Lower Interest Rate

Lower interest rates can hurt -Hindustan Business Line-17.10.2014

BY Radhika Merwin

In a sluggish economy, they may fuel inflation, impact investor confidence and kill the appetite to borrow

The latest monetary policy has revived calls for the Reserve Bank of India (RBI) to cut its policy rates so that India’s investment cycle can be kick-started once again. Over the last few years, the banks and India Inc have clamoured for lower interest rates, claiming that this is the only way to revive economic growth.

 

Banks expect lower rates to stimulate credit demand. For India Inc, the underlying assumption is that lower rates make new projects more viable, inducing them to borrow more and up their capital spending.

 

But the truth is that lower interest rates don’t always trigger either higher credit offtake or new investments, conforming to textbook patterns. An analysis of interest rates, GDP growth and credit offtake over the last decade shows that lower rates can sometimes prove detrimental in a sluggish economic environment, fuelling inflation, hurting investor confidence and reducing the appetite to borrow.

 

Lending and rates

Just before the latest monetary policy announcement, banks were urging the RBI to reduce its policy repo rate, pointing out that credit growth for the banking system had slipped to a five-year low. Year-on-year credit growth for banks, which was in the double digits at 12-14 per cent until August, was down to 9.7 per cent in September, the lowest in five years.

But the presumption that low interest rates will automatically spur lending is too

simplistic. Consider the experience in the past. Through most of 2007 and 2008, RBI’s repo rates steadily rose from 7.75 to 9 per cent, much higher than present levels of 8 per cent. During this period, with the economy growing strongly, bank credit growth remained at a healthy 25-30 per cent year-on-year. Robust growth in GDP at 8.5-9 per cent fuelled strong credit demand.

 

When RBI actually began to lower its repo rates between Oct 2008 and Feb 2010, with the rates finally bottoming at 4.75-5 per cent levels, credit growth too, surprisingly, lost steam. Growth in bank lending came off peak levels, and fell to 16-17 per cent in this period.
 

Even in more recent times, when the RBI reduced its repo rate between April 2012 and May 2013, credit growth scarcely responded. Between the two periods, the RBI reduced the repo rate by 125 basis points. But credit growth in 2012-13 decelerated further to 14 per cent, from 17 per cent in 2011-12.

 

Credit clearly, could not revive as long as economic growth was so sluggish. Real GDP growth, which was at 6.7 per cent in 2011-12, had slipped below 5 per cent in 2012-13. This clearly shows that bank credit offtake, the appetite to borrow, is more a function of economic growth and business confidence than the actual cost of money. Over the last ten years, the credit growth has been 2.5 to 3 times the real GDP growth and this multiplier has held good in bad as well as good times.

 

Today, the economy is going through one of its most troubled periods in recent history, growing less than 5 per cent for two consecutive years-- 2012-13 and 2013- 14. It is no surprise therefore that bank credit too, after growing at 22 per cent annually since 2004-05, slipped substantially in 2012-13 and 2013-14 to 13-14 per cent.

 

Faltering growth

This proves that credit offtake for banks depends mainly on the revival in GDP growth. But what has impacted growth?

 

The growth in the domestic economy has been slowing mainly due to a slowdown in the investment cycle. The main issue has been the delay in regulatory and environmental clearances as well as judicial activism that has stalled raw material and energy availability and impacted companies’ cash flows.

 

In its review of the economy released in April 2013, the Economic Advisory Council noted that for every rupee of capital invested in assets, entrepreneurs have earned much lower returns in recent years. This has weakened corporate profitability and balance sheets, and eroded investment sentiment. Data on the Incremental Capital Output Ratio (ICOR) (which measures how incremental income compares to increments to capital stock) show that the values for ICOR remained very close to 4 for the last three decades. But in the last two years, this productivity of capital has declined sharply as the ICOR has shot up. The ICOR for 2011-12 to 2012- 13 ranged from 5.4 to 11.4.

 

With older investments yet to pay off, corporates have reduced new outlays in the last few years. The gross fixed investments by the private corporate sector, which averaged 11.9 per cent of GDP during 2005 to 2008, slipped to 8.5 per cent of GDP in 2012-13.

 

According to an IMF working paper titled “Disentangling India’s Investment Slowdown”, swings in real interest rates account for only one quarter of the explained investment slowdown in India. Heightened uncertainty and deteriorating business confidence have played a larger role in the recent investment slowdown. Even a look at the movements in the index of industrial production (IIP) growth and interest rates suggests that during the rate cuts between April 2012 and 2013, the growth in IIP failed to perk up even with a lag.

 

The way forward

This suggests that the only way to get the economy to move ahead is, not by slashing rates, but by ensuring that the capital locked up in older projects starts paying dividends. Indian corporates who lined up aggressive expansion plans post the financial crisis, have already burnt their fingers. Court intervention, policy uncertainty and lack of access to natural resources, energy and in some cases land, have stalled many large projects in core sectors. It is unlikely that these companies will rush to put up new capacities, just because lending rates are lowered by a few percentage points.

 

Banks too are in the same boat. As they grapple with a large pile of bad loans, they have turned wary of enhancing their exposures to the embattled sectors. Indian banks are now adopting a more stringent risk-management framework to ensure that doubtful borrowers do not slip under the radar. With Basel III deadlines up ahead, they would rather conserve capital than aggressively lend to risky projects.

 

Overall, the RBI may be quite right to doggedly stick to its battle to tame inflation. Slashing rates at this point in time may really not prompt either banks to lend more or corporates to go on a borrowing spree. If RBI does succeed in curbing inflation , this will at least prompt the Indian saver to look at investment avenues such as debt or equity, that don’t siphon money out of the productive economy (which physical assets such as gold or property do). India has seen negative real interest rates since 2008, dis-incentivising savings. We need positive real interest rates to induce savings and thus provide a fillip to investments.

 

Low inflation also holds the key to consumer confidence. If consumers loosen their purse strings that will improve the demand environment for certain sections of India Inc and prompt fresh investments. With inflation trending lower, real interest rates have now, after a very long time, stepped into the positive territory which augurs well for savings and investments.

 

The bitter pill of higher interest rates, in the short-term, will lead to a more sustainable growth recovery over the longer run.

Also read Why and how Uniform Rate Regime is better written by me

Uniform Rate of Interest for all banks will be better than lowering of rates


Government should urge RBI to cut interest rates: Ex-finance minister P Chidambaram-Economic Times -16.10.2014

NEW DELHI: Former finance minister P Chidambaram said the government should persuade the Reserve Bank of India to cut interest rates if it believed the price situation would continue to improve, attributing the slowdown in inflation to declining global commodity prices.

Chidambaram dismissed the contention that the drop in prices was on account of steps taken by the NDA government. "What measures were taken by the government that contributed to decline in inflation rates?" he said in a statement on Wednesday. Inflation in September based on the wholesale price index fell to a five-year low of 2.38% on the back of declining food prices, prompting the government to assert that India was heading toward a"low and stable" price regime.

Retail inflation slowed to 6.46%, the lowest since the government started releasing the new consumer price index (CPI) series in January 2012. "I too rejoice in decline in inflation, but we must ask ourselves what has caused this happy development," the former finance minister said. "The main reason is the decline in commodity prices worldwide, especially the price of crude. Another key reason is the government's willingness to stick to the fiscal deficit target of 4.1% for 2014-15, originally set in the interim budget (by the UPA)," Chidambaram said.

If the government believed "that the decline in the rates of inflation will prove to be a secular decline, it should persuade the RBI to cut the policy rates," he said. Chidambaram said he regretted that the government has not moved forward on the Food Security Act, which might have saved the exchequer.`60,000 crore. Similarly, he added the government was holding back funds toward the rural jobs programme. "These unwelcome developments may have affected the demand," he said.

Referring to the government's initiatives to unload wheat and rice stocks in the open market, nudging states to amend the Agricultural Produce Market Committee (APMC) Act, asking them to take action against hoarders and imposing a minimum export price, he said these were a continuation of the UPA government's measures.
http://articles.economictimes.indiatimes.com/2014-10-16/news/55107399_1_upa-government-p-chidambaram-minimum-export-price

Read my views expressed in the year 2009

Banks are dealing with money deposited by public. Banks are custodian of public deposit. They have got no moral right to lend only to achieve the target set by the management. Government cannot justify its action in courts when it promotes waiver of loans or compromise with recalcitrant and willful defaulters. Non performing assets in all banks have been rising year after year and banks cannot guarantee the correctness of their published balance sheets. Banks cannot justify lending without earning profit or offer whimsical discounts endangering the overall health and overall future of banks. At the same time banks cannot charge discriminatory rate of interest for different home loan borrowers, say old and new.

 

If all government funds are taken out from banks or at least become eligible for payment of interest by banks, I think most of the banks will face unimaginable loss or at least erosion in their profit. Even in such pathetic condition and poor health of banks, some of CMDs of banks are advocating for lowering of interest rate just to please a few ministers and shying away from accepting uniform interest rate.

 

Lowering of interest rate by weak banks just to meet the challenge posed by strong banks will tell upon the health of such weak banks and ultimately jeopardize the deposits made by common men. After all who has given banks right to play with public deposits as per whims and fancies of ministers and Government of India. If private banks instigate rate war it is imaginable, but the painful truth is that it is PSBs which are lowering rates without taking care of cost of fund and possibility of erosion in their profitability. In olden days private merchants were accused of labour exploitation. In the modern era banks are earning profit by reducing manpower and exploiting existing manpower. Anyway, if even weak bank collapses due to wrongful policies prevailing in the market or promoted by government, it is none other than depositors who will suffer the most.

 

As such it is the interest of banking community as a whole that interest rate is made uniform and the focus of bankers is made to concentrate on more and more lending. It is to be kept in mind that a person who is ready to avail loan of Rs.20.00 lac or more is least bothered of one or two percent higher interest charged to him.

My write up of the year 2009 on Uniform Interest Rate

My Views expressed on uniform interest regime in year 2012


http://importantbankingnews.blogspot.in/2013/02/why-not-rbi-is-introducing-uniform.html