ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Financial Repression and All That

THOUGH financial sector liberalisation has been in the forefront of the government's stabilisation and structural adjustment policies, the Reserve Bank had not hitherto characterised the Indian system as financially repressed. One is surprised, therefore, to find the RBI governor in his latest credit policy statement describing the erstwhile administered interest rate structure as 'financial repression' which, he claims, he had been trying to eliminate since the mid-1980s. While interventionist policies in the form of high reserve requirements and directed credit constitute key elements of it, so-called financial repression quintessentially refers to situations in which interest rate regulation lowers interest rates to such an extent as to depress savings and hence funds for investment. Typical cases have been some Latin American countries where high negative real rates of interest over prolonged periods have made for a series of economic and financial maladies low savings and investment, uncertain and sharply fluctuating interest rates, distortion of priorities in lending and adverse selection and stunted growth of the financial sector. In the Indian case it cannot be said that banks' term deposit and loan rates have as a matter of policy ever been kept below the inflation rate so that real rales of interest have been negative for any length of time. In fact, the interest rate emerged right from the early 1970s as an important instrument of monetary management. No doubt interest rate regulation sought .to. .balance. multiple objectives, such as providing attractive returns to savers, limiting the cost of capital to viable levels, differentiating between inventory capital and investment capital with the interest cost of the former exceeding that of the latter and some degree of cross- subsidisation of socially desirable and vulnerable sectors and activities. With periodic changes of nominal rates in response to the developing macroand even micro-economic situations, interest rate regulation provided a measure of flexibility while imparting stability and certainty to the interest rate structure by insulating it from the vicissitudes of the market place. Overall there has thus been no question of interest rates being repressed in the Indian case. The Reserve Bank's sudden concern over financial repression is the more difficult to understand because the theoretical, empirical and policy foundations of the notion of financial repression and unqualified liberalisation of interest rates are coming to be increasingly questioned. It is being recognised that except in countries which have had severely and persistently negative real rates of interest and, as a result, low rates of savings and investment, interest rate liberalisation geared to free market determination tends to push up real rates of interest to unviable levels. These high rates, at the same time, have not been found to contribute to an increase in the domestic savings rate, even as they have rendered the cost of capital high, particularly for projects with average or below average rates of return. It has been well established that total savings are unrelated to real interest rates. Government and corporate savings are if anything adversely affected by high rates of interest. And if household savings in financial assets rise as a result of higher interest rates, more often than not it is due to constraints on their expansion in the form of physical assets which is generally linked to institutional credit. Autonomous expansion even in aggregate household financial savings is unlikely to result from higher interest rates. There may be shifts in holdings of different financial assets based on yield considerations, but aggregate household savings or even total financial savings are generally unaffected. At the same time, interest rates do affect the demand for bank and other institutional credit and if, following market practice, the rates for investment credit are higher than those for inventory financing, distortions arise in the application of scarce capital. Market-determined high interest rates adversely affect public finances, as is seen from the experience not only of developing countries but of a whole range of developed countries as well, particularly in Europe.

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