Interest rates on ‘call money'— sums that banks borrow from one another for extremely short durations — rose steadily from 4.6 per cent in 2003-04 to 7.2 per cent by 2006-07. These rates are a good proxy for the rising interest rate regime in the economy during that period.
Yet, this did nothing to dampen investment sentiment. Investments by the private sector vaulted from Rs 7 lakh crore to Rs 12 lakh crore in those three years. ‘Investments' here are measured by gross capital formation in the private sector.
Limited effect
It wasn't just a case of the private sector investing higher sums of money just because the economy was expanding. It was a case of their scaling up investments in pursuit of higher returns. For, even measured in relative terms, there was a step-up in investments. The private sector investments as a proportion of GDP (at current prices), grew consistently from 21.8 per cent to 24.9 per cent during the rising rate regime.
It wasn't very different in an earlier era either. Between 1991 and 1993, the Indian government introduced many policy reforms. Consequently, there were huge variations in interest rates. Rates climbed from 11.5 per cent in 1990 to a high of 19.5 per cent in 1992. Despite the magnitude of the rate increases though, private investments held up, edging up from 13.6 to 13.8 per cent of GDP.
Nor did a steep fall in interest rates from 1992 to 1994 stimulate investments. Rather, they fell during this period (see graph). In fact, overall, between 1983-84 and 2007-08, the trend in interest rates had little bearing on investments as a percentage of GDP.
No lag either
Some would argue that monetary policy and, in particular, interest rates affect related macro variables with a lag. But, even factoring in a lag of one year, private investments do not show a very significant relationship with interest rates.
The years from 1990 to 1994 saw huge year-to-year variations in interest rates, but this did not materially disturb the trend in investments, even with a one-year lag.
Other factors
Why do interest rates seem to have such limited bearing on investment activity in India? In India, there are important factors besides the cost of borrowing money that potentially affect investment plans of the private sector. Unavailability or shortage of land, power, and water, not to mention good roads, can all impact project implementation.
There are other less quantifiable, yet important factors, such as corruption and policy flip-flops, that can potentially affect investment spending. With these issues haunting investors, interest rate changes may reveal only a part of the story.
Interest rates don't seem to have an effect on prices either, if recent evidence is anything to go by.
A succession of hikes in the key policy rate (13 in all) in the last year and a half did not do anything to dampen inflation during this period.