We should blame weak demand rather than higher interest costs for a
likely reduction in economic growth this fiscal year
With the Reserve Bank of India (RBI) having increased the repo rate,
considerable concern has been expressed over its impact on growth. Spread
sheets are already being reworked to check how India’s growth in gross domestic
product (GDP) could be affected. Those against tighter credit conditions feel
that just when the Indian economy was showing signs of a pick-up, the Monetary
Policy Committee’s (MPC) decision to hike rates will affect its path. But that
is exactly the purpose of any rate hike.
Theoretically, when rates are increased by a central bank, both deposit and lending rates ought to increase, though the extent could vary. Lending rates increase with alacrity because all loans get repriced, while deposit rates rise by a lower quantum and with a lag, as old deposits will be repriced only at the time of renewal. Therefore, if monetary policy has to work, it must lead to higher rates at the first stage.
Policy rate insensitivity
Second is the impact on credit growth. Here too, when rates increase,
growth in credit slows down. That’s because the raison d’être of a
tighter-money policy is to slow down the economy by making capital more costly.
If policy cannot achieve this, then further hikes are needed, or else the
purpose is defeated. The US Fed is also hiking rates because of an urgent need
to slow down the American economy and contain high inflation; growth is steady
and joblessness is falling. India’s story is similar. Official data suggests
that GDP is doing very well, with India the world’s fastest growing major
economy. Also, contrary to data from the Centre for Monitoring Indian Economy,
which is at odds with official statistics, our unemployment rate has fallen.
Add to this new studies that show India’s poverty ratio is down, and in the
context of high inflation readings, there is reason to believe that the brakes
must be applied—which is what the MPC did on 4 May.
The important question to ask is whether this will help slow down the
economy or not. Also whether rate hike will help slow down growth in credit,
because this is the route taken by the policy transmission mechanism. The
accompanying table offers data on policy rate actions over the past decade or
so, along with growth in credit. There are evident leads and lags in all such
exercises that are hard to analyse because it’s always a challenge to separate
the effects of extraneous developments from those of monetary policy. But the
table does throw up some interesting results. In the decade ending 2009-10,
growth in bank credit had averaged 22.4% per annum, indicative of a boom.
Subsequently, there has been a distinct slowdown in credit growth, partly due
to India’s rather uneven overall growth performance. In the 15 years selected
here, there were three years when the repo rate was kept unchanged. There were
five cases of the repo rate being raised, and the last one after 2013-14 was in
2018-19. Seven fiscal years saw the rate lowered. The distribution is quite
even, with a tilt towards RBI’s so-called ‘accommodative stance’, which is
interpreted widely as a disposition not to raise rates. Therefore, from the
point of view of industry, there has been a proclivity towards lower credit
costs for business.
Interestingly, the five years of high repo rates did not really slow
growth in credit extended by the banking system. In 2007-08, this growth was
22.3%, which was the decade’s average. In 2011-12 and 2012-13, while growth was
higher in the former, a slowdown to 17% was still indicative of strong credit
expansion; indeed, this rate has never been exceeded since then, even though
the policy stance has been accommodative. In 2013-14, credit growth was
virtually unchanged at 13.9%, compared with 14.1% in 2012-13, while 2018-19 saw
growth improve.
The story for the years when RBI’s repo rate was lowered is a study in
contrast. In six of the seven years, there was a reduction in credit growth
when the rate was lowered. The exception was 2015-16. Rate status quo had
improvement in credit growth in two out of three years.
What does this record indicate?
The crux is demand. As long as it is buoyant and markets are expanding
at a rapid pace, a higher interest rate does not matter much for large business
players, though at the micro, small and mid-sized enterprise level, it does
hurt, even if it is still manageable. The reason is that a big company’s
interest cost as a proportion of turnover is typically just 3-5%, which is too
low to get in the way of investment decisions if robust demand is spotted. The
extra cost can either be absorbed or passed on in the final price of products.
However, when demand conditions are not upbeat, investments are deferred and a
higher working capital cost tends to pinch. This is especially so for smaller
companies with a heavier interest ratio burden.
So, how can one interpret the 40 basis points repo rate hike of 4 May,
considering that it was almost a fait accompli, with an increase expected of at
least another 50 basis points? It will all depend on the demand story.
Consumption will continue to be under pressure, as there have been no firm
steps taken to control the prices of fuel and edible oils, which have high
secondary rounds of impact on inflation. This will denude the consumption
baskets of most households. While private investment was looking like getting
back on track, it was always going to be contingent on a pick-up in demand and
capacity utilization.
Right now, things don’t look too exciting. Hence there is reason to
believe that growth in credit will slow down, even if it turns out numerically
higher than in 2021-22, mainly on account of certain infra-based sectors being
in expansion mode thanks to the government’s capital expenditure push. Yet, it
can be a touch-and-go situation. GDP growth will be lower this year than in
2021-22 for sure, but—while both factors work in the same direction—this will
be because of demand weakness rather than higher interest rates.
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