By Krishna Koundinya

Edited by Anjini Chandra, Senior Editor, The Indian Economist

Since UPA II, the government has been at loggerheads with the apex bank on the issue of interest rates. The monetary policy, being the prerogative of the Reserve Bank of India, is free to pursue its own course to meet its goals, as a part of the Inflation Targeting Program. The Finance Ministry, previously under P. Chidambaram and now under Arun Jaitley, has been pushing the RBI for a rate cut.

The central argument for a rate cut is as follows; when the RBI cuts interest rates, the commercial banks of the country are given some latitude in maintaining statutory monetary reserves, thus lightening their interest burden with the RBI. In other words, the banks are left with more cash. This benefit is transmitted to the industry and households, who get loans at a cheaper rate. Cheaper loans translate to increased investment from the private sector, as well as more demand for goods and services by households, as now, the idea of savings is not attractive, which further encourages spending. In this way, the economic cycle of investment, production, consumption and investment perpetuates, which brings about growth and prosperity.

This is a very simplistic and idealistic description of the economic system. It works smoothly only in the well integrated economies of the OECD countries. However, when it comes to India, the situation is very different. There are structural and systemic issues, which affect conventional wisdom.

Generally, the economic growth rate can be impacted adversely by interest rates only in the short term, however, in the long term there are no clear relations between the lending rate and the growth rate of the economy. In the long term, growth is significantly impacted by numerous variables like the productivity of the industry, the technology used, the innovation by the industry, the taxation system, the efficiency of infrastructure and the framework of policies and procedures.

The Growth Rate can be adversely affected, even if the lending rate is affordable, due to factors like-

  1. a) Global Economic uncertainties and their impact on the Indian Economy.
  2. b) Risk aversion by Indian banks, reflecting in difficult lending, mainly due to uncertainty – Non-Performing assets (NPAs) etc.
  3. c) Infrastructure and policy bottlenecks

As per a disclosure by former RBI Governor D.Subbarao, the interest rate is only 10% of the cost of production for the Indian Industry. Hence a 1% decrease in the interest rate should increase production by 0.1%. In the 2010-11 & 2011-12 financial year, the interest rates rose by 2%, but the growth rate decreased by 5.3%. This clearly shows that there isn’t a direct relation between the growth rate and lending rate. Moreover, the impact of a tighter monetary policy on the change in growth rate is higher than compared to other factors, thus giving strength to the RBI’s stance of containing inflation by stricter lending rates.

India Inc. has been liberally borrowing at low interest rates through the External Commercial Borrowings (ECB) route. ECB (including NRI deposits) are the biggest borrowings from abroad. The investment requirement is being met cheaply (when compared to Indian rates). The current borrowings of India Inc. stands at $3.7 billion. This also lends strength to the argument of, the interest rate structure not being very important at this moment.

In the short term, high interest rates may slow down growth because slower investments and high interest rates raise the inflation expectation. This then leads to a decline in demand, slowing down the growth percentage. Inflation expectation measured by the RBI comprises of parameters like household expectation, consumption etc. We also have to note that the underlying assumption that a slow interest rate translates to investment is not always true, especially for households who will shift from financial savings (like Fixed Deposits FD, National Savings Certificate NSC etc) to physical assets.

The relation between interest rates and the growth rate is also affected by the behavioural changes of people. People change patterns, from savings to consumption, regardless of interest rates, once they get used to them (i.e. the effect is only short term). As savings go down, the available investment goes down, thereby slowing down the economy.

The reasons behind why the transmission of a Monetary Policy is not efficient in India, are as follows.

Administered Rates:

India has administered rates, even now, in the priority sector. This decouples the monetary policy and the growth percentage. Also, outside the priority sector, there are a series of concessions provided. Eg: SCs get 1-2% less than market rates, interest subvention schemes by the government etc.

Administered Prices:

These are for commodities like fertilisers, seeds, kerosene and public distribution system food grains. These prices are not impacted by varying interest rates.

Fragmented Markets:

States are free to pursue their own taxation regimes (within certain limits). This leads to a difference in taxation and different interest rates (on savings) in different states, which creates a fragmented market. In this, the effect of the interest rate cut by the RBI is not uniform and sometimes difficult to predict.

Non Institutional Lending:

A major part of the total lending that goes on in the economy, (which as per the RBI website is 42.9%) is by non-institutional lending. This is especially true in rural areas. Added to that, Non-Banking Finance Corporations (NBFCs) and Micro Finance Institutions (MFIs) also lend, but are outside the scope of the RBI dictated interest rates. Hence, the rate cuts do not affect much of households and the rural industry. This is a typical Indian phenomenon.

To conclude, given the specific context of Indian economy and the numerous variables that affect the growth rate, it is not proper to single out the lending rate as the most important variable affecting growth.

On the contrary it is not a major factor at all.

The RBI is right in sticking to inflation targeting and it is prudent to let the RBI have autonomy in deciding the interest rate structure, especially in the context of FLSRC. While the government, and not the RBI, should be tackling the root causes of problems, which lie elsewhere.

He is an entrepreneur, Co-Founder of an e-Commerce start up. He holds MBA from IMT–Ghaziabad, B Tech gold medallist, state level boxer, cricketer, amateur musician & graphologist (AP Judiciary). He worked with Deloitte, Infosys, Vizag Steel specializing in IT, Finance. He assisted CFO, GMs in financial valuations and planning. He co-founded a robotics platform for R&D and successfully implemented home automation projects, car tracking and vibration test rigs using smart phone, https://www.facebook.com/krishna.koundinya.7, krishnakoundinyam.1988@gmail.com.

Posted by The Indian Economist | For the Curious Mind