RBI must cut interest rates

Govt push needed to boost consumption and investment

One way to devalue debt is via a rapid increase in inflation. As inflation climbs, the value of money falls and the real interest rate on historic loans is reduced. Governments and central banks understand this well and nations with high public debt often try to induce inflation. Conversely, public debt burdens look bigger if inflation falls. Tax collections stagnate in nominal terms. 

Central banks can manipulate money supply to tackle inflation/ deflation, while a government can easily refinance by issuing treasuries at lower yields. It can also impose higher tax rates. The financial sector also generally likes falling inflation. The portfolio of historic loans becomes more valuable for a lender. Also, falling inflation often induces higher consumption and higher credit offtake. But, most corporates carry a fair amount of historic long-term debt and it’s not easy to refinance that or roll over cheaper, even if interest rates come down as inflation falls. Unless consumption and investment expand, corporates must also assume revenue will tend to stagnate in a lower inflation regime. Flat revenues make it more difficult to service historic long-term debt.  

Worse, a manufacturer who bought raw materials at relatively higher prices might discover that costs cannot be passed on. Such a business has an incentive to cut production and workers could be laid off or stop receiving overtime and bonuses. The workforce then consumes less. This can lead to a deflationary spiral, where demand is adversely affected across the entire system. 

India has rarely had bouts of low inflation. Those periods have generally been associated with high investment and strong consumption demand. India Inc is now learning the hard way that low inflation, coupled with low consumption and low investment, is a recipe for big trouble. The Reserve Bank of India’s (RBI’s) projections about rising bank non-performing assets (NPAs) look grim and the trend of rapidly declining inflation could make things worse. RBI’s Financial Stability Report projects gross NPAs could rise to over 10 per cent, or even 11 per cent of all advances, in a worst case scenario by March 2018. In March 2017, about 9.6 per cent of gross NPAs were logged. Credit offtake declined to historic lows in March 2017, when credit growth dropped to 0.8 per cent for public sector banks and to 4.4 per cent overall, with foreign banks seeing credit shrink by 8.6 per cent. The rate of growth in gross fixed capital formation has also declined to an anaemic 2.8 per cent in 2016-17 and GFCF went negative in the first quarter of 2017. 

The low credit offtake and falling GFCF trends point to low investment and consumption demand. Indian corporate debt amounts to 55 per cent of gross domestic product. Private investment has almost dropped off a cliff, given that credit growth to industry is now running at 25-year lows. There are stressed assets visible across multiple sectors. Infrastructure assets in power, telecom and related sectors like steel and construction are among the worst affected. Several key ratios that measure the ability to repay corporate debt have deteriorated on average for listed corporates. The interest coverage ratio divides operating profits (Ebitda) by interest owed and indicates a firm’s ability to service debt. Ebitda should exceed interest payments for the same period by a comfortable margin.  The solvency ratio divides cash profits (net profits plus depreciation) by the quantum of debt (long-term and short-term). The higher the solvency ratio, the better the situation. The interest coverage ratio has worsened significantly, and so has the solvency ratio, in the second half of 2016-17. A third key ratio, debt to equity, has also deteriorated. 

Inflation has dropped to historic lows and could fall further. India now has the highest real interest rates in Asia and most corporates are exposed to long-term borrowings at double-digit nominal interest rates and many are struggling to service those loans. If consumption doesn’t pick up soon, more and more firms will struggle. The RBI must now cut rates for sure, and cut substantially. It must also pressurise lenders to pass those cuts on. But that in itself won’t be enough. A pick-up in consumption and in investment will come only if there’s a sensible and concerted policy push from the government.