The recent reduction in both policy rates and the cash reserve ratio by the Reserve Bank of India (RBI) appears to have cheered financial markets as well as the real sector. The logic behind this belief is that interest rate reduction could help in the recovery of the economy, which, in analysts’ view, bottomed out in the third quarter of the current financial year. In contrast, RBI held off on cutting policy rates until 29 January on the assumption that any reduction could fuel inflation.

The monetary policy statement said inflationary pressures, in particular core inflation, have declined in the recent period and that provides headroom for monetary easing.

The question that arises now is simple: can the lowering of interest rates give a fillip to investments? Then, is the decline in inflationary pressure real? The efficacy of the monetary policy depends on clarity on these two questions.

Looking at the policy statement, one can clearly see the recent rate cut is more of a hesitant action instead of being based on economic fundamentals. (Time and again, RBI has tried to substantiate its policy based on forecasts instead of trends, something that may not completely substantiate such cuts.) The rate cut only partially supports the actions taken on the fiscal side and in helping the growth recovery process.

What is the role of interest rates on investments in India? It is very hard to find a strong negative relationship between the two, at least empirically. A simple chart of interest rates and investment growth could tell us a very clear story. The fact that India’s high growth rate between 2003 and 2008 coincided with an upward moving interest rate cycle suggests that the role of interest rates in investments, though significant, is very weak compared with other supply-side determinants.

There could be two explanations: one, the interest-rate cost as a proportion of the overall production cost for companies is low (in fact, RBI estimates it at 3% of the total production cost). Two, it is not difficult to understand that large capital investments (other than working capital) are part of long-term interest rate cycles and, hence, interest rates at the time of borrowing may not be a major consideration. This is because aggregate interest payments at the end of the loan period will not be different. Rather, the transaction costs during a high-interest-rate period could be lower than in the lower rate regime. By these arguments, one could say that interest rates as such have, and should have, a limited role in reviving investments. This is more so in the vulnerable and extraordinary conditions the Indian economy faces in terms of the high twin deficits—fiscal and current account—slowing the economy with substantially sticky inflation.

On inflation, the monetary policy statement projects a 6.8% mark at the end of March. However, the supporting arguments that are presented do not seem to back this up. In addition to this, RBI still wants to “contain perception of inflation in the range of 4.0-4.5%". At the same time, money supply expansion has been aimed at 13% and economic growth and inflation have been assumed at 5.5% and 6.8%, respectively. Following the famous monetarist equation, both do not add up to money supply growth projections, indicating that either growth or inflation or both are conservatively projected.

The fact that the recent rise in fuel prices is not generalized, coupled with expectations of further increases in diesel prices, leads one not to expect any reduction in headline inflation in the medium term. Also, the role of interest rates in mitigating this policy-induced inflation is weak.

So, how do interest rates affect the economy? The explanation lies in the consumption-savings trade-off. At this juncture, it is also necessary to understand that the high growth in the pre-crisis period was largely driven by a substantial rise in savings, which at the same time put less pressure on the external balances. It was more of a savings-led growth rather than an investment-led one. Hence, the reduction in interest rates could shift the balance between consumption and savings and not necessarily in favour of investments.

At this time, it is also pertinent to emphasize the role of the financial sector in mobilizing and channelling resources from savings to investments. Interest rate cuts alone are not sufficient.

Will the recent cut help the economy? Under existing conditions, monetary policy can only provide partial support. As many studies have shown, when a country is facing both domestic and external vulnerabilities, there is a need for large doses of confidence-building measures such as the one the government provided in October. In fact, monetary policy and its transmission in such adverse situations are bound to be rather ineffective.

Fiscal policy should lead stabilization policies to restore confidence in both short-term financial markets as well as long-term investments.

At the same time, it is important for industry to respond positively to this unusual situation. Not compromising on profit margins and sitting on piles of cash can only aggravate the pains of the industry.

Comments are welcome at theirview@livemint.com

N.R. Bhanumurthy is a professor at the National Institute of Public Finance and Policy, New Delhi.

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