Lower interest rate encouraging investments may not always hold true Economic Times 7th November 2018

An independent study of RBI argues that over a longer time period, higher interest rates and fiscal deficit drive down investments, which is in consonance with the view held by successive governments. But is this really so? This question is important because the argument is more from the supply side where it makes sense theoretically. But if one examines say the last 7 years or so post 2011-12, the picture obtained is different. 

Let’s look at hard data. The average interest rate paid on outstanding debt, which is the metric for potential investors as this is the cost incurred by them, has come down continuously from 12.56% in 2012-13 to 10.39% in 2017-18, which is more than 200 bps. This means the policy has supported the lowering of rates in a gradual manner and the response of banks though sticky has been in the right direction. Yet, the investment rate defined as the gross-fixed capital formation rate has declined fr .. 

There are two parts of the story. The first is that investment has not been forthcoming from manufacturing as the capacity utilisation rate has been declining. RBI data show that the average rate was 77.8% in 2011-12 and came down to 72.3% in 2016-17 and improved to 73% in 2017-18. If this rise is sustained, there will be a good chance of investment picking up. The important thing is that until capacity utilisation (CU) rates improve in the region of 78-80%, fresh investment won’t be undertaken  .. 

Second, investment in infrastructureNSE -0.31 % is the other source of demand for funds. Here, given limited investment coming from the government which drives private investment, and stagnation in new opportunities, investment demand is restrained. CMIE data reveal that the quantum of investment dropped (shelved, stalled and abandoned) has been rising progressively in the last five years post 2011-12. To top it all, the NPA issue has added to the pressure on banks on the lending side as well as .. 

Therefore, the argument linking interest rates to investment can be debated. How about fiscal deficit? The theoretical reasoning is that when the deficit is high, borrowings tend to increase which, in turn, crowds out private investment. This sounds good. But does this really happen in India? The metric to use here is the net borrowings of the government, which has shown a downward tendency. The net borrowings of the government came down from Rs 4.67 lakh crore in 2012-13 (being higher than Rs 4 .. 

Curiously, the mandated SLR is 19.5%, but on an average basis, banks hold excess SLR of almost 7-8%. Holding these securities has been attractive for banks (besides the advantage of using a part for LCR requirement), as it helps them stave off NPAs – the PCA banks will be attracted to this option. The difference between return on advances and investment could be around 150 bps besides the MTM losses that have to be reckoned in a rising interest rate scenario which would be acceptable as there is .. 

For investment to revive, we need to look at both the demand and supply sides of the picture. Interest rate is one factor, which curiously did not hinder investment during 2009-12, when they had peaked along with investment!