ABSTRACT
The road to full convertibility passes through the pathway of domestic financial liberalization. Financial regulation before liberalization leant heavily on the administered interest rate regime. In the capital and credit short economy like India until the beginning of 1990s, the pressure on the interest rate was upward, and in order to make credit and capital available for investment at lower cost, a cap on interest rates was imposed. Inter-bank call money, bank deposit and lending, and long-term bond interest rates faced ceilings. In order to promote long-term investment in industry, the long-term bond or debenture rates were fixed at a lower level than the bank lending rates. The demand for bank credit always remained higher than funds available with banks due to pre-emption of a large share of banks’ resources by the Reserve Bank of India (RBI) and the Government by way of high Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements. The profitability rates of trade, business and industry were, however, much higher than the bank lending rates, and this continued to keep pressure on commercial credit availability from banks. The bank lending rates in 1991 were higher than the debenture interest rate by 4 to 5 percent. This compartmentalization of markets for short-term and long-term capital, and the Government pre-empting large resources for its long term borrowings from the banks, created a peculiar feature, which is unconventional in the financial theory. The yield curve, which usually slopes upward, was downward sloping and inverted in the Indian financial market for a very long period.
