RBI ain’t got no magic bullet: Financial Express: 8th JUne 2012

A lot being made of the imperativeness of RBI to lower interest rates to help the economy? Given that RBI has been increasing interest rates relentlessly in the last two years to control inflation, a view put forward is that Mint Street has been responsible for coming in the way of growth. The corollary is that, as this has not helped curb inflation, it should roll back rates to bring about growth. Is the equation as simple as this? There is no doubt that lower interest rates will help growth in two ways. First, lower costs on working capital improve profits. Second, lower rates make the internal rate of return on projects look better and hence can spur investment. But, is this action the be-all and end-all solution of our economic ills? The answer is a shoulder shrug. Today, government deficit, in particular its expenditure on subsidies, as well as high interest rates have been hyped, giving the impression that if these two roadblocks are addressed, the 8% gravy growth path will be achieved. This may not be true. Production takes place to satiate four sets of entities: consumption, investment, government and foreign trade. Consumption is dependent on an increase in income as well as inflation. Higher inflation has tended to deflect a part of savings for maintenance consumption, which, in turn, has affected incremental demand for consumer goods, and which explains why consumer durable goods did not do well last year. Investment is down, naturally, due to lower consumption demand as well as interest rates. In the last year, corporate profits have been affected by higher input costs and interest rates, which have not been fully passed on to the consumer. With demand down, there is no reason to invest at a high cost, which has gotten reflected in the production of capital goods where growth turned negative. The government cannot spend on projects because its deficit is high. Exports can help, but with the high trade deficit, the impact on GDP is negative. This is a rudimentary way of putting the GDP in perspective and we need all these pieces to work together to bring about growth, as they are interlinked. Now, one can turn to the last 20 years to see how interest rates and GDP and gross fixed capital formation have behaved. In the above table, growth rates have been taken for the latter two at 2004-05 prices while the same has been done to the prime lending rate and base rate for the last two years. The basic idea is to see how growth has behaved when rates have gone up—the same with gross fixed capital formation. The table shows that in these 20 years, there has been an increase in interest rates six times only. On four of these six occasions, capital formation remained robust. And while it was in a single-digit range in FY11 and FY12, this was a continuation of a pattern witnessed since FY09 when it came down, even though rates had fallen in two successive years. On three of the six occasions, there appears to be a one-year lag in terms of impact on growth in capital formation. But even so, GDP growth was affected with a lag on the last two occasions when we had the financial and sovereign debt crisis. This was curiously seen in the aftermath of the Asian crisis when growth slowed down considerably even as rates were lowered. Also, lower interest rates do not necessarily spur investment as evidently other factors such as demand and excess capacities and future prospects for growth are important. What does this indicate? Interest rate reduction by itself cannot be the magic wand we are looking for to drive the economy. The rate cut witnessed in April has not quite elicited enthusiasm from borrowers, even after being told that there would be no further hikes for some time. Evidently, there is something missing, which is holding back growth today. We need to have a consumption increase to provide impetus to investment as the government is quite impotent in this regard today, and exports are beyond our purview given the tenuous global economic situation. A related issue here is whether capital is being priced properly today. Interest rate is the price of capital and when demand is greater than its supply, the price should rise, as it holds for any good or service. Here, with RBI providing R1 lakh crore through the repo window, it looks like that there is a shortfall, with the government being the largest claimant of funds. If the government cannot be stopped from borrowing as much as it is doing, then demand will be exacerbated, thus justifying the higher cost of funds. Further, with inflation still high, the real interest rate based on the CPI is negative and around 1-1.5% based on the WPI. RBI will evidently be looking closely at all these aspects before taking a final call. While a decrease in interest rates could help lift sentiment, as it actually does not cost anything to the central bank. Savers would be impacted, but then with limited options, they have to settle for less. But we should not expect another 50 bps cut in rates to actually kick-start the economy, as while investment will gradually take place, industry will also be looking to the government to start its spending on infrastructure and private consumption to be revived. The question is when all this will happen?