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Since 1st March, 1999
 
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A DOUBLE PARADOX
- Why interest rates in India remain low while the Sensex soars

The sensitive index we are told is climbing new heights simultaneously with growing signs of industrial prosperity. Interest rates on bank deposits, however, continue to be low, suggesting that banks are not beneficiaries of the industrial bonanza. Is there a causal link between the phenomena, or are they coincidental'

The dramatic fall in share values immediately after the United Progressive Alliance government assumed power caused the finance minister to rush to Dalal Street. The reason is not far to seek. A general fall in share values, however caused, signals shrinkages in financial assets held by investors. For small agents, say households, it is past savings that determine the size of assets. When faced with declining asset values, they behave prudently to protect their funds from further devaluation. In particular, they curtail expenditure out of accumulated savings.

The total assets or capital of a large number of small investors add up to a respectable figure. If consumers turn cautious, the aggregate demand for industrial goods may well be adversely affected. This leads to a stockpiling of commodities with retailers and producers, unpaid bills, unserviced debts and a general slowdown of production.

Consequently, employment of labour falls and new investment projects are postponed. With overall demand plummeting, bankruptcies spread, expectations regarding the future turn gloomier and the economy is sucked into recession. This, of course, is the worst possible scenario, not a normal happening. But an abrupt general drop in share values, or the Sensex, is always worrisome.

While appealing to financial dealers, the minister must have believed that the economic health of the nation was sound and did not warrant the occurrences in Dalal Street. He apprehended nonetheless that the stock market could be manoeuvred to misbehave, out of tune with the state of the economy. The possibility was a matter of serious concern for him, since it could generate the aforementioned sequence of events. The financial bug, so to speak, could wreak damage, casting doubts in public minds about the government's credibility.

Quite obviously, there should be large players ready to unload shares for prices to be affected adversely. Such large traders can create price rises too by engaging in a buying spree. Indeed, this must be so since big investors can be drawn towards share markets mainly by the lure of profits to be made from the difference between selling and buying prices.

More concretely, they can initiate a price rise in the share market through a carefully planned sequence of buying. A series of hefty buying can start pushing prices up. Suppose for example, a share is selling for Rs 100 per unit and a large investor picks up substantial quantities of these shares for a few days in succession. Sooner or later, this will send a signal that the share in question has caught the fancy of investors. Consequently, on a particular day, to be called day 1, the market will start with a somewhat higher quote, say Rs 106 per share.

The development will attract smaller investors for two reasons. They might expect further rises, hence profit opportunities through a buy-now-sell-later strategy. But small parties are normally not speculators. They are more likely to buy shares in the expectation of a regular flow of dividends. Share price rises often lead them to believe in the robustness of the issuing company and hence in the security of dividend flows.

Whichever way the calculation goes, small investors would spend on the share on day 2, thereby raising its opening price further, say to Rs 110 on day 3. In the meantime, the heavy operators will not be sitting idle. They could spend further sums on the share, raising its price even more, say to Rs 115, which, in turn, will cause fresh participation of smaller traders and so on. The net result is that in a relatively short period of time, the price of the share rises to a high figure, say Rs 150, an appreciation of 50 per cent compared to day 1.

Given profit opportunities elsewhere at this point of time, the big participants can decide to sell off a part or the whole of their holdings. They bought cheap and sold dear, a dearness that they wangled their ways into. The absolute sum of their profit will be commensurate with the total quantity of funds invested in the venture. A sum of Rs 2 crores can reap a profit of Rs 1 crore.

As they start selling though, the share price starts to drop and beats the small investors, unless they are clairvoyant enough to anticipate the day the large holders will unload. In case of a general crash, however, of the kind discussed earlier (which, admittedly, may not necessarily materialize), the industry itself is affected, resulting in a drying up of the dividend flow to the shareholders. An event that corroborates the finance minister's probable line of reasoning.

Neither a fall nor a rise in the Sensex, therefore, need directly be initiated by industrial declines or revivals. The Sensex, in other words, is an imperfect indicator of industrial performance. Arguably, a far better index of industrial health is the dividend announced in the annual meetings of the companies. The dividends stand for profits made through production and sale, rather than through speculation.

Can the interest rates on bank deposits be linked to the state of the economy' The rates are expected to depend on the banks' returns from investments on a wide range of projects. If the economy is performing satisfactorily, there is no reason why the returns should not be high. For example, interest rates in the United States of America, even though traditionally low, have begun to show signs of upward movement with business recovery. In India, however, they continue to be low, though the Sensex soars high.

There is a major reason why the Indian phenomenon should not cause surprise. The statutory liquidity requirement for the banks makes it mandatory for them to hold a large part of their assets in the form of treasury bills, that is, short-term loans to the government. The government's ability to pay interest on these borrowings has been steadily declining in recent times, so the interest it offers on its loans is low. Correspondingly, the banks too are in a position to pay only small interests on their deposits.

A second reason relates to the fact that the banks do not hold more than 5 per cent of their assets in the form of private sector shares and debentures, because the law stipulates them to be conservative in their investments. Hence industrial success cannot be passed on to bank customers in the form of high interest rates.

Recent evidence indicates that the banks are loaning out their surplus funds in a big way to finance the purchase of consumer durables. It is tempting to conjecture that the loans are intended, presumably at the behest of the government, to prop up a weak demand for industrial products. If this is true, then it is surely a curious phenomenon. Banks are engaged in financing consumer expenditure in order to rejuvenate industry at the same time that the upward movement of the Sensex is being attributed to buoyancy in the industrial sector. It is unlikely therefore that the interest rates would rise even if the banks were to support industry directly.

Like the Sensex therefore, bank interest rates have no bearing on Indian industry, since the banks have at best a tenuous connection with industrial investments. Nonetheless, banks have recently started to act as intermediaries between the share market and households by offering guidance for investment in mutual funds. This is paradox- ical, too, since banks avoid risky portfolios at the same time that they are goading the public into risk- taking.

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