One big story of 2014 has been a crash in crude oil prices. In dollar terms, oil prices have dropped 45 per cent. For India, the drop in inflation has so far, been a blessing. But for energy importers like Japan and much of Western Europe, low oil prices have caused deflationary situations.
These regions had very low inflation before crude prices fell. A deflationary trend, where an entire basket of prices trend negative, can trigger cycles of lower demand and lower supply. Deflation also creates a tough situation for lenders and borrowers, since it takes longer to generate returns.
If interest rates are negative, the borrower is in effect, charging to use money! Negative rates sound topsy-turvy. But Japan, for example, has experimented with nominally negative rates several times. Switzerland recently imposed negative rates. Negative rates create growth stimulus and inhibit currency inflows, which helps weaken a currency when that is desirable.
While nominal negative rates are unusual, real negative rates are part of business cycles. Central banks set policy rates and governments sell treasury bills at market-driven yields. Commercial rates are built on top of T-Bill yields and central bank policy rates.
If interest rates are below inflation, or negative in real terms, there is incentive to borrow to expand capacity, and also to borrow to satisfy demand. Hence, negative real rates lead to stimulus. The opposite situation — positive real rates — discourage borrowing by an extension of the reverse logic.
This is over-simplified, of course. But in business cycles, growth accelerates during periods of negative real rates, while high positive real rates help prevent overheating. The recipe for healthy growth is to keep the economy in a sweet spot where lenders and borrowers both get returns.
India is currently in an odd situation. It has high positive real rates, since inflation has fallen quickly. Growth is low. So, there is a case for cutting rates by large amounts to create stimulus. Rate cuts are assumed to be a given in the next fiscal (2015-16) and this supports the projections of 6.4 per cent gross domestic product (GDP) growth. That assumption of large rate cuts has kept the banking sector buzzing.
But India also has massive amounts of bad loans — about 4.3 per cent of all bank advances are non-performing. That amounts to two per cent of GDP. India also has a highly-indebted private sector, with many companies dangerously leveraged. Shady accounting practices make it difficult to generate trustworthy numbers for debt:equity ratios or interest coverage ratios.
On the macro economic side, India has a large fiscal deficit, which might exceed the targeted 4.1 per cent of GDP this financial year. The government cannot safely borrow to spend more. The Reserve Bank of India (RBI) estimates capacity utilisation is at its lowest in four years. About 15 per cent of GDP is stuck in stalled infrastructure projects. The public sector banking system will need massive capital infusions to comply with Basel-II capital adequacy ratios.
Under the circumstances, making borrowing cheaper by cutting rates might not help the cause of growth. It could actually create dangers if it encourages higher fiscal deficits or more bad loans. That is the logical case for not cutting rates.
Any opinion poll at this instant will be overwhelmingly in favour of rate cuts through the next financial year. But RBI is supposedly an independent organisation and its current governor has demonstrated multiple times that he does have an independent mindset. If he doesn’t like the macro economic trends or the Budget, he could disappoint the market.
These regions had very low inflation before crude prices fell. A deflationary trend, where an entire basket of prices trend negative, can trigger cycles of lower demand and lower supply. Deflation also creates a tough situation for lenders and borrowers, since it takes longer to generate returns.
If interest rates are negative, the borrower is in effect, charging to use money! Negative rates sound topsy-turvy. But Japan, for example, has experimented with nominally negative rates several times. Switzerland recently imposed negative rates. Negative rates create growth stimulus and inhibit currency inflows, which helps weaken a currency when that is desirable.
While nominal negative rates are unusual, real negative rates are part of business cycles. Central banks set policy rates and governments sell treasury bills at market-driven yields. Commercial rates are built on top of T-Bill yields and central bank policy rates.
If interest rates are below inflation, or negative in real terms, there is incentive to borrow to expand capacity, and also to borrow to satisfy demand. Hence, negative real rates lead to stimulus. The opposite situation — positive real rates — discourage borrowing by an extension of the reverse logic.
This is over-simplified, of course. But in business cycles, growth accelerates during periods of negative real rates, while high positive real rates help prevent overheating. The recipe for healthy growth is to keep the economy in a sweet spot where lenders and borrowers both get returns.
India is currently in an odd situation. It has high positive real rates, since inflation has fallen quickly. Growth is low. So, there is a case for cutting rates by large amounts to create stimulus. Rate cuts are assumed to be a given in the next fiscal (2015-16) and this supports the projections of 6.4 per cent gross domestic product (GDP) growth. That assumption of large rate cuts has kept the banking sector buzzing.
But India also has massive amounts of bad loans — about 4.3 per cent of all bank advances are non-performing. That amounts to two per cent of GDP. India also has a highly-indebted private sector, with many companies dangerously leveraged. Shady accounting practices make it difficult to generate trustworthy numbers for debt:equity ratios or interest coverage ratios.
On the macro economic side, India has a large fiscal deficit, which might exceed the targeted 4.1 per cent of GDP this financial year. The government cannot safely borrow to spend more. The Reserve Bank of India (RBI) estimates capacity utilisation is at its lowest in four years. About 15 per cent of GDP is stuck in stalled infrastructure projects. The public sector banking system will need massive capital infusions to comply with Basel-II capital adequacy ratios.
Under the circumstances, making borrowing cheaper by cutting rates might not help the cause of growth. It could actually create dangers if it encourages higher fiscal deficits or more bad loans. That is the logical case for not cutting rates.
Any opinion poll at this instant will be overwhelmingly in favour of rate cuts through the next financial year. But RBI is supposedly an independent organisation and its current governor has demonstrated multiple times that he does have an independent mindset. If he doesn’t like the macro economic trends or the Budget, he could disappoint the market.
The author is a equity and derivative analyst