1. Raghuram Rajan’s dilemma: Why a rate cut is a necessity now

Raghuram Rajan’s dilemma: Why a rate cut is a necessity now

Prolonged regimes of high interest rates can adversely impact the health of small businesses and can have a significant bearing on growth

Updated: December 1, 2014 4:30 AM

Consider this. I am the owner of XYZ Ltd, a small-scale enterprise India. I and my peers (SMEs and MSMEs) together contribute nearly 17% to GDP, 45% to manufacturing output, 60% to manufactured exports, and employ nearly 40% of India’s workforce. Unlike the big corporates in the country, we are highly leveraged. As a result, we feel the pinch of higher interest rates all the more. Interest payments have made up nearly 70-100% of our earnings before interest and taxes (EBIT) in the last two years. Given the elevated levels of interest rates and inflation falling to low levels, we would appreciate a rate cut to save our margins and survive.

Higher interest rates have adversely affected the corporate sector’s performance, and CMIE data on non-financial corporates brings out the same. Interest coverage ratio of non-financial firms has been on a decline since the Lehman crisis. Interest coverage ratio (calculated by dividing a company’s EBIT by the company’s interest expenses for the same period) is a measure used to determine how easily a company can pay interest on outstanding debt. A ratio of 1.5 indicates that for every R1 of interest, the company makes R1.5 profit. The lower the ratio, the more the company is burdened by interest payments. Despite average gearing ratio of private corporate non-financial companies falling to 0.95 in the post-Lehman period (FY10-FY14) from 1.01 in pre-Lehman (FY04-FY08), the average interest coverage ratio fell to 2.7 from 4.2 in the corresponding periods.


The impact of higher interest rate burden is felt all the more by SMEs, given the fact that they are highly leveraged. The average gearing ratio for SMEs and MSMEs (considering the bottom 4 decile classes in the CMIE data as SMEs and MSMEs) was nearly 6.3 times that of large corporates (considering top 2 decile classes in the CMIE data as large corporates) in the post-Lehman period. Financial charges ratio to sales was nearly double at 7% for SMEs and MSMEs in post-Lehman as compared to large corporates. Clearly, SMEs feel the heat of interest rates all the more. Interest coverage ratio for SMEs and MSMEs worsened from (-)0.9 in the pre-Lehman period to (-)1.8 in the post-Lehman period.

This higher interest burden has impacted corporate profits, more so for small businesses. In an environment of high interest rates, high inflation and weak demand business took a hit. In the face of rising input and interest costs, businesses could not pass the increased costs to the consumers, thereby taking a hit on profits. However, in a situation of strong growth (as in the pre-Lehman period), increased costs could have been passed on to the consumers.

While we agree that a suitable policy environment is the biggest enabler for investment growth, one cannot ignore that higher interest costs have hurt corporates, especially small and medium enterprises in their day-to-day business and from undertaking fresh investments in the post-crisis period. Private corporate investment rate has come down sharply from 14.2% in FY08 to 8.5% in FY13.

Despite the corporate sector’s dismal performance, which is critical to a pick-up in India’s investment cycle, why is RBI hesitant to cut rates? The central bank’s long standing view is that inflation is a bigger evil and needs to be addressed before RBI can cut interest rates to spur growth. The central bank has time and again reiterated that the role of interest rates in overall investment activity is small and the relation between interest rates and investment is rather weak in the case of India. RBI’s view has been backed by IMF in a 2014 report stating that in case of India “only a quarter of the investment slowdown can be attributed to the increase in financing costs.” The IMF concludes that the “current Indian investment slowdown is primarily driven by weak business confidence and policy uncertainty.” However, in our view, a quarter is a substantial share.

While businesses usually focus on nominal rates of interest, real interest rates are automatically taken into account by businesses while evaluating an investment decision. During the estimation of future cash flows from an investment project, inflation expectations are taken into account. As a result, inflation is incorporated into the calculations. A look at real interest rates—nominal interest rates minus inflation rate—reveals that average real lending rates in the pre-Lehman period were nearly 300 bps higher than in the post-Lehman period. This is because lower real lending rates in the post-Lehman period were the result of higher inflation and not lower nominal interest rates. Yet investment growth was three times more in the pre-Lehman period than it was in the post-Lehman period. Higher interest rates were accompanied by higher growth, high demand and conducive business environment, where businesses had the option to pass on the increased costs.

The central bank has long maintained its anti-inflationary stance and has clarified that harmful impact of higher inflation can more than offset the beneficial impact of a rate cut. An RBI study clearly states that “the beneficial impact of lower real rates on growth that may be achieved through higher inflation tolerance is more than offset by the harmful effect of high inflation, particularly when it exceeds a threshold level of 6%.” Thus, higher inflation could act as a drag on investment. However, inflation has now been falling for three consecutive months and has already undershot RBI’s January 2016 target of 6% (also the threshold level, as stated in the RBI study) in October 2014. With this sharp fall in inflationary pressures, the corporate sector as well as the government have stepped up their demand for an interest rate cut. RBI, however, maintains that the decline in inflation may not be permanent (as commodity and oil prices may reverse) and supply-side bottlenecks and a fading base effect may reverse falling inflation trajectory.

Having said that, while RBI might not give in to the popular demand for a rate cut on December 2, it should not forget the fact that interest rates do matter significantly for SMEs and MSMEs, which are the engines of growth. Prolonged regimes of high interest rates can adversely impact the health of small businesses and can have a significant bearing on growth.

By Prachi Priya & Anuj Agarwal
The authors are corporate economists based in Mumbai

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