Do interest rates matter in India?

In India, lower interest rates are surely no magic wand.

Joseph Stiglitz and Larry Summers may not be on the same page on many matters these days. However, on the matter of asking the Federal Reserve not to raise interest rates, they both have sung from the same page. One could be excused for thinking that the Federal Reserve was about to push up the Federal Funds rate upwards of 200 basis points. It was supposed to raise the Federal Funds rate by 25 basis points after keeping it at around zero for the last six years. If they paused and reflected, Stiglitz and Summers would admit that their case would be inadmissible in the courts of common sense or prudent risk management. In the end, they prevailed. The Federal Reserve did not raise interest rates. That is a different matter for another occasion.


For all the hand wringing about the possible move by the Federal Reserve, evidence that prolonged low rates have helped the real economy to heal is conspicuous by its absence. Stephen Williamson, reviewing the volume of collected essays on the ‘Federal Reserve policy under the lens of economic history’ notes that no work establishes a link between Quantitative Easing, on the one hand and inflation and real economic activity, on the other hand. Indeed, there is much evidence that the effect of interest rates on investment is routinely overstated.

Interest rates and hurdle rates – the twain shall never meet
The authors of a Federal Reserve working paper published in December 2013 had surveyed Chief Financial Officers on the effect of changes in the monetary policy rate on their investment decisions. The answer is conclusive. Within normal ranges, there is no effect. If there is any effect, it occurs when the Federal Reserve increases interest rates substantially. That leads CFO to adjust their Weighted Average Cost of Capital (WACC) and the hurdle rate that the return on their proposed capital investments must exceed goes up. In other words, monetary policy seems to have an asymmetric impact on investments. Lower policy rates do not lead to downward adjustments in the hurdle rates. They remain fixed and are only adjusted upwards for large increases in the policy rate. Unsurprisingly, hurdle rates for investments have remained unchanged in the new millennium in the United States.

The story is similar in Europe. Recently, a quasi-academic article in Financial Times notes that corporations understand that a low interest rate environment also signals low cash flows for their investments. Further, they feel that in a world of zero interest rates, it is very difficult to find projects that would earn the WACC within the near future.

The Indian story
Now, let us turn our attention to India. Does the interest rate medicine work in India? In recent weeks, by sheer dint of repetition, the view has been established that India needs to have considerably lower interest rates and that the Reserve Bank of India (RBI) has perversely kept it too high. India’s Chief Economic Advisor feared that India could be on the cusp of deflation. That sounds too far-fetched. With its fragmented agriculture, industrial production and corporate structure, India is never far away from economic overheating. Its economy is too inefficiently organised to deliver non-inflationary growth for a long period, at a stretch. The question of whether interest rates are the right tool to address the inflation risks emanating from an inefficiently structured economy is a different subject. The more urgent question is whether interest rate reductions in India would revive investment spending. The monetary policy meeting of the RBI is scheduled for September 29.

In its annual India: Selected Issues published in March 2015, the International Monetary Fund (IMF) noted that banks in India adopt a peculiar strategy. When the Reserve Bank of India hikes the policy rate, they immediately increase their lending rates. When RBI cuts the policy rate, they lower the deposit rate. Monetary transmission is working but perversely in India. In a perennially savings-short country, what the banks are doing is a disincentive for savers. Similarly, banks do not stimulate lending when rates are lowered. Perhaps, a separate study is needed to measure the impact of banks’ behaviour on the Gross Domestic Product of India over the years. It could be substantial.

In this context, it is useful to assess what has held back investment spending in recent years (chart). Different explanations are afloat. From interest rates to high debts carried by companies in their books to corporate profitability to policy uncertainty, etc., there is no dearth of explanation for the investment slowdown. But, an end to the investment drought does not appear to be in sight.

Chart 1(Source: Handbook of Statistics on the Indian Economy, Reserve Bank of India)

Private Sector Capital Formation in India as a ratio of GDP at market prices. Both are at Current Prices. Years are financial years ending in March. Data up to 2011 are based on 2004-05 base year. After that, it is based on 2011-12 base year.

The role of Policy Uncertainty
In a working paper Disentangling India’s investment slowdown published in March 2014, the IMF addresses this issue. It undertakes several econometric investigations. The conclusions are compelling. Real interest rates do matter in explaining the changes in real gross fixed capital formation in India. It is not irrelevant as survey evidence from other countries suggest. Their investigation spans the period from 1996 to 2012. The overall explanatory power of their model was weak. So, the authors include a ‘Policy Uncertainty’ variable. Two professors at the University of Chicago have computed a Policy Uncertainty Index based on newspaper articles and their use of some select phrases that denote rising or falling policy uncertainty. For a better understanding of their methodology, one can visit the website, One can download their Excel file for India. They have revised their methodology for India with explanation provided as to the revisions.

Once it is included, the overall explanatory of their model almost doubles. Importantly, however, the individual explanatory power of the three key variables – the real interest rate, the policy uncertainty index and business confidence (an index compiled by the National Council of Applied Economic Research) – waxes and wanes, depending on whether any of the other two variables are in the equation or not. Nonetheless, it does appear that the policy uncertainty index and the business confidence index are individually more important than the real interest variable. These results are gleaned from Table 2 of the paper (p. 13).

Results that are more interesting are available in the following page in Tables 3 and 4. The dependent variable – the variable whose behaviour is sought to be explained – is changed. The ‘new’ dependent variables are new investment projects (project costs as percent of GDP) and shelved projects (project costs as percent of GDP). In fact, for new investment projects, the only thing that matters is policy uncertainty and not the other two variables (Table 3 in the paper). For shelved projects, the other two variables matter only if the ‘policy uncertainty’ variable is not there. However, the power of the model without ‘policy uncertainty’ is weaker.

This simple econometric investigation suggests that for the investment climate to revive in India, policy uncertainties from approvals to freedom to price to tax law changes must be removed expeditiously. The chart below shows the index of ‘Economic Policy Uncertainty’ for India.

chart 2

The new government can feel reasonably pleased that the downtrend in policy uncertainty that started in the summer of 2012 had continued uninterrupted since it took office. However, it must note that the spike in uncertainty in August 2015 puts the index level at roughly the same as it was in May 2014 when it took office. For instance, the Committee appointed to decide on the applicability of Minimum Alternate Tax on foreign institutional investors gave its verdict and the government accepted it. But, the issue remained unsettled for about six months when the first demands on FII were raised based on flimsy grounds. It was a needless uncertainty that took six months to go away. Much more needs to be done to reduce policy uncertainty and improve policy certainty and consistency. To name just two, the government of India has to address the issue of gas pricing and the pending tax disputes with Cairns, etc. Arguably, the headline effect of the resolution of these issues could be more important than their real effects.

Interest rates and investments
On the monetary policy front, there is a case for the RBI to lower the interest rate. Official inflation rate is around 3.7 percent and the policy rate is 7.25 percent. One of the reasons that the RBI maintains a high nominal policy rate is that it wishes to bring down inflation expectations. In reality, however, it seems to have very little control over it. At least, that is what the data show us. RBI has been conducting quarterly inflation surveys of households and others since 2006. The survey was conducted initially in 12 cities and has since been expanded to 16 cities. We compiled the data from the 5th survey since we could not find the first four surveys. Ever since the Indian public was caught out by the sudden inflation surge in 2008-10, they have simply upped their inflation expectations and not brought it down. Regardless of the current monetary policy setting, the gap between the officially reported inflation rate and the one-year ahead inflation rate anticipated by the respondents of the RBI survey on inflation expectations remains as wide as ever, if not wider (chart).

Chart 3
(Source: Reserve Bank of India and the author’s calculations.)

Official Inflation Rate is as per Consumer Price Index for Industrial Workers. 12-month ahead inflation rate is the mean inflation rate taken from the Quarterly RBI survey on inflation expectations. RBI started giving both mean and median survey responses from June 2012. We use the mean estimate for continuity reasons. The survey was expanded to sixteen cities in December 2012.

This is not a problem or deficiency on the part of the RBI in the conduct of monetary policy. This is an international phenomenon. Central banks are seldom able to influence inflation expectations except when they tighten too hard and push the economy into a recession as Paul Volcker did early in the Eighties. Much as central banks around the world swear by inflation targeting and the importance of inflation expectations for keeping actual inflation outcomes reasonably low and stable, they have precious little control over either. Indeed, monetary policy frameworks around the world centred on inflation targeting – and not just in India – should be re-examined. Indian economy, in particular, is characterised by extraordinary fragmentation of production in farms and in industry. It lacks the scale to innovate and to accrue productivity and efficiency gains. That is the source of India’s growth and inflation problems. Monetary policy has very little role to play in that. In other words, interest rate reductions will do little to revive growth sustainably. We will have more to say on this on another occasion.

Near-term, the question is whether the RBI policy stance will push India to take the steps to improve the structural foundations of the economy or it would result in RBI being scapegoated for economic stagnation. Pundits in India have begun to voice their dismay over what they see as a deliberately restrictive monetary policy. There is a case for lower rates but by how much is very much an open question.

The RBI Governor is of the opinion that there is little to gain over the long-term by stimulating growth in the near-term through unsustainable means. He is right. When policy rates were accommodative, capital formation in India happened. But, it was not of the right kind. Had it been so, India would not have run into severe overheating problems after 2008. It is true that real interest rates appear more relevant to capital formation in India than internationally. The corporate sector may decide to invest more, if interest rates are lower. Capital expenditure projections for 2015-16 are drastically lower for the current financial year. Half the year is almost over. Capital Expenditure plans of the Indian Industry were about 27 percent lower in 2014-15 than in 2013-14. Current plans for 2015-16 are far too low (chart). It is little over 800 billion rupees only.

Chart 4(Source: Private Corporate Investment: Growth in 2014-15 and Prospects for 2015-16*, RBI Bulletin, September 2015 and Urbanomics blog.)

Phasing of Capital Expenditure Plans funded by banks, financial institutions, external commercial borrowings and equity issuance. Years are for end of March.

However, without appropriate sectoral policies, lower rates may boost investment of the wrong kind and may bail out malinvestments of the past. A case in point is the real estate sector. Prices of homes in major Indian cities are unaffordable except for dual-income upper and upper-middle class families (Table). Lower interest rates may simply bail out the real estate developers and promoters without eliminating the underlying inefficiencies and profiteering that have made homes unaffordable. In fact, the RBI Governor was right to quash the idea of teaser loans (low interest rates on mortgage loans at the beginning to entice borrowers). Real estate promoters have rejected his suggestion to bring down prices of homes to make them affordable. What he suggested was elementary common sense. A reduction in interest rates can boost consumption spending. So too can lower prices for goods and services. Housing is a good place to start. That will also lower inflation expectations.

Slide1(Original Source: Liases Foras, Capitaline, Companies annual reports. Source: Business Standard (accessed on 19 September 2015) )

* Average price for key localities in the city
**Annual Average cost to the company in top banks & IT companies
^ Assuming a typical 2-BHK house with super-built area of 1000 sq. feet            

As for fiscal policy, the fiscal deficit is coming under control only slowly now. The government has committed to implement the One Rank One Pension scheme for the Indian Army. Recommendations of the Seventh Pay Commission report for salaries and pensions of staff at the Union government are due anytime. They will be effective in the current financial year itself. The government has not been able to derive much revenue through sale of stake in government-owned enterprises. Hence, it is not clear if fiscal policy has much scope to expand either this year or next. It may be feasible only in 2017-18. However, if global developments affect business confidence adversely in India and investment plans are further curtailed, the case for a carefully crafted investment-oriented fiscal stimulus might become both urgent and necessary.  For a lucid exposition of the need for fiscal spending in India, see Fiscal push to propel India’s economy by Dr Srinivas Thiruvadanthai.

For now, there is a case for a 50-basis point reduction in the repo rate before the end of the year. More can follow later, depending on the evolution of fuel and food prices in India. But, in India, with its inefficient farm and factory structure, lower interest rates are surely no magic wand. To that extent, the answer is that interest rates matter little. Much more needs to change elsewhere.

Photo: Surat Lozowick