Data supports RBI hypothesis that interest rates cannot be directly linked to growth as loans are only a facilitator
In the last two years, the Reserve Bank of India (RBI) has been constantly chided by everyone for slowing down the growth process by maintaining a high interest rate regime. The view is that by keeping interest rates high, investment has slowed down, which has affected growth. This has happened without really bringing down inflation, which is more structural in nature. RBI, on the other hand, has always argued that the link between interest rates and investment is tenuous, and there is evidence to show that low interest rates by themselves cannot bring about growth. This argument sounds right because nobody borrows money merely because it is cheap—like merely because interest rates come down, one does not buy a house as other conditions also matter such as own income and price of property. One does tend to look at overall economic conditions, which include not just the economic numbers but also the policy environment before taking a call to invest. Therefore, industry would be looking at future demand conditions, current capacity utilisation, future interest rates, etc, before taking a final call. The best way to see where the answer lies is to look at data. The accompanying table looks at the repo rate, GDP growth rate, gross fixed capital formation rate and growth in credit since FY01. The table provides some interesting observations. The first relation that can be examined is between interest rates and growth in credit, as it answers the question as to whether or not high rates deter borrowing. Declining interest rates between FY01 and FY05 witnessed a mixed trend in growth in credit, which also did not follow the GDP growth pattern as high loan growth was achieved in FY03 when GDP growth slumped to 4%. The interesting part then begins when rates were increased through till FY08, where growth in credit was high in all the three years. Here credit growth can be linked with GDP growth, which was robust at over 9% in all the years. Clearly, when economic conditions are good, interest rate is not a limiting factor, as rising demand enables higher demand for credit as investment also picks up. Subsequently, lower interest rates did not quite push up credit growth to the same extent as the entire world economy was recovering from the scare of the financial crisis. Here notwithstanding high GDP growth, credit growth was cautious. The post FY11 period was mixed: higher rates in FY12 had high growth in credit. But, in FY13, while rates came down, it was not adequate to push growth in credit. The picture emerging is that interest rates have less of an influence on credit growth than GDP growth, which can be taken to be a close proxy for economic conditions. A factor that can sever this relation could be the less flexible transmission mechanism wherein the policy rate change does not trigger similar movements in the base rates to affect demand for credit. The relation between interest rates and capital formation can be examined next. The interest rate regimes in the 13-year period can be divided into four parts. The first up to FY05 was one of declining rates that did see the capital formation rate increase gradually, though the rate was low between 23-25%. However, in the next period up to FY08, investment soared and peaked but was associated with robust economic conditions. In the next two years when rates came down, the capital formation rate remained virtually unchanged, while in the next two years up to FY12 it was higher than in the low interest regimes even though interest rates were high. In FY13, lower rates were associated with a decline in the investment rate. The data presented hence does not show a direct link between interest rates and credit growth and capital formation. The transmission mechanism is important, which has been rigid in these years. Also, expectations of interest rates play a role because if potential investors expect rates to come down further, they would defer decisions. But, more importantly, demand conditions are important because as long as demand is there, there will be incentive to produce and invest. In the absence of demand, which has been the case in India in FY13, there is little point in investing at a higher interest rate. Interestingly, the share of the public sector in gross fixed capital formation has been stable between 25-27% across the years and, therefore, the overall picture is dominated by the private sector—corporate and households. Government contribution to capital formation is not really influenced by interest rates as much as by fiscal compulsions. The capital formation rate has come down, especially in construction activity when the fiscal deficit has been under pressure. Otherwise, the government still continues to borrow at much lower rates than what is charged for the private sector. Also, the trends in investment in machinery closely follow that of overall capital formation. The picture in the last 12-13 years definitely supports the RBI hypothesis that interest rates cannot be directly linked with growth as loans are only a facilitator. While high interest rates do affect the internal rate of return for undertaking fresh investment or the profitability, they are just one element that affects investment decisions.
In the last two years, the Reserve Bank of India (RBI) has been constantly chided by everyone for slowing down the growth process by maintaining a high interest rate regime. The view is that by keeping interest rates high, investment has slowed down, which has affected growth. This has happened without really bringing down inflation, which is more structural in nature. RBI, on the other hand, has always argued that the link between interest rates and investment is tenuous, and there is evidence to show that low interest rates by themselves cannot bring about growth. This argument sounds right because nobody borrows money merely because it is cheap—like merely because interest rates come down, one does not buy a house as other conditions also matter such as own income and price of property. One does tend to look at overall economic conditions, which include not just the economic numbers but also the policy environment before taking a call to invest. Therefore, industry would be looking at future demand conditions, current capacity utilisation, future interest rates, etc, before taking a final call. The best way to see where the answer lies is to look at data. The accompanying table looks at the repo rate, GDP growth rate, gross fixed capital formation rate and growth in credit since FY01. The table provides some interesting observations. The first relation that can be examined is between interest rates and growth in credit, as it answers the question as to whether or not high rates deter borrowing. Declining interest rates between FY01 and FY05 witnessed a mixed trend in growth in credit, which also did not follow the GDP growth pattern as high loan growth was achieved in FY03 when GDP growth slumped to 4%. The interesting part then begins when rates were increased through till FY08, where growth in credit was high in all the three years. Here credit growth can be linked with GDP growth, which was robust at over 9% in all the years. Clearly, when economic conditions are good, interest rate is not a limiting factor, as rising demand enables higher demand for credit as investment also picks up. Subsequently, lower interest rates did not quite push up credit growth to the same extent as the entire world economy was recovering from the scare of the financial crisis. Here notwithstanding high GDP growth, credit growth was cautious. The post FY11 period was mixed: higher rates in FY12 had high growth in credit. But, in FY13, while rates came down, it was not adequate to push growth in credit. The picture emerging is that interest rates have less of an influence on credit growth than GDP growth, which can be taken to be a close proxy for economic conditions. A factor that can sever this relation could be the less flexible transmission mechanism wherein the policy rate change does not trigger similar movements in the base rates to affect demand for credit. The relation between interest rates and capital formation can be examined next. The interest rate regimes in the 13-year period can be divided into four parts. The first up to FY05 was one of declining rates that did see the capital formation rate increase gradually, though the rate was low between 23-25%. However, in the next period up to FY08, investment soared and peaked but was associated with robust economic conditions. In the next two years when rates came down, the capital formation rate remained virtually unchanged, while in the next two years up to FY12 it was higher than in the low interest regimes even though interest rates were high. In FY13, lower rates were associated with a decline in the investment rate. The data presented hence does not show a direct link between interest rates and credit growth and capital formation. The transmission mechanism is important, which has been rigid in these years. Also, expectations of interest rates play a role because if potential investors expect rates to come down further, they would defer decisions. But, more importantly, demand conditions are important because as long as demand is there, there will be incentive to produce and invest. In the absence of demand, which has been the case in India in FY13, there is little point in investing at a higher interest rate. Interestingly, the share of the public sector in gross fixed capital formation has been stable between 25-27% across the years and, therefore, the overall picture is dominated by the private sector—corporate and households. Government contribution to capital formation is not really influenced by interest rates as much as by fiscal compulsions. The capital formation rate has come down, especially in construction activity when the fiscal deficit has been under pressure. Otherwise, the government still continues to borrow at much lower rates than what is charged for the private sector. Also, the trends in investment in machinery closely follow that of overall capital formation. The picture in the last 12-13 years definitely supports the RBI hypothesis that interest rates cannot be directly linked with growth as loans are only a facilitator. While high interest rates do affect the internal rate of return for undertaking fresh investment or the profitability, they are just one element that affects investment decisions.
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