Reduction in of Lending Rate (MCLR) by 0.9 per cent, that is a reduction of 90 points at one go by State Bank of India (SBI) has brought cheer to the economy. This fall is the largest in the last few years by any bank at one go. With other banks following the cue, (though many banks have not done so) the new MCLR is 8 per cent for SBI, 8.65 per cent for Union Bank, 8.45 per cent for Punjab National Bank and 9.15 per cent for IDBI.

It is expected that in the coming days other banks will also follow suit, as they are all flooded with huge deposits post demonetisation. Since there is hardly any big growth in lending, while their lending capacity has increased manifold, it is expected that with reduction in lending rates, pickup of loans may increase significantly as demand for funds for capital formation including infrastructure, housing and consumer durables may increase due to fall in cost of borrowing. This may lead to an increase in profits of commercial banks.

In the last two months due to huge influx of old demonetised currency, cost of lending by commercial banks has come down significantly. Employees Provident Fund Organisation has also reduced its interest rate from 8.8 per cent to 8.65 per cent this year. Banks have reduced their deposit rates also and they are expected to come down further. SBI has recently reduced the interest on deposits above Rs.one crore by a huge 190 points; however it had brought a very small reduction in its lending rates then.

It is notable that the lending rates of commercial banks are determined by their respective MCLRs. Since MCLRs are different for different banks, their lending rates may also differ. In the coming days banks are going to reduce their deposit rates, therefore their lending rates may also come down heavily. The Prime Minister's announcement of interest subvention scheme on housing loans ranging from 3 to 4 per cent on 31st December has made it clear that effective rates on housing loans would come down accordingly. Reduction in MCLR by commercial banks and further interest subvention by the government on housing loans may bring down effective rates further. This implies that a person taking a housing loan of Rs.12 lakh who was paying an interest of 10 per cent previously will pay 9 per cent interest now and will get interest subvention of 3 per cent from the government. This means that the effective rate of interest on housing loan of Rs.9 to 12 lakh would only be 6 per cent.

Housing loans of an amount less than Rs.9 lakh would get interest subvention of 4 per cent, which means that the effective interest rate will only be 5 per cent. 

It is notable that one per cent reduction in interest rates brings down EMI by 8 per cent for a loan of 20 years and 6.5 per cent for a loan of 10 years. Earlier, for a loan of Rs.12 lakh repayable over 20 years, the EMI was Rs.11,850; now it will only be Rs.8,597. Therefore we can say that poor and middle income earners can more easily realise their dream of owning a house.

As such due to falling prices of real estate in the post-demonetisation period on the one hand and declining interest rates on the other, demand for housing is bound to increase. Interest rebate for 60 days on agricultural loans and doubling of credit guarantee for small and medium enterprises is also likely to give a boost to borrowings from banks. People in banking circles believe that with fall in interest rates, credit outflow from banks for infrastructure, retail, housing and agriculture is likely to increase significantly.

According to economic theory, reduction in interest rates is one of the important conditions to boost investment. When interest rates fall not only industrial investment and infrastructure investment gets a boost, even demand for loans for housing, cars and other consumer durables soars. Investments including infrastructure investment increase because the projects which were earlier not economically viable due to high interest cost may now become so.

For instance if we plan to build an expressway between Delhi and Meerut under a public-private partnership, we will require to collect toll to recover the cost. However, if interest rates are high, than we need to collect higher toll to recover the cost, which may not be possible. However, if the rate of interest goes down we may have to collect lower toll, which the traffic may bear.

Similarly industrial investments which may not be economically viable due to high interest rates may see the light of the day with reduced interest rates. We see that during NDA-I under stewardship of Atal Bihari Vajpayee, there was a fast growth in infrastructure especially road infrastructure. This was primarily due to lower interest rates. Rate of gross domestic capital formation (GDCF), which was only 24.5 per cent in 2000-01, jumped to 38.1 by 2007-08. However after 2007-08 due to fast increasing interest rates GDCF dropped to 34.1 per cent in 2014-15.

Developed economies like US and Europe have been adopting the policy of reducing interest rates to get rid of recession in their economies. In US, interest rates remained near zero for a long time. Similarly Japan and European countries have also been keeping interest rates low.

However, the decline in interest rates affects our senior citizens adversely as their major source of income is interest. In the interest of the economy at large, government can compensate their losses by offering higher interest rates for senior citizens. Cost of this compensation will be much less than the gains achieved in the form of high rate of growth of infrastructure, industrial investment and therefore of the economy.

The writer is Associate Professor, PGDAV College, University of Delhi,