By Invitation. Why lower rates may not unlock the purse

Revival in the private corporate investment cycle remains the key to sustainable recovery in the Indian economy. A host of factors influence the private sector’s decision to invest, including cost of credit (interest rates), demand and capacity utilisation, and business and regulatory environment. To be sure, some constraints have eased over the last year, but a full-fledged revival of the private corporate investment cycle is unlikely before the next fiscal despite the Reserve Bank of India (RBI) reducing the repo rate by 125 basis points (bps).

The RBI first started lowering the rate in January this year. The central bank, however, also lowered its GDP growth forecast by 20 bps to 7.4 per cent and its January 2016 inflation forecast to 5.8 per cent from 6 per cent.

Empirical studies show that monetary policy or interest rate cuts by a central bank impact the economy with a lag. In India, this lag is estimated at about 3 quarters — if commercial banks pass it on, that is.

Some banks indeed responded to the RBI cuts — but not in a like-to-like manner — by effecting lending rate reductions of 25-40 basis points. Axis Bank was the first off the block, cutting its base rate by 35 bps to 9.5 per cent after the RBI cut the repo rate by 50 bps. Others such as SBI, Andhra Bank, and Bank of India sliced their base rates and HDFC snipped its home loan rate by 25 bps to 9.65 per cent — all with effect from October 5. This partial transmission implies that impact on output and investment will be delayed as well as diluted.

The disparity in the nature of interest rates on term deposits and loans partly explains the delay in the transmission of rate cuts in India. Banks take term deposits at a fixed rate and tenure while they lend at floating rates. So, if banks immediately pass on the rate cuts to clients, their interest income will fall, while the cost of deposits will remain unchanged. Therefore, to protect margins, Indian banks wait for their average cost of deposit to decline before lowering lending rates.

To address this issue, the RBI wants banks to fix their lending rates based on the marginal cost of funds. It has issued draft guidelines that require banks to follow this method to compute the base rate from April 1, 2016. It also wants banks to offer floating rates of interest on term deposits. This change, should, over time, improve transmission.

In addition, the government needs to reduce interest rates on small savings instruments that are administratively fixed. The RBI, in its latest policy review, reiterated that it will work closely with the government to remove impediments to weak monetary transmission. But a month since the RBI moved, there is no announcement on reducing the small savings rate.

While the NDA government has addressed some of the ease of doing business issues, huge under-utilised capacities and sluggish pick-up in household demand continue to weigh on manufacturing investments.

A CRISIL Research analysis of capital investments across large sectors highlights the weak investment outlook for the current fiscal. Private corporate investment, which has a 38 per cent share of total investments, is unlikely to pick up before the latter half of next fiscal. The current level of capacity utilisation is lower than the five-year average for many sectors.

The RBI’s OBICUS survey also corroborates that capacity utilisation in the manufacturing sector was at a five-year low in April-June 2015. Weak global demand is also restricting capacity utilisation in the export-driven sectors. Plus a steep fall in global demand and prices is leading to dumping in sectors such as steel, already plagued with excess domestic capacity.

The government does recognise the need to stoke demand using policy tools. While treading the path of fiscal consolidation, it has increased allocation for capital expenditure in the current fiscal, given the headroom from lower oil subsidies (as crude oil prices fell) and a hike in excise duties on petrol and diesel.

Front-loading capital expenditure in infrastructure to trigger investment demand should offer mild support.

The OROP and Sixth Pay Commission recommendations should also help generate demand in the coming fiscal.

And if monsoon is normal next year, rural demand would also look up. Hopefully, by that time, banks too, would have cut their lending rates further. All these could persuade the private corporate sector to loosen its purse strings for capital spending in fiscal 2017.

The writer is Chief Economist, CRISIL