Why Chidu's new plan to revive consumer demand won't work

The finance minister, P Chidambaram is at it again. He wants public sector banks to cut their interest rates so that people borrow and spend more, and consumer demand improves.
The trouble is that the credit deposit ratio of banks is at extremely high levels. Latest data released by the Reserve Bank of India(RBI) shows that as on September 6, 2013, for every Rs 100 that banks borrowed as deposits, they had lent out Rs 78.52.
Banks need to maintain a cash reserve ratio of Rs 4 for every Rs 100 that they borrow as a deposit. This money is deposited with the RBI. They need to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 for every Rs 100 they borrow as a deposit in government bonds.
This means that Rs 27 out of Rs 100 that is borrowed as a deposit goes out of the equation straight away. Only the remaining Rs 73 can be lent out. But banks are lending Rs 78.52 for every Rs 100 that they raise as a deposit. This means that they are borrowing from other sources in the market to lend money.
This is happening primarily because banks have been unable to raise enough money as deposits. The deposit growth in one year(between September 7, 2012 and September 6, 2013) was at 13.5%. In comparison the loan growth has been at 18.2%.
Given that loan growth has been happening at a much faster rate than deposit growth, banks cannot cut interest rates. To cut interest rates on loans, banks will have to first cut interest rates on deposits. And if they do that they will find it even more difficult to raise deposits.
But Chidambaram seems to have found a way to get around this problem. A finance ministry press release pointed out yesterday that “It may be recalled that in the Budget for 2013-14, a sum of Rs. 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently.
The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two wheelers, consumer durables etc, at lower rates in order to stimulate demand.”
There are multiple problems with this plan. Where will the government get the money for the extra capital it is planning to offer to banks? It will borrow money by selling bonds, which will be bought by banks and other financial institutions. And where will the banks get this extra money to lend to the government? By trying to raise more deposits. And how will they do that? By offering higher interest rates.
The second and the bigger problem with the argument is that the size of loans for two wheelers, consumer durables etc is too small, for a fall in interest rates to make any difference. Lets assume an individual takes a two year two wheeler loan of Rs 50,000 from SBI at 18.05% per annum. The EMI for this comes to Rs 2497.4. If the interest rate falls to 17.05% per annum, the EMI will fall by around Rs 24 to Rs 2473.3. If the interest rate falls to 16.05% per annum, the EMI will fall by around Rs 48 to Rs 2449.35.
Of course no one is going to go ahead and buy a two wheeler because his EMIs have come down by Rs 24-48. When it comes to these kind of purchases interest rates don’t really matter. What matters is how people feel about their economic future. Questions like whether they will get a raise this year or even whether they will keep their job in the time to come are more important.
Given the bleak economic scenario that prevails, Chidambaram’s plan won’t work.

The article originally appeared in the Daily News and Analysis dated October 5, 2013 with a different headline
(Vivek Kaul is the author of soon to be published Easy Money. He tweets @kaul_vivek)