Why Any Further Lowering of Interest Will Stoke Inflation Rather Than Revive Investment
Interest is the price for capital. It is the price paid by borrowers and received by lenders of funds, and the market-determined interest rate should equate the demand and supply of funds in the economy, leading to an equilibrium. That is what theory says. Complications in real life, however, make it an unsolvable riddle.
Interest rate is one parameter in the economy that touches practically everyone. And, therefore, everyone has a view on what the appropriate level of interest rate is, depending on the nature and the extent of the impact.
Savers desire a higher rate, being recipients of interest, whereas investors or users of funds, such as the corporate sector and the government, are happier with a lower rate.
Savers, despite their large numbers and their vulnerable state (the elderly, the pensioners and the salaried), are not organised and their pleas for a higher rate are usually disregarded and ignored.
The business community is vociferous as is the government and their constant demand for a lower interest rate dominates. The truth, as always, is nuanced.
There are primarily three ways in which a lower interest rate helps the corporate sector. First, it reduces the expense on corporate borrowing. Interest expense constitutes approximately 5% of the total costs for the Indian corporate sector, with, of course, wide variations across companies and sectors.
Some highly indebted companies have a much higher component of interest expense and are likely to benefit immensely from lower interest rates.
Second, lower interest rate reduces the equated monthly instalments, or the EMIs, on housing and consumer finance. Consequently, housing and consumer durables companies experience a spurt in demand consequent to reduction in interest rate.
Finally, interest rates determine the cost of capital for the corporate sector and a lower interest rate enhances the value and the share price of companies. It also induces companies to undertake greater investments and, therefore, the overall investment in the economy increases. Hence, the corporate sector is always clamouring for a reduction in interest rates.
Interest rate is a critical tool in the hands of the Reserve Bank of India (RBI) to fight inflation. A high interest rate kills demand in the economy and helps reduce inflation. It is the stated objective of RBI to control inflation.
According to its mandate, RBI must aim for an inflation rate of 4%, with a possible deviation of 2% on either side. Frequent diatribes by corporate bigwigs against RBI’s efforts to rein in inflation should be taken with a pinch of salt.
Apart from inflation, there are many other factors that keep interest rates relatively high. One of the most important is fiscal deficit. In a low-income economy, with the government being responsible for the welfare of the poor, large fiscal deficit has always been a characteristic feature.
Last year, the fiscal deficit of the government of India was 3.4% of the national income. This was, however, what was stated in the Budget document. Many analysts feel that the actual percentage was much higher, with innovative ways, including accounting jugglery, hiding the real deficit.
The Comptroller & Auditor General of India (CAG) has determined the fiscal deficit at 5.85% which is substantially higher than stated. This is the deficit of only the Central government. The states put together also have a deficit in the range of 4%.
Combined, that is a huge deficit that leads to crowding out of private investment and ensures that the interest rates in the economy remain at a permanently elevated level.
Given these conditions, if RBI reduces interest rates beyond what it has done in recent times, we may be faced with higher inflation which is always damaging to the economy.
The interest of the poor and those with fixed incomes is particularly harmed by high inflation. Historically, India has been plagued by a high level of inflation which has built up expectations of even higher inflation in future.
People change their behaviour in line with such expectations, exerting even further pressure on prices. This vicious cycle needs to be broken and people need to be convinced that RBI and the government will ensure that inflation remains within the mandated level.
After the double-digit inflation after the 2012 fiscal boost, that is what RBI has been trying to ensure. A little laxity now would nullify efforts of the past six years and reverse the momentum built up.
It is pertinent to recall what the highly revered US Fed governor Paul Volcker had done in the late-1970s and early-1980s when he tightened the monetary policy and even the US government was forced to borrow at an unprecedented 20%.
The idea was to demonstrate the ability and the resolve of the authorities to kill the beast of inflation once and for all so that the economy can in future function without having to worry about the scourge of rising prices.
The credit for the booming decades of the 1980s and 1990s in the US must go to the efforts of Paul Volcker that did away with inflationary pressures. No economy has ever grown on a sustained basis with an elevated level of inflation.
RBI always considers the long-term factors to decide on the appropriate level of interest rates. Inflation in India is volatile and keeps changing due to factors beyond anybody’s control, such as oil prices and monsoons.
In India, supply-side constraints and cost-push factors have a much greater impact on prices than in the more developed economies. The average CPI (consumer price index) inflation for industrial workers for 10 years leading up to 2017-18 was 8% per annum.
While it has come down substantially since then, it remains to be seen whether the reduction is permanent or transitory. In any case, RBI has already reduced its repo rate by 110 basis points in 2019 which is significant.
The government of India pays a very high rate of around 8% for some of its popular schemes such as public provident fund and small savings schemes. Such a high rate on government-backed instrument distorts the whole structure of interest rates and virtually rules out low rates in India.
The ratio of household savings has come down from 23.64% in 2011-12 to 17.2% in 2017-18 which is a huge fall. Reviving savings rate is a prerequisite to get investment going. Else, the gap between savings and investment will be more inflationary than output-enhancing. An environment of rising public deficit and falling savings is incompatible with reduction in interest rates.
While interest rate is usually a significant factor in reviving investment, in India, currently, there are no viable projects and the corporate sector is not keen to take chances with further investment. The missing element in investments is the animal spirits and the solution lies more in the domain of the government than RBI.
I believe that while global interest rates are extremely low and the trend continues to be downward, India may not see a significant reduction in interest rates from the current levels.
It is not in our interest to have much lower rates which is likely to stoke inflation rather than encourage investments. The salvation of the Indian economy currently lies in the fiscal rather than monetary arena.
(Sunil Mahajan, a financial consultant and teacher, has over three decades experience in the corporate sector, consultancy and academics.)