In the past few years, capital formation and growth showed a negative relation with policy rates, no matter which way the rates moved
There is a clarion call for the reduction in interest rates. The decibel level has increased ever since the latest IIP growth and CPI numbers were released. Growth continues to be low and inflation is sort of under control. RBI has indicated it would wait and watch how inflation pans out before taking a call on rates. The counter-view is that if high interest rates have not helped in reducing inflation, why not just start lowering interest rates. The question is, if high interest rates have not brought down inflation, will lower interest rates necessarily kick-start the economy?
The view here is that inflation has eroded purchasing power, which has affected demand for industrial products. In particular, consumer goods demand has been lacklustre and this has had negative backward linkages with other sectors. With capacity utilisation (based on RBI data) being 75% on an average, there is no need to invest more when demand is slack. Thus, investment can come only from infrastructure, where uncertainty has held back activity because, notwithstanding clearances and easing of administrative processes, there has been little traction here. If this is the case, then lowering interest rates will just not work in the desired manner.
To check how far this theory is true, we can look at the past decade and examine how these variables have moved. There have been five interest rate regimes in the last decade. The first was a long period between FY04 and FY08, when the repo rate was increased continuously by RBI. The next phase of two years, which coincided with the post-financial crisis regime, was when interest rates were lowered sharply. The third phase comprises FY11 and FY12, when rates were increased, while the next two phases were of single years each, when RBI lowered rates in FY13 and then increased in FY14.
The accompanying table juxtaposes interest rate movements with other growth rates such as GDP growth, capital formation rate, industrial growth, growth in consumer durable goods and in capital goods, and growth in credit.
The table shows that the first phase was a boom time when GDP growth was up with industrial growth also being in the double-digits. Hence, even though interest rates were increased, investment, as depicted by capital formation and growth in capital goods, rose at a high rate. Growth in credit averaged over 26% for this period, questioning the link between interest rates and credit growth. Importantly, consumer spending was high, which kept the machines rolling, and CPI inflation (industrial workers) averaged 5% per annum.
In the second phase, which coincides with the post-Lehman crisis years, when the government went for the stimulus programme, the picture was distorted as consumption was high due to the stimulus with fiscal spending adding a new dimension. However, low interest rates did not spur investment, and capital formation came down as production of capital goods slowed down sharply from an average of 14% to a little over 6%. Growth in credit also slowed down as uncertainty led to lower demand for credit. There was a negative relation between growth in interest rates and growth, as industrial growth slowed down. During this period, inflation doubled to 10.8% per annum.
In the third phase, we went back on the stimulus and increased interest rates, yet, with steady growth in consumer demand, there was an uptick in capital formation, industrial and GDP growth. There was a pick up in credit growth too, which averaged a little over 19%. Once again, a negative relation was witnessed between direction of interest rates and capital formation and growth. Inflation was high and averaged 9.4%.
The next two years have been typified by low growth in consumer demand and, hence, notwithstanding either higher or lower interest rates, capital formation was down, as was growth. Growth in capital goods was negative during this period and growth in credit slowed down to 14% in both the years—the lowest in this period. Inflation continued to be high, at 10.4% and 9.7% per annum.
While the textbook says that lowering interest rates leads to higher growth in credit and in overall economic growth, it is a simplistic theory, based on ceteris paribus. One needs to look at overall economic conditions and assess whether there is demand. Typically, no entrepreneur will invest at a time when surplus capacity coexists with higher interest rates. However, when demand is buoyant, interest rates will not be a limiting factor.
The other big-ticket driver of the economy is infrastructure investment. Here the situation is tenuous, since the government has shown its commitment to fiscal austerity and is not willing to go beyond to provide support for such investments. The stated direction is the PPP route, but this would take time to work out as investors would not like to lock into a high interest rate and would prefer to wait for interest rates to come down.
So, the recovery process will be gradual and by merely lowering interest rates not much can be achieved. The quantum of lowering of rates and expectations of the same will matter more for any entrepreneur who is looking to invest in the infra space. The move by RBI to allow banks to raise preemption-free resources for infra purposes will help them charge a lower rate, but then the borrower has to be convinced and would generally wait for the economy to turnaround first.
A lesson learned is that post-crisis, a ‘V-shaped’ recovery is not sustainable and that a ‘U-shaped’ recovery is more likely which will be relatively stable. Pressurising RBI to lower rates under these circumstances may not work. In FY13, RBI lowered rates by 100 bps, but growth continued to be anaemic.
There is a clarion call for the reduction in interest rates. The decibel level has increased ever since the latest IIP growth and CPI numbers were released. Growth continues to be low and inflation is sort of under control. RBI has indicated it would wait and watch how inflation pans out before taking a call on rates. The counter-view is that if high interest rates have not helped in reducing inflation, why not just start lowering interest rates. The question is, if high interest rates have not brought down inflation, will lower interest rates necessarily kick-start the economy?
The view here is that inflation has eroded purchasing power, which has affected demand for industrial products. In particular, consumer goods demand has been lacklustre and this has had negative backward linkages with other sectors. With capacity utilisation (based on RBI data) being 75% on an average, there is no need to invest more when demand is slack. Thus, investment can come only from infrastructure, where uncertainty has held back activity because, notwithstanding clearances and easing of administrative processes, there has been little traction here. If this is the case, then lowering interest rates will just not work in the desired manner.
To check how far this theory is true, we can look at the past decade and examine how these variables have moved. There have been five interest rate regimes in the last decade. The first was a long period between FY04 and FY08, when the repo rate was increased continuously by RBI. The next phase of two years, which coincided with the post-financial crisis regime, was when interest rates were lowered sharply. The third phase comprises FY11 and FY12, when rates were increased, while the next two phases were of single years each, when RBI lowered rates in FY13 and then increased in FY14.
The accompanying table juxtaposes interest rate movements with other growth rates such as GDP growth, capital formation rate, industrial growth, growth in consumer durable goods and in capital goods, and growth in credit.
The table shows that the first phase was a boom time when GDP growth was up with industrial growth also being in the double-digits. Hence, even though interest rates were increased, investment, as depicted by capital formation and growth in capital goods, rose at a high rate. Growth in credit averaged over 26% for this period, questioning the link between interest rates and credit growth. Importantly, consumer spending was high, which kept the machines rolling, and CPI inflation (industrial workers) averaged 5% per annum.
In the second phase, which coincides with the post-Lehman crisis years, when the government went for the stimulus programme, the picture was distorted as consumption was high due to the stimulus with fiscal spending adding a new dimension. However, low interest rates did not spur investment, and capital formation came down as production of capital goods slowed down sharply from an average of 14% to a little over 6%. Growth in credit also slowed down as uncertainty led to lower demand for credit. There was a negative relation between growth in interest rates and growth, as industrial growth slowed down. During this period, inflation doubled to 10.8% per annum.
In the third phase, we went back on the stimulus and increased interest rates, yet, with steady growth in consumer demand, there was an uptick in capital formation, industrial and GDP growth. There was a pick up in credit growth too, which averaged a little over 19%. Once again, a negative relation was witnessed between direction of interest rates and capital formation and growth. Inflation was high and averaged 9.4%.
The next two years have been typified by low growth in consumer demand and, hence, notwithstanding either higher or lower interest rates, capital formation was down, as was growth. Growth in capital goods was negative during this period and growth in credit slowed down to 14% in both the years—the lowest in this period. Inflation continued to be high, at 10.4% and 9.7% per annum.
While the textbook says that lowering interest rates leads to higher growth in credit and in overall economic growth, it is a simplistic theory, based on ceteris paribus. One needs to look at overall economic conditions and assess whether there is demand. Typically, no entrepreneur will invest at a time when surplus capacity coexists with higher interest rates. However, when demand is buoyant, interest rates will not be a limiting factor.
The other big-ticket driver of the economy is infrastructure investment. Here the situation is tenuous, since the government has shown its commitment to fiscal austerity and is not willing to go beyond to provide support for such investments. The stated direction is the PPP route, but this would take time to work out as investors would not like to lock into a high interest rate and would prefer to wait for interest rates to come down.
So, the recovery process will be gradual and by merely lowering interest rates not much can be achieved. The quantum of lowering of rates and expectations of the same will matter more for any entrepreneur who is looking to invest in the infra space. The move by RBI to allow banks to raise preemption-free resources for infra purposes will help them charge a lower rate, but then the borrower has to be convinced and would generally wait for the economy to turnaround first.
A lesson learned is that post-crisis, a ‘V-shaped’ recovery is not sustainable and that a ‘U-shaped’ recovery is more likely which will be relatively stable. Pressurising RBI to lower rates under these circumstances may not work. In FY13, RBI lowered rates by 100 bps, but growth continued to be anaemic.
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