Why cutting interest rates will have little impact on industrial production

Vivek Kaul 
The index of industrial production (IIP), a measure of the industrial activity in the country, grew by a meagre 2% in April 2013, in comparison to the same period during 2012. The index was expected to grow by around 2.4% (source: India: Weak growth and sticky retail inflation. Sonal Varma and Aman Mohunta, Nomura). In the month of March 2013, the index had grown by 3.4%.
This slowdown of industrial growth reflected in the low IIP number is expected 
to lead to call for a cut in the repo rate by the Reserve Bank of India(RBI). Everyone from the Finance Minister to business lobbies to business leaders are expected to join the chorus. The logic is that at lower interest rates people will borrow and spend more, so will businesses. This will create demand and thus help revive overall industrial activity and in turn the overall economy. Repo rate is the interest rate at which the RBI lends to banks.
Naina Lal Kidwai, President of Federation of Indian Chamber of Commerce and Industry, 
told The Economic Times “Consumer durables segment registered one of its highest falls since 2009 and calls for moderation in interest rates to stimulate demand.”
Similar statements were made by Presidents of CII and ASSOCHAM, the other two industry bodies.
But there are several reasons why a cut in interest rate by the RBI may not work.
During the last one year the banks have lent around Rs 83 out of every Rs 100 that they have borrowed. Ideally they should not be lending more than Rs 70 out of every Rs 100 that they borrow. This is because banks need to maintain a cash reserve ratio of 4% i.e. for every Rs 100 that they raise as a deposit, they need to deposit Rs 4 with the RBI.
Banks also need to maintain a statutory liquidity ratio of 23%. For every Rs 100 that banks raise as a deposit, Rs 23 needs to be compulsorily invested in government securities. Government securities are essentially bonds issued by the central and the state governments to borrow money to make up for the difference between what they earn and what they spend.
What this means is that for every Rs 100 that banks raises as a deposit, Rs 27 gets taken out of the equation straight away (Rs 23 as SLR and Rs 4 as CRR). That leaves around Rs 73 to lend (Rs 100 – Rs 27). So in a healthy situation a bank shouldn’t be lending more than Rs 70 out of every Rs 100 that it raises as a deposit.
But as we see above, banks have lent Rs 83 out of every Rs 100 that they have raised as a deposit during the last one year. This means they haven’t been able to raise deposits as fast as they gone around lending money. Hence, interest rates on deposits cannot be brought down because banks need to correct this mismatch between deposits and loans, by raising deposits at a faster rate.
So even if the RBI cuts the repo rate, the question is will the banks be able to match that cut? As explained above that seems unlikely.
But for the sake of argument lets assume that the RBI cuts the repo rate and the finance ministry is at least able to push the public sector banks to cut interest rates. And if public sector banks cut interest rates on loans, chances are even the private sector banks may have to match them to remain competitive.
This may or may not happen, and at the cost of reiterating let me state that I am only trying to make a point here. Lets consider the car industry, which is a very good representation of overall industrial activity. As TN Ninan wrote in a 
column in Business Standard in January 2013, “The car industry is a key economic marker, because of its unmatched backward linkages – to component manufacturers, tyre companies, steel producers, battery makers, glass manufacturers, paint companies, and so on – and forward linkages to energy demand, sales and servicing outlets, et al.”
As is well known by now car sales have been slowing down over the last seven months. 
In the month of May 2013, car sales were down by 12.3%. When car sales are down it obviously means that car companies will report lower sales and profits, unless they manage to cut costs dramatically, which is not possible beyond a point. What it also means is that car companies will not produce as many cars as they can given their production capacity. As has been reported on Firstpost, Maruti, India’s largest car maker, did not make any cars on June 7, 2013. This for a company which makes 5000 cars every day.
When a car-maker does not make cars it obviously slows down industrial activity. It also slows down the production of every company which provides inputs to a car company. This ranges everyone from steel companies to paint companies to tyre companies to battery manufacturers to steering manufacturers and so on. And this in turn slows-down the overall industrial activity.
To revive industrial activity, hence it is important that more cars are sold. And more cars will be sold when loans are available at low interest rates, goes the logic. But lets try and understand why this logic doesn’t work hold.
Lets consider the case of an individual who borrows Rs 4 lakh to buy a car at an interest rate of 12% repayable over a period of 7 years. The equated monthly instalment for this works out to Rs 7061. Lets say the bank is able to cut the interest rate by 0.5% to 11.5%. In this case the EMI works out to Rs 6955, or Rs 106 lower.
Even if the bank cuts interest rates by 1%, the EMI goes down by Rs 212 only.
If we consider a lower repayment period of 5 years, an interest rate cut of 0.5% leads to an EMI cut of Rs 100. An interest rate cut of 1% leads to an EMI cut of Rs 200.
So the bottomline is that an individual will not go and buy a car just because the EMI has come down by Rs 100 or Rs 200. There is something else at work here. And the logic that people are not buying cars because interest rates are high just doesn’t hold.
As RC Bhargava, a car industry veteran and 
the Chairman of Maruti Suzuki India told Business Standard in a recent interview “In India, over 70 per cent of car purchases are financed by banks. An interest rate reduction of, say, one percentage point doesn’t change a person’s decision of buying or not buying a car…With the uncertainties prevalent today, a consumer does not know what his job would be like after a year – whether or not he will have an incremental income, or even a job.”
So people are not buying cars simply because they are insecure and are not sure whether they will be able to hold on to their jobs in order continue paying their EMIs. And given that they wan’t to avoid the risk of defaulting on their EMIs. Hence, cutting interest rates are in no way going to help kick-start car sales. Also, if the logic of cutting interest rates leading to people buying cars does not hold, there is no question of it working for consumer durables as well, Kidwai’s statemnt notwithstanding.
Real estate is another sector which has strong linkages with other sectors like steel and cement. A cut in interest rates will bring down EMIs significantly on home loans. But even with lower EMIs people are unlikely to buy homes. This is because the cost of homes especially in cities has gone up big time. And even the lower EMIs will be very high for most people. Hence the sector continues to be in a dump and is likely to continue to be in one.
Given this, all the talk about lower interest rates improving the industrial activity and in turn economic growth, is at best just talk, and needs to be taken with a pinch of salt.

 The article originally appeared on www.firstpost.com on June 13, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek)