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Could High Real Interest Rates Dampen Investment In India?

Nov 19, 2018 | Asia, India

India’s Monetary Policy Committee’s two preemptive interest rate hikes, along with the lower-than-expected trend in inflation, have prompted some economists and analysts to question whether real rates in India are too high to support a nascent recovery in investment.

The real interest rate, which adjusts the nominal rates for inflation, are an important influence on investment decisions. Some, including MPC member Ravindra Dholakia, feel that India is running real interest rates which are too high.

The real interest rate exceeded four percent in October, when measured by adjusting the 1-year Treasury-Bill rate for consumer price inflation. While the central bank has in the past acknowledged that real interest rates, being an unobservable variable, can be approximated by using multiple measures, it has given guidance of using the 1-year T-Bill rate as a proxy to the nominal rate of interest.

The current high short term rates have raised the cost of borrowing, said Saugata Bhattacharya, chief economist and senior vice president at Axis Bank Ltd.

"Apart from higher borrowing costs, rise in real interest rates are likely to reduce cash flows and profits and decelerate growth momentum, thus hampering deleveraging of corporate balance sheets."

Alternate measures have also found real interest rates close to this level.

The real repo rate, an alternative to measure real interest rate, is also elevated. It has averaged 2.1 percent over the past four years and is now at 3.1 percent, wrote Christopher Wood, chief equity strategist at CLSA in his weekly GREED & Fear report last week.

The RBI suffers from a narrow focus on mechanistic “inflation targeting”. It formally targets headline CPI and against this measure India has been running very high real interest rates for an extended period.

Real Interest Rates On The Rise

Investment Implications

Real interest rates are important as they have a strong correlation with investment.

A working paper on India’s investment cycle, published by the central bank in October, found that real interest rate, along with GDP growth and bank credit, are the major determinants of investment activity in India.

The working paper, approximates that a one percentage point increase in the real lending rate reduces the real investment rate in the range of 0.3 to 0.4 percentage points. Real interest rate for the purpose of this study was found by deflating the weighted average lending rate by expected inflation. An earlier study by the Reserve Bank of India in 2013 had found an even stronger negative relation, concluding that for every 100 basis points increase in real interest rate, investment rate declined by as much as 50 basis points.

Repo Rate Deflated By Inflation

Case For Rate Pause

High real interest rates could further reduce the probability of another rate hike this year. Chances of the next rate hike has been pushed back significantly well into FY20, says Bhattacharya, while SenGupta, is in favour of a rate cut.

Ravindra Dholakia, one of the six MPC, had taken cognizance of rising real interest rate at the last policy meeting in October, when voting against a rate hike.

"Real interest rate is significantly higher than two percent even after considering the inflationary expectation. There is no justification for increasing it further by a rate hike at this point."

Article Source : bloombergquint

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