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The Reserve Bank’s policy announcements would go a long way in silencing the hue and cry over decreasing the repo rate and the reverse repo rate in order to make available cheap bank credit.
The recent increases in interest rate have been a cause of stress for the business community. But investment is not directly impacted by interest; it is affected by profit. Therefore, the clamour for lowering rates seems overstated, and the RBI, perhaps realising that, has responded appropriately by reducing only the cash reserve ratio (CRR).
ROLE OF INTEREST
That interest is not the only determinant of investment demand is borne out by the data compiled by us from RBI studies covering 2,000 companies, derived from “Finances of Large Public Limited Companies”. They show that interest cost as a percentage of cost of output of industry declined from 3.09 per cent in 2009-10 to 2.90 per cent in 2010-11. Interest cost showed a declining trend in terms of percentage to income from 2.68 per cent in 2008-09 to 2.66 per cent in 2009-10, but rose to 2.74 per cent during 2010-11 due to fall in output of industry as a result of depressed external and domestic demand.
During the same period interest as a percentage of gross profit reported decline from 22.43 per cent to 19.50 per cent. This was precisely the period of rate hikes. It means that despite the increase in interest rate, growth of gross profit was higher than increase in interest rate.
It may be recalled that towards the end of 2009-10, the monetary authority raised the repo rate to 4.75 per cent by 25 basis points on February 13, 2010, along with increase in Cash Reserve Ratio by the same number of basis points to stop the growth of domestic demand so that inflation rate may be held in check from further rise.
As inflation could not be tamed, the RBI kept raising the repo rate, which reached a level of 8 per cent by July 26, 2011.
It is the increase in price of inputs, wages and the tax liability of the corporates which depressed their retained earnings, and consequently their investment growth.
Besides, dividend payment and manufacturing expenses also dented the earning capacity of the corporate sector, and therefore industry was able to allocate relatively less resources for further investment. This is reflected in terms of net fixed investment of the companies as percentage of total net assets, which fell from 42.4 per cent in 2008-09 to 35 per cent in 2010-11. So, interest rate may not have been a major factor at work.
According to the RBI annual report 2010-11, “there was a perceptible slowdown in investment in the second half of 2011, when growth of gross capital formation was lower at 24 per cent during 2010-2011 than that of 38.4 per cent in 2009-10.”
PROFIT FACTOR
Profit ratios increased during 2009-10 but declined during 2010-11. For instance, gross profit ratio to total net assets went up from 12.0 per cent in 2008-09 to 14.0 per cent in 2009-10 but decreased to 12.7 per cent in 2010-11. Similarly, gross profit to sales ratio rose from 12.8 per cent to 14.8 per cent, but went down to 13.5 per cent during the same period. It means during 2010-11, profitability of industry declined and if profit ratios decline the investment also goes southwards, irrespective of lower interest rate.
In India, industry’s profitability showed a depressed trend in 2010-11 not only due to increase in interest rate but because of decline in external demand as well as domestic demand. In view of these factors, it is apparent that the cry for interest rate reduction would have been futile.
The RBI step to reduce CRR from 4.75 per cent to 4.50 per cent will result in enough liquidity to support economic growth, provided it is used in a productive manner.
Both Marx and Keynes argued that interest is paid out of profit and is a monetary phenomenon. Keynes noted that interest determines demand for investment funds as well as supply of these funds. Keynes further argued that rate of interest on money plays a peculiar role in setting a limit on the level of investment.
Interest rate has negative correlation not only with demand for investment funds but also with production, profit, employment and economic growth.
(The author is a former Economic Advisor to SEBI.)
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