Six months ago, I wrote a column, ‘Why bother about small interest rate changes in India?’, (goo.gl/7cFp1L, September 16, 2015) that I could reproduce and yet be spot on after the RBI’s cut in interest rates last week. It will not change GDP growth, industrial production or the inflation rate. It may not even change bank lending rates significantly.
It proves once again how limited are the instruments at the disposal of central bank governors, and how media hoopla keeps exaggerating the power of the minor instruments.
Lost in Transmission
The problem is not limited to the Indian central bank. It relates to all of them. Central bankers have been striving mightily to revive country after country and failing for years. Massive monetary stimuli unprecedented in history have left economies flaccid, like failed Viagra.
Last week, the RBI cut its repo rate by 25 basis points (0.25%), and announced some measures to improve liquidity in the market. Media hoopla may have led the naïve to believe that something momentous was about to happen. But at a Mumbai conference, Professor Avinash Persaud of the Peterson Institute said the cut in interest rate didn’t matter a tinker’s damn, and I am inclined to agree.
It will make no difference to the macroeconomic situation. At most, it may marginally benefit a few interest-sensitive sectors like housing finance (by lowering the equated monthly instalments).
RBI governor Raghuram Rajan is struggling with the problem that his interest-rate cuts are not translating into lower lending market rates. He has cut the RBI’s repo rate by a total of 1.5% in recent times. But bank lending rates have gone down by just maybe 0.5% to 0.75%. Why are RBI cuts not transmitted to the whole financial market, as in the West?
One reason is the smallness of India’s corporate bond market. But a much bigger reason is that the government arbitrarily fixes interest rates for small savings far higher than a free market would bear. This political ploy aims to woo middle-class voters. But it means banks are reluctant to cut deposit rates for fear that savers will shift their bank deposits into other small savings instruments.
A second problem, highlighted the other day by finance secretary Ratan Watal, is the existence of interest-rate subsidies for various categories of favoured borrowers, from farmers to exporters. Many interest subsidies are open-ended and uncapped. This distorts the financial market and transmission of RBI interest-rate cuts.
Agricultural economist Ashok Gulati has castigated the Rs 15,000 crore budgeted for interest-rate subventions to agricultural credit. The direct subvention is 2%, with an additional 3% for farmers who repay on time. In Madhya Pradesh, chief minister Shivraj Singh Chouhan has provided additional subsidies reducing the farm borrowing rate to zero.
One result is that short-term farm credit has been growing at a whopping 18% annually, when lending to other sectors barely reaches double digit growth. Has this boom in farm lending spurred a production boom? No. Production is stagnant. (Though this owes much to a drought.)
Gulati says government budgets simply don’t provide enough to compensate banks for the interest subsidy they are forced to implement, and could be an additional reason for bank distress and reluctance to cut lending rates in line with RBI cuts. Moreover, the subsidies are so large that it makes sense for many farmers to not use the money for farming at all, but to relend it at open market rates. In effect, they have become moneylenders parading as farmers.
A New Money Plant
Gulati says short-term agricultural credit from banks and other financial institutions now exceeds the total value of all inputs into agriculture by 10%! Besides, official data show that 44% of loans taken by farmers come from non-bank sources, and some of this is clearly cheap money borrowed by some farmers and relent to other farmers at commercial rates. Gulati fears that maybe 30-40% of subsidised farm loans are getting diverted — an absolute scam.
Such subsidies distort not just the financial market but the whole economy. This constitutes a strong case to shift from interest-rate subsidies to direct cash transfers to farmers. Pilot projects are urgently needed. Once the government subsidises farmers rather than farm loans, diversion to non-farm sectors will stop, farmers will stop turning into moneylenders, and the transmission of interest-rate cuts will improve.
Transmission is hardly the only problem. In countries where central bank rates are 0-2%, a change of 0.25% may have some impact. But in India, companies are borrowing at 10-14%. For them, a change of 0.25% is irrelevant. Interest costs average only 3% of total costs.
If the RBI interest-rate cuts reduce this to 2.8% or 2.9% of total costs, that will hardly matter. It cannot soothe the woes of companies complaining of insufficient domestic demand, a collapse in exports, an overvalued exchange rate, dumping by China, and oodles of red tape despite Narendra Modi’s attempts to improve the ease of doing business.
Mumbai businessmen say interest-rate cuts of at least 1-2% are needed. But that is not on Rajan’s agenda.