The RBI has been managing interest rates at levels lower than warranted all through this cycle (since recovery began in 2009). This can’t go on, says Morgan Stanley
A rise in real rates in India will be inevitable considering the outlook for US real rates and the US dollar. The key to risk asset performance will be the government’s policy reforms to reverse distortions in the price of land, labour, and capital, improving the productivity dynamic and helping GDP growth to accelerate by supporting a rise in the ratio of investment to GDP. This will be critical to bring back the virtuous circle wherein real GDP growth is much higher than real interest rates. This is the observation of Morgan Stanley analysts in their research note on rising interest rates and its effect on GDP growth.
Morgan Stanley argues that the RBI has been managing interest rates at levels lower than warranted all through this cycle (since recovery began in 2009). A central bank’s dharma is to provide the appropriate counterbalancing force in the overall economy to achieve optimal growth and inflation outcomes for maximization of economic welfare.
On the recent decision of the RBI to increase interest rates, Morgan Stanley feels that it is the correct thing for the economy. Though private investment did not respond to low real rates, the RBI's accommodative monetary policy gave the government continued support to run a high fiscal deficit – one of the key factors behind high inflation. While high government deficits meant a decline in public saving, negative real rates for savers caused a further decline in household saving. As savings declined faster than investment, the current account deficit kept widening. In the context of the government's inability to quickly augment public saving by aggressive pro-cyclical fiscal tightening, hiking real rates was the only credible way to demonstrate a commitment to reduce the saving-investment gap.
The Morgan Stanley research note in its conclusion says that even as we expect saving to rise and investment to slow over the next 12 months, the current account will still be in deficit (i.e., India will still be short of saving). Hence, trends in US real rates/the US Dollar will remain the key driver of domestic real rates. “We thus believe the key will be to lift real GDP growth with policy reforms and change in expectation of the returns on investment for entrepreneurs by systematically addressing the issues related to the business environment,” says Morgan Stanley.
On the other issue of inflation, the government must take policy decisions to improve on all the factors driving inflation upwards, which include: (a) aggressive government spending (largely revenue in nature); (b) a large, sustained increase in rural wages (largely reflecting the externality of the national rural employment scheme) and (c) higher global commodity prices, particularly oil, at a time when India's mining sector output was constrained (d) negative real rates for savers.
Credit Suisse analysts continue to remain cautious on the corporate lenders as both asset quality and growth will come under pressure, they say in their research note. Also, continued growth in stress segments would mean that current asset quality issues are unlikely to dissipate quickly
Even as the GDP growth in moderated to 4.4% in 1Q, Indian banks’ loan growth continues to be relatively high at 17%, according to Credit Suisse in its research note. The credit multiplier (to real GDP) for the economy therefore is now running at 4x compared to its last 10-year average of 2.9x. Factoring in the WPI moderation, the macro slowdown is even more stark with growth down 8 pp from last year’s levels. The contrast has been especially striking in the past six months, as the incremental loan growth as a % of GDP growth has moved up to about 100% (versus the past 5-yr average of about 61%).
The recent pick-up in loan growth to 17% in August from 15% in July, can be partly attributed to the tightening in money markets and corporates’ shift away from instruments such as CPs (commercial paper). However, even adjusted for the CP issuances, loan growth is relatively high at 15%. Another potential explanation, argues Credit Suisse, could be the substitution of foreign currency borrowings with rupee debt by corporates, given the sharp depreciation in the currency. However, ECB (external commercial borrowings) borrowings data does not corroborate this and even in the month of July, ECB issuance was relatively high at $3.7 billion.
The divergence in credit growth versus GDP growth is shown in the following chart:
According to Credit Suisse, in addition to the relatively high growth rates, a growing problem is that a large share of incremental growth continues to emanate from high stress segments. Most banks have increased their focus on the consumer segment and growth here has picked up from 14.5% to 17% year-on-year. However, for the overall banking system, the retail contribution is still relatively low at about 30% of incremental loans. On a YTD basis, the infra segment has contributed about 45% of incremental loan growth. There has been an increase in instances of re-financing for over-leveraged companies.
Continued growth in stress segments would mean that current asset quality issues are unlikely to dissipate quickly. Credit Suisse analysts therefore, continue to remain cautious on the corporate lenders as it is expected that both asset quality and growth will come under pressure.
The following chart clearly shows the growth observed in stress segments: