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Interest Rates: Stars Are Aligning, Not In The Direction Markets Hope!
Will a reduction in interest rates by (say) 100 basis points kickstart the private investment cycle?
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Interest rates are always in the news, but decibel levels on India's rates have gone up manifold since the last quarterly GDP growth print (of 5.7%) came out. The general refrain has been that India's rates, especially real interest rates (ie, net of inflation) are too high, and are adversely affecting growth and other macro outcomes like jobs. At the receiving end of most criticism has been the Reserve Bank of India (RBI), for not cutting policy rates aggressively.
Unfortunately, like it is most of the times, the noise is likely to remain just that. Macro variables have not only vindicated RBI's stance on keeping rates steady, but also point towards marginal hardening of market yields.
To start with, the global monetary cycle, after years of easy money, is turning. Of the three major Central Banks (in US, Europe, Japan), two have embarked on a major unwinding of the Quantitative Easing (QE) that started after the global financial crisis in 2008, and injected trillions of dollars of liquidity in the global markets. At the same time, the global economy has started showing a coordinated upturn - IMF has recently upgraded its global growth forecasts to their best levels in five years. Global growth is expected to be 3.6% in 2017 (compared to 3.2% in 2016), driven by both developed markets (22% in 2017, compared to 1.7% in 2016) and developing markets (4.6% versus 4.3%). For well over a year, we have seen the goldilocks period in global growth since 2008 - with jobs, industrial production and global trade all moving up in tandem in a secular trend across the world. Both these factors, ie, unwinding of QE and strong global growth, together have meant that global interest rates are on their way up, limiting the headroom for Indian interest rates to decline from current levels.
India's macro variables on the other hand have started worsening at the margin. The key ballast for the economy in the last couple of years has been stable twin balance sheets (fiscal and trade) and low inflation, even as the economy settled to a low(er) growth equilibrium. The twin deficits have worsened. One, trade deficit is trending higher (averaging $12.6 billion in FY2018 compared to USD8 billion in the previous year). Two, fiscal situation of both state and central government have worsened, with farm loan waivers, state pay commission payouts, and now, the big bank recapitalisaiton plan (more of that later). To make things a little more interesting, inflation too seemed to have bottomed out, with more upside risks as global oil prices approach the USD60 level. In a nutshell, there is more at risk today for RBI to cut interest rates than many would have us believe.
The last piece in the interest rate jigsaw is the mega bank recapitalisation plan, funded substantially via a 1.3 lac crore Recap bond issuance. Ostensibly, this shouldn't expand the fiscal deficit - as many in the government, led by the Chief Economic Advisor have been at pains to explain. While "below the line" is the fashionable imprimatur of the Recap bonds, the impact of such definitions are optical rather than real. Effectively, the government (or some government institution) will issue bonds. While there might be adequate liquidity in the system to subscribe to these bonds, it expands the supply of bonds in the economy. In other words, it takes up the debt-GDP ratio, and skews the demand/supply dynamics for the bond market, adversely at the margin. At the end of the day, all bond (and equity) supply has to be financed by the same pool of financial (largely household) savings in the economy. Ergo, a large addition to the existing stock of bonds makes additional demands on the same pool, irrespective of the accounting treatment.
At the end, the real question is, does it matter? Will a reduction in interest rates by (say) 100 basis points kickstart the private investment cycle? When capacity utilisation in industry is running at mid-70% levels, the answer is almost obvious. In the last three year, the Indian economy has been marked by remarkable macro-stability in an increasingly uncertain world. By lowering rates today, is the marginal gain, in terms of higher potential growth, worth the risks of deteriorating macro? Historically, there has been very little correlation between interest rates and growth in India. Our growth challenges are elsewhere, in inadequate demand. Lower interest rates don't make for a good enough solution in the toolkit - the rates doves are barking up the wrong tree!
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.