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.)
 
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    COMMENTS

    DrRajesh Bheda

    1 week ago

    We really don't know what we want. We want consumption to go up and simultaneously want higher savings. How can both be achieved.? When we are capital starved how much can the rates be lowered without savings going down further.

    RAMESH GOBINDRAM MEHTA

    1 week ago

    It would have been great IF the author has clarified "how lowering interest rate would lead to higher inflation". The author seems to be certain of that but has not provided any logic/reason to the readers of the same.

    Ramesh Poapt

    1 week ago

    more soever,when stimulus has not desired result, it will be catch 21
    situation. India and the world had such situations. rather than reducing
    rates, other policy measures may have better outcome. inflation, like
    GDP and deficit is under/over projected. CAG reports that 7 lac crores
    of deficit is hidden. slowdown may be temporary. growth will pick up
    in due course without much stimulus. but when inflation will pick up
    and growth will not then? side benefit for banks to show treasury income
    /profit to write off NPA burden to some extent. real interest rate
    differential required to protect seniors. Govt has so far rightly not reduced
    rates for that aggressively. corp orates will ALWAYS cry for more wrongly.
    they will add fat or will be defaulters easily. this has happended, happening
    and will happen always.

    Nayeem ahmed

    1 week ago

    Very informative article . Thanks

    Kochar Bipin

    1 week ago

    Given the lack of pensions, most retired people depend on interest income. RBI must hence ensure that the real riskfree interest rate (rate paid on popular government savings schemes like EPF, PPF, NSC etc less inflation) is between 1-1.5% -

    REPLY

    Subramani Suresh Kumar

    In Reply to Kochar Bipin 1 week ago

    To address the cyclical slowdown RBI is on a rate cut spree. As RBI states that output gap is wide (it is both in India & abroad) then rate cut will not help propel invst demand. Bank Credit data is also pointing to an inevitable slowdown post a stupendous rise to non-industry sectors in last 3 yrs. Further, due to low income effect in the previous growth phase, rate cuts is unlikely to propell leveraged consumption. So then who benefits from interest rate cuts?
    Banks are the immediate beneficiaries as it increases their wealth - Treasury income + higher loan spreads.
    Will Banks pass on the wealth effect? Unlikely in current environment of regulatory oversight over PSU employees and new source of NPAs.
    Have Banks done it in the past....yes aggresive lending which ends up in NPAs by end of the cycle. If Banks are not expected to exhibit aggresive lending behaviour this time around then not sure on who benefits from the current monetary easing? Hence agree with your view that RBI should preserve its fire power for more rainy days.

    India's July retail inflation inches-lower to 3.15%
    India's retail inflation inched lower to 3.15 per cent in July from 3.18 per cent in June and 4.17 per cent in the corresponding month of the previous year.
     
    According to data furnished by the National Statistical Office (NSO), the Consumer Food Price Index (CFPI) inflated to 2.36 per cent during the month under review from an expansion of 2.25 per cent in June 2019 and 1.30 in July 2018.
     
    However, among the non-food categories, the fuel and light segment's inflation declined on a year-on-year (YoY) basis to (-) 0.36 per cent in July.
     
    Product-wise, prices of vegetables, eggs, meat and fish pushed the retail inflation higher on a YoY basis. In contrast, decline in prices of 'sugar and confectionery' capped the overall food inflation.
     
    Accordingly, the prices of vegetables increased 2.82 per cent, meat and fish by 9.05 per cent, eggs by 0.57 per cent and pulses and its products by 6.82 per cent.
     
    On the other hand, prices of milk-based products rose 0.98 per cent, cereals and its products 1.31 per cent and sugar and confectionery (-) 2.11 per cent.
     
    The sub-category of food and beverages recorded a 2.33 per cent rise in last month over July 2018.
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
  • User

    Inching Closer to a Global Recession: Morgan Stanley
    Economies globally are showing signs of acute weakness and the next stage could be a worldwide recession, if Morgan Stanley is to be believed, in nine months from now.
     
    Escalation in trade tension between the two largest economies—US and China—is the chief factor nudging the world economy towards a recession.
     
    Warning signals are also coming via other reliable indicators of recession: the bond yield curve. The yield curve has typically inverted before recession and it is now nearly similar to what was seen ahead of the 2008 financial crisis.
     
    Morgan Stanley believes if the trade war further soars via US again raising tariffs on all goods imported from China to 25%, "we would see the global economy entering recession in three quarters."
     
    India, however, is not close to a recession, but is witnessing a crippling slowdown. Some sectors like the automobile industry are dangerously close to recession. 
     
    India's economy has declined for three straight quarters and the growth forecast is also not encouraging. Both industrial production and core infrastructure sectors have witnessed a decline. 
     
    A far greater threat of recession hangs over UK's economy and other European economies. Political uncertainty owing to Brexit led its second quarter GDP to contract, raising fears of an imminent recession.
     
    Besides, the soaring trade tension, several indicators of global economic health have turned negative since the Federal Reserve said that the rate cut was merely a 'mid-cycle adjustment' and not necessarily the beginning of a rate cut cycle.

    Global central banks have sprung into action amid a global slowdown. India cut the benchmark policy rates by an conventional 35 basis points, New Zealand's cut it by 50 and Thailand also by a surprising 25.
     
    Although, the threat of a recession in India is not imminent, the government and the policy makers cannot ignore the possiblity of it and not begin to strengthen the fences.
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
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    COMMENTS

    Ramesh Poapt

    2 weeks ago

    Indian may gather growth momentum next year..

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