Relying too much on interest rate cuts: Buisness LIne 31st July 2015

Monetary policy is no magic wand that will deliver growth. Our demand-constrained economy needs a fiscal stimulus

Today, world over economic policy is geared towards resuscitating economies through monetary policy. All central banks have been entrusted with the task of lowering interest rates and adopting unconventional policies like quantitative easing to revive growth.

Yet the progress has been uncertain and most of them are still struggling to come to grips with the meltdown that took place after the Lehman crisis.

In India discussions invariably come back to the RBI. There is a demand to keep lowering interest rates. Just how important is monetary policy? More importantly, can it be a singular tool for bringing about growth under ceteris paribus conditions?

If we go back a few years and trace the actions of the Fed and ECB, the picture we get is a case of the famous ‘liquidity trap’ which the economist John Maynard Keynes had spoken of. He had argued that this is a situation where the demand for money becomes flat; in other words, when interest rates are lowered to close to zero demand remains flat.

Easing all the way

Central banks have reacted with a higher flow of liquidity in the form of quantitative easing programmes. Since banks were less willing to lend to one another as they were not sure of their credit worthiness, the only way to break the impasse was for the central bank to buy back paper (government paper or asset backed paper) to provide liquidity.

The QE programme of the Fed has injected almost $ 3.5 trillion over a period of 5 plus years while the ECB will be injecting almost € 1.1 trillion by September 2016.

However, this has not quite restored equilibrium. US is just about trying to get back on its feet while the euro area is still in a state of flux with the Greece crisis casting a shadow on the future of a single currency.

In fact, a large part of these funds have moved over to the debt and stock markets emerging economies through ‘carry trade’. The unintended consequence was volatility in the exchange rates as a response to any purported move by the Federal Reserve.

Even today we keep tracking the Fed intention to alter interest rates as it affects flow of funds which actually were never meant for the emerging markets!

Let us look our own situation. The economy is displaying some signs of growth. However, investment is still lacklustre with the gross fixed capital formation rate declining in the last 3 years.

The RBI has been constantly told to lower rates and when it was done in 2012-13, it did not work. In 2015, rates have been lowered by 75 bps so far, and we are still waiting to see the impact.

The demand question

The first thought here is that while theoretically lower rates affect investment, it is not a sufficient condition. We need to have demand for physical goods.

RBI data shows that the average capacity utilisation rate is in the region of 70-72 per cent. Consumer goods growth has been negative in the last two years and barely positive in the preceding two years. Investment is unlikely to be considered by companies under such circumstances.

Further, potential investors will wait for rates to come down before going in for infra projects as no one wants to get stuck with a higher rate (even though the 5 by 25 scheme will offer a change once the first term comes to an end).

Second, when the RBI lowers the interest rate, banks do not respond with alacrity. Assuming that 1 per cent of net demand and time liabilities flows through repos (overnight and term), even if ₹80,000 crore is borrowed on an annual basis, a change in interest rates by 100 bps affects the cost by ₹800 crore in an interest expense of above ₹600,000 crore which is less than 0.1 per cent of the total.

Therefore the RBI change of rate is more of guidance which banks follow and may not be linked to cost of funds as such, with interest on deposits constituting around 90 per cent of the overall cost.

Further, banks need to look at their asset-liability match before taking a call on rates, which makes transmission tardy and could take six months.

Third, with a bi-monthly review, there is always an expectation of what the RBI will do, which gets factored in the market. Hence when the policy action actually takes place, the impact may be more muted.

It does matter

Curiously, whenever the RBI lowers the SLR, it still does not matter much except at the margin where banks which are on the periphery gain some liquidity. The system otherwise holds on to excess SLR paper to the extent of 5-6 per cent of NDTL. So, does monetary policy matter?

The answer is that it does, but cannot on its own work its way through, as the tools that are available cannot spur demand, or rather, generate demand. Nobody borrows money unless there is growing demand.

For this to happen we require a Keynesian solution of spending which can be done only by the government, as it is the only entity that can borrow at a low cost. One may remember that post Lehman crisis the government had gone in for a fiscal stimulus which worked well with a monetary stimulus. This can be a faster way to growth — though this route has provoked the charge of causing inflation.

In economics we do tend to view things with a narrow periscope given our ideological leanings towards Keynesianism or Monetarism or Rational Expectations. Often a combo approach is probably more suitable where monetary policy keeps an eye on inflation while a Keynesian push creates demand in case we have to expedite the pace of recovery. With fiscal discipline being adhered to in a rigid manner, relying only on interest rate to spur growth would take a longer time to work its way through.

This has also been witnessed in the West where there are concerns over fiscal ratios in US, UK, Japan, and some of the euro countries.

We may have to think differently from relying solely on the repo rate or a signalling ratio rate (SLR or CLR) to change things around.