Interest rate threat to GDP growth

Even as fixed investments may suffer, household consumption, which accounts for 57% of GDP, will hold up.

It has taken 11 rate increases by the central bank to cool the economy. While there is no meaningful downward trend in inflation, growth is clearly coming off. However, that does not mean the Reserve Bank of India is done with its tightening. Despite corporate India crying foul over the steep 50-basis point rise last time, the central bank may raise rates by another 50 bps in 2011, believe economists.

If it does happen, how meaningfully will the tightening affect the GDP growth? While India Inc has been screaming blue murder, there is a school of economists that believes, despite the 475-bps effective rise in nominal policy rates, interest rates are stimulative. Credit Suisse’s Devika Mehndiratta says: “Interest rates, whether you look at the 8-per-cent policy repo rate, 8.45-per-cent 10-year government bond yield, 10.5-per cent mortgage rates or the 14.25-per-cent banks’ benchmark lending rate, all are below nominal GDP growth, which stood at 18 per cent in the first quarter of 2011.” Nominal GDP growth for first quarter of FY12 was 16.7 per cent, still higher than key interest rates. And, this has been the trend since 2003. Interestingly, nominal interest rates in India have never really exceeded the nominal GDP growth, at least since 2003.

The real interest rate is in negative territory (-140 bps), which, effectively, is the difference between India’s policy rate (the repo rate being 8 per cent) and the inflation rate (WPI inflation is 9.4 per cent). Whether it’s corporate bond yields, mortgage rates or project finance costs, most are, evidently, far below the nominal GDP rate.

However, there is some good news despite the economy slowing. While GDP growth is expected to slow to 7.5 per cent this financial year, chances of a hard landing seem remote. India’s household consumption (57 per cent of GDP) is unlikely to be particularly hard hit, as households are not leveraged. Fixed investments will suffer, as a large part of corporate India depends on bank lending, which will not be forthcoming. Yes, very few large corporates actually borrow overseas at lower rates. However, debt on most companies’ books seems sustainable. While companies have taken on higher debt over the last 10 years, Credit Suisse says the equity base, too, has kept pace, resulting in the gross debt-equity ratio (of 255 listed companies) actually coming off over the long-term, from about 0.64 in 2002 to 0.52 now.