This calendar year didn’t begin easy for policymakers. GDP growth came in at 5% and inflation print came in at 7.4%. Inflation was at 65-month high and growth at 11-year low. India’s misery index (constructed in a crude way by the addition of inflation rate and unemployment rate, as defined by Arthur Okun) is at 43-month high. High inflation poses a policy dilemma for RBI to support growth by cutting interest rates. Inflation remained low and within the RBI comfort zone for long, barring some seasonal spurts. This time around, too, headline inflation is driven by a spurt in food inflation, contributing about 73% to the latest print. Core inflation remains low. While RBI targets the headline number, it really can’t influence over 50% of the index. An increase in repo rate by 50bps won’t really lead us to consume less fruits and vegetables and bring down inflation in the category.
High inflation brings down real interest rates—which consider the inflation rate and are computed by subtracting the inflation rate from the nominal interest rate. Many analysts have pointed to the fact that the cost of funds in India remains amongst the highest in the region.
With headline inflation at 7.4%, real repo rate is negative, real deposit rates are negative, real MCLR is closer to zero, and real base rate is below 2%. In November 2019 round of the Households’ Inflation Expectations Survey, 3-month ahead and 1-year ahead inflation sentiments rose to 9.2% and 9.9%, respectively. Households’ assessment of current inflation was 8.2%. Using these numbers, real interest rates are even lower. Using core inflation, real interest rates are still positive.
Real interest rates can be lowered in two ways—reduction in nominal rates and a non-aggressive response by the central bank to rising inflation, which allows real rates to fall. A 2013 RBI research paper shows that rising real interest rates have a negative impact on GDP and investment in the economy. While firm level decisions with regards to investments are based on nominal rates, it takes into account its own effective real interest rate, depending on its own inflation expectations as part of cash flow projections, and effective nominal cost of capital. However, lower rates alone cannot lead to growth. Firms would invest if the IRR (internal rate of return) of an investment is greater than the cost of capital. The IRR is influenced greatly by sentiments. Positive sentiments can raise the expected returns and the IRR, and investments might be undertaken even under a high interest rate environment. In a situation of economic slowdown and weak sentiments, perceived risk can rise, and the IRR can fall despite low interest rates, and hinder fresh investments. Hence, low interest rates can provide a limited stimulus to revive investments.
The paper mentions falling marginal efficiency of capital can also lead to weak investments despite lower policy rates. This can be on account of weak investment sentiments, weak outlook for return on investment, domestic and global factors, etc. The Incremental Capital Output Ratio (ICOR)—a measure of the productivity of capital investments—has been rising over the last three fiscal years. A higher ICOR is an indicator of inefficiency—a higher level of investment is needed to produce one extra unit of GDP.
In theory, negative real interest rates should encourage spending by consumers and businesses, but poor sentiments prevent them from doing so. The Economic Survey 2018-19 stressed upon the need for lower real interest rates to stimulate investment. It stated that savers and borrowers can be decoupled, since savings are more a function of demographics and income, while investment is more dependent on cost of funds. If it’s true, it allows reducing rates to stimulate investment and demand without much impact on savings rate. The increased investment will generate more income and, in turn, greater savings. Lower deposit rates might also lead to savings (determined to a greater extent by demographics and income) to be diverted away from bank deposits to other asset classes—helping other markets to develop, deepen. It can incentivise money to move from risk-free assets to riskier assets in search for a higher real return.
The current scenario of low real interest rates will be short-lived since they are a result of higher inflation rate led by food and not lower nominal rates. Over the course of 2019, nominal repo rate has come down by 135bps while headline CPI has gone up by 538bps. The RBI paper mentioned that low real rates, by tolerating high inflation (above 6%), are unlikely to have the desired positive impact on growth. High levels of inflation will adversely impact consumption demand and, in turn, investments.
So, with this low growth and high inflation, is India really witnessing stagflation? Maybe not. The high inflation will ease in a couple of months as food inflation comes down. There isn’t much of a strong reason for the core inflation to jump in a big way. Low growth numbers deserve greater attention. Low interest rates can provide a limited push to investments. In the pre-Lehman period, despite higher real interest rates, investments were doing well on account of a conducive policy environment, positive outlook for demand, and positive global and domestic economic cues. A well-coordinated package on the fiscal, monetary and policy front is needed to revive growth. Patchwork will not work.
