As finance ministers, Pranab Mukherjee, P Chidambaram and Arun Jaitley have at times expressed public displeasure that RBI has kept interest rates high. RBI seemed to believe that inflation could be kept in check with higher interest rates. So when inflation moderated, they expected interest rates to fall. Lower interest rates were expected to stimulate industrial growth, and hence economic growth.
A more nuanced argument was that inflation was a result of increased money supply meeting a shortfall of goods and services. Restricting money supply and higher interest rates could bring down inflation. But India could suffer a crop failure or a shortage of onions or pulses. This would raise food prices, hurting lower income groups for whom food is a major portion of household expenditure. Money supply and interest rates cannot moderate food inflation. It requires increased and better distributed supplies. We are then left with non-moderated food prices and high interest rates. This adversely affects industrial production and international competitiveness. If food price inflation cannot be influenced by monetary actions, why not reduce interest rates which could stimulate industry?
There might be merit in this argument. In India, the effects of monetary actions are mainly on industry and trade.
The former is less than a fourth of GDP and may not be as much of a driver for growth. Lower interest for trade might not always get passed on as lower prices to consumers. It could be argued as to which sector is so much benefited that economic growth will be stimulated?
Household expenditures might improve with easier loans and lower interest rates. In the last 20 years, household borrowings have surged. When the economy has heavy household borrowings, lower interest rates could stimulate consumption and hence stimulate the economy. This is what developed countries have tried for the last many years, with interest rates ruling from 0% in Japan to 2% or so in the US and Europe. But their stimulating effect (except to an extent in the US) seems to have worn out.
Indian households have rising borrowings on credit cards for consumption and for house purchases. Lower interest rates would stimulate these expenditures and help stimulate the economy. However, this effect hinges on consumer confidence about job stability and security.
Bank loans to farmers (except from cooperative banks) were limited at one time. Moneylenders were the principal source. Their rates were exorbitant. If a crop failed, many farmers lost their mortgaged land because they could not repay, or they became bonded labourers. As public policies changed and ‘priority’ sector lending included farmers, banks began lending to them. These farmers were not dirt poor small farmers. But governments through state-owned banks (the majority) sought to curry for votes of farmers in times of distress. The practice of writing off farmer loans became common. This greatly weakened bank finances and their balance sheets.
The financial position of state-owned banks was further weakened by government interference in loans for infrastructure and industry. Sources of all finance for Indian companies have been banks, self-generated from profits or advances from suppliers, other companies or directly as fixed deposits from the public at even higher rates.
Cheaper development finance for building assets was from government-owned financial institutions like IDBI and IFCI. The cost of long-term finance was lower than that of working capital. This is no longer the case.
The Tandon-Chore committees (1974-1979) on working capital developed norms for commercial banks for lending for working capital. They were useful for companies to manage working capital carefully.
The pressure on RBI to reduce interest rates resulted from strong pleas from industry and trade associations that high interest rates were preventing faster industrial growth. But other factors requiring government actions lead to project delays, shortfalls in production and inflation. These are not addressed. RBI, as custodian of low inflation, is understandably hesitant to add easing of monetary factors that might aid inflation.
Lending rates are 2% in Australia, 14.25% in Brazil, 0.5% in Canada, 0.05% in the Euro Area, 4.85% in China, 0.5% in Indonesia, 0% in Japan and 7.25% in India. For top Indian companies, interest outflow was many times higher than in many competing countries. Indian companies have good reason to agitate for lower interest rates.
The WPI is used by the government to measure inflation. The CPI usually rises by more than the WPI. Inflation measured by WPI underestimates the impact of price rise on consumes.
The collapse in crude oil prices has led to a sharp fall in WPI. But CPI has not fallen at the same rate. The reduction in prices of consumer products (petrol, diesel, cooking gas) has been countered by rising prices of foodstuff and especially of pulses, vegetables and fruits.
RBI did reduce rates by 0.75% over 2014-15. But banks did not reduce lending rates correspondingly. This must have been to recoup some of their losses on account of government, mentioned earlier. Banks, in fact, are reluctant to reduce lending rates to healthy borrowers.
Long-term financing of debt after the demise of ‘development finance’ has not seen new inflows for the purpose.
Other countries finance utilities from household savings invested in safe long-term instruments—insurance, gratuity, provident and pension funds, etc. The government controls their funds.
Reducing interest rates in India requires many other preconditions in economic policies, administrative procedures and project implementation. Lenders must be fully diligent in checking borrower capabilities before lending.
Monitoring mechanisms must be in place and suitable action taken when a loan is not being used in a way that will enable the project to be completed in time and start repaying the lender. Governments must not set priorities for lending for projects or people, nor lower debt-equity ratios, and not demand long-term guaranteed tariffs from project developers. Government permissions must be timely. Long-term savings must be available for long-gestation utility projects. Lenders should have speedy legal recourse against recalcitrant borrowers.
Policies must enable stable food prices so that inflation is not a concern for the poor. Agricultural policies must target for more crop security and prices. The government must develop agricultural infrastructure and prevent speculation. State-owned enterprises such as FCI, Coal India, BHEL, state-owned electricity undertakings, etc, must become more efficient. There must be no interference in pricing of commodities such as power or petroleum products. For reduced interest rates, lenders must have confidence that their money is safe. Today, it is not.
The author is former director general, NCAER, and was the first chairman of the CERC