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Monday, October 06, 2003

The Power of Monetary Policy

Brad has recently been posting on the powerful impact of monetary policy. Well here's a piece from Rajiv Lall in the Business Standard (thanks to Rueben at the zoo station ) about just how powerful the effect of declining interest rates might be in India.

Ten, five, even three years ago I would have, and did, make the bet that China's growth rate would outperform India's. Today, I would have to be more circumspect. My bet is that India will begin to outperform China within the next five years. What accounts for this change in perspective? Sustained improvement on many fronts including the development of physical infrastructure (especially roads, ports and telecommunications), trade and tax policy reform, and the coming of age of a new generation of Indian entrepreneurial talent all add up to impressive change.

But, by far the most significant development in the Indian macro story is the declining cost of capital. It is difficult to exaggerate the impact that falling interest rates have had on the functioning of the Indian economy. Over the past three years, borrowing rates have declined by about 600 basis points for most medium to large sized enterprises in the country. Whereas such companies were paying 14 per cent on one-year loans three years ago, today they are paying only 8 per cent. Borrowing rates for some of the largest corporates are up to 200 basis points lower.

In part, the declining interest rates reflect a fall in the rate of inflation. But even in real terms, interest rates have fallen sharply. What is key is that this does not reflect merely a cyclical adjustment, although that is part of the story. It is in fact largely the result of the progressive dismantling of a system of administered interest rates in the country. To be sure the system is still not fully disbanded. Rates on small savings deposits are still fixed by administrative fiat. But now there is at least greater flexibility and pragmatism in how they are set. So what we have seen is a significant structural decline in interest rates that has the potential to trigger fundamental improvements elsewhere in the economy.

First, compared to China and the rest of East-Asia in its high growth phase, India’s manufacturing sector is much smaller (16 per cent versus 35 per cent of GDP). The popular perception, until very recently, has been of an uncompetitive Indian manufacturing sector hobbled by poor physical infrastructure and rigid labour regulations. It turns out that perhaps the most serious handicap faced by Indian manufacturing has been the relatively higher cost of capital. Between 1997 and 2000 real interest rates on the average five-year loan fell from 7.8 to 4.9 per cent, whereas in India they actually rose from 6.4 to 7.8 per cent (due to a decline in the domestic inflation rate).

Since 2000, however, the trend has reversed thanks to several cuts in the administered interest rates in India. For the first time that I can remember, real interest rates in India are lower than in China. And the effects of this are dramatic.Consider the following: Every 10 per cent fall in interest rates leads on average to a 30 per cent increase in profits before tax (PBT) for larger Indian corporations. For firms in manufacturing that operate with higher levels of debt relative to the average for all companies (companies in the less asset intensive service industries can operate with lower debt-equity ratios), the impact on PBT of declining interest costs is likely to have been even larger.

Given that borrowing costs for larger corporates have fallen as much as 40 per cent in the past three years, profits before tax for these companies have more than doubled, raising returns on equity to well above the cost of capital. Suddenly, even manufacturing activity is looking like an attractive proposition in India. Second, India's predominantly state-owned banking system has been capital constrained for many years, weighed down by non-performing assets created during the investment boom following the initial years of economic reform in 1993/95. As a result banks have become risk averse tying up more than three-quarters of their balance sheets in government securities. The decline in interest rates has handed this passive banking system a salutary bonus in the form of enormous paper gains on their portfolio of government securities.
Source: Business Standard

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