In the absence of labour market reforms, the capital intensity of Indian economy has increased over the years, particularly after 1991.
Cost of capital, namely, interest, is an important consideration for all types of enterprises, ranging from small and marginal firms to large corporations. In a pessimistic global economic environment, rising input cost, growing competition from cheap imports from low cost countries, and high cost of funding does hurt businesses because of its implications for working capital and debt servicing.
Again, in project planning, one of major considerations is the discount rate. Thus, high cost of capital (i.e. high interest cost), by lowering expected profit, may induce businesses to shelve expansion projects that in turn lowers future productive capacity.
A recent study of 850 non-financial companies shows that interest burden as a share of EBITDA (earnings before taxes, interest, depreciation and amortisation) has gone up by more than 35 per cent for them in the last three years, thereby lowering their net profitability and future capacity to expand.
Many companies (small and large) in the construction, housing and infrastructure sectors are over-leveraged. Sustained high rates of interest increase their operational cost and reduce their margins. They find it difficult to complete on-going projects or take up new ones.
Policy tightening by RBI has succeeded in bringing down inflation (10 per cent to 7.2 per cent), but it has also taken a heavy toll on GDP growth rate (from 8.5 per cent to 5.5 per cent) as well.
In the last two decades, interest rate sensitivity of domestic consumption expenditure has increased immensely with the growing share of retail and housing loans in credit offtake.
High rates of interest adversely affect sectors like automobiles, construction and infrastructure, housing and retail, as a substantial portion of their demand is credit-financed; that, in turn, lowers investment in subsequent periods.
Given the predominance of these sectors in India’s economy, and the backward and forward linkages these sectors have with sectors such as cement, coal, electricity or steel, overall investment sentiment is dampened. GDP growth is thus constrained from both sides (demand and supply) by high rates of interest.
Credit to GDP ratio in India has increased from 19.2 per cent in 1991-92 to 52.1 per cent in 2011-12. This underlines the significance of interest rate in the economy. The solution lies in loosening monetary policy and letting the investment pick up and bring the growth rate back to 8-9 per cent. The recent cut in CRR and repo rate by 25 basis points each is thus a step in the right direction. Tackling inflation calls for supply-side measures, as inflation in India is primarily a supply side problem.
(The author is Group Economist of a corporate house. The views are personal.)