of Banking in India 1956, pp 81-83.

" in t e r e s t Rates on Deposits and Advances of Scheduled Banks . . .," Reserve Bank of I n d i a Bulletin (October, 1 9 5 9 ) , p 1257.

' D u r i n g the pe r iod o f 1957-58 when the cotton tex t i le indus t ry p i l e d up large inventories, the reasonably efficient firms were able to finance the increase f r o m banks w i t h l i t t l e difficulty, other t han a reduct ion in margins, since the goods were con­sidered def ini te ly saleable by the banks.

5Even Tata I r o n and Steel Com-pany found it impossible to raise a w o r k i n g cap i ta l loan of 20-30 crores of rupees f r o m any one bank, and it was necessary to f o r m a consor­t i u m .

" I f we assume that the smaller banks lend to the smaller firms and the newer entrepreneurs, this com­parison of rates indicates that the special f inancial ins t i tu t ions do not charge an interest rate h i g h enough to cover the r isk—since it should be a rate at least 1-2 per cent above that charged by the smaller banks.

7 A tax-free y i e l d is computed by assuming tha t the tax ( a p p r o x i ­mately 25-30 per cent of the y i e l d ) is p a i d by the f i rm before the d i v i ­dend i s d i s t r ibu ted . T h i s w o u l d have the effect of ra i s ing the charge to the company by the amount of the tax—thus the charge to the company w o u l d be over 5 per cent fo r a y i e l d of 4 per cent tax-free to the security-holder. Most debentures

are issued w i t h the yields taxable— so that the company's payment to the shareholder w o u l d be above the tax-free y i e l d ; most shares are is­sued tax-free.

8Reserve Bank of I n d i a , Report on Currency and Finance, 1958-59. Statements 40 and 43 .

"Reserve Bank of I n d i a art icles on Company Finance, Op. cit., October, 1958, p 2 1 , August , 1959, p 26.

10These are Reserve Bank Survey years—i. e. 1950 extends f rom J u l y 1, 1950 to June 30, 1951.

" T h e rate that could be earned by invest ing in risk-free government bonds.

1 2 T h i s difference appears to be s m a l l ; and probably has not chang­ed ve ry s ignif icant ly in recent years. However , f o r the reasons mentioned ear l ier the published rate of re turn may substant ia l ly underestimate the actual rate.

1 3 This assumes also that the banks reserves went up to p e r m i t this or otherwise that they shifted f r o m in-vestments in governments.

1 4If the credi t inst i tut ions offered te rm credi t at h igher rates—let us say up to 12 per cent to poorer r isks —th i s too m i g h t lead to a greater demand for such credi t . Now there is no such credi t source, and the would-be entrepreneur must go to the moneylender and pay f o r higher rates i f he wishes capi ta l .

1 5We are not discussing the i n ­fluence of other factors on the I n d i a n interest rate d u r i n g the same per iod . Supp ly o f credit m i g h t rise and demand not rise to the same extent (because of , let us say, i m p o r t restrictions) and as a result the rates (o r some of them) w o u l d f a l l—as bank rates have in 1958-59.

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