How important are Interest Rates in nudging Investments?

Every time the RBI changes or decides not to change the bank repo rate, it invariably is front page news in all newspapers and portals. This decision is also minutely analysed by economists, analysts, and editorial columns. The discussion invariably centres as to how it would affect the economy in terms of accelerating or damping investment rates and consequently the economic growth, and inflation rates. A side issue is what would be the effect on interest rates on bank deposits and loans. This line of thinking pre-supposes that interest rates are the primary factor effecting economic growth and inflation rates and have a direct and proportionate effect on both.

While it is true that employment, investment, or growth is directly linked to the amount and kind of investment a society or country makes, the assumption that supply of and demand for credit are solely or even largely dependent on interest rates is simplistic and fallacious since it ignores two critical determinants, namely, the terms of credit and animal spirits. That is, for investment to happen, two preconditions are essential. First, availability of easy and reasonably priced external funds to supplement and leverage the promoter's capital, and second, entrepreneurs’ confidence that they would get adequate return on their investment. These two pre-conditions are independent of the government’s efforts to prime the pump through reduction in interest rates. We seem to be failing on both counts.

Interest rates are the cost of capital, i.e., the price agreed between the borrower and lender for any borrowing / lending transaction. In any borrowing / lending situation while the first leg of the transaction (lending) happens in the present the second leg (payment of interest as well as repayment of principal) happens in the future. As all of us are aware the future is always unknown. This in turn creates something known as credit risk, i.e., whether the borrower will repay as agreed, or does he have both the capability and the intention of repaying. A very difficult question at the best of times.

To reduce credit risk, banks stipulate a host of conditions on the borrower which go under the rubric “terms of credit”. This includes aspects such as security (collaterals), purpose, amount, tenor, positive and negative covenants, legal documentation, penal charges etc. etc. These conditions are stipulated in the hope that the borrower is encouraged to repay. In the Indian context, the primary instrumentality for determining the terms of credit is the banking system, which due to its broken governance systems has been unable to evolve a reasonably workable conceptual framework or associated processes to evaluate and determine the various terms of credit. The end result is difficulty along with prolonged delays in accessing bank credit, with many of the stipulated terms of credit having no relationship with the relative credit exposure.

Bank credit is not the sole source of external funds, but the comfort it provides in terms of the assurance that some kind of due diligence has been done and someone is monitoring the borrower, is what enables other sources - both formal and informal (NBFCs, MFs, friends and relatives etc) - to free ride and provide supplementary funding. 

The fact that Indian industry is not getting adequate credit manifests itself in various ways. For example, Bank Credit to GDP in India at around 50% is virtually half the global average and a quarter of levels reached by China. Or the fact that while the Services sector of the Economy contributes more than 50% of the GDP, it receives only about 30% of bank credit. Even the meagre amounts of credit it is able to raise is largely predicated on availability of collateral security and not on its ability to service debt. 

No political dispensation wants to let go or reform the banking system since its control gives it tremendous power. Moreover, no reform in the banking system is possible as long as DOFS exists in its present form, since it provides humongous control rents to its mandarins with no equity stake. A situation of clear and extreme perverse incentive to maintain the status quo.  

Now coming to the second reason – the dropping levels of animal spirits. This term owes its origin to John Maynard Keynes who in his 1936 book The General Theory of Employment, Interest and Money used it to describe the instincts, proclivities and emotions that ostensibly influence and guide human behavior, and which can be measured in terms of, for example, consumer confidence. It has since been argued that trust is also included in or produced by "animal spirits".

Trust is the basic glue which holds society together and builds confidence, essential for animal spirits to emerge and encourage entrepreneurs to make productive investments. The result of the emergence of the strategy of fostering continuous friction between different social groups as the primary means for maintaining political power, is that the level of trust has naturally reached a very low ebb in our society, and is continuously receding. Naturally, this has resulted in adversely impacting the willingness of our entrepreneurs to make investments.

Both these conditions hit our informal / MSME sector especially hard. The sector which not only generates the bulk of our production, employment, and exports but provides the very foundation on which the economy rests.

The five trillion dollar question therefore is, would reducing interest rates without addressing factors affecting the terms of credit and levels of animal spirits, have any kind of positive effect on our investment levels?

Without first addressing both these issues, namely rebuilding trust in society and reforming our banking system, there can be no succor.

Think!