Misplaced assumptions behind rigid monetary stance

There is a chorus of appeal for interest rate cuts from the industrialists, some economists, journalists and oblique references from the Union Finance Minister, a clear indication of growing impatience with the unyielding stance of the RBI, despite the WPI touching zero.

RBI’s refrains are (i) it is not interest rate alone which is holding up investments and (ii) the inflation should settle down at stipulated levels first.

Intriguing stance

Inflation is and may be yo-yoing – the drop may be temporary and monetary policies cannot flip flop in tandem. But does it make sense to insist that such a volatile factor settle first before RBI initiates action. In a globalised world, the chances of inflation stabilising or holding steady below any stated level are remote.

Policies are not like court judgements – they are made for the future based on assessments. The statements emanating from the monetary authorities cannot be called assessments of the future – they seem at best fears and apprehensions of what might go wrong in the future.

For most other stakeholders, trying to understand its stance is like a deaf man trying to appreciate Mozart.

Kinds of decisions

RBI officials have been reported to be saying ‘not just credit cost, other factirs also are slowing loan offtake’ as justification for their reluctance to adjust interest rates downwards.

RBI’s stance would have a justifiable basis, if investments were being made by assigning weights to interest rates, licences, environment clearances, land acquisition, etc. A lower score on just one factor alone (interest in this case) would not hold back investments.

There are situations in physical investments which follow this method – like the choice of locations which may be based on water, road connectivity, manpower availability, tax incentives, etc. Choice of technology may be based on royalty, yearly maintenance outgo, experience of others, etc.

For a credit rating agency, a good asset cover does not compensate for weak demand, and a good gearing cannot take care of regulatory risks. The rating agency assigns weights to various factors and scores on each such factor to come to a weighted ‘rating’.

But where it concerns interest rates, permits, or land acquisition investors in physical assets do not come to a conclusion by weighting. Each such factor is like ‘go-no-go’ gates. The proposed investment will have to pass through each of them.

No business will undertake a project where the net returns are poor or below cut of even if all the other factors are favourable.

Poor Net Returns

The net returns (excess of returns on capital employed (ROCE) over weighted average cost of capital) for many industries have been continuously declining for the last few quarters and for many of them are deeply in the negative at the current interest rate scenario.

The real interest rates (calculated as nominal interest rates less inflation) if calculated industry wise is so high for most industries that it does not make sense investing in them.

Ironically, the problem is more acute for industries sourcing agro inputs where the inflation (the main reason for high interest rates) has been rather high but output prices increasingly linked to import parity have just not moved up.

There are no precise studies on the single dominant factor holding back investments.

The RBI may be correct in saying that interest rates are not the sole villain. Sure the legislations in the last few years has tied the industry in all kinds of knots – FTAs, Green Tribunals, land acquisition laws, unprecedented tax aggression, and of course various court rulings. There are also wide spread problems of excess leveraging.

But if all of them were to fall in line, would the prevailing interest rates and negative net returns attract additional investments? The answer is a clear ‘no’. Most commercial projects have a target of 3-4% net excess of ROCE over WACC. A 2% ‘excess’ interest (or 1.3% after tax) is a sizable proportion thereof. It is a serious enough hurdle that can stall/kick start at least 25-30% of the projects which are otherwise capable of proceeding ahead.

Inappropriate to tackle growth induced inflation

Inflation and growth are positively co-related. Presumably, inflation leads to lesser real interest rates making investments attractive. It is also indicative of healthy demand which is facilitative of investments.

But the other lesser popularised way of growth leading to inflation is increase in relative prices. If productivity in other sectors increase, these sectors may be willing to pay more for, say, agricultural products even if agri-productivity does not go up. If weights remain the same, there will be inflation – a situation where inflation may not have its usual adverse consequences.

In the last few years, increased productivity in other sectors have been shared with agri-cultural sector through administrative orders like increased MSPs causing high food inflation and its consequent impact on general inflation.

Whether this needs to be contained by restrictive interest rates is doubtful.

Likely Impasse

As per its own statistics capacity utilisation of most industries including capital goods sector is low – nowhere near full capacity which is when it needs to be stifled by higher interest rates. Given the current circumstances the policy stance seems misplaced or born of inappropriate reading of the situation.

If real investors also wait for everything from government policies to court judgements, interest rates to labour laws to settle down before investing in similar manner to our monetary stance, perhaps no physical investments will ever take place anywhere.