The Affluent Society

What India Inc needs to understand about interest rates

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Vivek Kaul


Big business has been after the Reserve Bank of India (RBI) to cut the repo rate or the rate at which the central bank lends money to the banks.
There seems to be a certain formula to the whole thing. Before any monetary policy the business lobbies make a series of statements asking the RBI to cut interest rates. And when the RBI does not cut the repo rate, they make another series of statements explaining why the RBI should have cut the repo rate.
The belief is that a cut in the repo rate will lead to banks cutting the interest rates at which they lend. The statements made by the business lobbies normally try to explain how a cut in interest rates will lead to people borrowing and consuming more and companies borrowing and investing more. The RBI hasn’t entertained them till now.
In the monetary policy statement released on December 2, 2014, the RBI said that it might start cutting the repo rate sometime early next year.
The business lobbies immediately issued statements expressing their disappointment on the RBI not cutting the repo rate. Confederation of Indian Industries (CII), one of the three big business lobbies, said in a statement: “At this juncture, even a symbolic cut in policy rates would have sent a strong signal down the line that both the government and the RBI are acting in concert to harness demand and take the economy to the higher orbit of growth.”
The phrase to mark here is harness demand (which I have italicized). As explained earlier the logic is that when the RBI cuts the repo rate, banks will cut their lending rates as well and people will borrow and spend more. This will mean businesses will earn more and will lead to economic growth.
Only if it was as simple as that: .
As John Kenneth Galbraith writes in The Affluent Society: “Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment.” And vice versa—a large cut in interest rate decreases the monthly payment by a very small amount.
Let’s understand this through an example. An individual decides to take a car loan of Rs 4.5 lakh at 10.5%, repayable over a period of five years. The monthly payment or the EMI on this loan amounts to Rs 9,672. Now let’s say the RBI decides to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage).
The bank works in perfect coordination with RBI (which is not always the case) and decides to cut the interest loan on the car loan by 50 basis points to 10%. The new EMI now stands at Rs 9,561 or around Rs 111 lower.
If the interest rate is cut by 100 basis points to 9.5%, the EMI falls by around Rs 221.5. Hence, a nearly one tenth cut in interest rate (from 10.5% to 9.5%) leads to the EMI falling by around 2.3% (Rs 221.5 expressed as a percentage of Rs 9,672, the original EMI).
Now will people go and buy cars just because the EMI is Rs 111 or Rs 221.5 lower? Obviously not. People spend money when they feel confident about their economic future. And that is not just about lowering interest rates.
For loans of smaller ticket sizes (consumer durables, two wheeler loans etc.) the difference between EMIs when interest rates are cut, is even more smaller. Hence, the logic that a cut in interest rates increases borrowing, isn’t really correct. As Galbraith puts it: “During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans.”
What about the corporates? The business lobby CII felt that if the RBI had cut interest rates it would have “improved the poor credit offtake by industry”. In simple English this means that corporates would have borrowed and invested more, only if, the RBI had cut the repo rate.
But is that really the case? As John Kenneth Galbraith points out in The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand.”
But that doesn’t really happen. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low [the emphasis is mine],” Galbraith points out.
The last sentence in the above paragraph summarizes the whole situation. And it is difficult to believe that corporates do not understand something as basic as this.
This was also pointed out in a recent research report titled Will a rate cut spur investments?Not really, brought out by Crisil Research. (I had referred to this report in detail on an earlier occasion).
In this report it was pointed out that investment growth in fiscals 2013 and 2014 fell to 0.3%, despite negative real interest rates (repo rate minus retail inflation). The real interest rate during the period was at minus 2.1%, whereas the real lending rate was only at 2.8%.
In contrast for the period between 2004 and 2008, had a real interest rate of 7.4%, and the average investment growth stood at 16.4% per year, during the period. Why was that the case? “The rate of return on investments – as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database – have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years,” Crisil Research points out.
This is precisely the point Galbraith makes— Business firms borrow when they can make money and not because interest rates are low.
To conclude, Indian businesses seem to have great faith in monetary policy doing the trick, when there are too many other factors holding back growth (I haven’t gone into these factors partly because they are well known and partly because that’s a separate column in itself).
Indian businessmen are not the only ones who seem to have great faith in monetary policy. This is a trend that is prevalent throughout the world. The central bankers are expected to use monetary policy and come to the rescue of the beleaguered economies all over the world.
Where does this faith stem from? Galbraith explains this beautifully in The Affluent Society: “There is no magic in the monetary policy…[It] is a blunt, unreliable, discriminatory and somewhat dangerous instrument of economic control. It survives in esteem partly because so few understand it…It survives, also because active monetary policy means that, at times, interest rates will be high – a circumstance that is far from disagreeable for those with money to lend.”

The article appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 8, 2014

Food inflation is down but the figure Raghuram Rajan is watching hasn’t even budged

ARTS RAJANVivek Kaul  

As soon as some new economic data is declared by the government, the business lobbies demand that the Reserve Bank of India(RBI) should cut interest rates. The response is almost Pavlovian. Something similar happened yesterday as well. The index of industrial production(IIP) shrunk by 0.6% for the month of December 2013.
The manufacturing sector which constitutes close to three fourths of the index declined by 1.6% during the month. In comparison, it had declined by 0.8% during December 2012. The IIP is a measure of the industrial activity within the country and given that the number is in negative territory, what it tells us is that all is not well with the Indian businesses.
No sooner had the number been declared, the Confederation of Indian Industry I(CII), a leading business lobby in the country demanded that interest rates be cut. “We are especially concerned about the performance of the manufacturing sector, which continues to be in the red,” CII Director General Chandrajit Banerjee said. “We look forward for an accommodative monetary policy to spur demand and revive investment activity especially as inflation has started receding,” he added. Accommodative monetary policy essentially refers to the RBI cutting the repo rate, the rate at which it lends to banks.
The logic is that if the RBI cuts the repo rate, the banks will cut the interest rates at which they lend. This will ensure that people will borrow and spend more, which will translate into greater revenue and profit for businesses. Once businesses start making more money, they are likely to invest more as well. All this will lead to a higher economic growth, which for this financial year is likely to be at or around 5%. Or so goes the argument.
Another reason why business lobbies feel that the RBI should be cutting interest rates is the fact that the consumer price index(CPI) inflation in January 2014 fell to a two year low of 8.79%. This was on the back of food inflation falling to a 22 month low of 9.9%. Food products constitute nearly half of the consumer price index. Food inflation was at 12.2% in December 2013.
Food inflation came down because of the vegetable prices falling by 13.2% between December and January. This was primarily on account of greater supply of vegetables hitting the market. During the period August-September 2013, farmers made significantly better returns on their produce. This led to them planting more vegetables, leading to an oversupply in the recent months.
So with the consumer price inflation falling to a two year low, the business lobbies want the RBI to start cutting interest rates in order to revive consumer demand, which has been stagnating for a while. The IIP data when looked from a use based point of view, indicates towards the same. The consumer durables measure fell by 16.2% during December 2013.
But the question is will a cut in interest rates revive consumer demand? While in theory the link appears to be fairly straightforward, that is really not the case. Let’s consider a case where an individual takes a three year two wheeler loan of Rs 40,000 from the State Bank of India to be repaid over a period of 36 months at an interest of 18.25%. The EMI for this comes to around Rs 1451.
Now lets assume that interest rates crash dramatically by one third from their current levels and the rate of interest on a two wheeler loan from the State Bank of India falls to 12.25%. In this case, the EMI falls to Rs 1333 or around Rs 118 lower. Hence, even if interest rates come down by a third, the EMI falls only by around Rs 118 or a little over 8%.
Someone who wants to buy a two-wheeler will definitely not be influenced by it. As John Kenneth Galbraith writes in The Affluent Society, first published in the 1950s, “The customer, in contemplating the purchase, is less aware of the interest rate than of the monthly charge…There is, in fact, considerable agreement that monetary policy does not make any effective contact with consumer borrowing and spending. During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans.”
Given this, the customer who wants to purchase a consumer good by taking on a loan should be comfortable with the idea of paying an ‘x’ amount of money every month as an EMI, irrespective of what the interest rate is.
In this scenario, what becomes very important is the rate of inflation. For more than five years, inflation as measured by the consumer price index has been very high. This has largely been on account of food prices having gone up at a very fast rate. High inflation has eaten into the incomes of people and led to a scenario where their expenditure has gone up faster than their income. This has led to people cutting down on expenditure which is not immediately necessary. This is reflected in the consumer durable number which fell by 16.2% in December 2013.
Food prices have now started to come down and that is some good news for the Indian consumer. But if one looks at what economists call core inflation (i.e. non food non fuel inflation which forms around 40% of the consumer price inflation index) that remains to be high at 8%, as it has over the last few months. The core inflation contains measures of housing, medical care, education, recreation, transport, personal care etc, basically, everything that is required for a reasonably comfortable living.
Interestingly, this number is closely tracked by the RBI governor Raghuram Rajan. He had said on January 29, 2014, “that he would have liked to see a greater reduction in core inflation.” A day earlier in an interaction with the media he had said that “. Core (inflation) tells us something about the second round effects. Even within core, there are some which we need to pay attention to like some aspects of services like education, which have been going up quite strongly.” Given this, it is unlikely that the RBI will cut the repo rate anytime soon.
If the consumer demand story is to be revived again, the core inflation needs to be brought down, so that consumers feel comfortable in spending money. The ironical part here is that despite the economic growth falling from more than 10% to less than 5%, over the last few years, core inflation continues to remain high. The explanation for this lies in the fact that the high price of food, leads to a demand for higher wages and that leads a higher core inflation. When businesses have to pay higher wages, they, in turn, demand a higher price from consumers. And this in turn impacts consumer demand.
The government can definitely play a role here by cracking down on hoarders of food and at the same ensure that there is no shortage of wheat and rice in the market, of which it has enormous stocks.
As far as businesses lobbies are concerned it is worth looking at what Galbraith said in that context. “To restrict consumer borrowing by increasing the interest cost on instalment and other loans collides abruptly with the process of consumer-demand creation…Any step to discourage borrowing and buying will be automatically opposed by the machinery for consumer-demand creation.”
 The article originally appeared on www.FirstBiz.com on February 13, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)