What India Inc needs to understand about interest rates


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.”
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…It survives, also because active monetary policy means that, at times, interest rates will be high – a circumstance that is far from disagreeable for those with money to lend.”

The article appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 8, 2014


It’s time big business stops blaming Rajan and RBI for everything


Vivek Kaul

When small children don’t get enough attention from their parents, they cry. And until they get attention, they keep crying.
Big business in India is a tad like that. For the last one year it has been crying itself hoarse in trying to tell the Reserve Bank of India(RBI) to cut interest rates. But the RBI led by Raghuram Rajan hasn’t obliged.
In the monetary policy statement released yesterday, the RBI decided to maintain the status quo and not cut the repo rate, as big business has been demanding for a while now. Repo rate is the interest rate at which RBI lends to banks.
The lobbies which represent the big businesses in India reacted in a now familiar way after the monetary policy.
The Confederation of Indian Industries said that the economic recovery was still fragile and a decision to cut interest rates would have helped the small and medium enterprises (SME) sector, which is credit starved currently. The lobby further added that if interest rates would have been cut businesses would have borrowed more.
On the face of it this sounds like a very genuine concern.
But Raghuram Rajan explained the real issue with SMEs not getting enough loans in a recent speech. The bad loans of Indian banks, in particular public sector banks, have gone up dramatically in the recent past.
As on March 31, 2013, the gross non performing assets (NPAs) or simply put the bad loans, of public sector banks, had stood at 3.63% of the total advances. 
Latest data from the finance ministry show that the bad loans of public sector banks as on September 30, 2014, stood at 5.32% of the total advance.
Why have bad loans gone up by such a huge amount? “The most obvious reason,” as Rajan put it was “that the system protects the large borrower and his divine right to stay in control.” Who is the large borrower? Big business.
As Rajan explained: “The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken — the promoter threatens to run the enterprise into the ground unless the government, banks, and regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the upside, forgetting the help he got from the government or the banks – after all, banks should be happy they got some of their money back.”
Banks have tried to repossess assets offered as collateral against these loans in order to recover their loans, but haven’t been very successful at it. As Rajan put it in his speech: “The amount recovered from cases decided in 2013-14 under debt recovery tribunals was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake.”
Big businesses have been able to hire expensive lawyers and managed to stop banks from repossessing their assets. The small and medium enterprises haven’t been able to do that. Rajan said just that in his speech:“The SARFAESI [ Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest] Act of 2002 is, by the standards of most countries, very pro-creditor as it is written. This was probably an attempt by legislators to reduce the burden on debt recovery tribunals and force promoters to pay. But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”
Hence, small and medium enterprises have had to face problems because big businesses have decided to borrow and not to repay.
The CII further suggested that if RBI had cut interest rates businesses would have borrowed more. It needs to be clarified here that interest rates are not simply high because the repo rate is high at 8%. There are other reasons for it as well.
Big businesses have defaulted on such a huge quantum of loans that banks have had to charge the borrowers who are repaying a higher rate of interest. As Rajan put it in his speech “The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7% even while the policy rate is 8%. The difference, also known as the credit risk premium, of 5.7% is largely compensation banks demand for the risk of default and non-payment.”
This when the average home loan in the country is being given at 10.7%. Hence, a home loan to an individual is being given at a lower rate of interest than loans to power companies. And only big businesses defaulting on their loans are to be blamed for it.
Rana Kapoor who is the President of a business lobby called Associated Chambers of Commerce and Industry of India said: “RBI has obviously overlooked strong demand from the industry for a cut in the interest rates. The industry’s demand for lower interest rates was fully justified.”
Kapoor is the founder managing director and CEO of Yes Bank. It needs to be pointed out here that the bad loans of Yes Bank for the period of three months ending September 30, 2014, went up by 178.3% to Rs 54 crore in comparison to the same period last year.
What is surprising here is that a banker whose bad loan book has exploded is demanding a rate cut. I am sure Mr Kapoor understands how credit risk operates.
Also, business lobbies and businesses tend to totally ignore the fact that the RBI cannot do much about creating economic growth beyond a point.
As economist Tim Dudley puts it: “As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying (and under-appreciated) impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”
The phrase to mark here is “well-managed economy” and that is largely the government’s prerogative. Rajan acknowledged this
in the latest monetary policy statement. As he said towards the end of the monetary policy statement “A durable revival of investment demand continues to be held back by infrastructural constraints and lack of assured supply of key inputs, in particular coal, power, land and minerals. The success of ongoing government actions in these areas will be key to reviving growth.”
Criticising or trying to tell RBI what it should be doing, is not going to help big business much. If they have to criticise, it is the government they should be criticising. But that as we all know is not going to happen any time soon. Meanwhile, the RBI will continue to be the favourite whipping boy of big business.

The article originally appeared on www.FirstBiz.com on Dec 4, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

RBI and Rajan are on the right track: the inflation monster needs to be killed first


There is almost a formula to it.
A few days before the Reserve Bank of India(RBI) is supposed to meet to review the monetary policy, business lobbies and industrialists start coming out with statements demanding that the RBI cut the repo rate. Repo rate is the interest rate at which RBI lends to banks and sets the benchmark for the interest rates at which banks in turn lend to businesses and consumers.
This time was no different. “We hope for a 50 basis points cut in the repo rate as retail inflation has started receding,”
Confederation of Indian Industries (CII) Director General Chandrajit Banerjee had said on March 30, 2014.
Rana Kapoor, president, Associated Chambers of Commerce and Industry of India (Assocham), echoed the same sentiment when he said that the RBI should cut the repo rate by 50 basis points. One basis point is one hundredth of a percentage.
But the RBI did not oblige the lobbies this time as well. In it’s first First Bi-monthly Monetary Policy Statement, 2014-15, the central bank decided to keep the repo rate at 8%. This, despite the fact that inflation as measured by the consumer price index(CPI) has been on its way down.
In February 2014, CPI inflation was at 8.1%. This after it had touched 11.24% in November 2013. A major reason for the fall has been a fall in food prices.
As RBI governor Raghuram Rajan had said in speech on February 26, 204 “inflation measured by the new CPI has remained in double digits during April 2012 to January 2014, averaging 10 per cent over this period. Food inflation, which has a weight of 47.6 per cent in the index, has contributed the largest share of headline inflation. Food inflation itself has stayed in double digits throughout this period, edging down to 9.9 per cent only in January 2014.” In February 2014, food prices rose by 8.57% in comparison to last year.
Has the risk of food prices rising at a much faster rate gone away? Not really. Unseasonal rains and hailstorms in parts of the country have damaged crops, and this is likely to push up prices again. The RBI also thinks that the fall in food prices may be temporary. “Retail inflation measured by the consumer price index (CPI) moderated for the third month in succession in February 2014, driven lower by the sharp disinflation in food prices, although prices of fruits, milk and products have started to firm up,”
the RBI statement said.
It also feels that vegetable prices may not fall any further. “Since December 2013, the sharper than expected disinflation in vegetable prices has enabled a sizable fall in headline inflation. Looking ahead, vegetable prices have entered their seasonal trough and further softening is unlikely,” the RBI statement said.
The central bank also feels that there are “risks…stemming from a less-than-normal monsoon due to possible el nino effects.” Even this could drive up food prices.
Having said that, what is the link between interest rates and food prices? Prima facie there does not seem to be any link. But Rajan explained a link in his February speech. As he said “There has been an increase in liquidity flowing to the agricultural sector, both from land sales, as well as from a rise in agricultural credit. More loans to agriculture have fostered substantial private investment in agriculture, but may also have pushed up rural wages.” This in turn has played a part in pushing up food prices in particular and overall prices in general. And hence it is important to maintain high interest rates.
Rajan had also said that “monetary policy is an appropriate tool with which to limit the rise in wages, especially urban ones. The slowdown in rural wage growth may be partly the consequence of tighter policy limiting wage rise elsewhere.”
Also, non fuel- non food inflation, which constitutes around 40% of the consumer price index continues to remain high. “Excluding food and fuel, however, retail inflation remained sticky at around 8 per cent. This suggests that some demand pressures are still at play,” the RBI statement said. This number has barely budged for a while now. Non fuel-non food inflation takes into account housing, medical care, education, transportation, recreation etc. And this is a major reason why the RBI does not seem to be in any mood to cut the interest rate.
Business lobbies need to understand a basic point here. India’s retail inflation continues to remain high despite a collapse in investment. As Chetan Ahya and Upasna Chachra or Morgan Stanley write in a recent research report titled
Five Key Reforms to Fix India’s Growth Problem and dated March 24, 2014, “Public and private investment fell from the peak of 26.2% of GDP in F2008 to 17.3% in F2013. Indeed, private investment CAGR[compounded annual growth rate] was just 1.4% between F2008 to F2013 vs. 43% in the preceding five years.”
Now imagine what would happen if investments were to pick up a little? Inflation instead of coming down would have gone up for sure, creating further economic problems.
As economist Rajiv Malik of CLSA writes in a column in the Business Standard today “In fact, it is more than likely that if the investment had not weakened as much as it needed to – or if it had recovered sooner or more strongly than has been the case – India’s macroeconomic imbalances, including elevated inflation, would have been much worse.”
If India’s economic growth has to come back on track, the inflation monster needs to be killed first. And given that RBI and Rajan are on the right track.

The article appeared on www.FirstBiz.com on April 1, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek)