If interest rates are lowered without foreign equity flows, the risk of the flight of foreign portfolio capital is high
A Crisil research report on corporate profitability has projected a weak 3% growth in the just ended April-June quarter. It has attributed the weak earnings growth to soft commodity prices, slow growth in investment-linked sectors, and subdued rural demand. This comes against the backdrop of three successive rate cuts by the Reserve Bank of India (RBI), which has lowered lending rates by 75 basis points since January.
The focus on getting the economy going is the right one. But as an earlier Crisil report in November last year stated, the overemphasis on interest rates to spur growth is an erroneous one and the lowering of interest rates by the central bank has a limited effect on the economy. Lower interest rates drive up consumption in the retail and wholesale sectors but are incapable of catalysing the investment cycle that the country desperately needs. I had said something similar last year, early in this government’s term, during a debate in Parliament where MP after MP had jumped on to a bandwagon of calling for low interest rates. The focus should be on restarting the investment cycle and that requires equity flows to lead the credit demand. Investment growth, particularly private corporate investment, plummeted in the fiscal years 2013 and 2014, despite low real interest (adjusted for inflation) rates.
During the time, the policy rate in real terms—repo rate minus retail inflation—had been negative, and real lending rates averaged 2.4%. This was significantly lower than the 7.4% seen in the pre-crisis years (2004-2008), yet investment growth dropped to 0.3%, down from an average 16.2% seen in the pre-crisis years.
Investment growth has slowed down sharply in the last two years even though policy rates have been negative in real terms and real lending rates have averaged less than 3%. The primary reason for this is the sharp fall in investments. Equity capital flows are critical to revive equity starved sectors such as infrastructure and manufacturing, among others. Moreover, they add to investible resources, provide access to advanced technologies, assist in gaining production know-how and promote exports.
Foreign direct investment (FDI) into India during the October 2014-April 2015 period rose by 48% year-on-year to Rs 1.76 lakh crore after the launch of Make-in-India initiative; in spite of that, India lost its top ten position in the 2015 FDI Confidence Index, a survey of 300 countries conducted by AT Kearney. The last time India had dropped out of the top 10 list was back in 2002. In 2015, the country has been ranked 11th on the list, down from the seventh position it held last year.
Credit and interest rates are only relevant if there are equity capital flows. Further, if interest rates are lowered without foreign equity flow, the risk of the flight of foreign portfolio capital is high. In recent years, as risk aversion has grown, large parts of foreign portfolio capital inflows are being invested in domestic debt, which are, in turn, very sensitive to domestic interest rates. FDI is generally known to be the most stable component of capital flows needed to finance the current account deficit and also be a counterweight for the rupee, when interest rates moderation cause foreign portfolio capital flowouts. Therefore, to kick-start and spur growth, it is critical to restart the investment cycle, and we need increased equity capital flows and more FDI. Investor confidence revival is a condition precedent to interest rate moderation.
For investment cycle and equity flows to restart, the government needs to create an enabling environment that repairs and rebuilds investor confidence and sentiment. Over the last several years, investors have been battered and bruised scam after scam and multiple policy and regulatory failure/captures. This repairing and rebuilding is a slow, diligent work that requires the government to deliver good corruption-free governance, stable, consistent policies, and rebuild credible, independent sectoral regulators. The Make-in-India initiative can be a good way to attract this required capital. But it needs to go beyond slogans and the ease of business, and do more by way of structurally redoing policies and regulations.
This is the time for the government to focus on reconstructing institutional capabilities and roles. RBI has had a mixed track record on several fronts including banking supervision over the last decade. It has been a mute spectator as NPLs exploded, almost crippling the domestic banking sector and putting taxpayers on hook. However, it has done well in monetary policy and it’s important the current debate on growth doesn’t dilute this role of RBI. Ours is a complex economy and monetary policy must be independent of typical short-term and often short-sighted political or bureaucratic considerations. Moody’s report has also warned against fiddling with the autonomy of RBI as it may hurt India’s credibility—and credibility is key to reviving foreign investor confidence.
The focus on reviving the economy is clearly the Modi government’s main priority. Moody’s latest report has warned that India’s economic prospects face new hurdles amid falling investment, and medium- and long-term growth would suffer without sufficient and quick reforms. That’s where the focus must be—to rapidly fix and repair the places in the economy/government that are impacting equity flows. That should be the main priority, not fiddling with RBI’s interest rate fixing autonomy.
The author is an MP and a technology entrepreneur.