With the elections resulting in a successful return of the NDA government, the focus of attention is now on what will be the stance taken by the MPC? Against the background of not showing a convincing uptick and out of force of habit, there are already calls for reduction of interest rates, with the decibel level being higher for 100-200bps cut. It is, hence, necessary to analyse the pros and cons of reductions in interest rates.
Interest rates have been looked at normally from the corporate lens, and hence the view is these should be lowered to spur investment. Is there a real relationship between the two? Also, as interest rates have a bearing on savings, should this perspective also be looked at? Last, as there tends to be regular comparisons of real interest rates in India with those in the developed world, is there a basis for doing so?
The best indicator of investment is the gross fixed capital formation (GFCF) rate, which is expressed as a percentage of GDP at current prices. The GFCF rate has been declining since 2012-13, from 34.3% to 28.9% in 2018-19. A decline of 5.4 percentage points is significant. During this period, the return on advances for all banks based on RBI data declined from 10.42% in 2011-12 to 8.31% in 2017-18 (the latest year for which data is available)—a decline of 211 points. Therefore, to argue that lowering rates is the panacea for investment can be contested by data.
The disconnection between the two can be explained. First due to over-investment in the pre-2011-12 era following the financial crisis, the stimulus provided on fiscal and monetary sides gave investment a boost. But much of this went into infrastructure, which was afflicted with irregularities in sectors such as coal, iron ore, power, telecom, among others. This led to projects getting stalled, which later got translated into NPAs after some umbrella cover was provided through the CDR route. This led to projects still being in the stalled mode or abandoned. Therefore, private sector interest in investment is limited irrespective of the interest rate regime.
The second reason for low investment is surplus capacity in most industries. Typically, a utilisation rate of around 78-80% is required to push investment. With the rate being stagnant in the 70-73% range on an average, there is limited push here. The latest RBI data shows this has crossed 75%, which is not consistent with the declining IIP rate. Unless this number improves, only then will fresh investment take place.
Now, the way out is really on the demand side for capacity utilisation and on structural issues relating to NPAs and regulation to reignite interest in infrastructure. Under these circumstances, there have been some collateral effects on savings, which have declined during this period.
The ratio of household savings came down from 23.64% in 2011-12 to 17.2% in 2017-18—a fall of 6.4 percentage points. This is significant because bank deposits are today around Rs 125 lakh crore, and another Rs 12 lakh crore are in debt mutual funds. Lowering of rates affects income received, which, in turn, affects spending power and consumption. The average cost of deposits of banks has come down from 6.28% in 2011-12 to 5.02% in 2017-18—a decline of 126bps. Thus, hasty decisions on interest rates can have a negative impact on savings. Curiously, the decline in average return on advances of 211bps was higher than that in cost of deposits of 126bps, but savings rate of households fell at a higher rate!
An interesting takeaway from the accompanying table is the spread between return on advances and cost of deposits has come down from a high of 414bps in 2011-12 to around 330bps in 2017-18, and the benefits have been more to the borrowers than the deposit-holding public.
The other issue on real interest rates does raise a fundamental question. Can we really compare the real interest rate in India with that in a western economy? The interest rate is the cost of capital and should reflect the same. This is what theory says. The cost of capital is the result of demand and supply for funds, and if supply is less as revealed by the higher CAD ex post, then it means the economy is capital-scarce. In such a situation, the interest rate level has to be higher than that in other developed economies. Lowering the interest rate to a level that is not supported by the market can lead to distortions. The table also provides the real interest rates in various countries based on the policy rate adjusted for CPI inflation. As can be seen, the higher ranges of real interest rates are in some of the faster growing economies where there is greater demand for funds. While it can be argued that 3% real interest rate should be 2% or 1.5%, it must be realised that the real rate is looking higher due to low inflation, which is due to supply factors rather than demand. In 2013-14 and 2014-15, CPI inflation was 9.3% and 5.8%, respectively, in which case the real repo rate would have been negative.
The argument on comparing the real repo rate with those in other countries should not be considered in isolation. The low inflation rate that is being witnessed today is due to unusually low farm and fuel prices. The average CPI inflation for industrial workers up to 2017-18 was 8% per annum in the last 10 years, with seven years of above-6% mark. So, rather than looking at current inflation rate for reckoning real rate, an average may be advisable as these rates tend to be quite volatile—at times due to single commodity price effects.
The discussion points to a few conclusions. One, interest rate should be considered looking at both investment and savings, and has to be balanced as it can lead to distortions on the consumption side. Second, lower interest rates are just one factor going into investment decisions, and are not a guarantee for positive response. Third, the global real interest rate comparison misses the point that nations are different, as are their credit markets. Last, even the concept of real rates runs into problems when inflation increases, as the same train of thought can justify significantly higher repo rates when prices of, say, potatoes or onions increases, which can be adverse for future growth.
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