There are demands from various quarters for pruning interest rates to spur the economy.

But how effective is a rate cut in the Indian context? In 1999-2000, the RBI floored the gas-
pedal -- the bank rate -- to one of its lowest levels at 8 per cent (Apri l 29, 1999 through
March 2, 2000). Shockingly, recent CSO data reveal that growth in private corporate sector
fixed capital formation in fiscal 2000 actually fell 1.3 per cent. The CMIE estimated a fall of
18 per cent in government capital expenditure in the same period. How do we make sense
of this seemingly puzzling result? Let us work it through.
INTEREST rate is essentially a nominal variable. Does it have any impact on the real
economy? If it were a panacea to our problems, would it not have been abysmally low by
now, with the economy booming? But that is not the case. A cut in the interest rat e is
expected to expand output through increased investment. Interest rates make for a
relatively convenient policy variable and growth -- a noble goal in macroeconomics.
Therefore, the true expansionary effect of interest rate cuts has gone largely unqu estioned.
While the theory underlying this relationship is fairly sound, in the Indian context, its
relevance could be overemphasised.
First, the government (read the Finance Ministry) can at best tinker with the rate at which it
can borrow. Small savings (which includes Kisan Vikas Patra, Indira Vikas Patra, National
Savings Certificate, and so on) is the government's little piggy-bank . A cut in these rates
immediately renders government borrowing cheaper. This shows a notional cut in
expenditure. Directly, other government spending decisions become more profligate and
reckless. This affects the fisc's health, dousing sentiment. And r ightly so, as government
spending is largely revenue (read unproductive) in nature.
Second, the interest rate structure is not smoothly interlinked. Does a rate cut have a
positive fallout on the cost of funds for private investment? First, rapid asset market
adjustment assumes almost no time-lag for interest rates to change across the board. This
is not necessarily true. A cut in the EPF, GPF rates last fiscal did not see commercial banks
scramble to reduce their PLRs. However, in the upward direction, the response is more
encouraging. (Also we must remember that only the blue-chip co rporates can borrow at
rates close to the PLR.)
Now, let us assume that the RBI cuts the bank rate, a closer proxy for interest rates as it
has a greater bearing on the PLR. The bank rate is the rate at which the RBI refinances
banks. Suppose one bank bells the cat and cuts its PLR, while all others f ollow suit. (Banks
in India are not altogether fond of lending. With the provisioning norms getting stricter and
their being saddled with huge NPAs, banks cannot but exercise over-cautiousness in lending
decisions.) Theory would have us believe that this cut would spur private investment (by
firms). The logic is sound. But, in practice, most bank borrowings by corporates are for
short-term working capital purposes.
Strictly speaking, short-term funds cannot be employed to enhance productive capacity.
This is largely funded by debentures and corporate bond floats, which are long-term
financial instruments. As an aside, we must remember that a change in interest rate s does
not alter the total supply of money. It only results in a reallocation of assets within
portfolios. Elementary economics tells us that a rate cut triggers the demand for corporate
bonds and, consequently, bond prices harden. This encourages fresh bond floats.
Does this necessarily imply new investment demand because capital becomes cheaper?
Typically, in a recession mode (usually, that is when rate cuts are prompted), the
benchmark rate is cut and corporates are seen to retire high-cost debt by borrowing at p
revailing cheaper rates. There is only a change in the maturity and yield on paper, while the
underlying asset remains the same. There is no real fresh investment demand, as one might
hope.
The argument can be extended to long-term funding. For instance, if, in response to a rate
cut, corporations fund expansion through tapping the primary market -- debt or equity. For
a greenfield project, typically, the process from the feasibility study to arranging for a lead
bank, to the stage of allotment (when the proceeds can be used) takes a typical MNC a little
more than a year.
If the homework has already been done, from the time of the board decision on an issue till
the allotment stage takes an average of three months. Considering that interest rate is
often used as a remote control to manage the rupee, it is anybody's guess what changes it
may go through in response to the very volatile forex market. This unpredictability takes
away most of the punch of rate-cut announcements. This is one reason why it loses
relevance with long-term funding decisions. Another perspective is as follows:
Corporate investment demand is a function of various parameters: End-product demand,
competition in industry, terms of the technology tie-ups and the availability of capital goods.
Interest rate is just one of them. Assuming that the particular capital g ood required needs
to be imported, a cut in interest rates might make credit cheaper.
But in the forex market, the narrowing of the interest rate differential may cause a capital
outflow. This makes the rupee weaker, rendering the imports, in fact, more expensive -- a
classic Catch-22 situation! In fiscal 1999, India imported 71 per cent of its capital goods
requirement, while in the estimate for fiscal 2000, imports constitute as much as 76 per
cent of the total value of capital goods.
So far, the discussion has centred on the organised sector. A look at what happens in the
unorganised sector shows that it is even more shocking. Imagine a farmer borrowing from a
moneylender at 24 per cent. When interest on PPF drops 100 basis points fr om 12 per cent
to 11 per cent, his indifference is not misplaced. Rate cuts in these unreachable areas are
futile.
To sum up, first, interest rate cuts help the government book lower expenditure and delude
us with notional savings. Second, they do not exactly result in cheaper finance for the
private sector due to glitches in the market mechanism. Third, cheaper cred it is offset by
dearer imports. And, finally, interest rate changes are only temporal in nature, as it is like
one stone trying to hit too many birds.
We must keep in mind that real interest is but a function of capital. A cut in it can boost
demand, but the oft-overlooked supply curve in our context is considerably inelastic. At the
end of the day, India's economy is still capital-scarce. Thus, a cut in interest rates can at
best be illusory, and it ultimately seeks its level of equilibrium. Only in the long run can this
situation can be corrected by encouraging R&D, protecting IPRs and freeing all barriers on
FDI, to attract capital and lift the pro duction function.