THE ECONOMIC WEEKLY
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
industrialist, the various credit
institutions influence his investment
behaviour in its effect u p o n two
variables—the supply of finance and
the price, assuming s u p p l y is avail-
able at a price. T h e shape of the
s u p p l y curve may be such that w i t h -
in a certain range of prices some
finance w i l l be available, b u t beyond
that amount none is available, re-
gardless of his willingness to pay.
( T h e r e may also be no supply avail-
able at any p r i c e . ) The relation-
ship between the p r i c e of finance, or
the rate of interest (the rate of
r e t u r n he either must forego in alter-
native investments if it is his o w n
funds or that he must pay if he bor-
rows) and the expected r e t u r n on
the use of that finance, or the mar-
ginal rate of profit, w i l l determine
his willingness to invest his own,
and other people's, funds in an i n -
dustrial undertaking.
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 first look at the struc-
t u r e of interest rates in I n d i a and
the rates of r e t u r n on i n d u s t r i a l i n -
vestment. In order to thoroughly
compare the rates of r e t u r n w i t h the
rates of interest, and their effect on
i n d u s t r i a l investment, we should
ideally examine the rates in fields of
activity alternative to i n d u s t r y . We
cannot do t h i s — i t is u n l i k e l y , how-
ever, that these alternative rates of
return ( i n a g r i c u l t u r e , o r trade) have
changed a p p r e c i a b l y w i t h i n the past
ten years in I n d i a . O u r r e t u r n data
w i t h respect to i n d u s t r y is also not
m a r g i n a l for there are no separate
data w i t h respect to the new invest-
ments as compared w i t h the older
ones. F u r t h e r m o r e we know l i t t l e ,
if a n y t h i n g , about those gains taken
by the entrepreneur in the f o r m of
capital gains f r o m the sale of i n -
dustrial 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 l a n t w o u l d reflect
themselves in the level of returns
The article 'is a draft of a chap-
ter of the f o r t h c o m i n g book on
I n d i a n Capital Markets, the mate-
r i a l for w h i c h the author gathered
d u r i n g his stay in I n d i a in 1958-
59 for the Massachusetts Institute
f o r Technology Centre for Inter-
national Studies Project in I n d i a .
George Rosen
made by the entrepreneur who buys
the plant.) For our r e t u r n 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 b a n k i n g system a n d p a i d
in the organized capital market by
the organized i n d u s t r i a l sector.
The m a i n 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 f o r one
dale - t h e 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
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 s k y and most l i q u i d
of the securities offered are govern-
ment a n d trustee securities, g o l d
and silver b u l l i o n , a g r i c u l t u r a l mer-
chandise under the bank's lock and
key. f a r m land, and fixed deposits
w i t h banks; g o l d ornaments, shares
of joint-slock companies, and non-
a g r i c u l t u r a l products under the bank's
lock and key are considered of me-
d i u m risk and l i q u i d i t y ; w h i l e hypo-
thecated corn m o d i ties (not under the
bank's lock and k e y ) , and nonagri-
c u l t u r a 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
799
the borrowers n o r m a l l y allowed to
hypothecate their security, w h i c h
w o u l d explain the low m i n i m u m
rate against such securities; in the
same way those firms allowed " c l e a n "
advances w o u l d n o r m a l l y be better
risks. On the other hand g o l d orna-
ments are l i k e l y to be offered as
security for personal loans, as dis-
tinguished f r o m loans for produc-
tive purposes and w o u l d be charged
a higher m i n i m u m rale.
A g a i n , the rates of interest tend
to v a r y inversely w i t h the size of the
bank, a l t h o u g h there is some over-
l a p p i n g ; the overlapping would re-
flect variations in the rates charged
by any bank due to the v a r y i n g qua-
lities 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
security
what thereafter; in 1958-59 the
average rate on scheduled bank ad-
vances 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 a n d 6.9 per c e n t ; ' but the range
charged against different types of
security was probably as wide as in
1956. The larger well-established
firms w o u l d have paid at the lower
end of the range and the more risky
eligible firms at the higher range.
At these rates the total amount of
bank credit allowed a firm varies by
the type of output the ownership of
the firm, and the l i m 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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M a y 28, 1960

800
THE ECONOMIC WEEKLY
been granted f o r short-term, or osten-
s i b l y short-term periods, although
subject to r e n e w a l .
LONG-TERM RATES
T h e rates of interest on long-term
credit are definitely higher t h a n the
average rates charged by the m a j o r
and m e d i u m size scheduled banks.
In 1958-59 the m i n i m u m rate of the
I n d u s t r i a l Credit and Investment Cor-
poration of I n d i a ( I C I C I ) was 6½
per cent, and its rate f o r foreign
currency loans 7¾ per cent; the I n -
dus! r i a l Finance C o r p o r a t i o n charges
a rate of 7 per cent w i t h a rebate
for p r o m p t payment. T h e State
Finance Corporations charge ap-
p r o x i m a t e l y the same rates; com-
m e r c i a l banks w h i c h refinance me-
d i u m term loans t h r o u g h the Re-
finance C o r p o r a t i o n charge at least
61 per cent. For the b o r r o w i n g
firm there are also a d d i t i o n a l charges
and stamp taxes that raise the effec-
tive rate to the b o r r o w e r 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 i m i t s f r o m their
banks and pay short-term rates, by
the banks willingness to renew the
ostensibly short-term loans repeated-
ly for a long period.)
What have been the rates w h i c h
firms must pay to raise funds in the
open market? T h e rates earned by
Government o f I n d i a securities i n
1958-59 averaged 3.5-4 per cent
depending u p o n the security, and
its m a t u r i t y date (several non-
terminable securities were above 4
per c e n t ) . The average y i e l d s —
tax free— 7 on outstanding private
debentures in 1957-59 was about
4.1-4.2 per cent; on fixed d i v i d e n d
preference shares the yield ranged
f r o m 5.9-6.0 per cent; a n d on v a r i -
able dividend securities from
6.3-6.9 per cent. In m a n u f a c t u r i n g
industries specifically, the tax-free
yield ranged f r o m a low of 4.3-5.0
per cent for i r o n and steel shares
to a h i g h of 6.7-7.6 per cent for
paper industry shares, Not sur-
p r i s i n g l y the yields on securities,
like the rates charged by banks,
801
M a y 28, 1960
tended to rise f r o m 1954-55 u n t i l
1957-58, and there was a slight de-
cline thereafter. 8 The yields on
new issues—which may he consider-
ed as the marginal yields -centered
at 6 per cent taxable (or a p p r o x 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
still 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
institutions and the banks, although
they w o u l d be above the bank rates
on short-term loans.
GILT-EDGEDS AND DEDENTURES
At this point b r i e f mention might
be made of the closeness of the rates
on government securities and on
private debentures. T h i s is pro-
bably a major reason for the very
l i m i t e d demand f o r private deben-
tures they offer only a slightly
higher yield, than (Governments for
probably a much higher risk, A
change in the rate structure to raise
the yield on p r i v a t e debentures re-
lative to government's w o u l d pro-
bably raise the demand for the
f o r m e r significantly from t h e L I C
(as it d i d w i t h private insurance
companies after the w a r ! and w i t h
the increasing number of i n d i v i d u a l
savers.
What were the rates of return
earned after taxes, on the total ca-
p i t a l employed i n i n d u s t r y ? W e
shall use a measure of return to
include profits net of depreciation
and taxes, but gross of interest,
and managing agents commission;
and capital is defined as capital
used in production or sale of pro-
ducts net of depreciation ( i . e. ca-
pital 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 t c ) . The rales of
return measured in this fashion, f o r
the Reserve Bank Survey companies
average 7.5 per cent f r o m 1950-
1958 inclusive 1 0 and range from
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 l e change over
time.
COST OF CAPITAL TO INDUSTRY
H o w do these earning rates com-
pare to the cost of capital to these
THE ECONOMIC WEEKLY M a y 28, 1960

firms? We estimate crudely that this might be renewable f o r longer- capital, and more long-term capital,
short-term assets (stocks and stores term purposes. However, the rate to make the special finance usable.
plus renewables) are somewhat was close to 5 per cent for the best Banks w i t h higher deposits were
above one-half the net assets includ- risks; for somewhat smaller or w i l l i n g to lend to them on short
ed in our definition of capital, and riskier firms it m i g h t rise to 7-9 term for w o r k i n g capital purposes
that these are financed by these per cent. Long-term credit other or subscribe to their security issues,
firms f r o m banks at about 4-5 per than this was p r o b a b l y not avail- in part because they d i d get the
cent; that the long-term capital is able other than f r o m the p u b l i c special long-term c r e d i t ; at the
financed one-third by reserves at an market, and this was o n l y available same time individuals were attract-
i m p u t e d rate of 4 per cent 11 and to a few f i r m s ; or f r o m the un- ed to these firms, financed in p a r t
two-thirds by securities or mort- organized market in small amounts by special institutions, and offering
gage loan at a p p r o x i m a t e l y 7-8 per at very h i g h rates. securities at yields higher than
cent. T a k i n g a weighted average of might be earned on governments,
SUPPLY AND DEMAND M O V I N G UP
these charges we get an overall cost and w o u l d subscribe to their issues.
rate of about 5.5 per cent on c a p i t a l ; W i t h the special credit institu-
in contrast to an average r e t u r n on tions long-term credit became avail- W i t h o u t the existence of the cre-
capital earned by these companies able at rates consistent w i t h other d i t institutions the additional bank
of 7.5 per cent. 12 W h i l e we are long-term rates and yields; simul- deposits or savings of i n d i v i d u a l s
unable to measure expected earn- taneously a demand for this greater created by the Plans might either
ings this may be higher in the l i g h t supply of finance arose, in p a r t not have been used at all in indus-
of government expenditures and because of the very existence of the t r y ; or w o u l d more probably have
policies and the clear industrializ- credit institutions. Entrepreneurs, been invested in safe securities—
ation of the economy. attracted by the expected profits governments and blue chips -and
arising f r o m government expendi- raised their prices, thus forcing the
W h a t has been the effect of the ture^ and the Five Year Plans, rate of interest d o w n in the orga-
increase in credit facilities over the were interested in expanding or nized sector. We can conclude
past five years on the rate of i n - starting new firms; at the same therefore not that the additional
terest and the supply of capital? time the government expenditures special finance led to lower interest
The rates of interest charged do created new deposits in banks and rates in this sector; but rather to
not appear to have varied substan- thus in t u r n additional supplies of u p w a r d shifts in the supply and
t i a l l y w i t h the increase in finance bank credit. M a n y of these firms demand curves of finance, but at
available d u r i n g the past 5-10 years. could meet part of their financial approximately existing rates.
Rather one may say that the effect needs f r o m the special institutions
and would not have been able to This can be summarised by the
of the increased activities of the
do so unless these institutions ex- f o l l o w i n g d i a g r a m showing in the
special institutions and the banks
isted—and they could do so at rates organised financial markets the two
has been to make more credit avail-
able at the existing rates, and to consistent w i t h long-term rates f o r supply curves of finance to indus-
fill p a r i of the gap i n rates between comparable securities. The fact try and then the two demand cur-
the organized and unorganized mar- that they were able to gel finance ves of industrial finance before and
kets. F o r m e r l y the banks lent only from the special institutions had after the special institutions came
to the best industrial firms for effects on their demands for other into operation. Curve S-l is a hy-
short-term credit purposes, though c r e d i t - - t h e y w o u l d require w o r k i n g pothetical supply curve before the

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THE ECONOMIC WEEKLY
special i n s t i t u t i o n s h a d their effect;
curve S-2 a hypothetical s u p p l y
c u r v e after t h i s effect was felt.
At the lowest interest rates there
w o u l d b e l i t t l e o r n o increase i n
s u p p l y of c r e d i t ; b u t at the rates
at w h i c h most bank credit is avail-
able (3-6 per cent) m o r e credit
became available to i n d u s t r y 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 institutions since banks
w o u l d consider firms receiving spe-
c i a l finance good risks. 1 3 F o r m e r l y
as the rates increased a n d approach-
ed 7-8 per cent the s u p p l y curve
o f c r e d i t f r o m organized c r e d i t i n -
stitutions became progressively
more inelastic and f i n a l l y showed
no change w i t h h i g h e r rates; now at
7-8 per cent the special institutions
stepped i n w i t h t h e i r credit supplies
a n d so too d i d i n d i v i d u a l investors
i n t o the security m a r k e t . T h e sup-
p l y curve for the organized credit
markets now does not become per-
f e c t l y inelastic u n t i l about 10 per
cent. T h e horizontal difference
between curves S - l and S-2 is thus a
measure of the s u p p l y effects of the
special f i n a n c i a l institutions at the
same rates of interest.
S i m i l a r l y at the highest interest
rates demand w o u l d r e m a i n h i g h l y
inelastic a s o r i g i n a l l y ( D - l ) . But
after the credit institutions are i n -
troduced ( c u r v e D - 2 ) , at about 8
per cent the demand f o r long-term
credit w o u l d increase i n p a r t be-
cause there is now a s u p p l y of cre-
d i t a t this rate a n d f o r m e r l y there
was none at a l l . 1 4 T h e g r a n t of
t h i s special credit increases the de-
m a n d f o r supplementary long-term
financing at about these same rates;
and, as a result of these new or ex-
panded firms, there is now a greater
d e m a n d f o r short-term credit for
w o r k i n g capital purposes f r o m the
banks at their lower rates. T h e
horizontal distance between D - l
a n d D-2 is a measure of the i n f l u -
ence of the special institutions on
d e m a n d . However, it is noted that
i n t h i s case the e q u i l i b r i u m p r i c e
of finance remains the same before
a n d after the e n t r y of the special
institutions into the c a p i t a l market
— a n d this is r o u g h l y the situation
in India.15
NOTES
We assume that the stated returns
are correct. In fact it is possible,
t h r o u g h a network of controlled raw
material selling agencies and finish-
ed p r o d u c t selling agencies f o r an
M a y 28, 1960
entrepreneur to m a n i p u l a t e the ret- are issued w i t h the yields t a x a b l e —
urns at a n y stage of the i n d u s t r i a l so that the company's payment to
process to show a level that he may the shareholder w o u l d be above the
desire, f o r tax or other purposes. tax-free y i e l d ; most shares are is-
See also Final Report of the National sued tax-free.
Income Committee, F e b r u a r y 1954, 8
p64. Reserve Bank of I n d i a , Report
on Currency and Finance, 1958-59.
2
F r o m Reserve B a n k of I n d i a , Statements 40 a n d 4 3 .
Trend and Progress of Banking in
India 1956, pp 81-83. "Reserve Bank of I n d i a articles
on Company Finance, Op. cit.,
" i n t e r e s t Rates on Deposits a n d
October, 1958, p 2 1 , A u g u s t , 1959,
Advances of Scheduled Banks . . .," p 26.
Reserve Bank of I n d i a Bulletin
10
(October, 1 9 5 9 ) , p 1257. These are Reserve B a n k Survey
years—i. e. 1950 extends f r o m J u l y
' D u r i n g the p e r i o d o f 1957-58
when the cotton t e x t i l e i n d u s t r y p i l e d 1, 1950 to June 30, 1 9 5 1 .
up large inventories, the reasonably " T h e rate that could be earned
efficient firms were able to finance b y investing i n risk-free government
the increase f r o m banks w i t h l i t t l e bonds.
difficulty, other t h a n a r e d u c t i o n in 12
T h i s difference appears to be
margins, since the goods were con- s m a l l ; and p r o b a b l y has not chang-
sidered definitely saleable by the ed v e r y significantly in recent years.
banks. However, f o r the reasons mentioned
5
Even T a t a I r o n and Steel Com- earlier the published rate of r e t u r n
pany f o u n d it impossible to raise a may substantially underestimate
w o r k i n g c a p i t a l l o a n o f 20-30 crores the actual rate.
of rupees f r o m a n y one bank, a n d 13
it was necessary to f o r m a consor- This assumes also that the banks
reserves went up to p e r m i t this or
tium.
otherwise that they shifted f r o m in-
" I f we assume that the smaller
vestments in governments.
banks lend to the smaller firms a n d
14
the newer entrepreneurs, this com- If the c r e d i t institutions offered
parison of rates indicates that the t e r m credit at h i g h e r rates—let us
special financial institutions do not say up to 12 per cent to poorer risks
charge an interest rate h i g h enough — t h i s too m i g h t lead to a greater
to cover the risk—since it should be demand f o r such credit. N o w
a rate at least 1-2 per cent above there is no such credit source, and
that charged by the smaller banks. the would-be entrepreneur must go
7
A tax-free y i e l d is computed by to the moneylender a n d pay for
assuming t h a t the tax (approxi- higher rates if he wishes capital.
mately 25-30 per cent of the y i e l d ) 15
We are not discussing the i n -
is p a i d by the firm before the d i v i - fluence of other factors on the
dend i s d i s t r i b u t e d . T h i s w o u l d
I n d i a n interest rate d u r i n g the same
have the effect of r a i s i n g the charge p e r i o d . S u p p l y o f credit might
to the company by the amount of
rise a n d demand not rise to the
the tax—thus the charge to the same extent (because of, let us say,
company w o u l d be over 5 per cent
i m p o r t restrictions) and as a result
f o r a y i e l d of 4 per cent tax-free to the rates ( o r some of them) w o u l d
the security-holder. M o s t debentures
f a l l — a s b a n k rates have in 1958-59.
805
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806