Part 1 of this article made the case for breaking out of the vicious cycle of macroeconomic imbalances caused by slowing growth, large fiscal and current account deficits, the weakening rupee and persistently high inflation. Using monetary policy as the dominant lever to address the multiple concerns admittedly carries risks of further fuelling inflation. But, on balance, we think it is worth the risk, in light of the worsening growth-inflation balance. Of the three issues underlying this thinking, two were looked at yesterday. The third issue is this: would monetary policy easing (using a combination of rate cuts and liquidity easing) really have any perceptible effect on boosting investment, or is the slowdown predominantly due to policy implementation bottlenecks, as has been widely advertised?

How might rates have affected growth? A look at the post-Lehman period in 2008-09 and after is instructive. Growth had fallen to 5.6% and 6.4% in the last 2 quarters of that year, but the dynamics of those quarters were very different from the current scenario. Due to a massive stimulus (both fiscal and monetary), consumption had held up, but investment had fallen to levels very similar to the last 2 quarters of FY12. Then, it was predominantly a liquidity story, intensified by a collapse of trade credit. In the last 2 quarters of FY09, there was a net outflow of trade credit of $4.2 billion and $ 5.5 billion, respectively, compared to an average net inflow of $4.4 billion in the four preceding quarters. Capex had shrunk mainly due to the squeeze in funds; bank credit growth had shrunk rapidly in 6 months, from 29% in late October 2008 to 18% at end March 2009.

Graph 1 shows trends in interest rates that are operative for banks? cost of funds (shorter maturity borrowings and term deposits) and for corporates (Commercial Paper, CP). The start of monetary policy tightening since January 2010 was aggravated by a sharp liquidity squeeze in June 2010, following the spectrum auctions. One-year bank Certificate of Deposit (CD) rates had increased from 6% in April 2010 to over 10% in March 2011 and stayed at those levels. These funds are about two-thirds of total bank deposits. It was right after this period that, as if on cue (remember the 12-18 month transmission lag), investment rate had slowed sharply.

A simple heuristic exercise to approximate the higher interest burden in the current slowdown phase is as follows: bank credit to Indian corporates is roughly R40 lakh crore. Interest costs have increased about 2.5-3.0 percentage points (pps) over the past couple of years. This translates into additional interest payments of R1.2 lakh crore per year, assuming the entire loan portfolio gets re-priced. In addition, bank credit is roughly half the total flow of debt funds to corporates. This means that the total increase in cost of funds would have been R2.4 lakh crore.

However, the interest burden is not evenly distributed. Graph 2 shows trends in interest burdens for corporates across different slabs of sales revenues. Interest costs are a significant chunk of smaller companies, having increased from 7% of their sales revenues to close to 9%. Larger companies (in the range of sales revenues of R100-1,000 crore) pay 4-5% of their revenues (which increased by 1 pp).

Project Internal Rates of Return also get affected. Approximate calculations indicate that for long gestation projects (like road and other infrastructure concessions), a 3 pp increase in costs is likely to reduce project IRRs by 2 pps. Projects bid at 14-15% IRRs are likely to have become unviable.

What about real interest rates? Graph 3 shows 2 operative interest rates for banks and corporates (certificates of deposit and commercial paper are proxies for cost of funds). Current real rates (deflated by WPI inflation) are positive and more importantly at levels of 2007-08, when growth was 9%, domestic savings and foreign capital flows very high, and confidence booming. It was only the final burst of monetary policy tightening in mid-2008 (just before the collapse) which pushed real interest rates higher than current levels. Telling this story using the CPI as the deflator yields much the same shape, only the entire curve shifts lower, and real interest rates for April 2012 are marginally negative.

It is a non sequitur that the genesis of the current investment slowdown has been a combination of implementation problems and higher interest costs, but the impact of interest rates appears to be larger than what statements based on casual empiricism seem to suggest.

Attempting to boost growth (and investment) by easing rates certainly carries the risk of increasing credit to specific sectors that might have a larger effect on consumption than capital projects, but this could be moderated through targeted measures like risk weights and provisioning requirements, as has already been done in previous policy exercises. The bottom line of this article is that the rupee?s slide has been damaging to the economy and has kept inflation up compared to levels warranted by global commodity prices, that monetary policy tightening has had an effect on investment, and consequently that monetary policy easing now should ensure liquidity at levels which ensures a drop in the cost of funds.

The author is Senior Vice-President, Business and Economic Research, Axis Bank. Views are personal

This two-part article is now concluded