Real interest rate must be positive: Rangarajan

Chakravarty Rangarajan, chairman of the 12th Finance Commission, today made a strong pitch for higher real interest rates for bank deposits as well as loans.

Delivering the convocation address at the first annual convocation of post-graduate programmes in banking and finance at the National Institute of Bank Management, Rangarajan said the nominal interest rates (on bank deposits) must "move in tandem with inflation (rate)."

This observation assumes significance in the context of wholesale price-based inflation rate touching 7.51 per cent for the week ended July 24 making the real interest rates on all bank deposits negative. Reserve Bank of India (RBI) Governor YV Reddy said Rangarjan's opinion on "real interest rates" was valid. "Conceptually it is relevant. The issue is: how to compute the real rate?" Reddy said.

According to Rangarajan, despite controversies relating to the impact of interest rates on savings, "it is obvious that the real rate of interest "" nominal rate of interest adjusted for inflation "" at the minimum must be positive".

The 12th Finance Commission chairman also pointed out that the real interest rate in a country which wants to grow at 7 to 8 per cent annually must necessarily be higher than countries which treat 2.5-3 per cent as the potential for growth. In other words, he made it very clear that in India the real rate of interest must go up. With inflation rate crossing 7.5 per cent, all bank deposit rates are now offering negative real interest rates.

The maximum interest rates offered by longest maturity bank deposits (of three years and above)are in the range of 5 to 5.5 per cent. State Bank of India (SBI) in fact cut its short- term rates by a quarter percentage point on Saturday.

"While nominal interest rates must move in tandem with inflation, it is necessary to have a view on the appropriate level of real interest rate on deposits and loans. These must have a relationship to the expected growth of the economy," Rangarajan said. He also urged the commercial banks to make available adequate credit for productive purposes.

"The cash reserve ratio (CRR) was cut to enable banks to extend credit," he said. According to him, banks must reorganise their rural branches to ensure credit flow into the agriculture sector.