Deepak Mohanty: Interest rates and economic activity
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, to the
Association of Financial Professionals of India (AFPI), Pune, 23 August 2013.
* * *
The assistance provided by Sitikantha Pattnaik and Abhiman Das in preparation of the speech is acknowledged.
I thank Ms. Preeta Misra, Director & Member Secretary, Association of Financial
Professionals of India (AFPI) for this opportunity to interact with distinguished professionals
of corporate India. In the recent period, there has been an animated debate on the role of
interest rates in influencing real economic activities. In particular, the discussion has been on
how a change in policy interest rate impacts the lending rates, and thereby industrial
performance and overall economic activity. In this context, the last decade through 2012-13
has been eventful with rapid changes in the monetary policy stance responding to the
evolving growth-inflation dynamics. This is a period in which we recorded one of our highest
output growth rate as also one of the lowest. Inflation showed significant variation. We also
experienced the global financial crisis, the adverse effects of which are still lingering.
As you know, Indian economy is currently passing through a very challenging phase: growth
has slowed; though wholesale price inflation has come down consumer price inflation
remains close to double digits, and financial market volatility has increased. A major factor in
the recent growth slowdown is a significant deceleration in private corporate investment.
Since you are the key professionals taking investment decisions, I thought it will be relevant
to discuss how does monetary policy decisions, through interest rate changes, affect
investment decisions and thus economic activity? Another motivation for this subject is that
colleagues in the Reserve Bank have done substantial research in this area and a paper
entitled "Real Interest Rate Impact on Investment and Growth: What the Empirical Evidence
for India Suggests?" was placed in the public domain.1 I will urge you to look at that paper so
that it generates further research and discussion.
Against this background, my presentation will be as follows: I will briefly review the stance of
monetary policy and economic outcome during the last decade through 2012-13; discuss
monetary transmission with a focus on the interest rate channel; and examine the impact of
interest rate changes on economic activity both at the macro and micro levels.
Changes in monetary stance
In the last 10-year period from 2003-04 to 2012-13, monetary policy response can be
broadly categorised into four phases based on growth-inflation outcome and the rapidly
changing monetary policy response:

Phase I of 5 years of 2003-08 of high growth but rising inflation concern towards the
later part of the period when repo rate was raised from 6 per cent to 9 per cent and
the cash reserve ratio (CRR) was raised from 4.5 per cent to 9 per cent.

Phase II of 2 years of 2008-10 following the global financial crisis when the repo
rate was reduced from 9 per cent to 5.25 per cent and CRR was reduced from 9 per
cent to 5.75 per cent.

Phase III of 2 years of 2010-12 of monetary tightening responding to rising inflation
when policy rate was raised from 5.25 per cent to 8.5 per cent but CRR was
reduced to 5.5 per cent.

Phase IV of over a year of monetary easing in 2012-13 and 2013-14 so far with the
repo rate reduced to 7.25 per cent and CRR lowered to 4.0 per cent; though since
mid-July 2013, the RBI has tightened the monetary and liquidity conditions without
changing the policy repo rate and CRR to address exchange market volatility.
Monetary policy stance in any particular phase is generally conditioned by the
growthinflation balance, the outlook for growth-inflation in a forward looking context and an
assessment of macroeconomic risks. Essentially, monetary policy aims at attaining high
growth in a non-inflationary manner. But at times high growth in excess of potential growth
could trigger inflation putting the sustainability of the very growth path to risks. Hence,
monetary policy tends to do a careful balancing act so that it is not too accommodative of
growth in excess of its potential and at the same time not too stimulative of inflation.
However, there could be periods of rising inflation and falling growth below its potential. This
could arise from several sources such as the lagged impact of policy stimulus from earlier
phases and adverse supply shocks, both domestic and external, which persist.
The challenge of rebalancing growth and inflation is evident from the four phases of
growthinflation presented in Table 1 and Chart 1. In the first phase, high growth coincided with low
inflation. However, towards the latter part of the period as inflationary pressures rose it
warranted monetary tightening. In the second phase, reflecting the impact of global financial
crisis, growth decelerated and weak commodity prices globally and relatively stable
exchange rate contained inflation. That created the space for monetary easing. In the third
phase, India recovered ahead of the global economy, and actual growth in 2010-11 at
9.3 per cent exceeded significantly the post-crisis estimated potential growth of 7.5-8.0 per
cent. With a sharp recovery in growth, inflation too caught up rapidly, partly complicated by a
rebound in global commodity prices. The anti-inflationary thrust of monetary policy became
unavoidable to contain inflation and anchor inflationary expectations.
Table 1
Post-crisis as growth recovered inflation picked up
In the fourth phase, softening of inflation created space for monetary easing. However,
growth is yet to pick up reflecting both weak global demand, domestic supply constraints and
slowdown in corporate investment. In this context, the role of monetary policy has also come
to the fore: the question being to what extent monetary policy has played a role in the growth
slowdown? Let me try to address this issue.
Monetary policy transmission
While there is considerable attention even to small changes in policy interest rate, the
question is: does this really matter? The response to this question lies in an assessment of
how does this policy rate changes affect market rates, particularly the cost of credit, and
ultimately impacts the investment and consumption decisions of economic entities. Apart
from market rates, expectations about future outcomes play an important role. There could
also be transmission lags. Moreover, the magnitude of change in market interest rates may
be different, ranging from money market rates to lending rates.
While policy rate changes do matter, it is not that straight forward as to how they impact
lending rates in the transmission chain. In this context, how policy rate changes, impact bank
deposit rates become important as banks rely on cost plus pricing of their loan products.
Apart from cost of deposits, banks also load a risk premium which may change in different
phases of the business cycle, and therefore, the lags could be longer. Hence, how fast the
banks are able to change these parameters would largely determine the changes in their
lending rates. Thus, nominal lending rate determination in the market is a complex process,
and how changes in lending rates impact overall growth is even more uncertain. This is the
reason why monetary policy transmission is often dubbed as a "black box".2 Hence,
explaining monetary transmission is a constant challenge for every central bank.
Let me now turn to the issue of transmission of monetary policy in India. In the last few years,
there have been several empirical studies, examining the interest rate channel of monetary
transmission. The general conclusion from these studies is that increases in policy rate have
a statistically significant negative impact on output and moderating impact on inflation.
However, the negative effect of a policy rate increase is first felt on output before the
moderating impact on inflation. The lags in policy rate changes on output are 2-3 quarters
and on inflation 3-4 quarters. The total impact on policy change could, however, linger for
8-10 quarters.3
A notable feature of monetary policy transmission in India is the asymmetry one observes
during different phases of a monetary policy cycle. Usually, during a phase of rising policy
rate, banks may be quick in raising their lending rates while in a phase of falling policy rate,
banks may be slow in reducing their lending rates as cost of deposits does not adjust
commensurately given the fixed nature of deposit contracts. This pattern reflects that loans,
being mostly at variable rates, can be re-priced at a quicker pace than the fixed rate bank
deposits.
The asymmetric transmission also needs to be seen in relation to overall liquidity conditions.
For example, in a tight liquidity condition, even if the policy rate is reduced banks may not be
in a position to reduce deposit rates and hence lending rates with the apprehension of losing
deposits. There could be other considerations for not lowering deposit rates if rates of return
in competing products such as small savings and mutual funds are more attractive. Another
consideration in a falling interest rate scenario could be that banks might want to protect their
profit margin through a more sluggish adjustment of their lending rates.
Notwithstanding various complexities, the interest rate channel of monetary transmission has
been evident over the monetary policy cycles in the recent years. The policy interest rate
changes did impact the market interest rate in the same direction, though at varying intensity.
The magnitude of changes in lending rates, however, more closely followed the changes in
deposit rates (Table 2).
Table 2
Transmission to the money market rates was much faster than to lending rates
Nominal or real interest rate?
Another aspect of monetary transmission is whether it is the nominal interest rate or the real
interest rate that can influence growth and investment. In the literature, the stance of
monetary policy is judged as loose or tight depending on the level of real policy rate. Most
economists believe that it is the real interest rate that could influence real economic activity.4
However, as individuals and corporates we take economic decisions looking at the nominal
rates as these are the rates that we can observe. Is it that these are two distinct concepts? I
do not think so. Notwithstanding apparent differences, is it not that at the back of our mind
there is no inflation metric while planning an investment project, howsoever different it may
be for different entities? Is it not a fact that a negative real interest rate favours debtors
whereas a positive interest rate favours creditors?
The link between the real interest rate and nominal interest rate is provided by the famous
Fisher equation which postulates that the nominal interest rate is the sum total of a real
interest rate and expected inflation.5 One implication of this is that the nominal interest rates
should move in tandem with inflation. In the real world, nominal interest rates may not
change one for one with the inflation rate but the direction more often is similar. Countries
with higher inflation tend to have higher nominal interest rates than countries with lower
inflation. Accordingly, the nominal interest rates in advanced countries tend to be lower than
in emerging market and developing countries.
While the notion of a real interest rate poses conceptual difficulties, the compilation of a real
lending rate is even more difficult. It involves two steps: first to compute an effective nominal
lending rate, and second to deflate it with an appropriate inflation metric. In our context, while
the base rates of banks generally provide the floor to their lending rates actual borrower
specific lending rates are different. Estimates of weighted average lending rate (WALR) of
banks both in nominal and real terms are presented in Chart 2. The real rates are obtained
by deflating the nominal rates by the annual average wholesale price inflation.
During the period of the high growth phase of 2003-08, WALR of all scheduled commercial
banks stood at 12.4 per cent, which dropped to 11.0 per cent during the crisis period of
2008-10. Subsequently, it went up and has remained around 12 per cent thereafter
(Chart 3). WALR in real terms declined sharply from 6.9 per cent in the high growth phase of
2003-08 to 5.0 per cent in the crises period of 2008-10. It fell further to 2.7 per cent during
2010-12 period and then went up to 4.8 per cent in the subsequent period. Despite
stickiness in the nominal interest rate, the reduction in the real rate was higher as inflation on
an average turned out to be higher. However, in 2012-13 as inflation showed a significant
moderation the real lending rate has risen.
Why did the investment growth slacken despite moderation in real lending rates? In this
context, let me now turn to micro-level corporate finance data of a fairly large diversified
sample.6 The analysis shows that interest cost as a ratio of sales went up from 2.6 per cent
in the high growth phase of 2003-08 to over 3 per cent during the crisis period of 2008-10.
However, during this period the average sales growth declined from about 21 per cent per
annum to 15.7 per cent. Following subsequent recovery to 19.5 per cent per annum, it has
plummeted to 9.5 per cent in 2012-13. Consequently interest cost to sales ratio rose to
3.8 per cent. It will thus seem that deceleration in sales growth has accentuated the interest
burden on the corporates at the micro level.
The Reserve Bank study I cited earlier suggests that for 100 basis point increase in real
interest rate, investment rate may decline by 50 basis points and real GDP growth may
moderate by 20 basis points. As indeed the real interest rate has moderated in the post-crisis
period, it should not have had a large negative impact on investment, but for significant
deterioration in the prospects of return on investment driven by non-monetary factors.
Decline in marginal efficiency of capital
In this context, let me turn to the investment decision at the firm level. This is an area in
where you are better informed than me. At the firm level, investment decisions may be driven
by a comparison of the internal rate of return (IRR) with the hurdle rate.7 As long as interest
rate is lower than IRR, additional investment may continue. While IRR is seen in nominal
terms, marginal efficiency of capital (MEC) which is measured in real terms plays an
important role. In a phase of sustained slowdown in economic growth, non-monetary factors
may lower MEC faster than the extent to which interest rate may decline. As a result, despite
a lower interest rate, investment may not pick up. The fall in IRR could be driven by adverse
shocks to cash flows and deterioration in macroeconomic conditions.
At the macroeconomic level supply bottlenecks and sluggish demand can depress MEC,
which can more than offset the beneficial impact of a lower lending rate on investment and
growth. The incremental capital output ratio (ICOR) has been rising in India in the last four
years since 2008-09. The implicit marginal productivity of capital (MPC), which is the inverse
of ICOR, accordingly has been declining (Chart 4).
Conclusion
Let me conclude. The Reserve Bank has been traversing a growth-inflation knife edge in
recent years. The sluggish growth conditions in the last two years and the dampened
investment activities warranted a shift in the stance of monetary policy. The extent of
monetary policy easing, however, has been circumscribed by the persisting risks to inflation
and the external balance position. Price stability and exchange rate stability are necessary
preconditions to sustainable high growth. Furthermore, when non-monetary factors are
impeding a robust revival in growth, lower real or nominal interest rates may not be just
enough to stimulate growth.