The perils of lowering interest rates

There is a constant call to lower interest rates, with the Reserve Bank of India, at the receiving end, branded as being too conservative. It is, however, forgotten that the call on the repo rate is no longer the prerogative of the RBI and that there is a Monetary Policy Committee which decides on the course of action. Curiously so far, the majority has tilted towards this so-called conservatism.

Lowering interest rates sounds logical when economic growth is slow and there is a compelling need to increase investment. The gross fixed capital formation rate has fallen continuously from 33.4 per cent in FY13 to 27.1 per cent in FY17, and quite clearly the private sector is not investing adequately. Also, lower interest rates help to make companies more profitable even though interest outgo accounts for just around 3-4 per cent of total cost. This is so as when lending rates come down, all loans get re-priced at the new rate. Hence, there is an economic rationale for lowering rates.

But the RBI has been quite steadfast, and rightly so, in making its interest rate calls. The same approach was praised in the context of keeping India insulated from the Great Financial Crisis of 2008, as it was conservative in opening up the markets. After crude oil prices came down and inflation came under control, the RBI has followed the global practice of lowering rates in a calibrated manner. Between January 2015 and August 2017, the RBI lowered the repo rate by 200 bps, but this has not led to any perceptible increase in investment. Lowering rates just for the sake of doing so could have some unintended consequences, which may not be good in the long run. Hence, it is essential to take a balanced view on the issue.

There are some important concerns which surface when debating this issue. First, lowering interest rates rapidly has the potential to generate a new kind of a bubble or crisis; there could be adverse selection by banks when they are nudged to enhance lending to spur the economy.

This is what happened in the post-Lehman period, when we went in for aggressive stimulus through government spending and lowering of interest rates. The result was that several large projects were undertaken as funds came in cheap, leading to a pile-up of high NPAs in the system. Almost all the large NPAs had their genesis in this period. In fact, easy money and higher deficits resulted in an increase in inflation which, combined with the phenomenon of higher oil prices, caused CPI inflation to remain in the double digit range.

The same situation can be replicated with the difference this time being that the Government is not spending beyond what has been budgeted. Everyone is critical of the banking system for generating high NPAs, which was more due to their stretching the limits to prop up growth, compromising credit standards. Are we indirectly asking them to do the same now by putting pressure on both the RBI and banks to enhance lending?

At present, the capacity utilisation rate in industry is around 70-72 per cent, and there is stagnant demand. Until this rate touches 80 per cent there is less likelihood of additional investment taking place in the normal course. Further, large companies in the infra space are already in a spot, grappling with their NPAs. In such a situation expecting demand for credit to pick up would be quite naïve. Forcing banks to lower lending rates and enhance lending may become counter-productive.

Second, the segment which has shown higher growth in credit, which could be incentivised by lower rates, is housing. But the sector per se has been challenged thrice in the last year. First, demonetisation has affected the housing industry as a large volume of transactions, earlier done in cash, can no longer be carried out. This was followed by RERA which, though favourable to the buyer, has put the onus on the seller in terms of compliance. Add to this the introduction of GST and the entire housing industry is going through fairly turbulent times. Pushing forth loans should not be done at the cost of prudence, the absence of which brought about Lehman. While securitisation is not a risk in India, there has been a tendency for even PSBs to follow the model of increasing the share of retail loans where mortgages dominate. Hence, the possibility of a bubble here should be kept in mind all the time.

Third, the continuous reduction in interest rates has also caused a disruption in savings preferences. Growth in deposits was just 1.2 per cent between April and November 10, 2017, compared with 7.9 per cent during the same period last year. Household savings constitute around 60 per cent of total savings in the economy. A little over 60 per cent of household financial savings reside in bank deposits. With bank deposit rates coming down, there has been a tendency for funds to flow to equities and mutual funds where the lure of higher returns prevails. As both of them carry benefits on the tax front, there has been an undue rush for mutual funds, which in turn has resulted in some degree of irrationality in stock market movements. The new heights scaled by the stock indices are more due to domestic investment than FPI, which conventionally tended to dominate the landscape. The danger here is that when the stock market reverses, which should happen at some point of time as a correction in response to corporate prospects, the fall in value of these savings will affect households sharply.

Fourth, to the extent that savers have stuck with bank deposits which give a return of around 6-6.75 per cent return, the income earned by fixed-income households has been eroded. This has affected purchasing power and is also evident in the limited discretionary spending for households that depend on interest income. As this proportion of the population is quite high, lower consumption feeds back into the demand for products, which in turn will regulate the growth of capacity utilisation.

To conclude, it may be said that lowering interest rates should be viewed more as a policy response to the existing conditions. It should not become an overriding objective as this can lead to adverse selection of borrowers in an effort to expand the balance sheet size. While the immediate gains would be attractive it can lead to magnified proportions of NPAs in future. We must not forget that the present scenario is a repeat of a similar ideology pursued in the past.

The writer is the chief economist at CARE Ratings. The views are personal