Lower rates do not lead to higher investment. This is dependent on the state of the banking system and opportunities for growth.
With RBI signalling a change in stance to the lowering of rates and some banks decreasing their lending rates, there is a positive sentiment in the market. Interest rates were hiked twice during 2018 which had put industry on the back foot as procuring funds became expensive. Banks as well as borrowers have always been talking of interest rates to be lowered and hence should be satisfied that there can be more rate cuts to come in the coming months if inflation remains range-bound. How exactly does this translate into higher investment growth?
Theoretically, lower interest costs provide an incentive to companies to invest which in turn helps to foster growth. It also brings down the interest cost for companies which helps in stabilising profits. This will vary across industries as the interest-to-turnover ratio averages around 2-3% for non-financial companies and could stretch to around 10% for capital intensive industries. This looks logical.
The attached graphic juxtaposes the movement in weighted average lending rates of banks (WALR) on new loans given for the last five years along with growth in credit to various sectors to ascertain if there are any connections. Interest rates have actually come down by 210 bps since 2013-14, with the fall being 220 bps by 2017-18 before the repo rate was increased by RBI. Therefore, there has been a tendency for banks to lower rates continuously over this time period. As of March 2014, the repo rate was 8% after which it has come down without any upward revision to 6% by March 2018. In a way, it can be concluded that the transmission has been quite efficient as lending rates on new loans have come down in a commensurate manner. This is significant because, often, it has been argued that banks have not been proactive in terms of lowering their lending rates when RBI takes such an action.
Now, the pattern of growth in bank credit is quite interesting. The rate of growth has actually been declining or unchanged in 3 of the 4 years leading to 2017-18. Secondly, the rate of growth in credit-to-industry, which is what one can relate directly with investment, has been coming down and turned negative in 2016-17, before recovering with an anaemic 0.7% growth in 2017-18. This sector constitutes around a third of total credit and is hence quite dominant. Typically, the lowering of cost of capital should have led to higher credit flow to this sector.
Thirdly, growth in credit-to-agriculture has been buoyant in 4 of the five years which, again, is driven more by statute as it comes under priority sector lending. Fourthly, retail loans have been growing at the highest rates, which is positive for the household sector and has supported both the housing and auto sectors. Also, in the last couple of years, there has been a tendency for even PSBs to concentrate more on retail loans and hence build up a better portfolio given that NPAs tend to be lower in this segment.
Fifthly, the service sector has witnessed a mixed growth pattern and declined to 5.7% in 2014-15 before recovering in the next two years and then slowing down, again, in 2017-18. Here, NBFCs and trade are the two leading sectors which account for around half of credit to the services segment. Lastly, in 2018-19, growth in credit has picked up across all the sectors which is contrary to what conventional wisdom would support as this was a period when interest rates increased.
What this data indicates is that merely lowering rates does not lead to higher growth in credit across the sectors. It is most effective for the home segment which is also preferred by banks. In case of industry, a lot would depend on the state of capacity utilisation and investment opportunities that are there. Lowering interest rates works in case there is appetite for investment. In FY19, for example, RBI data shows that capacity utilisation rates have been improving and was at 74.8% in September from 73.8% in June. Therefore, some industries were in a position to scale up by borrowing more even though interest rates had increased. In the preceding years, this rate has hovered between 70-72%, which in turn proved to be a deterrent even though the cost of borrowing had come down.
The services sector needs further probing. NBFCs are re-lenders as they borrow money from banks and use the same for onward lending. Here they would tend to switch across different sources like corporate debt and CPs. Lower interest rates, for example, tend to feed into the market-driven instruments at a faster pace thus making such switches attractive. Interestingly, the weighted average 10-years GSec yield had come down from 8.54% in 2013-14 to 6.89% in 2017-18, which is a drop of 165 bps. Corporate bond yields for AAA-rated paper came down from 8.92% to 7.57%, which is a drop of 145 bps while that of AA paper was around 75-80 bps.
Another issue which becomes important is the willingness of banks to lend. Here, the reference is to the NPA issue where the overhang has made banks cautious on the lending side. This has tended to be concentrated in sectors like power, steel, telecom, etc., where the demand for fresh funds has also been subdued as companies try and sort out the resolution issues.
The fallout of the declining interest rates scenario has also meant that it has had an impact on growth in term deposits. The chart below shows how the growth rate has been coming down quite sharply over the years, from a range of 17% to a low single-digit rate in the last 3 years. Now this is a concern for two reasons. Firstly, from the point of view of banks, this is something which can pressurise liquidity, which, in turn, will call for affirmative action from the central bank in the form of support from OMO and term repos. Secondly, at the broader level, this has an impact on financial savings. The overall savings as per CSO is down from 33.1% in FY13 to 30.1% in FY18 which is a concern. Further, within financial savings, migration to the capital market through the mutual funds route or direct equity has also increased the risk taken by households which can be volatile depending on market conditions.
The issue of low interest rates is often looked at from the point of view of borrowers. While lower rates do cause cost of funds to come down, it is not necessary that it will lead to higher investment. This depends on the state of the banking system as well as opportunities for growth. Continuous reduction in rates also flags the possibility of banks finding it harder to garner deposits, which is also the case today where RBI intervention has been almost relentless. Therefore, there are trade-offs to be chosen as savers, too, would have their preferences.