If you ask me the definition of "Interest", I can't say off-hand. Despite my so-called years of experience in the Treasury space. If you ask me 'What is sub-prime?' I will jump as if I have been offered a lollypop. That's the irony. We get so much merged with the ultra that we forget the basics.

Dictionary.com defines Interest as : a) a sum paid or charged for the use of money or for borrowing money; b) such a sum expressed as a percentage of money borrowed to be paid over a given period, usually one year.

Let us understand the theory of Interest. Keynes, in his colossal book 'The General Theory of Employment, Interest and Money' put forth the concept of 'Liquidity Preference Theory'. He embarked on the role of the interest rate as the reward for doing without the advantages of money as the only perfectly liquid asset.

In other words, the interest rate is determined by the demand and the supply of money. It is the price paid for surrendering liquidity. While this theory appeared very sound, this did not presuppose that interest can be a compensation for saving or waiting. Without saving, we cannot possibly think of surrendering liquidity.

Now, why do interest rates differ?

We have seen in the 70's, the range of interest rate was 4% simple under Differential Rate of Interest (DRI) Scheme and 18% compound for overdrafts. In the present day scenario, we have seen home loans being offered at 7.5% fixed, and at the same time, the credit card default interest rate goes upwards of 40%!

We have also seen zero rates on interest in Japanese Yen, not so long ago. Well, then what are the factors that determine the interest rate? Differences in distances, varieties of risks, duration, nature of security, amount of the loan, productivity of capital, and of course the presence of Imperfect Competition are responsible for determining the rates of interest.

Why do we always clamour for lower interest rates for our loans and higher for our deposits?

That's again because we want to lose as little as possible in our portfolio of assets and liabilities. We hardly observe the steady rise in the prices of our day-to-day purchases; but we, nevertheless, shout when we read that the Central bank has hiked the rates!

We probably do not know that the rise in prices (more popularly known as 'Inflation' or 'Headline Inflation' for the more journalistically correct) and the rise in the interest rates are directly related.

There is a constituency in India, which always believes in the Utopian. You would note that when the inflation abates considerably and consistently, it would stay put with the objection of lowering of provident fund interest rates. So much for the knowledge of the basics of Economics!

The Indian scene

We talked of presence of Imperfect Competition. If there is a single money-lender in an area, he will enjoy monopolistic power to determine interest rates. In the pre-liberalisation India, the Reserve Bank of India [Get Quote], by its fiat, was dictating the interest rates.

Banks could not charge anything more or less. With the post-nationalisation social obligations under DRI Scheme, as well as various Loan Melas, Self-Employment Schemes like SEEUY and SEPUP, Banks started feeling the burden of low productivity of their capital. The timely advent of liberalisation of the economy saved many a financial institution.

Rates started being determined by market forces. But this also gave in to unbridled hikes in rates. Competition forced Banks and Financial Institutions lower the lending rates and increase the deposit rates. And the customer benefited. In 1997, as the spread between the lending rate and the deposit rate got narrowed, in order to survive, banks resorted to overlending, thereby precipitating shortage of funds.

This resulted in overnight rates shooting up to near 80%. Suddenly banks started booking deposits of short and medium term maturity at a high cost - upto 20% Prime Lending Rate

In India, the Reserve Bank of India has directed that the banks should charge interest on loans etc. in accordance to its directives vide RBI Master Circular on Interest Rates 1.1. It also says that the commercial banks are free to determine their own lending rates.

Banks can fix their Prime Lending Rate (PLR) taking into account Banks' cost of funds and transaction cost. This is the reason one finds the PLRs of various banks being at great variance with one another. Banks also are given the freedom to operate different PLRs for different maturities.

As a further step to deregulation, banks were also made free to offer fixed or floating rates, provided PLR stipulations are complied with. This means that the nature of alignment with the PLR, whether the rate is above or below PLR, and with how much basis point, needs to be made explicit at the time of the sanction of the loan.

Yield enhancing products

On the other side of the spectrum is the rate offered for deposits of various tenors. Whereas the Central bank has allowed various derivatives to help borrowers reduce costs through hedging, hardly any effort has been made to let the depositor take a call on hedging his deposits.

There are various yield-enhancing products available in nearer-home countries like Singapore, Indonesia etc. Products like Dual Currency Deposits (DCDs) - Digital Option, Principal Protected Double No Touch Deposits, Bond-Linked Deposits, and Equity-Linked Deposits; there is a plethora of products, which the Central Bank needs to look into. In these cases, the depositor decides to link his deposit to the movements in bonds, equities or a pair of currencies.

While initially products like DCDs may not be permitted, as in this product principal is not protected, other products mentioned need to be explored, as principal is invariably protected. In certain cases like Bond-Linked Deposits a minimum rate is also guaranteed. High Net worth Individuals (HNIs) may also be permitted to hedge their deposits against foreign currencies.

This would make the market more competitive. And we know competition begets better pricing for the customers. We should, however, precede this with a series of education seminars all over the country for prospective depositors, so that untenable situations like the one witnessed in respect of the CHF derivatives are not confronted by them.

In conclusion, while the power of Central Banks is universally accepted and rightly so, and Reserve Bank of India has time and again shown the flexibility to accommodate new products and theories, a fresh look may be required in case of the yield-enhancing products.

Amrit K Basu is a Foreign Exchange Consultant and promoter of proFX consulting & allied services. Acknowledged as an expert in the field, he offers currency trading strategies to corporate.