More pain, less gain

The recent increase in interest rates by the Reserve Bank of India presents a cause for serious concern since rising interest rates are likely to slow down corporate investment. The implicit argument that guides the central bank is that the decrease in investment would reduce demand, cool down prices and thereby ease inflationary pressures. However, since the inflation seems to be primarily due to bottlenecks on the supply-side, my fear is that these rate hikes will not do enough to control inflation. However, they will end up doing sufficient damage to economic growth by reducing corporate investment. To precisely assess the potential impact of the current rise in interest rates, in this piece, I analyse empirically what has been the impact of rising interest rates on corporate investment by all firms listed in the BSE and NSE.

I use historical data on the Prime Lending Rates (PLR) of banks from RBI?s Website for the time period 1996-2010. I complement the same with data on Capital Expenditures and R&D Investments for all BSE-NSE listed firms from the Centre for Monitoring of Indian Economy (CMIE)?s Prowess database. The second and third columns in the table show the weekly average of the maximum and minimum prime lending rate across all banks for each year from 1996 to 2010. The fourth and fifth columns show the annual R&D expense and annual capital expenditures for an average firm listed in the BSE or NSE or both.

Using the above data, we examine the statistical relationship between the average rate at which the firm can borrow and its investment. While the prime lending rates have been decreasing, on average, there have been periods where the prime lending rates have increased. For example, during 2005-2008, the prime lending rates increased considerably.

Figure 1 plots the relationship between the minimum prime lending rate and the annual R&D expenditures while Figure 2 plots the relationship between the minimum prime lending rate and the annual capital expenditures. We notice that there is a robust negative relationship between interest rates and corporate investment in the form of research and development and capital expenditures. In other words, an increase in interest rates lowers corporate investment. The relatively low R-squared of about 15-20% suggests that interest rates are only one among several other factors that determine corporate investment (see columns two and three of table).

What are the reasons for the decrease in corporate investment due to an increase in interest rates? An increase in interest rates can hurt corporate investments in two ways. First,?since firms fund their investments using a mix of debt and equity, an increase in the interest rate in the economy increases the cost of raising funds through debt. Therefore, for all firms in the economy, high interest rates raise the cost of making a new investment, either in the form of capital expenditures or investments in research and development. As the cost of funding a project increase, the project?s payback period, which denotes the time period over which the project will recoup its investment and start delivering profits, becomes increasingly longer. In particular, the net present value of the project decreases as the cost of funds increase since the opportunity cost of deployed funds increases. As a result, firms decide to postpone their capital expenditures as well as R&D investments till funds get cheaper.

Second, high interest rates can hurt consumer demand as demand is, in an increasing number of industries, driven by the easy availability of cheap credit. For a good example of this situation, consider what happened to Cisco Systems in 2000. Because a huge part of its sales went to the telecommunications industry, Cisco?s profitability depended on the health of the telecom industry. In 2000, the telecom industry?s debt had ballooned to $700 billion. This debt became the telecom industry?s financial Achilles? heel, which, in turn, led to telecom companies buying less especially from Cisco. As a result, Cisco?s profits shrank. From March 2000 to March 2001, Cisco?s stock fell by nearly 70%! As of September 2001, Cisco?s stock price continued to decline because the companies that were Cisco?s customers were hurting financially. Anticipating such decreases in consumer demand, firms postpone any expansion plans.

Economically, the statistical relationship we have obtained shows that an increase of 1% in the prime lending rate reduces investment by an average firm by about Rs 38 crore. Given the 5500 firms listed at the BSE and the NSE, this implies that a 1% increase in the prime lending rate would collectively reduce corporate investment by over Rs 2,00,000 crore. Over the last twelve months, repo and reverse-repo rates have increased by about 3%, which will certainly translate into an increase in the prime lending rates. While large firms that borrow at sub-prime lending rates may not be affected as much by the rate hikes, the small and medium sized firms will certainly be affected since the rate hikes will increase their borrowing costs. Thus, even allowing for the fact that the decrease in aggregate investment will not be one-to-one and the increase in prime lending rate will not be one-to-one with respect to the hikes in money market interest rates, this implies that aggregate corporate investment will reduce by over Rs 4,00,000 crore (approximately twice the change for a 1% increase). This is a conservative estimate since there are scores of other unlisted firms that will decrease their investment as well, but are unaccounted for in the above estimate. Such large decreases in corporate investment are bound to significant dampen economic growth in the medium to long run. However, these rate hikes are unlikely to have a dampening effect on inflation. So, we may be in for a period of slowing down of economic growth together with continued high inflation.

The author is assistant professor of analytical finance at ISB, Hyderabad