Are Interest Rate Subventions a Cure to Improving Financial Health of SME & Small Agriculturists?

Prof. Pulapre Balakrishnan’s article, Independence and accountability published in The Hindu, dated 9^th November 2018 is well written and a balanced exposition. However, his suggestion (“If, in the spirit of contriteness as it were, the government wants to reach out to them, the right course would be to provide interest rate subvention”) for providing interest rate subvention for improving the financial health of medium and small enterprises seems to be dictated more by emotions than by either logic or empirical evidence on such interventions.

Interest rate subsidies, which such subvention would entail, creates various distortions and negative consequences for the economy and society. These include,

a)      It is available only to those who have taken bank loans, ie a small minority of the populace.

b)      Such policy generates excess demand for bank credit, which gets rationed essentially through exercise of political and economic power. That is, those with political and economic muscle corner a greater proportion of bank loans.

c)      This in turn leads to growing levels of income and wealth inequality. First, because the rich and powerful now have larger capital at their disposal. Second, they get it at cheaper rates than the market clearing rate. Third, their incentive to repay is lower.

d)     The excess demand for credit cleared through extra-constitutional means, also leads to generation of humungous amounts of corruption – affecting  politicians, bureaucrats, and banks.

e)      The losses on account of bad loans in turn make the banks weak / sick.

f)       This in turn forces banks to give lower returns to their depositors. (Incidentally, the Governor of RBI has gone on record in his speech dated 26th July 2016 stating, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”!). A direct consequent of lower interest rates on deposits is that it reduces the savings rate of the economy, making the country rely more on foreign capital.

g)      Since the benefits are concentrated and the resultant pain extremely diffused over the entire society there is little concentrated efforts to counter it. These aspects of negative consequences of cheap credit is hardly visible in the media or policy documents.   

Furthermore, interest rate subvention would have to be substantial if it is to make a difference to the financial viability of any project, especially considering that total interest costs may not be a very large proportion of overall costs for any but the most profitable projects.

As such, with large amount of the interest rate subvention all the negativities and distortions associated with using interest rate subsidy in promoting trade / industry would very well come into play. 

As an underdeveloped country, higher levels of capital in all forms (physical, financial, human, technological etc.) are required. Making it cheap, but difficult to obtain is not helping anyone, least the intended beneficiaries. It just salves middle class conscience and converts us into a society of alms-receivers. Availability of credit is much more important than cost. Pushing cheap credit does not solve problems of connectivity (roads / telephone lines), irrigation, power, social equality, lack of information, lack of basic skills which make people productive, good health etc. Not having ability to usefully employ credit, is like giving an illiterate man a book on religion or philosophy with the hope that it would do enlighten him! Credit given to persons without ability to utilize it helps in driving borrowers into a debt trap.

A better way to promote accumulation of financial would be by focusing more on the deposit side of the banking business. Especially using technology and redesign of process to make it  easier to open and operate simple depository accounts. Presently, the processes we have implies that for a daily worker to operate his account he / she has to forego a full day’s earnings. Is it any wonder that there are so many dormant PMJDY accounts or that the level of operations in the non-dormant accounts is low?