Going by the latest industrial production numbers that were announced last week, it seems that higher interest rates have squeezed consumption more than investment. This perhaps means that the economy can be cooled down without harming its medium-term growth prospects.
Industrial production this March was 12.9% higher than it was 12 months ago. But this headline number hides a big dichotomy. The production of television sets, washing machines and other consumer durables grew by a very modest 2.7%; that comes on the heels of a poor showing in February as well. A high statistical base could explain one part of the sharp deceleration in 2006; but surely another part is due to higher interest rates, since consumer durables are increasingly being bought with instalment plans.
The production of capital goods—an indication of investment activity—has slowed down a bit, but is still growing at a faster pace than overall industrial activity. With Indian industry facing capacity constraints and consumers having to pay higher prices for many industrial goods, there is little doubt that the strong growth in capital goods production is good news in terms of both output and inflation.
The interesting question: Why has investment activity been minimally impacted by higher interest rates?
We can offer two tentative answers. First, companies are rolling in cash. The national accounts show that corporate savings have climbed sharply in recent years, and are now close to 8% of GDP, which is more than double the 2001-02 level. These savings are now being put to use. Anecdotal evidence shows that companies are using their reserves to fund a large part of their capex, though corporate leverage, too, is increasing after nearly a decade.
Naturally, capital spending using shareholder funds is less sensitive to interest rates. What needs to be seen is what happens when companies run through their reserves and increase their dependence on borrowed funds. Perhaps, higher interest rates will then affect investment activity more than they do now.
This is where the second explanation of why investment activity continues to be strong kicks in—the trend in corporate profits. Mint’s analysis of 1,544 corporate results for the fourth quarter of 2006-07 shows that net profit growth (47.36%) is growing faster than net sales (30.77%). In other words, profit margins are still rising. The trend may reverse in the coming quarters as input and wage costs rise further.
Yet, corporate profit margins are so impressive right now that a small rise in nominal interest rates is unlikely to force growth-hungry companies to put their capacity expansion plans on the back burner. In standard Keynesian terms, the marginal efficiency of capital is very high in India today, making corporate investment an attractive proposition, despite a nominal rise in interest rates.
Monetary indicators also show that bank credit and money supply are decelerating (though these are still beyond the central bank’s comfort zone). It is very possible that items like housing and consumer loans are leading the slowdown in bank credit. It will be worth looking out for more detailed banking statistics that will explain which category of loans are driving the gradual slowdown in bank credit growth.
India’s economy was heavily dependent on consumption between 1997 and 2003. Since then, investment picked up and is now perhaps the biggest driver of economic growth. There is a lot of talk about supply and infrastructure constraints in India, and these can be removed only if the surge in investments is maintained in the years ahead. There were fears that higher interest rates would break this surge. While it is too early to tell for sure, recent data suggests that capacity building continues.
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