What good or evil have India’s monetary policy regimes wrought? The clamour for the cutting of interest rates is intense, but so far the Reserve Bank of India (RBI) has resisted all blandishments.

Does it have a point? Neither it nor rate cut protagonists have offered evidence as to the consequences of interest rate policy. The patterns of empirical regularities are unknown. There has been heat but little light shed on the consequences of macroeconomic policy on real sector outcomes.

I statistically analysed firm-level RBI data on company finances for public limited companies, and present patterns in respect of these key Indian firms for which data were available for all years between 1976-77 and 2013-14. I present an assessment of the results for the post-liberalisation years between 1991-92 and 2013-14. Empirical regularities established by granular firm-level data permit in-depth evaluation of dynamic performance patterns in India’s industrial microeconomy.

Rise and fall of profit ratesThe first empirical regularity : Over time, firms have steadily increased profitability. Profit rates increasing after 1991, when liberalisation made markets contestable, putting pressure on profits, show these firms to have responded to changes. They have been profitable in the new millennium. Thus, firms evaluated are of proven competencies.

The second empirical regularity : Unsurprisingly, as the RBI has increased interest rates, average corporate profit rates have declined. This is hardly profound, since rising interest rates means higher interest costs will have eaten into firms’ margins. The pattern of corporate profits and interest rates are displayed in the figure; the correlation between the two data series is significantly negative. As interest rates have gone up, profit rates have come down. Do negative relationships between interest and profit rates hold between different political regimes?

Unexpected finding For the 7-year period between 1991-92 and 1997-98, when the Narasimha Rao, Deve Gowda and Gujral administrations were in place, the relationship between interest rates and corporate profit rates was positive. This is unexpected. Logic dictates otherwise. During this period, the RBI’s interest rates were sky-high; being, on average, 12 per cent.

This was a period when, in spite of liberalisation, enforcement of competition policy sanctions and customer protection norms were non-existent, as were financial sector reforms. In this regime, the finance ministry engaged in no banking sector monitoring, financial sector customer protection or competition policy enforcement. In spite of rising interest rates leading to high costs, firms made greater profits even though financing costs went up, because cost increases were passed on to consumers and prices raised without fearing sanctions.

Genuine reforms in India started with the Vajpayee government, of the years 1998-99 to 2003-4. Competition policy rules were formulated, and major financial sector reforms, such as the transition from FERA to FEMA, were initiated. During this period, the relationship between interest and corporate profit rates was significantly negative, as expected in a properly-functioning market economy.

Interest rates came down sharply by over half, from over 12 per cent in 1997-98 to around 6 per cent in 2003-04. As interest rates went down, firms’ profit rates went up. This was expected, as financing costs would reduce and leave a greater surplus. Between 2004-05 and 2013-14 interest rates steadily went up.

Again, the relationship between rising interest rates and corporate profit rates was negative. As financing costs went up, profits were hit because of the impact of monetary policy.

To maintain control over the financial sector, a central bank Governor engages in moral suasion. To do this, the person must be impervious to moral suasion. But, that has not happened. Since 2003-04, successive RBI governors have fallen prey to the intellectually-vacuous whisperings of long-defunct monetarists with out-of-currency ideas.

Since 2003, gubernatorial incumbents have been administrators who occupied grassroot positions as district collectors, while the incumbent is a financial economist with academic work in corporate finance, a branch of financial economics dealing with borrowing behaviour of firms.

These individuals know better, but by keeping interest rates high, they have displayed an intellectual suppleness going against their own innate beliefs and experience. This unfortunate acceptance of an egregious theoretical ideology has led to significant corporate profitability declines in India.

Negative impact So what if businesses make less money? Actually, the consequences are extremely severe. Given the supply of periodical profits, firms continuously reinvest their retained earnings in projects, and such a feature is classified as corporate gross savings put back into the business. As the quantum of corporate gross savings rises, the need for borrowed funds reduces.

The third empirical regularity :The statistical relationship between corporate profitability and corporate gross savings is negative. In other words, as corporate profits have fallen so have corporate gross savings.

The fourth empirical regularity : The statistical relationship shows that as interest rates have risen, corporate gross savings have fallen. Rising interest rates have meant that firms have reduced the quantum of internal funds reinvested in business because, they have had to deal with rising interest costs.

Hence, rising interest rates, as instruments of monetary policy, have engendered rising costs and reduced corporate gross savings rates. These are unfortunate negative outcomes of India’s current and recent monetary policy regime. Industry has been emasculated.

How borrowings growThe fifth empirical regularity : The statistical relationship shows that as corporate gross savings rates have fallen, firms have increased the ratio of borrowings to equity. These are profitable firms in which the growth desire is ingrained, and to do so the funds have to come from somewhere. In the absence of internally-generated funds, firms have borrowed more.

Firms first use their internal funds to grow the business, and thereafter they use borrowed funds. The resorting to borrowings by the firms evaluated suggests that they wish growth and, given the declining internal funds, have had no recourse but to go for expensive borrowings which further inflate their cost structures and make India a high-cost economy.

So what? All economic growth is microeconomic growth. Economic growth occurs because microeconomic agents and firms invest, reap profits, reinvest these profits and then expand their businesses. The RBI’s relatively high interest policy has meant a drop in corporate profitability, gross savings and reinvestments, and a rise in borrowings, leading to a spiral of increasing costs and other negative outcomes.

The RBI’s interest rate policy, clearly, bars India’s economic success. Removal of this critical and crucial barrier will entail dropping of rates. The Centre has also to examine options as to how the interest rate determining authority’s governance and leadership is structured.

The writer is a professor of technology strategy at the University of Texas in Dallas

Related Topics
comment COMMENT NOW