Mr Mahindra and Mittal, low interest rates do not always lead to faster economic growth

indian rupeesVivek Kaul

The Reserve Bank of India releases sectoral deployment of bank credit data every month. The latest data shows that loan growth of banks for the one year period between September 20, 2013 and September 19, 2014, slowed down to 8.7%.
Interestingly, in the one year period between September 21, 2012 and September 2013 it had stood at 17.9%. What is worrying is that the bank loan growth in this financial year has almost come to a standstill. Between March 21, 2014 and September 19, 2014, the bank loan growth stood at a very low 1.8%. The growth between March 22,2013 and September 20, 2013 had stood at 6.7%.
Not surprisingly, calls for a repo rate cut by the Reserve Bank of India (RBI) have become very fashionable these days. Repo rate is the rate at which the RBI lends to banks.
A PTI report quotes industrialist Anand Mahindra as saying “It might be time for the RBI to think of a rate cut.” “The need of the hour has changed and its time to start to look to support growth,” Mahindra added. Sunil Mittal, chief of Bharti Airtel, also suggested the same when he told CNBC TV 18 that the finance minister Arun Jaitley “had spoken for the nation,” when had asked for an interest rate cut. In a recent interview to The Times of India Jaitley had said “Currently, interest rates are a disincentive. Now that inflation seems to be stabilizing somewhat, the time seems to have come to moderate the interest rates.”
The logic is that if the RBI cuts the repo rate, banks will also cut interest rates, and this in turn will lead to people borrowing and spending more. Companies will also borrow more and expand and invest in new projects. And this will lead to faster economic growth.
Nevertheless, the thing is that economic theory and practice don’t always go together. So, a cut in interest rates doesn’t always lead to an increase in investment by the corporate sector. As Crisil Research points out in a report titled
Will a rate cut spur investments? Not really “the monetary policy tool of cutting the interest rate is conventionally used to energise a flagging economy. But this does not hold true under all circumstances.”
Crisil Research comes to this conclusion after comparing the last two financial years with the pre-crisis years of 2004-2008. During 2004-2008, private corporate investment increased despite high interest rates. The same has not been true during the last two years. As the report points out “Investment growth, particularly private corporate investment, plummeted in the fiscals 2013 and 2014, despite low real interest rates. During this time, the policy rate in real terms – repo rate minus retail inflation – has been negative, and real lending rates averaged 2.4%. This is significantly lower than the 7.4% seen in the pre-crisis years (2004-2008). Yet investment growth dropped to 0.3%, down from an average 16.2% seen in the pre-crisis years.”
The question to ask why has that been the case? Most corporates while making a decision to increase their investment take a look at the expected return. “Investments are undertaken when the expected returns on them are more than the real lending rate (real borrowing cost for corporates). The average rate of return on corporate investment (non-financial firms) – as proxied by return on assets – fell sharply to 2.8% in fiscal 2013 and 2014 from nearly 6% in the pre-global financial crisis years,”Crisil Research points out.
A very good example of this is the road construction sector where investments are made by looking at the internal rate of return on the project. The internal rate of return on road projects during the period 2008-2009 was between 16-18%. It has since fallen to 8-14%. And the major reason for this is cost overrun for which corporates are themselves responsible to a large extent and delays in projects clearances by the government. These projects have also found it difficult to acquire land. Interest rates have had almost no role to play here.
This is basic economics at work. And our politicians and businessmen need to be aware of this. Further, what our politicians and businessmen do not talk about is the fact that many large business groups are heavily indebted and this has led to their interest costs shooting up. One sector where companies are heavily indebted is infrastructure. As Crisil Research points out “The ratio of interest cost to operating income for infrastructure companies has increased sharply in recent years from 4.7% in fiscal 2010 to 13.2% in 2014. However, the analysis suggests that this worsening had more to do with high indebtedness of infrastructure companies than elevated interest rate.”
Also, India has fallen constantly in the global competitiveness rankings. India’s position in the Global Competitiveness Index fell to 71 in 2014. It was at 60 in 2013 and 49 in 2009. The RBI was not responsible for any of this. This was a mess made the politicians of the Congress led UPA which ruled the country for a decade and the businessmen who went on a borrowing spree and underestimated costs of setting up projects.
Also, the Indian consumer is not ready to get his shopping bags out as yet though he flattered to deceive briefly, after Narendra Modi was elected as the prime minister. This is reflected in a variety of numbers from low manufacturing inflation to low index of industrial production and car sales.
The reason for this is that inflationary expectations ((or the expectations that consumers have of what future inflation is likely to be) continue to remain high. Hence, the Indian consumer is still not convinced that the high inflation that he has had to deal with over the last few years has finally been killed.
The Reserve Bank of India’s Inflation Expectations Survey of Households: September – 2014 which was a survey of 4,933 urban households across 16 cities, and which captures the inflation expectations for the next three-month and the next one-year period. The median inflation expectations over the next three months and one year are at 14.6 percent and 16 percent. In March 2014, the numbers were at 12.9 percent and 15.3 percent. Hence, inflationary expectations have risen since the beginning of this financial year.
lnflationary expectations be reined in once inflation remains low for an extended period of time. And consumer demand is likely to pick up only after this happens.
To conclude it has become fashionable for the government and the businessmen to blame RBI for slow economic activity in the country. Nevertheless, it is time they started to get their own act right. The RBI can only do so much.

The piece originally appeared on on Nov 5, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)