 "rate cut, interest rate, RBI")
A general perception that is being built these days that lower interest rate is the only solution to slow growth, especially after BJP leader Subramanian Swamy raised it. Theoretically and logically this sounds correct.
In an article, veteran journalist Prem Shankar Jha points out that the Modi government faces two choices – allowing the real rate of interest to stay in the 10-12% range, and keep blaming corrupt investors, complaisant bank managers and the ‘global downturn’ for India’s woes, or bring lending rates down very, very sharply to a level that will revive consumer goods sales, allow debt ridden firms to cut down their interest burden drastically by refinancing their loans, and then allow the most heavily indebted among them to re-structure their debt by issuing controlling shares to their creditor banks.
Jha goes on to suggest that the first choice will lead to massive sell-outs to foreign companies at bargain basement prices, and will wipe out of a large section of the Indian entrepreneurial class, while the second will not only save the economy but also the Indian entrepreneurial class. Swamy too has a similar line of thinking and blames Rajan for being slow to act in reducing interest rates.
These arguments raise two questions. First, does lowering interest rate result in demand and growth pick-up in the economy and economic activities. And second, are India and Indian banks ready for a lower interest rate regime?
Economics 101 will point out that lower interest rate results in higher demand and greater economic activity. It dissuades savers from putting their money in the bank and buy stuff thereby increasing demand. But this was good in olden times.
In the new era, what is now being known as the ‘new normal’, this rule does not apply. A look around the world tells us that low and near-zero interest rate and free flow of money through quantitative easing has failed to induce growth. Many countries have now resorted to negative interest rates, but even then there are no consumers at the stores. Not only consumers, even corporate houses are unwilling to risk adding new capacities, despite almost zero interest rates. In India too, the 150 basis points reduction by Rajan has failed to bring in growth.
This brings us to the second point – are India and Indian Banks ready for interest rate reduction.
There is no doubting that Indian corporate houses are gasping for money. But those holding the purse strings refuse to open it, even at high interest rates. Data presented in a State Bank Ecowrap report shows that deposit growth of 26 Indian banks, 18 public and 8 private, has grown only by 1.6%. But more importantly advances have declined by 1.9%. Six PSU banks posted negative credit growth rate and none of the PSU banks posted a double-digit credit growth.
Even when borrowers were lining up at their doors willing to pay higher interest rates, public sector banks refused to entertain them. Banks are busy cleaning their mess as they continue to do now. Lower interest rate will only be a theoretical number if these banks are not willing to lend.
Credit growth data, as per the Ecowrap has again started to decline, after a small blip in March 2016. As on April 29, 2016, credit growth has declined to 9.2% as compared to 11.3% in mid-March and 10.3% during the same period in 2015. It needs to be highlighted here that the low credit growth rate has happened at a time when the central bank was continuously cutting interest rates.
The report points out that the banking sector loan book is not showing significant traction as of now on the back of a stagnant pipeline of projects.
The report hints at a chicken-and-egg situation and concludes that the supposed correlation between balance sheet cleaning and credit growth picking up will only happen once the growth cycle picks up significantly.
Growth will now have to happen before credit growth. Unless banks get the confidence to lend, there is no way the economy will get the benefit of low interest rates, if at all.
