Why monetary easing alone is not enough

Monetary easing has been ineffective in lowering the cost of funds. The challenge is for the central and state governments to work together to revive the animal spirits of entrepreneurs

Lowering interest rates is seen a policy device to nudge the economy out of its sluggish growth phase. Introductory macroeconomic theory tells us that lowering interest rates will reduce the cost of funds, which in turn will induce firms to demand more, increasing firms’ investment, boosting aggregate demand and thereby encouraging economic growth. But this simplistic explanation suggests that the only reason firms are not investing is the high cost of funds. But is that the only reason? Will reduction in interest rates by itself help?

The NCAER Business Expectations Survey conducted in June 2019 asked firms about the credit scenario and it sheds light on the above question. The key results were as follows:

Overall, 49.4 per cent of respondents reported that they were planning to borrow to meet their working capital needs in the next six months. In the South and the North, respectively, as many as 90.6 per cent and 55.6 per cent planned to borrow. In contrast, in the East, only 23.2 per cent of firms were planning to do so. An assessment across firm size revealed no significant variations except for firms with annual turnover in the range Rs 100-500 crore. In this category, 60.5 per cent of the firms were planning to borrow in the next six months.

Only 25.9 per cent of firms planned to borrow for investment purposes, with the maximum number of such firms being in the North, at 50.4 per cent, and the minimum being in the East, at 6.4 per cent. The corresponding numbers in the West and South were 19.7 per cent and 25.2 per cent. An analysis based on firm size reveals that among firms with turnover in the range Rs 100-500 crore, 32.1 per cent said that they were planning to borrow for investment purposes in the next six months. Only 6.9 per cent of firms with annual turnover of less than Rs 1 crore were interested in investment finance in the next six months.

In June 2019, 64.5 per cent of firms reported that the availability of working capital was the same as it was six months previously. These trends were broadly similar across regions and firm size. The significant exception was the West, where 48.8 per cent of firms perceived credit availability to be the same in June 2019 as in December 2018, and 43.3 per cent responded that it was better.  

When asked about expected working capital availability in December 2019 as compared to June 2019, 50 per cent of firms responded that it would be better. Here, there are significant variations. On the one hand, only 31.7 per cent and 32.5 per cent of firms in the East and South, respectively, expected credit availability to be better in December 2019 as compared to June 2019. On the other, the corresponding numbers for the West and the North were 63.8 per cent and 69.6 per cent respectively. Broadly speaking, a majority of firms (64.5 per cent) reported credit availability in June 2019 to be the same as in December 2018, and 50 per cent expected it to improve in December 2019, over June 2019.

Discussing credit availability for investment purposes in June 2019 compared to December 2018, and the expected change in availability in December 2019 over June 2019, a majority (65.6 per cent)  reported it to be the same as in June 2019 versus December 2018, and 58.4 per cent expected it to remain unchanged in December 2019, over June 2019.

The present credit availability situation for specific business activities like investment finance, exports and imports was also assessed. Overall, 61 per cent of respondents reported that credit for investment finance was easily available, whereas 32.6 per cent and 6.4 per cent, respectively, said “credit was available but at higher rates of interest”, and “it was very difficult to get”. Overall, 50.4 per cent of respondents stated that credit for export financing was easily available, whereas 44 per cent and 5.6 per cent, respectively, reported that “credit was available but at higher rates of interest” and “it was very difficult to get”. Overall, 49.8 per cent of respondents said that credit for import financing was easily available, whereas 37.1 per cent and 13.1 per cent, respectively, reported that “credit was available but at higher rates of interest” and that “it was very difficult to get”. 

These numbers reveal that monetary easing has been largely ineffective in lowering the cost of funds and improving the credit outlook. To quote the Fourth Bi-monthly Monetary Policy Statement 2019-20 of the Reserve Bank of India (RBI): “Monetary transmission has remained staggered and incomplete. As against the cumulative policy repo rate reduction of 110 bps during February-August 2019, the weighted average lending rate (WALR) on fresh rupee loans of commercial banks declined by 29 bps. However, the WALR on outstanding rupee loans increased by 7 bps during the same period.”

Furthermore, there were regional variations in firms’ interest level in borrowing for either working capital or investment purposes. While the RBI continues to follow an accommodative stance, the challenge is for the central and state governments to work together to revive the animal spirits of firms, especially the smaller ones. A larger research question that remains to be answered is whether monetary policy is having a differential regional impact.    

Bhandari is a senior fellow, Gupta is an associate fellow and Sahu is a senior research analyst at NCAER. Views are personal and do not represent those of NCAER