Is RBI fighting the wrong battle?

Reserve Bank of India Governor Shaktikanta Das believes that low interest rates are required to promote private sector investment and reignite growth.

The problem with interest rates, however, is that they are rising. The Union budget for 2021-22 has implied that the central government will need to borrow a record Rs 12 lakh crore this year (about $167 billion). If you add the borrowing requirement of the states, going by past trends, the amounts involved could easily double. When demand goes up, prices (yields) start to rise as in any other market. An interesting game is thus playing out in the Indian bond markets.

The RBI is reluctant to let the yields rise. It had made huge efforts in the past to push the yields down. The instrument used was the Repo rate: this is the rate at which RBI lends to banks. This rate had been brought down from 8% in January 2014 to 6% by April 2019 and 4% by May 2020, which is where it still is currently. The 10-year yield had, in response, earlier been steadily reducing from a high point of around 9% in early 2014 to a low of about 5.7% by July 2020. Historically, the spread difference between the Repo and the 10-year yield curve is around 150 bps.

It then changed tack. It has further risen by an additional 27 bps in the past month to a recent high of 6.17%. It seems to be violating the historical trend. The experience of witnessing increased yield rates despite an unchanged repo is causing discomfort.

However, it is oft forgotten that a silent factor which had aided the RBI drive to reduce yields in the recent past was the decline in inflation rates due to the global commodities price crash of 2014/15, caused by a China slowdown coming on top of the EU/US growth stagnation around the time.

The crash had been sharp. Between mid-2014 and early 2016, the global economy witnessed very large crude oil price declines. The 70% price drop during that period (from around $120 to the mid-40s and later even further below) was one of the three biggest declines since World War II, and the longest lasting since the supply-driven collapse of 1986.

Iron ore/coal etc., had also similarly fallen. Indian inflation rates fell from a peak 10.9% in 2013 to 6.35% by end 2014 to a low of 2.49% by 2017. However, inflation has now started going up. This is because in India, inflation is endemic, created by our regulatory management systems operating outside the purview of the RBI. In 2019, inflation was around 4.76%. In March 2020, it was reported to be around 5.84%, and 6.69% in August 2020. Thereafter, the weights used in the formula to calculate inflation were altered. Inflation accordingly fell and was reported at 4.5% by December in the new system.

A significant increase in oil prices happened regularly thereafter, likely to support further inflation. Policy Repo rates have not been changed. A rate divergence is thus happening, which the RBI does not like.

Till now, the RBI had managed to keep a lid on interest rates by using devices like Operation Twist (sale of lower yield short-term paper to buy up higher yield long-term paper to drive down long-term yields) and anonymous stealth borrowing by getting PSBs to front for it.

Unfortunately, past excesses always tend to catch up. The bond holdings of the hapless public sector banks are already higher than the Statutory Liquidity Ratio (SLR) limit, at times crossing 30% of deposit funds. The bond traders are also now not responding as they did in the past. Announced bond auctions are often failing, forcing repeated interventions by the central bank, fueling a sense of frustration amongst officials and bond investors alike.

Forgotten in this tug of war is the question of whether interest rates really matter under Indian conditions. Admittedly, economic theory says that they should matter. But the Indian reality is that it does not. At least, this is what the CMIE economic outlook data regarding ‘project announcements’ (2000/01 to 2018/19) reveals.

The correlation between the values of project announcements/completion and the Repo rates is very low (range of 0.27 to 0.44 for time lags upto ‘T plus 3’ years). The reason for this lack of influence of interest rates on the investment behaviour can be found in the ‘Profit and Loss’ accounts of our companies available in the CMIE database. The share of interest cost, in the Indian Corporate’s Profit and Loss account is seen to fluctuate between 1.7% to 2.4% of sales realisation, much lower than the share of taxes paid, which ranges between 6-8%. The share of all other ‘Management Expenses’ is seen to vary between 10-14%. Thus, the interest burden, if it is a burden, is the least of the burdens on our hapless entrepreneurs, at least if we accept that revealed behaviour is more important than ‘talk’.

No promoter will talk about their actual fears. They can’t afford to annoy the powers that be. So, they take the easy way out and talk about interest rates. But actually, investment is not happening because of fears and apprehensions about regulatory overreach in a variety of areas. A regulatory calming is therefore required, to improve the ambience for risk-taking behaviour, not interest rate gymnastics.