No point in tinkering with interest rates

 

 

How important is the credit policy? That depends on how important you think the level of interest rates is for India’s economic growth. According to a recent paper by International Monetary Fund economists Rahul Anand and Volodymyr Tulin, titled Disentangling India’s Investment Slowdown, it doesn’t count for much.

The economists find that 1) interest rates, both nominal and real, are negatively related to investment growth; 2) real interest rates are more important for investment activity than nominal rates; 3) other things being equal, a one percentage point rise in the real interest rate has a two percentage point cumulative impact on the investment rate over the next four quarters; and 4) the most significant finding that real interest rates account for only a quarter of the investment slowdown.

A surprising result is that of a positive correlation between real interest rates and new investment—the authors explain it by suggesting that higher interest rates, after controlling for business confidence and policy uncertainty, may be associated with higher expected returns from investment as well as higher demand for investment funding. They conclude that while the level of real interest rates matters for investments already in the pipeline, it is not a deterrent to new investment.

If the level of real interest rates explains only a quarter of the investment slowdown, what factors account for the other three-quarters? The authors point to two of them—low business confidence and policy uncertainty, while they also mention supply bottlenecks.

To be sure, lowering nominal interest rates will certainly provide relief to firms that are neck deep in debt. But the crux of the problem, as the paper points out, is that in the absence of structural changes in the economy, any lowering of interest rates will lead to a revival of demand that will soon come up against supply bottlenecks, stoking inflation.

What should the Reserve Bank of India (RBI) do on Tuesday? The latest number for retail inflation has come down to 8.1%, but core CPI (Consumer Price Index) inflation is sticky at a high 7.9%, indicating that any pickup in growth could lead to a revival of inflation.

With the repo rate at 8%, the real policy rate is still slightly negative. It would be much more negative if we take inflationary expectations into account, rather than current inflation. It remains to be seen whether the fall in food prices was seasonal. All these factors signal caution.

As the paper cited above argues, what really matters for investment is the removal of policy uncertainty. That can only happen if we have a business-friendly government after the elections. Lowering interest rates before that would be pointless and can only fan inflationary expectations.

 

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