RBI’s neutral stance in its latest monetary policy statement has been primarily driven by its long standing argument of “stickiness of core inflation”
Third quarter GDP data released by the CSO has fuelled scepticism, as growth witnessed only a marginal slowdown to 7.0% from 7.3% in H1FY17. What is surprising is the fact that fixed capital formation grew at 3.5% after three quarters of contraction despite demonetisation. The CSO has been quick to point out the caveats with respect to expenditure side data.
Leaving aside the debate on the credibility of the data, there is much more to worry about. There is enough evidence to suggest that India’s capex cycle is yet to recover. Capital formation as a share of GDP has fallen from 39% in FY12 to 33% in FY16. Capacity utilisation levels have fallen from 80% in 2011 to 72% currently. Industrial credit growth contracted 1.2% in FY17 (Apr-Jan). Interest cover ratio—a measure used to determine how easily a company can pay interest on outstanding debt; the lower the ratio, the more the company is burdened by interest payments—has fallen drastically from pre-Lehman levels of 4 to 2. Further, the 2016 IMF Global Financial Stability Report also pointed that interest coverage ratio in India was amongst the lowest, only better than Brazil.
As per RBI’s latest business performance survey for H1FY17, almost 32% of debt is held by manufacturing companies with interest coverage ratio less than 1. This is not a pleasant state for the manufacturing industry. SMEs and MSMEs seem to be in a worse situation. Interest payments make up 70-100% of their earnings before interest and taxes (EBIT). Interest coverage ratio for SMEs and MSMEs worsened from (-)0.9 in the pre-Lehman period to (-)1.9 in the post-Lehman period. The withdrawal of old currency notes has worsened the situation further. SMEs and MSMEs together contribute nearly 17% to GDP, 45% to manufacturing output, 60% to manufactured exports and employ nearly 40% of India’s workforce. Unlike big corporates, they are highly leveraged.
While we agree that a suitable policy environment is the biggest enabler for investment growth, one cannot ignore that higher interest costs have hurt corporates, especially SMEs. A look at real interest rates reveals that average real lending rates in the pre-Lehman period were nearly 300 bps higher than in the post-Lehman period. This is because lower real lending rates in the post-Lehman period were the result of higher inflation and not lower nominal interest rates. Yet investment growth was three-times more during the period. Higher interest rates were accompanied by higher growth, high demand and conducive business environment, where businesses had the option to pass on the increased costs. However, in spite of the reduction in repo rate and lending rates by SCBs, real interest rates in India continue to be on a rise—interest burden on businesses remains high.
This higher interest burden has impacted their profits too. Japanese economist Richard Koo’s analysis shows that the private sector behaves outside the conventional framework of neo-classical economics when their balance sheets are stressed. In other words, they do not increase borrowings even at lower interest rates. This happened in Japan where record low interest rates did not spur investment demand. Thus, monetary policy renders itself ineffective in a situation where debt levels are high. In such a scenario, corporates try to minimise debt instead of maximising profits, hence the transmission mechanism between the banking system and real economy breaks down. CMIE data shows that borrowings of private non-financial sector have grown almost four-fold since FY07. A lower interest rate regime would first enable corporates to reduce their debt burden and then undertake new investments.
Despite corporate sector’s dismal performance which is critical to pick up in India’s investment cycle, why is RBI hesitant to cut rates? The central bank’s view is that inflation is a bigger evil and needs to be addressed before it can cut interest rates to spur growth. Simply put, RBI’s fixation with inflation target has resisted it from cutting rates. India’s headline inflation has been on a downward trajectory since July 2016. Headline inflation halved to 3.2% in January from 6.1% in July. The dramatic decline has been led by softening food prices which fell from a two-year peak of 8.4% in July to 0.5% in January.
RBI’s neutral stance in its latest monetary policy statement has been primarily driven by its long-standing argument of “stickiness of core inflation”. Core inflation (not excluding impact of diesel and petrol) has remained sticky around 5%. Core ex-diesel and petrol has eased from 5.1% in July to 4.7% in January.
One should realise that inflation is only natural to a growing economy. Some amount of inflation is necessary for an economy to grow—it incentivises demand, production and investment. That is not to say that the central bank should not keep a check on inflation. However, monetary policy has no control over food inflation (45% weight in the CPI basket). Food and beverages inflation has averaged 7.9% since January 2012. Clearly, food inflation is unlikely to remain at very low levels for sustained periods of time. Even if food inflation maintains itself around 5%, core inflation will have to be brought down to around 3% to achieve a headline inflation of around 4%. Core inflation has halved from close to 10% in 2012, and remained sticky around 5% for the last two years. Various experts have suggested that 3-5% inflation is suitable for the Indian economy without having an adverse impact on growth.
The hue and cry to come down harshly on inflation is also usually politically motivated. Single-minded pursuit to bring down the headline number by maintaining high interest rates and curbing core inflation (proxy for demand) might actually hurt growth—both at the consumers’ as well as producers’ end. Perhaps, RBI should have a relook at the headline inflation target or should target something other than the headline number—core CPI.
Many commentators point out that there is excess capacity in the system and lower interest rates cannot do much to stimulate investment. In a situation of negative output gap, lower interest rates can help stimulate demand and ease out this output gap without any adverse impact on inflation. This pick up in consumption can help producers use their excess capacity. Once this excess capacity is utilised, business will have an incentive to undertake fresh investments.
Corporates also often complain of how they do not get a level playing field with respect to imports from foreign countries as India has been dismantling import duties (through FTAs), but not addressing other constraints like high interest costs, infrastructure deficit and bureaucratic delays. In fact, India’s cost of capital is the highest amongst the emerging Asian economies. Unless the government addresses these concerns, we cannot expect our domestic businesses to be competitive both in domestic as well as foreign markets.
With demonetisation shaving off some of the demand, inflation at low levels and healthy current account, this was an appropriate time to move towards a lower interest rate regime. If we don’t act now, we will soon be going the Japanese way. And that is not a very happy situation to be in.
The authors are corporate economists based in Mumbai. Views are personal