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Can Interest Rates Really Make A Difference?

Sutanu Guru examines if the Reserve Bank of India decision to remain an inflation hawk can revive animal spirits

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So Urijit Patel seems to have demonstrated that he is as much of an inflation hawk as his predecessors Raghuram Rajan and D Subbarao were. The repo rate has been left unchanged at 6.25 per cent. The monetary policy committee has deemed that this is not the right time to cut interest rates as a policy instrument to revive investor sentiments. There is already the usual round if TV debates about the RBI deciding to stick to its inflation target of 4 per cent. Was that a wise decision? Monetary policy fundamentalists will nail this as a bold move since there was enormous pressure to cut interest rates, perhaps by about 25 basis points. Others will argue that the RBI decision will hardly make a difference to the structural problems that bedevil the Indian economy. If holding on to interest rates contains inflation, Urijit Patel can claim success. But that is a big if.

In any case, many have expressed doubts if interest rate changes do make a difference to inflation rates in an economy like India, where most of the economic and business activity occurs in the informal and unorganized sector. Besides, if the root cause of high inflation is rising food prices, there is little that interest rate changes can do. D. Subbarao was the RBI governor from 2008 to 2013. During his tenure, ostensibly to tame inflation, the RBI raised interest rates 13 times.

Millions of middle class Indians who take taken home loans on floating interest were devastated by this. The domestic cost of capital became unaffordable high for many private sector investors, there is little doubt that the repeated hikes in interest rates played a role in the slowdown that gripped the Indian economy since 2011-12. Strangely, there was hardly any impact on inflation rates which remained in double digits till 2014.

Interest rate "fundamentalists" also ignore a simple fact. Despite incentives and prodding by the NDA regime, private sector investment has simply not recovered. In fact, capital formation rates entered negative territory towards the end of 2016, clearly indicating deeper structural problems. Take the example of the power sector. Piyush Goyal is indeed right when he claims that enough power is available in India for anyone who wants to buy it. But the problem is, not enough are buying,mor simply don't have the money to buy, like mist state electricity boards. Latest figures indicate that for the first time in about 10 years, capacity utilization in thermal power plants has fallen below 60 per cent. Coal India Ltd had set a sales target of 434 million tons in the April-December, 2016 period. Actual sales amounted to a little more than 390 million tons. What really can interest rates do to solve structural issues like this.

Then again, there is the Damocles sword of non performing assets hanging over the banking system in India. The previous governor Raghuram Rajan had Imolemented tough measures and promised that the NPA crisis would ease by early 2017. Nothing of the sort has happened. For example, about Rs 40,000 crores of loans taken by Bhushan Steel became NPA way back in 2012. It's almost five years and there has been no resolution. The RBI itself admits that gross NPAs in the banking system are at an alarming 12 per cent. How can bleeding banks struggling to clean up their books lend credit to the private sector? In any case, private players are not in a position to take loans, saddled as they are with a mountain of debt.

Interest rates do play a significant role in any economy. But let's not overestimate their ability to impact the real economy.