As we progress to August 4, 2015 towards RBI’s third bi-monthly policy statement, the pleas to reduce policy interest rates will reach a crescendo as has been the case, before every RBI policy statements in the last few months. Prominent proponents of a rate cut justify their arguments by highlighting two benefits. Firstly, a lower interest rate will boost capital investments and secondly, an interest rate cut will reduce the real interest rate, which may weaken the rupee and thus exports will benefit. Any text book on macroeconomics will fully agree to these arguments. However, there is one problem — the data on the Indian economy is not fully supportive of both these arguments.
Investment and interest rates: The period FY04-FY08 and FY10-11 has seen robust investment activity in the economy since these years exhibited among the highest gross domestic capital formation (GDCF) growth in the last 15 years. GDCF may be considered a proxy for investment activity in the economy. However, the period experienced an increasing interest rate regime. The repo rate moved from 6% in March 2004 to 9% in August 2008. As per the RBI, the weighted average lending rate to industrial sector during the period ranged from 13.5% to 12.4%. On the other hand, the spike in investment activity seen in FY10-11 may have been supported by the low interest rate prevailing during that period.
From the high capital investment activity during the period one may opine that while level of prevailing interest rate may be an important consideration it need not be a driver of the same. Today, the comparable lending rates are possibly lower than 12.4%. Given the current industrial capacity utilisation of around 70%, it may be over-optimistic to expect that corporates struggling with decade high debt woes would go into investment mode even if interest rates are cut by 100 basis points in one go. Possibly, corporates do not see significant demand which may boost up the capacity utilisation level to 80-85% in the next 12-18 months and thus limited financial justification for them to indulge in capex. Or as RBI’s research article titled ‘Real interest rate impact on investment and growth: What the empirical evidence for India suggests’ has ‘gravely’ expressed “marginal productivity of capital or expected return on new investment has also declined”.
INR depreciation and exports: Someone looking at India’s export data may actually be forgiven for thinking that Indian exports benefit from INR strength. Between May 2002 to July 2005 INR appreciated from 48.99/USD to 43.53/USD. Over the same period non-oil exports grew at an annualised rate of above 20%. After a brief depreciation INR again appreciated from August 2006(46.53/USD) to February 2008(39.37/USD) and again a very strong export growth was observed. On the contrary, post September 2008, one finds stretches when INR depreciated and Indian exports in USD terms has also fallen, possibly the volume of export have also fallen for certain products.
The assumption that a weak rupee leads to export volume growth is over-simplistic if not downright incorrect. As such the strongest and most consistent driver of Indian export has been global demand and this explains quite well the observed export growth. Given that the consumption demand in India’s export destinations are unlikely to show significant growth it is doubtful to what extent a weak INR may boost exports.
Why erode the real interest cushion for uncertain benefits: Because of falling inflation, which is driven more by global factors than anything under domestic control, real interest rate in India has improved. Indeed, this creates some room for a rate cut. However, the real interest cushion is possibly among the very few potent tools India has, as of now, to handle any external shock. Reducing the interest rate, eating away that real-interest cushion and depreciating the currency based on the expectation of benefits, existing mostly in text books, but which has not been supported by the behavior of Indian economy in the past may not be the most prudent thing to do. The solution to India’s growth problem possibly lies in fiscal stimulus, expecting monetary measures to achieve the same outcome is wishful thinking.
