Why are Interest rates not being cut despite of Consensus across the board?

This article written by me was first published by myind.net here

Raghuram Rajan has challenged his critics of high interest rates. He has asked them to prove that inflation has fallen. He has quoted consumer price index (CPI) data to argue his case. There are arguments about whether CPI should be used for setting interest rates or WPI (wholesale Price Index) should be used. Some economists will also show you that there wasn’t such high inflation in the first place. There are those from the government side who argue that lower interest rates are necessary for economic recovery. Industry associations too argue for lower interest rates.

Thus there is a consensus among mainstream economists, business press journalists, business lobbies, finance and commerce ministries of the government that interest rates must be brought down for economic growth.  This consensus has lived through UPA years and the present NDA years. Recent revelations by former RBI Governor Subba rao show that “Both Pranab Mukherjee, now the President, and P Chidambaram pressed for interest rate cuts to revive investments even though accelerating inflation called for the opposite.“(Read)

BJP leader and MP, Subramanian Swamy has said that Rajan is responsible for suppressing economic growth and hurting Indian businesses and job creation due to his insistence on high interest rates.

It seems that the RBI’s, irrespective who is at its helm, have been a lone discordant voice against a great and rare consensus for lowering interest rates.

Interest rates act asymmetrically on growth

High interest rates may impede growth but lower interest rates may not automatically spur growth. The developed world gives ample evidence of the latter. Even in India, rate reductions made no dent on growth. Whatever growth India has achieved has been due to Modi Government’s successful push for infrastructure, Make in India, Ease of Doing Business, and higher FDI etc. Direct Benefit Transfers and Mudra loans may also have contributed, but we have no data on this.

On the other hand, when interest rates are raised they have faster effect of slowing down.

Effects of interest rate raises and reductions on growth are not symmetrical.

Interest rates reflect efficiency of economy

Interest rates are more of an effect of certain things, rather than being merely a determinant of growth.  High interest rates are caused by friction or drag on movement of money. There are several sources of this friction.  At micro level, goods take much longer to travel in India than in the developed world because of conditions of roads and multiple check points for tax collection. At macro level, we know that our decision making processes are too long winded -whether it is the GST legislation or court cases it takes decades. Project approval and clearances take long.  All such things lock up human and financial capital. They impede flow of money and delay benefits. The result is higher interest rates unless money is printed.

Rewind to 1987. For purchasing an apartment, I obtained a housing loan at the interest rate of 14.5% for 20 year tenure. These days’ home loans are available for at sub 10% rates. This 4.5% or more reduction has taken place through various ‘tightening and easing’ cycles of interest rates for almost three decades. In my opinion, the main reason for this secular reduction in interest rates is economic liberalization forced on the Rao Government since 1991. It became progressively easier to build factories (though it is still difficult to shut them), receive and send Forex, buy cars and two wheelers of choice, get telephone connections, book travel tickets, send and receive payments, hold video conferences and do countless other things. Things have become faster, friction in the economy has gone down.

Black economy imposes costs

There is another big factor -the black economy. Estimates for the size of black economy vary but one can reasonably assume that its size is quite significant. The black economy creates friction because of conversion costs, delays, and Forex round tripping etc. Black money also leads to poor allocation of capital. Black money finances crime, drugs, and terror adding to enormous social costs -these effects are rarely estimated.

Inefficient banks

Our banks, particularly public sector banks, are inefficient, they need higher than normal interest rate margin to stay afloat.  Bad loans impose costs and huge friction on flow of money. (Read Will India’s Economic Juggernaut Stall? )

When above causes of friction are removed, economy will be more efficient and a stage for lowering interest rates will be set.

Is our inflation still high?

If you are a blue chip company you may ‘see’ a low inflation. Your raw material costs have dropped, you can raise foreign capital at low rates, but cost of Indian capital stays high for you.

If you are a common man, the answer is yes. Cost of food items keep increasing with some exceptions. In the last two or three years, cost of a cup of Chai at road side tapri is gone up by 50% and that of a hair cut in a modest saloon has gone up by 40%. Prices of rail, bus, and air tickets are increasing. Prices of all types of services are increasing. All this is happening despite a worldwide slump in commodity prices. There is no respite for common man. Rajan’s 5.6% CPI feels like much more like 10% on ground.

Lowering interest while retail inflation stays high is bad politics

If you are a business with proportionately large amount of capital locked you benefit from lower interest rates. But lowering interest rates may not revive your demand -as housing sector shows. Previous rate reductions had little impact in housing sales. If you are an exporter a lower Rupee on account of lower interest rates might help you -but as the last 18 months’ experience shows, this is far from certain.

If you are a common man, lower interest rates will reduce the interest you get on your savings. You will be particularly hit hard if you are a retired person living on interest on your savings or fixed annuity. You will be hit by lower income and higher expenses. This, in fact, may be happening now and may be cause of low demand.

Reducing interest rates when the real economy is not ready (means friction for transactions not lowered enough) will encourage inefficient businesses at the cost of efficient ones and at the cost of the hapless individual savers -not a wise thing to do. It is illogical to do it when our country is crying for capital (If not, why do we need FDI?).

Reducing interest rate when inflation on the street is still high, will be bad politics for Modi Government. A few jobs that will be created will not compensate for angering the fixed income or interest income classes. Moreover, artificially low interest rates won’t be sustainable. They will cause another cycle of poor growth. Modi Government won’t like this, since it aims to stay in power for two or more terms.

Economy is not growing fast enough because it isn’t ready

If the economy is not growing as fast as some people wish it to be growing, it is because of lack of demand as many have pointed out. Lower interest rates will not stoke consumer demand except in case durables like automobiles and housing (even this has not happened due to very imperfect housing market). It may benefit some businesses more than others through lower interest costs but it will not have much impact on bad loans.

The good thing is that India’s economy is becoming more efficient due to Modi Government’s many initiatives mentioned above.  GST, better highways, dedicated freight corridors, more efficient Railways, better air connectivity, rollout of nation-wide broadband, building agricultural supply chains, and better availability of electricity will reduce the friction to transactions considerably. Technology based smart tax administration, stringent laws related to black money, and national electronic payment systems will bring more transactions in the main economy.

What needs much more attention by Modi Government is improving housing sector by bringing transparency and speed in land and building related records, buy and sell transactions, and approvals. Realty market needs to be brought on the level of stock markets. That’s a long way to go. Same thing needs to be done in agriculture market.

An alternate view

The economy is being readied.  As this happens, the cost of money will come down, ground level inflation will come down and the conditions for lowering interest rates will be there. Institutions like RBI should develop better tools to gauge this and start lowering rates then.

The RBI Governor is hinting at some of these things but he is not telling it to us properly. It will be far better if our Finance Minister educates us in this way.  He should also influence RBI and other institutions to develop better leading indicators and tools for understanding changes in economy instead relying on CPI or WPI kind of crude methods. He should hold RBI more accountable for its job of supervising banks. But he should avoid pressurizing the RBI Governor on interest rates.This will be good politics too.