Above: Union Finance Minister Nirmala Sitharaman with Reserve Bank of India Governor Shaktikanta Das (centre) at an RBI Board meeting, in New Delhi/Photo: UNI
RBI’s lowering of interest rates may not help the economy. Instead, it could tempt the government to borrow more to fund populist schemes, lead savers to save less and weaken the banking system
By Sanjiv Bhatia
Recently, the Reserve Bank of India (RBI) lowered the repo rate to 5.15 percent, the fifth rate drop this year. This move is not a surprise given the widespread belief among Indian policymakers and their economic advisors that the country’s economic slowdown is cyclical (temporary), and that lowering interest rates will somehow magically fix things. The argument is that lower interest rates make it easier for businesses to borrow and invest money and for consumers to borrow and spend, thereby increasing private consumption and economic growth.
The evidence, however, suggests otherwise. Japan lowered interest rates to zero percent 20 years ago, but its GDP growth over this period has averaged only 0.4 percent per year and has crossed 2 percent only once. In the US, interest rates were lowered to close to zero after the 2008 financial crisis, but GDP growth averaged around 2 percent, which is significantly lower than the long-term average of 3.8 percent. The table provides the three-year average interest rate (as provided by the 2-year government bond yields) in countries in the Eurozone and the corresponding GDP growth. Even with negative interest rates, GDP in these countries has remained below 1.5 percent.
Why aren’t the economies of these countries with very low interest rates booming? As it turns out, even with interest rates near zero, businesses and consumers are not borrowing more, but instead it is the governments that are loading up on cheap debt. Japanese government debt as a percent of GDP has doubled since rates dropped to zero, while business and household debt have dropped by 23 percent and 8 percent respectively. In the US, government debt has increased by 42 percent, but household debt has fallen by 20 percent.
The beneficiaries of low interest rates are, therefore, not businesses and households that create growth, but populist governments offering large welfare schemes. Normally, governments issuing additional debt see borrowing costs rise, which discourages them from overdoing it. But with lower interest costs, governments feel they can borrow more. This results in higher fiscal deficits and greater economic instability. India faces a similar risk, with fiscal deficits (of central and state governments combined) expected to increase to 7.5 percent of GDP. If the borrowings of state-owned companies are included, the combined borrowings of the government are likely to be around 10 percent of the GDP. With savings at a 20-year low, and the government grabbing a bigger share of these savings, there is little left for the private sector to borrow. Private investment, already at a 16-year low, could get worse with lower interest rates.
Interest rates are a two-sided coin. On one side is the cost of capital to borrowers and on the other side is the return to saver. When rates are lowered, savers of capital lose. In a country like India, which does not have a social security system, the vast majority of people save for their retirement through fixed deposits in banks. Lower interest rates will adversely affect their corpus and reduce their purchasing power.
Lowering interest rates alone will, therefore, not fix the economy, and may even do more harm than good. At lower rates, the government will be tempted to borrow more to fund its populist welfare schemes, and savers will save less. As a result, private investment, which is the real driver of economic growth, will get crowded out even more. Lower rates will also adversely affect the profitability of commercial banks and weaken the banking system at a time when banks are facing an existential crisis from their portfolio of bad loans—a threat which could worsen with the economic slowdown. The average return on equity (ROE) for India’s commercial banks has dropped from 13.8 percent in 2012 to 1.9 percent in 2018 mainly due to high credit costs and provisions for losses at the state-run banks. Lower interest rates will hurt them even more.
I have written extensively about how it is not the price of money (interest rates), but the supply of money which is contributing to India’s economic woes. Instead of these small periodic reductions in interest rates, the RBI should do what the Bank of Japan did after the 2nd World War and the US Federal Reserve in 2008—buy all the bad loans from the commercial banks at face value and free up the banking system to start lending again. The NPA problem hangs like a dark cloud over the economy and must be resolved quickly not only because it will improve credit flow in the economy, but for the strong signal it would send to the financial markets and the real economy.
The most urgent need is a reform of the financial system and a significant reduction in the monopolistic power of the banking sector in general and state-run banks in particular. The role of a strong financial system is to efficiently facilitate the transfer of capital from savers to borrowers at the lowest possible cost. India’s financial system runs on one engine, the banking system, and 70 percent of that system is owned and operated by the government and for the government.
As a result of this monopoly, the costs to transfer capital from savers to borrowers (called the intermediation cost) are among the highest in the world. The average intermediation cost in India’s banking system is 5.6 percent—in contrast, China is at 2.9 percent and the US at 1.2 percent.
High costs of financial intermediation are associated with credit rationing, lower levels of credit channelled to borrowers and lower financial inclusion, all of which adversely impact economic growth.
A stable and liquid financial market is at the heart of a modern capitalist economy. A well-functioning financial market brings together savers and borrowers of capital at minimal intermediation cost, which benefits both borrowers and savers.
A robust financial market also allows for the efficient allocation of a scarce resource like capital by taking away resources from declining sectors and reinvesting them in rising industries. Most importantly, stable financial markets allow risks to be borne by investors who are best placed to bear them.
In India, banks are the primary providers of capital and the entire risk is borne by them. If instead, bank loans could be pooled and packaged as debt or equity instruments, the risk of default would be shared by a diversified group of investors. Home loans, for example, could be packaged into mortgage-backed securities, and commercial loans, student loans, car loans and credit card debt can be converted into asset-backed loans. In fact, any loan which has a regular payment (EMI) can be packaged and sold to investors.
India must move away from this excessive reliance on bank capital and develop a robust market for corporate and municipal bonds as an alternative funding source for corporate and infrastructure borrowing. The US has $8.8 trillion of corporate bonds outstanding—India has only $ 480 billion. Municipal bonds, which fund infrastructure in US cities, are a $3.8 trillion market compared to a minuscule $200 million in India. The government can do its part and encourage the growth of bond markets by making the interest on bonds tax-free for investors. The RBI can help by relaxing investment limits for foreign investors and easing restrictions on currency convertibility. In 2009, a committee headed by ex-RBI governor Dr Raghuram Rajan developed a comprehensive document for financial sector reform titled A Hundred Small Steps. The government would be wise to use that as a blueprint to engage in immediate reform of this vital sector.
These reforms will take time, but the government needs to move towards them rapidly. In the immediate short-run, however, both the government and the RBI could become a little more transparent when it comes to letting the people know about the health of the economy. The RBI collects millions of data points on the state of the economy, yet its commentary on it and its outlook changed from being “optimistic” in April to expressing “concerns” in August and calling the economy’s outlook “fraught with risks” in October.
In less than six months, between April and October, RBI’s forecast of GDP growth dropped from 7.2 percent to 6.1 percent. The RBI compiles a lot of data on leading indicators, and every indicator has been screaming “slowdown” since last year.
How could the experts at RBI have missed the data showing that the flow of credit to the commercial sector had fallen by 88 percent from a year ago?
Or the RBI’s own survey showing consumer confidence on employment and income hitting a six-year low? It is not hard to connect the dots. Either the boys who run the RBI’s economic analysis department aren’t very good at forecasting or they are too busy carrying the government’s water and misleading the markets.
The markets expect deceit and false rhetoric from politicians in government. But the consequences of a lack of transparency from an independent central bank cannot be overstated. For example, the RBI governor recently stated that the government’s fiscal deficit would be unaffected by the slowdown. Firstly, it is extremely disingenuous for a person who is responsible for managing monetary policy to make comments about fiscal policy which is clearly outside his domain. Secondly, even a layman using simple math knows that the deficit must increase when there is a significant shortfall in GST collections, plus there is the potential revenue loss of Rs 1.45 lakh crore from the recent corporate tax cuts. The government’s own figures show that 103 percent of the annual deficit target for 2019-2020 has already been breached by October with six months left in the fiscal year.
Given the absurdity of his comments on the fiscal deficit, it is hard for the markets to take the RBI governor seriously when he claims that the banking sector is healthy and stable. The credibility of the head of the country’s central bank is essential in times of crisis. His voice needs to be a voice of trust, backed by sound knowledge of markets and the economy. Unfortunately, that is currently not the case.
The government too has to recognise that it can use its power to manipulate economic data and influence the courts, the police and investigating agencies, the media and even the Election Commission, but it is powerless when it comes to the markets.
There is a reason why politicians don’t like free markets—they have no power over them and can’t pressure them. It is India’s free markets that will eventually decide if the emperor has any clothes.
—The writer is a financial economist and founder, contractwithindia.com