Why Raghuram Rajan Was Right To Be Wary of Low Interest Rates

Low interest rates are demanded in the name of helping small and medium-sized enterprises, but in reality, it is the over-leveraged corporates that will most likely benefit from it.

A worker makes auto parts on a machine inside a workshop in Faridabad, India, on December 24, 2015. Credit: Reuters

A worker makes auto parts on a machine inside a workshop in Faridabad, India, on December 24, 2015. Credit: Reuters

The latest to join the low interest rate bandwagon is India’s commerce minister, Nirmala Sitharaman, who wants the Reserve Bank of India (RBI) to reduce the benchmark interest rate – the rate at which the central bank lends money to commercial banks in the event of any shortfall of funds – by a whopping 200 basis points or 2 percentage points.

According to Sitharaman, the cost of credit is very high for cash-starved small and medium enterprises (SMEs), which make up for 45% of the manufacturing GDP and 40% of exports. The SMEs thus need urgent relief in the form of cheaper capital to create jobs and push exports.

Before her, BJP leader Subramanian Swamy criticised former RBI governor Raghuram Rajan, saying his hawkish interest rate policy was hurting the SMEs.

However, given the heavily indebted status of India’s top companies – especially those from infrastructure, realty and metals businesses – a rate cut would be more helpful for them rather than SMEs. This, in turn, is needed to improve the health of India’s banking system, which is troubled by stressed loans despite having one of the highest interest rate spread of 3.5% – mainly because of its over-exposure to big business, which Rajan had been trying to rein in. It is worth noting that large borrowers account for 86% of all bad loans.

Rajan was correct when he said, “Often when monetary policy is easy, it becomes the residual policy of choice”. Low interest rates cannot be a substitute for the structural reforms that are needed to encourage growth.

In India, many consider interest rate cuts a panacea for all the macroeconomic challenges the country faces – of investment in particular. Gross capital formation, an indicator of new capacity addition by businesses, shrank by 3.1% in the first quarter of the financial year 2016-17.

Firms that have borrowed heavily from the central bank, and stand to benefit the most from a rate cut, claim that investment is the key to job creation and high interest rate – by making capital expensive – acts as an obstacle to that.

Economic logic

The economic logic is simple: a rate cut will reduce cost of capital and increase its demand, i.e. rate of investment. If investment increases, it will automatically push GDP growth and create jobs.

If that is the case, then why is investment not happening either in Japan or Eurozone, where interest rates are negative? Supporters of interest rate cuts would like to say that India, being a developing economy, is different from Europe or Japan.

However, experience shows that investment will continue to grow irrespective of interest rates (the real rate of interest was 7% during the boom period of 2003-08) if investors are confident about recovering their money. The cost of capital is thus important, but only one factor in the investment decision.

Another important determinant is demand, low at present in domestic and export markets, which is why no business wants to add new capacities and would prefer lower interest rates to reduce interest cost and improve margins.

India is certainly different from Eurozone and Japan, but it suffers from sluggish global demand, growing trade protectionism, over capacities and dumping of cheap Chinese products from steel to textile.

Moreover, less than 5% of India’s household savings flow into equity and mutual funds. Another two-thirds go into low-risk bank deposits and small saving instruments such as provident fund and the balance goes into gold and real estate.



A rate cut – especially when inflation is high (5% versus 1.3% in China in August 2016) will divert more savings into gold/real estate, thereby reducing the supply of savings into financial channels – and in turn India’s capacity to make investment – as over 70% of India’s savings comes from households.

Lower interest rates also tend to increase income inequality by hurting savers and pensioners. It discourages the inflow of cheaper foreign funds to India, which is needed to keep the rupee stable.

Pruning interest rates on savings lowers the purchasing power (via negative wealth effect) of households and hurts business prospects from the demand side as consumption demand accounts for 60% of aggregate demand.

Services aren’t dependent upon external demand and are (mostly) consumed locally. A key sub-sector, real estate is suffering from buyers’ disinterest accentuated by the unwillingness of builders to meet basic contractual obligations on timely delivery and quality. Yet, not even BJP-ruled states have shown any urgency to establish real estate regulator that can improve the credibility of the sector and bring back buyers.

Delayed completion of projects slows demand for not only inputs such as cement and steel (supplied by large companies) but also demand for services such as electrification, plumbing and interior decoration – mostly supplied by SMEs.

The problem of SMEs is not ‘cost of credit,’ but ‘access to credit’ that forces them to rely on money lenders and traders who charge a higher interest without requiring much documentation or collaterals.

SMEs also suffer from poor accounting and book-keeping and dealing in cash as credit from institutional sources is conditional on demonstrable revenue streams.

Moreover, making capital artificially cheaper promotes its sub-optimal use in a labour abundant economy like India. That may induce adoption of labour saving production technologies, especially if labour laws are not business friendly. Raising minimum wage without any commensurate rise in productivity does the same and kills jobs.

The major supply side problem for businesses, especially first time entrepreneurs, SMEs or foreign investors, is poor contract enforcement that increases the cost of doing business and in turn discourages investment.

The World Bank, in its latest ranking on enforcing contract, has put India at 178, along with Liberia (176) and Comoros (179). Yet, most discussions on ease of doing business escape any mention of India’s contract enforcement regime.

The way forward

Top Indian corporates are heavily indebted and an interest rate cut will surely provide them an immediate relief, but at the cost of savers and pensioners. Lower rates will not induce heavily indebted corporates to add new capacities till the problem of demand deficit persists.

Besides, RBI cutting policy rate doesn’t mean commercial banks will pass on the benefits to borrowers when nonperforming assets (NPA) are at an all time high at 7.6% and stressed loans are 11.5% as in March 2016.

Between January 15, 2015 and April 5, 2016, the RBI has reduced its policy rate by 150 basis points, but commercial banks have reduced their lending rates by 60 basis points.

Lower interest rates encourage financially stressed firms to seek more money from banks and add to stressed loans that will reduce the availability of credit (hence raise its cost) for other borrowers, including SMEs.

Realistic interest rates, reflecting the true scarcity-value of capital along with macroeconomic stability, will bring in investment from all sources if demand and supply side concerns are addressed.

To help SMEs, the government should instead focus on initiatives like the Mudra Bank. Similarly, strengthening micro finance institutions (MFI), which provide small loans without collaterals, will help. If small borrowers are ready to borrow from MFIs at 24%, then cost of bank credit at 12% cannot be a problem.

If indeed the government wants credit to be cheaper, it would be better to put a cap on interest rate spread, say from 3.5% to 2%. That would make banks more efficient and will also encourage them to avoid lending to the likes of Vijay Mallya.

Ritesh Kumar Singh is a corporate economic advisor and a former government official based in Mumbai.

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