The fig-leaf revelations and the reality

There is no stopping BJP leader Subramanian Swamy. In response to Raghuram Rajan’s refusal to take up a second term as governor of the Reserve Bank of India, the BJP leader said that the decision to discontinue was a fig leaf to cover the “reality”. By “reality”, he was referring to Rajan’s decision in the past to hold rates to rein in inflation, that allegedly hurt businesses.

But truth does seem stranger than fiction. If lower interest rates could indeed spur demand and fresh investments, it is a mystery why credit growth has slipped to decadal low levels of 8-9 per cent in the last two years, even as banks slashed lending rates. And this anomaly is not a singular event. The presumption that low interest rates will automatically spur lending has always been too simplistic and there is enough evidence in the past to disprove this.

Through most of 2007 and 2008, the RBI’s repo rates steadily rose from 7.75 to 9 per cent, much higher than the current rate of 6.5 per cent or even the 8 per cent that Rajan chose to hold through 2014. But between 2007 and 2008, credit growth was a robust 25-30 per cent.

If, indeed, Swamy’s allegation that higher interest rates have “destroyed” small enterprises holds water, then how did bank credit manage to grow at record levels, despite the high interest rates? Besides, there is nothing from past data that suggests that lower interest rates have been able to stimulate demand and induce borrowings.

When the RBI actually began to lower its repo rates between October 2008 and February 2010, with the rates finally bottoming at 4.75-5 per cent levels, credit growth had surprisingly slipped to 16-17 per cent levels. Even during the rate easing cycle between April 2012 and May 2013, credit growth scarcely responded. In fact, credit growth has hardly responded to rate changes in the last four or five years. Then, what explains the weak credit offtake in the last couple years?

Much of what has transpired in recent years is due to the slowing growth in the economy, a point that can hardly be argued against even by those who have campaigned against the RBI’s single-minded focus on inflation. During 2007 and 2008, it was the robust growth in GDP at 8.5-9 per cent that had driven bank credit growth, even as interest rates spiked. Since then, the slowdown in the economy has dragged credit growth lower. It is evident that the appetite to borrow is more a function of economic growth and business confidence than the actual cost of money.

Over the last decade or so, credit growth has been 2.5 to 3 times the real GDP growth. With growth in the economy faltering, credit growth has also followed suit and fallen, despite rate cuts. In fact, the credit growth to GDP multiplier has shrunk to about 1.3 to 1.5 times in the last two years, clearly indicating a growing risk aversion to fresh investments and borrowings.

It is time the Centre and its allied bureaucrats took some responsibility for India Inc’s sorry state of affairs.

The growth in the domestic economy has been tardy mainly due to a slowdown in the investment cycle. The main issue has been the delay in regulatory and environmental clearances as well as judicial activism that has stalled raw material and energy availability, and impacted companies’ cash flows.

With substantial capital stuck in these projects, companies have been reluctant to commit new funds to fresh projects. While the Government has done a lot to revive stalled projects in core sectors over the last two years, much of it is yet to yield results. According to an International Monetary Fund working paper titled Disentangling India’s Investment Slowdown , swings in real interest rates account for only one-quarter of the explained investment slowdown in India: the role of heightened uncertainty and deteriorating business confidence has been larger. Credit, hence, clearly cannot revive as long as economic growth is sluggish.

This suggests that the only way to get the economy to move ahead is not by slashing rates but by ensuring that the capital locked up in older projects starts paying dividends. Corporates who lined up aggressive expansion plans after the financial crisis have been hit hard. It is unlikely these companies will rush to put up new capacities. Even if the economy revives, these companies will first look to trimming their debt, rather than invest aggressively in new projects.

If corporates are reluctant to take on new projects, banks too, grappling with a large pile of bad loans, have turned wary of lending to the stressed sectors. The recent clean-up activity undertaken by Rajan has, to some extent, prepped the pitch for the next leg of lending. But it’s unlikely to pick up pace any time soon. Given the overall risk in the system, banks are also unlikely to wage a ‘price war’ to induce borrowings. Given the weak balance sheets and capital position of public sector banks, the Centre is in no position to arm-twist these banks to slash their lending rates.

Rather than going after banks and the regulator, the Centre has to roll up its own sleeves and get its act together to revive the economy. After all the central bank can only help achieve some of the goals of economic policy. While the RBI’s monetary policy seeks to achieve economic objectives such as promoting growth, it also has the onerous task of controlling inflation and maintaining a stable exchange rate. With inflation down to low single-digits and forex coffers brimming there is little doubt on whether Rajan has succeeded in achieving these objectives.

Also, rather than looking to banks to fund projects, the Centre will have to look at alternative channels such as bond markets, to meet the needs of smaller enterprises. This can only happen if efforts are taken to widen the bond market — something that has been in the offing for a while. Even now it is only large corporates and those that are highly rated that are able to raise loans easily from banks and tap into bond markets. Working with regulators to open up alternative channels of funding would be a more sustainable solution to tackle the issue of funding small businesses.

In the final analysis, Rajan has been quite right to persistently stick to his battle to tame inflation. India has seen negative real interest rates since 2008, dis-incentivising savings. With inflation trending lower, real interest rates have now, after a very long time, stepped into positive territory which augurs well for savings and investments. This will at least prompt the Indian saver to look at investment avenues such as debt or equity that don’t siphon money out of the productive economy (which physical assets such as gold or property do).

Low inflation also holds the key to consumer confidence. If consumers loosen their purse strings, it will improve the demand environment for certain sections of India Inc and maybe prompt fresh investments. It would be a shame if the Centre chooses to undo the work that Rajan has done to rein in inflation, purely on the whims of market players and cronies. After all, nothing in the past suggests that slashing rates would work, aside from the tall claims made by a few.

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