There have been significant financial sector reforms through the 1990s. One of the major policy changes affecting the financial markets has been reduction in government's recourse to claims on loanable funds through statutory liquidity ratio as well as high levels of Cash Reserve Ratios. The central government has switched to market borrowing to finance its fiscal deficit on a larger scale than before. There is a general move towards market determined rates and flows in the financial sector. One area where administered rates are still important is the small saving instruments. The government sets these interest rates and mobilises funds for meeting the fiscal deficits at the centre and more so at the state level. If these rates were to be determined by the markets, what would happen to the interest rates in general. One argument is that the small saving rates act as a floor to the deposit rates of the banking sector and hence also determine the lending rates. If the overall balance of demand and supply of loanable funds is such that interest rates can be lower, the small saving rates do not let that emerge. Further, as interest rates decline, there would be significant gains in economic growth. This paper is an attempt to examine this viewpoint. We develop a monetarist model of the economy and assess the implications of alternative methods of financing the fiscal deficit of the government, central and states combined. The results support the view that overall interest rates would decline if the small saving rates were to be liberalised but the gains in economic growth would not be dramatic.
