An issue which generates controversy every now and then is whether or not interest rates should be lowered. It is almost axiomatic that just before a credit policy is announced, there is a clarion call for lowering of interest rates. Is this really justified? The decibel levels for lowering have increased ever since the decision to target CPI inflation number at 4% (with a 2% band). With inflation below 6%, it is logical to argue heuristically for the same. Inflation-targeting makes sense, but ideally the path for action should be defined, like if inflation moves from 5 to 4.5%, the repo rate will be lowered—so on and so forth. While this would make policy more objective, it would be predictable and remove discretionary power of the MPC. To this extent, the MPC can deliberate on the appropriateness of a rate-cut.
There are some questions here. First, does lending increase if repo rate is lowered, assuming that banks pass on part of this? Second, is interest rate the only, or even the most important, factor that determines borrowing levels? Third, is there a risk involved when rates are lowered and lending increases sharply, leading to the build-up of an adverse portfolio?
The accompanying grahic provides movement in both bank credit growth and the repo rate since 2000-01. The coefficient of correlation between the two variables is low, at -0.03. While the sign is negative, the number is too small to relate the two absolute variables. However, in terms of changes in the rate of growth in credit and changes in repo rate, the sign becomes positive 0.26 (meaning thereby that when repo rate is lowered, the change in rate of growth if credit also declines, which is not what is normally expected) but it is not significant. Hence, statistically the relation between the two is weak.
Data also shows that the highest growth in credit was recorded in the phase 2005-08 (29.1%) when interest rates increased by 175 bps. Similarly, the lowest growth came in the last three years of 2014-17 when growth in credit was 8.1% with repo rate coming down by 175 bps. Quite clearly, the relationship between the two variables is not very clear, and there is no assurance that by merely lowering rates, growth in credit will pick up.
This leads to the second factor of the importance of interest rates in fuelling bank credit growth. Access to funds is important for two reasons: investment and working capital. For the latter, there is always the possibility of accessing the CP market which is what was witnessed in the phase of declining interest rates where o/s CPs increased at an average of 56.3% (though it was also high in the phase of high interest rates between 2005-08, at 39.6%). Hence, in this case, the transmission of interest rate matters for firms which choose between the two modes of finance. However, when it comes to investment what is relevant is bank credit. Here it has been observed that demand factors play a role. With low capacity utilisation levels, there is less demand for credit from industry. Companies do not invest merely because interest rates have come down. Conversely, when demand conditions are robust, they would not be loath to invest even at higher interest rates.
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Further, the current frustration in banking, involving NPAs and stalled projects, has played a role in hindering demand for credit. There are two forces hindering business. Demand is low as there are few viable projects with several projects being in abeyance. Second, there is less enthusiasm from banks to lend, and where it is to take place, the risk factor is high—to the extent that even though the base rate or MCLR has come down, the cost of borrowing for such projects is still high. Putting these two demand-based factors together, lower rates do improve the profitability of indebted companies by lowering interest costs. However, for such rates to translate into higher investment, the demand-side factors have to pervade.
Third is the aspect of credit standards, which tend to be compromised during phases of high growth in credit. It may be recollected that during the phase of high economic growth, when GDP growth ~8.5% prior to 2011-12, bank credit growth was at an impressive annual average of 22.2%, with lower interest rates as the government and RBI provided a dual stimulus to the economy. This was the time when heavy investments were made in infrastructure as banks funded several projects in this space as well in steel and natural resources. The downswing that followed quite sharply has resulted in the build-up of NPAs.
There is hence a warning signal here. Lowering rates for the sake of boosting credit growth may be hasty when conditions are below normal. Pushing bank loans through lower rates tends to bring in indiscipline in lending which can lead to build-up of adverse portfolios. The Chinese case stands out where lending by state-owned banks was accelerated to create infrastructure, resulting in NPAs. In retrospect, we may have replicated a similar model with similar dimensions. The important thing is that the interest rate should reflect not just the cost of capital but the risk involved.
Today, retail loans appear to be the flavour as it is believed that the possibility of NPAs building up is lower. Such an approach, combined with financial engineering, led to the financial crisis in the US in 2007-08. Hence, bank lending should be based on judicious principles as the overall credibility of the financial system can be questioned. Therefore, discretion should be called for when linking lower interest rates with higher growth in credit. While prima facie, the link appears alluring, banks need to be cautious on the lending side. This is the takeaway.