Reduction in interest burden could possibly prevent more companies heading towards bankruptcy

The ‘tight fiscal, easy monetary’ policy mix can better address problems that plague private investment.

Written by Ila Patnaik | Updated: January 18, 2016 8:15 am

The finance ministry has stressed that it will stick to the path of fiscal consolidation. This is good news. While a move away from the announced targets to give the economy a stimulus may have seemed attractive in light of the signs of slower growth, the policy would not have been the most suitable for reviving investment, the biggest challenge facing the economy.

After the mid-year review suggested that fiscal targets may need to be revised, many economists emphasised the benefits of staying put on the announced path of fiscal consolidation. First, the debt to GDP ratio would remain under control. Equally important, the finance minister would maintain his credibility, particularly since he has already deviated once from the path. The decision of the government to stick to the path of the announced fiscal targets is good not just in the long run. It is also more likely to help in the short term.

One immediate gain of sticking to the path of consolidation will be to create space for monetary policy easing. The sharp decline in global commodity prices and the slowdown in demand in the domestic economy have reduced inflationary pressures. The policy interest rate — that is, the repo rate — stands at 6.75 per cent. Unlike, say, in Europe, where there is no scope for cutting the policy rate that is near zero, in India, there is ample scope to cut it. But while in principle the policy rate can be reduced significantly, the question is how to give monetary policy the space to do so.

A fiscal stimulus would increase the likelihood of demand rising and pushing up the inflation forecast. While deciding the policy interest rate, monetary policymakers target the forecast of inflation and analyse the pressures of demand on core inflation. With a slowdown in global demand, investment and domestic demand, a greater easing of the stance of monetary policy may be more possible today than perhaps even a year ago. This opportunity could be lost if the government had chosen to pursue a policy of fiscal expansion.

Monetary easing in the last one year has been cautious. A number of factors were responsible for this. One, the United States Federal Reserve was expected to raise interest rates in 2015, which could impact volatility in financial markets, especially currency markets. Two, there was a sharp increase in the prices of food items like onions and pulses, feeding into higher food inflation. Three, right at the beginning of the year, the government moved away from the path of fiscal consolidation. The fact that the policy rate was eased by only 125 basis points over the year, though inflation fell by about 500 basis points, can partly be explained by fears of rising inflationary pressures later. Today, when the Fed has finally raised rates and food inflation is expected to remain within control, deviating from the path of fiscal consolidation could keep fears of inflationary pressure alive and keep monetary easing cautious.

A loose fiscal policy would, therefore, have effectively meant that policymakers would be choosing the “loose fiscal, tight money” policy mix. This is sometimes justified by arguing that, given the poor transmission of monetary policy in India, its impact is limited compared to that of public investment, which involves direct spending by the government and raises demand instantly. While, in theory, this may hold, there are two reasons this may not be true in India today.

First, the capacity of the government to spend is limited. A large share of the capital expenditure allocated in Budget 2015 is yet to be spent. Many good plans have been approved and money allocated, but the shovel is yet to hit the ground. While, in theory, public investment can spur private investment, limited state capacity may be one reason why the magnitude and lags involved may make this strategy less optimal than theory suggests.

Second, private companies are unable to repay the interest on their debt. Banks are increasingly seeing loans get in trouble. High interest rates hurt not just the companies whose revenue growth has fallen sharply but also banks whose stressed assets have been on the rise. For private investment to pick up, companies need to have the ability to borrow, and banks the ability to lend. Raising demand through a fiscal stimulus does not address the balance-sheet stress of companies and banks, while a reduction in interest rates would.

Early in 2015, the government and the RBI adopted inflation targeting as an objective of monetary policy. Inflation targeting is adopted by governments and central banks to tie down their own hands. The benefit of low inflation goes to the elected government that gains by way of providing a low-inflation environment to citizens. While endless arguments can be made about the effectiveness of monetary policy in India, the efficiency of the transmission mechanism, the role of food inflation, and so on, there is little doubt that the objective of low inflation is consistent with the preferences of the bulk of the population. The suggestion made by some economists that the government should rethink and review its commitment to inflation targeting, instead of finding ways to meet it, is unwise.

The best strategy for the government, therefore, lies not in giving up the inflation target, or in changing the measure of inflation adopted, the consumer price index, because it is higher than the wholesale price index, or in changing the glide path towards the target, but in creating the conditions that would keep inflationary pressures down.

In the present context, adhering to the announced path of fiscal consolidation would allow the “tight fiscal, easy monetary” policy mix that is more suited to addressing the troubles that plague private investment. The RBI should respond to this commitment by cutting interest rates. There is clearly no magic bullet for reviving investment. However, a reduction in the interest burden could possibly prevent more companies from going towards bankruptcy. This is a greater need of the hour than higher demand.

The writer is professor, NIPFP, Delhi

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  1. K
    Jan 18, 2016 at 5:57 am
    The reduction of interest rate should help small and medium enterpreneurs to continue their business with less anxiety of fear of bankruptcy. This will stimulate business activity and help faster growth of the economy.
    1. A
      Feb 8, 2016 at 12:29 pm
      The decrease in interest rate hurts senior citizens who have to live on interest. Our economy does not have means for them to sustain
      1. O
        Jan 18, 2016 at 9:52 am
        Absolutely the wrong analysis. Monetary policy and interest rates also impacts the fact that bank interest is the ONLY instrument that 90% indians have of saving for their future. Their is no social security for the public, barring govt servants , who have inflation linked Pensions thru dearness allowances. Why should the self emplo, senior citizens and the farmers, industrial workers be badly affected by lowering their returns? Also, food inflation is the only inflationthat effects over 85% of the potion, and that is still at 8%. In fact FD rates at banks should be at least 11%.
        1. D
          Dr. Sonali
          Jan 18, 2016 at 4:16 am
          Total stupidity. Senseless arguments. Meaningless propositions.
          1. D
            D. S. Kolamkar
            Jan 18, 2016 at 2:27 pm
            Nice analysis. However we are ping through exceptionally turbulent situation. Hence fiscal policy should also play its role. Of course, efficiency of public expenditure should be ensured. We need not be unduly worried about rating agencies, particularly when the economy is struggling to recover; difficult external environment is making the situation worse notwithstanding soft commodity prices. Credibility of India or debt:GDP ratio are not such critical issues at this stage that we should limit our efforts to deal with slow-down. RBI should primarily focus on bringing down inflation on sustainable basis. While some room can be created for easing repo rate, zero or near zero real interest rates cannot be justified in India.
            1. D
              Dillip Patnaik
              Feb 3, 2016 at 2:56 am
              The basic idea behind the monetary policy is that the lowest interest rates generate more consumption and more investment; therefore the following could be included in the cur of demand: Lowest interest rates stimulate spending of consumption by making it more attractive to get loans to buy things such as housing and a car. The lowest interest rates stimulate expense of investment and the businesses become profitable because a greater number of them have potential investment projects. In other words if the interest rates are at ten percent, the companies would only be willing to get money in a loan to invest in projects with return rates that are higher then ten percent. But if the interest rates fall to five percent, all the projects with return rates that are over five percent become variable, and this makes the company solicit more loans and start up on new projects. Government need to introduce low interest to improve current economic situation. The domestic industries will gain benefit and able to invest in new equipments to increase production and people can by goods and houses in cheaper rate. A lot of people can be absorbed in employment. On the government side there should be fiscal responsibility not expand government and government bureaucracy.
              1. A
                Jan 18, 2016 at 5:20 am
                Wonderful to see this column being revived. Would support fiscal restraint, but not a further easing of interest rates. The 125 basis points reduction made, a little reluctantly by the RBI, has not been ped on by the banks due to their own concerns with NPAs and profitability. Inflation is hovering just below 6%, an important threshold, notwithstanding a collapse of oil and other commodity prices. Depositors also tend to move into non financial ets when real interest rates are low or negative.
                1. A
                  Jan 18, 2016 at 4:38 am
                  why not reduce interest rates to ZERO for companies who have taken 1,000's of crores in loans and are unable to repay . Better still, we must increase taxes on the lazy , unproductive middle-cl who do not create any jobs and use that money to offer subsidized interest rate loans to companies that are already stressed .
                  1. P
                    Prodipto Ghosh
                    Jan 18, 2016 at 2:40 am
                    Basically this is an argument for reducing the policy interest rate to below the inflation rate so that corporates that have borrowed heavily encounter negative real interest rates. This would only push depositors to options such as gold and land for retaining the value of their savings, but would ensure that the savings are no longer available for productive investment. There is both poor monetary and fiscal transmission in India, and neither will impact domestic demand in the short term. However the author has determined in favour of monetary policy easing by favouring the borrowing community over the savers consuency, with deleterious long-term impacts on the economy.
                    1. R
                      Jan 17, 2016 at 9:02 pm
                      To the layman, this analysis sounds good. However, a few points to ponder. One, with China adopting yuan devaluation there might be a possibility of compeive devaluation among emerging market economies forcing India to follow suit. This in turn would affect our trade balance. As it is exports have shown a secular downturn for better part of last year. The depressed oil prices, undoubtedly, has helped with reduced forex flows. But any uptick in the latter half of the year in oil prices, (eminently possible) would upset India's applecart. Two, reduced agricultural production is likely to put upward pressure on inflation thereby precluding any move by RBI to cut interest rates further. Three,There is a distinct possibility of US Fed initiating further interest rate hikes ( as early as March). This would lead to outflows from EMs including India. The dollar would, therefore, strengthen vis a vis rupee. Four, commodity prices have plummeted leading to recessionary conditions in commodity driven economies. Hence, India would find it difficult to remain insulated for long. Fifth, if public investment is to be tightly controlled due to fiscal consolidation and private investment refuses to pick up, job creation is first casualty leading to further pressure on Govt. Can India withstand these strong headwinds likely to affect us during 2016?
                      1. S
                        Sid Srivastava
                        Jan 18, 2016 at 2:19 pm
                        Guide to cronyism . The recommendation is to reward the defaulting corporations, reward bad business decisions, reward the corporations at the expense of the banks. Essentially people should pay for follies of fat cats, through public sector bank losses and through inflation. Of course after this bail out, corporations will be repeat this bad behavior again and again. Cloaked under big words like fiscal, monetary policy, consolidation, I.E. Has unwittingly published the guide to cronyism, the scourge of our nation. I suggest let these corporations go bankrupt. Punish the bad behavior of enrichment at the expense of the people and the banks. Future will then Belong to business competent, fiscally responsible corporations, and not crony capitalists.
                        1. T
                          Jan 18, 2016 at 5:05 am
                          I do not understand the point of using the CPI, and more specifically, food inflation as one of the metrics for gauging the effect of monetary policy. No one borrows money from the bank to buy food. Any change in interest rates would therefore have close to no impact on food prices. If at all the RBI wants to target inflation, surely monitoring WPI - which measures inflation in w and industrial goods - would be a better way to evaluate the efficacy of its policies
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