What India Inc needs to understand about interest rates - The Daily Reckoning
The Daily Reckoning by Vivek Kaul
On This Day - 8 December 2014
PRINTER FRIENDLY | ARCHIVES
What India Inc needs to understand about interest rates A  A  A

- By Vivek Kaul

Vivek Kaul
Big business has been after the Reserve Bank of India (RBI) to cut the repo rate or the rate at which the central bank lends money to the banks.

There seems to be a certain formula to the whole thing. Before any monetary policy the business lobbies make a series of statements asking the RBI to cut interest rates. And when the RBI does not cut the repo rate, they make another series of statements explaining why the RBI should have cut the repo rate.

The belief is that a cut in the repo rate will lead to banks cutting the interest rates at which they lend. The statements made by the business lobbies normally try to explain how a cut in interest rates will lead to people borrowing and consuming more and companies borrowing and investing more. The RBI hasn't entertained them till now.

In the monetary policy statement released on December 2, 2014, the RBI said that it might start cutting the repo rate sometime early next year.

The business lobbies immediately issued statements expressing their disappointment on the RBI not cutting the repo rate. Confederation of Indian Industries (CII), one of the three big business lobbies, said in a statement: "At this juncture, even a symbolic cut in policy rates would have sent a strong signal down the line that both the government and the RBI are acting in concert to harness demand and take the economy to the higher orbit of growth."

--- Advertisement ---
Hidden High Potential Companies Revealed!

Are you aware of these Hidden Companies that are giving investors double-triple digit returns?

Some such companies in the past have delivered returns like 217% in 3 Years and 11 Months, 288% in 2 years and 5 months, and 100% in just 1 year 8 months.

And since they have such high potential, very soon every investor would want to invest in companies like them.

So act now and be the first to invest in them to get maximum returns!

Click here for full details...
---------------------------

The phrase to mark here is harness demand (which I have italicized). As explained earlier the logic is that when the RBI cuts the repo rate, banks will cut their lending rates as well and people will borrow and spend more. This will mean businesses will earn more and will lead to economic growth.

Only if it was as simple as that:

As John Kenneth Galbraith writes in The Affluent Society: "Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment." And vice versa-a large cut in interest rate decreases the monthly payment by a very small amount.

Let's understand this through an example. An individual decides to take a car loan of Rs 4.5 lakh at 10.5%, repayable over a period of five years. The monthly payment or the EMI on this loan amounts to Rs 9,672. Now let's say the RBI decides to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage).

The bank works in perfect coordination with RBI (which is not always the case) and decides to cut the interest loan on the car loan by 50 basis points to 10%. The new EMI now stands at Rs 9,561 or around Rs 111 lower.

If the interest rate is cut by 100 basis points to 9.5%, the EMI falls by around Rs 221.5. Hence, a nearly one tenth cut in interest rate (from 10.5% to 9.5%) leads to the EMI falling by around 2.3% (Rs 221.5 expressed as a percentage of Rs 9,672, the original EMI).

Now will people go and buy cars just because the EMI is Rs 111 or Rs 221.5 lower? Obviously not. People spend money when they feel confident about their economic future. And that is not just about lowering interest rates.

For loans of smaller ticket sizes (consumer durables, two wheeler loans etc.) the difference between EMIs when interest rates are cut, is even more smaller. Hence, the logic that a cut in interest rates increases borrowing, isn't really correct. As Galbraith puts it: "During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans."

What about the corporates? The business lobby CII felt that if the RBI had cut interest rates it would have "improved the poor credit offtake by industry". In simple English this means that corporates would have borrowed and invested more, only if, the RBI had cut the repo rate.

But is that really the case? As John Kenneth Galbraith points out in The Economics of Innocent Fraud: "If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand."

But that doesn't really happen. "The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low [the emphasis is mine]," Galbraith points out.

The last sentence in the above paragraph summarizes the whole situation. And it is difficult to believe that corporates do not understand something as basic as this.

This was also pointed out in a recent research report titled Will a rate cut spur investments?Not really, brought out by Crisil Research. (I had referred to this report in detail on an earlier occasion).

In this report it was pointed out that investment growth in fiscals 2013 and 2014 fell to 0.3%, despite negative real interest rates (repo rate minus retail inflation). The real interest rate during the period was at minus 2.1%, whereas the real lending rate was only at 2.8%.

In contrast for the period between 2004 and 2008, had a real interest rate of 7.4%, and the average investment growth stood at 16.4% per year, during the period. Why was that the case? "The rate of return on investments - as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database - have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years," Crisil Research points out.

This is precisely the point Galbraith makes- Business firms borrow when they can make money and not because interest rates are low.

To conclude, Indian businesses seem to have great faith in monetary policy doing the trick, when there are too many other factors holding back growth (I haven't gone into these factors partly because they are well known and partly because that's a separate column in itself).

Indian businessmen are not the only ones who seem to have great faith in monetary policy. This is a trend that is prevalent throughout the world. The central bankers are expected to use monetary policy and come to the rescue of the beleaguered economies all over the world.

Where does this faith stem from? Galbraith explains this beautifully in The Affluent Society: "There is no magic in the monetary policy...[It] is a blunt, unreliable, discriminatory and somewhat dangerous instrument of economic control. It survives in esteem partly because so few understand it."

What is holding back corporate investment in India? Post your comments or share your views in the Equitymaster Club.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Get The Daily Reckoning directly
in your mail box.
Just enter your e-mail address » 

Read our Privacy Policy and Terms Of Use.

Equitymaster requests your view! Post a comment on "What India Inc needs to understand about interest rates". Click here!

7 Responses to "What India Inc needs to understand about interest rates"

parimal shah

Dec 9, 2014

I fully agree with you. Even if rate is reduced by 100 basis point (1%) except so called signal the creditofftake will only increase if businesshouse feel that they will make money.
It is a bogey just to reduce the cost of fund as and when they do decide to borrow.

Like 

fram

Dec 8, 2014

In response to "What India Inc needs to understand about interest rates"- By Vivek Kaul.

First thing to do is to look at all the dead inventory Banks are financing in built -up real estate & other manafacturing like dead automobile stocks, these are N.P.A'S AS STOCK IN TRADE, tighten this if necessary, auction these off at what the 'market will bear" then industry & everyone else will come to their senses with proper pricing and that will lead to more sensible pricing of products in future and that will lead to more demand ..... then the rest follows automatically...... but since no one want to take a hair -cut things will remain the same --- Kudos to the RBI for realising that.

Like 

SP Swaminathan

Dec 8, 2014

Awesome Vivek, We as readers are just floored with your style and simplicity in explaining things. We can see ourselves in you, which we generally miss.

Like 

R N Mantri

Dec 8, 2014

Mr. Vivek Kauls reports in the The Daily Reckoning are thought provoking and I enjoy reading his column.

Like 

Subramanian Murthy

Dec 8, 2014

Though I agree with you,such an impetus on the monetary policy especially interest rate cut was not perceived as a major factor in India couple of decades back when the rate of interest was highest. With globalisaton and foreign investors looking for a better market, this definitely plays a part while deciding on investing in countries. This is not essentially towards domestic market or domestic consumer but for global investors. Any Interest rate cut by RBI is definitely seen as a positive vibe by Investors. In current scenario, government keeps on saying that GDP has improved, inflation has lowered and the economy is looking up which are considered more as a political statement whereas resistance by RBI to keep the rate down shows all is not that well as seen. From the perspective of domestic market, unless there is a spurt in employment market and real increase of disposable income in the hands of the customer any rate cut will be more of an exercise in futility.

Like (1)

S.M. Paranjape

Dec 8, 2014

You have explained in simple terms the fallacy of linking cut in interest rate by 50-100 basis points with a supposed change in consumer sentiment.
Another point that needs to be noted is that banks have not passed on to the consumers the rise and consequent high levels of interest rates to deposit holders; their rates have remained stagnant at 4% p.a.a for over four years! So it is evident that banks have pocketed gains.
Similarly, linking fuel prices with rates on the international market remains on paper with Government pocketing the gains through excise duty hikes.
Only genuine economic growth and removal of unemployment / underemployment will result in any real upswing in consumer spending. And of course banks such as SBI should stop throwing away largesse such as the unsolicited $1 bn loan to an industrialist close to the Prime Minister - hallmark of crony capitalism.

Like (2)

AJIT KUMAR

Dec 8, 2014

What a prudent central banker like Dr.Rajan refuses to do, the babus who are ever willing to indulge their political masters will gladly do, even if it serves to undermine the authority of the RBI governor by pressurising the banks to lower the interest rates on deposits and consequently, on lending. Instead of attracting deposits to the severely undercapitalisedbanking system(to the extent of 40 0dd bilion dollars) and which has substantially whitewashed the NPA burden, this is a case of the "ostrich sticking it's head in the sand".

Like (1)
  
Equitymaster requests your view! Post a comment on "What India Inc needs to understand about interest rates". Click here!

Recent Articles:
Trump Takes a Beating
August 18, 2017
Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.
Which Gods Will Bring Down the US Empire?
August 17, 2017
Mr Trump is in the White House and the gods are in their heavens; what's not to like?
Will They Haul Off Trump's Statue, Too?
August 16, 2017
All across the country, the old gods become devils. New, gluten-free gods take their places...
Farm Loan Waivers: Why Bad Economics Makes for Good Politics
August 14, 2017
It is because the negative effects of the waivers aren't clearly visible.