CRISIL Insight - Will a Rate Cut Spur Investments (1)

8/10/2019 CRISIL Insight - Will a Rate Cut Spur Investments (1)

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CRISILInsightNovember 2014

Will a rate cut spur investments? Not really

IN ETER ST

RATES

REGULATORYHURDLES


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CRISILInsight


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1

Will a rate cut spur investments? Not really

CRISIL Research study show s investm ents have slow ed in t imes of low er interest rates. What matters

more is the business environment, or the expected return on investments

The chorus on an interest rate cut to revive the economy has got louder with the recent climb-down in

inflation. To be sure, the monetary policy tool of cutting the interest rate is conventionally used to energise a

flagging economy. But this does not hold true under all circumstances. Our study shows that factors behind

the recent slowdown in economic growth and investment in India have little to do with high interest rates. The

slowdown is largely because of government policy and slowing domestic demand. In such a situation, leaning

on monetary policy to revive investments will yield little benefit. And, it carries the risk of reversing the recent

gains in inflation, which, in any case, is nothing much to write home about.

Here are some of our findings on the dynamics of the current economic slowdown, which counsel against a

rate cut.

Investments slowed despite a relatively benign interest rate environment. Investment growth,

particularly private corporate investment, plummeted in the fiscals 2013 and 2014, despite low real

interest rates. During this time, the policy rate in real terms repo rate minus retail inflation has

been negative, and real lending rates averaged 2.4%. This is significantly lower than the 7.4% seen in

the pre-crisis years (2004-2008). Yet investment growth dropped to 0.3%, down from an average

16.2% seen in the pre-crisis years.

Falling returns on investment largely to blame. Investments are undertaken when the expected

returns on them are more than the real lending rate (real borrowing cost for corporates). The averagerate of return on corporate investment (non-financial firms) as proxied by return on assets -- fell

sharply to 2.8% in fiscal 2013 and 2014 from nearly 6% in the pre-global financial crisis years. If the

return on investments already made has fallen so sharply, expected return on investments planned but not yet

made would have plummeted even more, rendering them unfeasible. A regression analysis of investment

behaviour conclusively proves it is policy uncertainty and a sharp slowdown in domestic demand,

rather than high lending rates, that have slowed investments.

Micro-analysis of slowdown in interest rate-sensitive sectors confirms the dominant role of

policy-related factors. Our comprehensive analysis of two interest rate-sensitive sectors --

automobiles and infrastructure also shows that interest rates are not to blame for the prevailing

stress in these sectors. Policy uncertainty, lack of clearances, and weak demand are the real reasons.And high inflation, by discouraging consumption demand, eroding export competitiveness and raising

input costs for corporates, has made the situation worse.

Therefore, the most important thing is for the central and state governments to continue to improve the policy

environment to raise the expected return on investment. To its credit, the new NDA government has taken a

number of steps, which will yield results over the next few quarters. On its part, we believe the Reserve Bank

of India (RBI) should continue its fight to stabilise consumer price inflation below 6% and that would require

standing pat on the repo rate. Lower inflation will help revive consumption demand and reduce input costs,

boosting return on investments.


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CRISILInsight

Indias interest rate regime has been relatively benign

Interest rates in India, as measured by the RBIs policy rate (currently the repo rate) and bank lending rates,

have been relatively benign in the last few years. This comes out quite clearly if the interest rates over the last

decade are compared after adjusting for inflation. The policy rate in real terms repo rate minus retail inflation

averaged -3.1% in the last six years compared with +1.8% in the pre-crisis period (2004-2008). Real bank

lending rates, which have a risk mark-up over the policy rates, too, fell to an average of 1.7% from 7.4% in the

pre-crisis period.

During fiscals 2013 and 2014, when investment growth slumped to 0.3% per year, the real repo rate was still

minus 2.1%, while the real lending rate was only +2.8%. Only in June 2014, for the first time in six years, did

the real repo rate turned mildly positive (Chart 1). Now compare this to the pre-crisis period (2004-2008) when

investments were booming. Real policy rate then was positive and much higher at 1.8%. So prima facie,therefore, interest rates do not appear to be driving the current investment slump.

In our opinion, India's investment growth slipped in fiscal years 2013 and 2014, not so much because of

interest rates but because of the emergence of factors detrimental to the business climate and profitability of

corporates. This worsening business climate is reflected in Indias competitiveness ranking, which fell to 60 in

2013 and 71 in 2014, from 49 in 2009, according to the Global Competitiveness Index. In terms of the World

Banks Ease of Doing Business, Indias ranking has kept sliding and is currently 142 among189 countries.

Chart 1 After 6 years, real repo rate (adjusted for CPI inflation) turns positive

Note: Nominal repo rate at the fiscal year-end minus average CPI inflation, F=Forecast

Source: RBI, Central Statistical Office, CRISIL Research

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2011-12

2012-13

2013-14

2014-15F

%

Real repo rate (adjusted for CPI inflation) Fixed investment growth, y-o-y


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Analysing the investment slide

How are investment decisions taken?

Simply put, investments are made when the expected rate of return on them is higher than the real borrowing

cost or the lending rate adjusted for inflation. This expected return is influenced by potential domestic and

external demand, as well as regulatory clarity and policy certainty. Consumption demand, in turn, depends on

income prospects and expected inflation. The lending rate depends on the policy rate which forms the floor,

and the risk premium, which depends on the demand for, and the supply of, funds.

Since fiscal 2009, the floor set by monetary policy a negative real repo rate was so low that it couldnt be

the reason for investment slowdown. The slowdown in investments, therefore, is not due to an unsupportive

monetary policy. Lending rates in real terms have also been much lower than in the pre-crisis years (Chart 2).

Investments have in fact been discouraged because the decline in expected return on investment has been

very severe (Chart 2). In the current slowdown, for investments planned but not implemented, the returns

have dropped below the lending rate.

Our findings resonate with recent research on corporate investment behaviour by Kothari et al1 for the US

economy. Using 60-year data, it shows that business environment and corporate profits are dominant

variables influencing decision to invest and not interest rates. This means interest rates will not succeed in

spurring investments if these other critical factors are unfavourable.

Expected returns on skid row

And why have the expected rate of return on investments fallen? Because of high policy uncertainty, slowing

domestic and external demand, and rising input costs driven by persistently elevated inflation. The rate of

return on investments as proxied by return on assets (RoA) of around 10,000 non-financial companies as

per CMIE Prowess databasehave fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis

years (Chart 2). If the return on investments already made has fallen so sharply, expected return on

investments planned but not yet made would have plummeted even more, rendering them unfeasible.

1The Behaviour of Aggregate Corporate Investment(September 2014 paper), by S P Kothari (Massachusetts Institute of Technology -

Sloan School of Management), Jonathan Lewellen (Dartmouth College - Tuck School of Business; National Bureau of EconomicResearch), and Jerold B Warner (Simon Graduate School of Business, University of Rochester)


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CRISILInsight

Chart 2: Real cost of borrowing and return on investments

Note: ROA: Return on assets

Source: RBI, CRISIL Research, CMIE prowess

The decline in the expected rate of return has discouraged investment demand, leading to weak demand for

funds, and putting downward pressure on lending rates. At the same time, there was liquidity shortfall due to

high government borrowings, slowdown in household financial savings and rising riskiness of borrowers. If not

for these, lending rates would have come down even more with slowing corporate credit demand, and

lowering of the repo rate in fiscal 2013.

Liquidity shortage, rising lending risk stem further fall in real lending rates

In fiscal 2013 and 2014 (April 2012 and September 2013) even though the repo rate was lowered by 125

basis points, lending rates as measured by the weighted average lending rate published by the RBI came

down by only 44 basis points (Table 1). There were two reasons for this:

First, regulatory uncertainty, policy bottlenecks, and slowing domestic and external demand delayed efficient

implementation of projects and raised their riskiness, pushing up the risk premium charged by banks over and

above the repo rate. Reflected in rising policy uncertainty and falling business-optimism indices, this created

downward rigidity in lending rates (repo rate plus risk premium) even as policy rates eased.

Second, high and persistent retail inflation resulted in deposit rates becoming negative in real terms (Annex

Charts 1, 2). Consequently, household savings moved more into gold and real estate, while the share of

financial savings fell sharply. This lowered bank deposit growth, and curbed flow of liquidity towards

investments. Consequently, banks had to raise deposit rates to attract financial savings, thereby increasing

their cost of funds. In addition, high government borrowings added to tight liquidity, leading to stickiness in

lending rates (Annexure Chart 3).

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2011-12

2012-13

2013-14

% Real lending rate (adjusted for inflation) ROA


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Table 1: No downforce on lending rates

Notes:

*Lending rates considered were the so-called prime lending rates or PLR prior to March 2010, and the weighted average

lending rates thereafter, when banks moved to the Base Rate system.

**CPI corresponds to CPI-Industrial Workers for the historical period where CPI-combined is not available.

Source: RBI, Dun and Bradstreet Business optimism Index, Policy Uncertainty Index by Baker, Bloom and Davis,

and CRISIL Research

Investments will recover once expected returns on them rise.

Yet, despite the downward rigidity in lending rates, they remain relatively low in real terms bank lending

rates in real terms are currently around 2.5% significantly lower than the 7.4% seen in the pre-crisis years.

In spite of this, investment growth dropped to 0.3% during fiscals 2013 and 2014, down from an average

16.2% in the pre-crisis years.

Under the circumstances, investments can be made attractive by raising the expected return on capital, ratherthan lowering real lending rates. In any case, with improved liquidity in the banking system, lending rates

should being to move southwards in the coming months, even without lowering the repo rate.

Government efforts to reduce regulatory bottlenecks and a gradual revival in demand due to low and stable

inflation are what will pave the way for better returns and investment growth.

Regression analysis vouchers our hypothesis of investment slump

By conducting a regression analysis, we found that the primary factors behind investment slowdown in the last

three years have been rising policy uncertainty and slowing domestic demand (Table 2). The impact of policylogjam was captured through the EconomicPolicy Uncertainty Index (created by Scott R Baker, Assistant

Professor of Finance at Northwestern University, Kellogg School of Management; Nick Bloom, Professor of

Economics at Stanford University; and, Steven Davis, Deputy Dean of The Faculty, University of Chicago

Booth School of Business. It is a monthly index constructed from newspaper coverage of terms pertaining to

policy uncertainty)

If not for the rise in policy uncertainty, investment growth during fiscals 2012 to 2014 would have averaged

around 7.5% compared with the actual 4.3%. This is the direct impact of policy uncertainty. A stable policy

environment would also have reduced the riskiness of investment projects, enabling banks to lower lending

Average CPI**

Change in

repo rate

Change in

lending rate*

Average

deposit

rate

Average

Economic

Policy

Uncertainty

Index

Average

Business

Optimism

Index

Oct 2005-Oct 2008 6.5 3.00 3.00 8.4 70.5 173

Oct 2008-Mar 2010 11.3 -4.25 -2.00 8.4 119.5 124

Mar 2010-Apr 2012 9.7 3.75 2.11 8.7 146.3 157

Apr 2012-Sep 2013 10.0 -1.25 -0.44 9.1 162.9 141

Sep 2013-Sep 2014 8.7 0.75 0.00 9.1 98.8 148


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CRISILInsight

rates (in sync with policy easing in fiscal 2013). This would have further boosted investment growth. In fact,

every 100 basis points reduction in lending rate boosts investment growth by 60 basis points (See Box on

regression analysis, Table 5).

While rising policy uncertainty is the single-biggest factor dragging down investment growth, the positive

contribution from domestic demand to investment growth has also declined markedly in the last three years

(Table 2).

Note: Real repo rate is calculated using CPI-Industrial Workers as a long series for CPI combined is not available. Real

lending rate is calculated using Prime lending rate and CPI-Industrial Workers.

Source: CSO, RBI, CRISIL Research, Economic Policy Uncertainty Index

Further, estimating the investment function using real policy rate instead of real lending rate clearly shows that

the policy rate is not even a significant variable in explaining trends in investment growth (Box on regression

analysis, Table 4). Yet, if one still considers it, the real policy rate has actually been supportive of investment

growth in the last six years. While every 100 basis points increase in the real policy rate reduces investment

growth by 36 basis points, the negative real policy rate since fiscal 2009 implies it was actually a positive

factor driving up growth in fixed investment in the last three years. The increase in policy rates in the last fiscal

(after September 2013) has only reduced the magnitude of positive contribution from monetary policy to

investment growth. It continues to be supportive, nevertheless (Table 3).

Table 2: Slowdown in investment growth explained Table 3: Slowdown in investment growth not

by rise in policy uncertainty and high lending rates due to monetary policy

FY06-FY11 FY12-FY14 FY06-FY11 FY12-FY14

GFCF growth (%) 11.4 4.6 GFCF growth (%) 11.4 4.6

External demand growth 2.5 2.8 External demand growth 2.4 2.8

Policy uncertainty -4.1 -7.0 Policy uncertainty -4.3 -7.4

Real lending rate -2.3 -3.2 Real repo rate 0.7 0.5

Domestic demand 10.1 7.7 Domestic demand 10.2 7.8

Constant 4.9 4.9 Constant 1.9 1.9

Other factors 0.4 -0.7 Other factors 0.6 -1.0

Which can be explained by: Which can be explained by:


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Box: Regression Analysis

Source: CSO, CRISIL Research

Notes:

P>|t| or p- value indicates the level at which the coefficients are significant.

Real repo rate is calculated using CPI-Industrial Workers as a long series for CPI combined is not available

Real lending rate is calculated using the prime lending rate and CPI-Industrial Workers

The Economic Policy Uncertainty Index is a monthly index constructed based on newspaper coverage of terms

pertaining to policy uncertainty

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Mar-09

Jun-09

Sep-09

Dec-09

Mar-10

Jun-10

Sep-10

Dec-10

Mar-11

Jun-11

Sep-11

Dec-11

Mar-12

Jun-12

Sep-12

Dec-12

Mar-13

Jun-13

Sep-13

Dec-13

Mar-14

Jun-14

%, y-o-yActual GFCF growth Fitted GFCF growth (w/repo rate)

Fitted GFCF growth (w/lending rate)

Table 4: Regres sion res ults with repo rate Table 5: Regres sion res ults with lending rate

Coefficient P>|t| Coefficient P>|t|

External demand growth 1.8005 0.001 External demand growth 1.8321 0

Policy uncertainty -0.0487 0.011 Policy uncertainty -0.0462 0.013

Real repo rate -0.3597 0.258 Real lending rate -0.5979 0.101

Private consumption growth 1.2364 0.009 Private consumption growth 1.2209 0.008

Other factors 1.8667 0.67 Other factors 4.9054 0.248

Number of observations 36 Number of observations 36

R-squared 0.6011 R-squared 0.6191

Dependant variable: Real investment Growth Dependant variable: Real investment Growth

(Real GFCF Growth) (Real GFCF Growth)


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CRISILInsight

Micro evidence on stress in interest-sensitive sectors

The two sectors in the economy that are currently under stress are automobiles and infrastructure. Credit

penetration is high in the auto sector and therefore, interest rate can be a significant factor influencingdemand. In infrastructure, on the other hand, it is high leverage that increases sensitivity to lending rates.

Automobiles: In this sector, in addition to income prospects, another factor crucial to demand is lending

rates. Within auto, the two most interest-sensitive segments are commercial vehicles, followed by cars (mostly

small-car segments where customers have low affordability). Thats because these are also the segments

with the highest finance penetration rate.

In these two segments, nominal lending rates are higher today compared with the high-growth phase and real

lending rates are similar. However, real lending rates have fallen during the past two years due to persistently

high inflation (Chart 3). Despite lower real lending rates which favour borrowers, there is a sharp slowdown in

both, loan disbursals and sales growth, especially after fiscal 2012 (Chart 4).

The decline is especially pronounced in the commercial vehicles segment and is most likely due to factors

such as stalling of infrastructure projects, general slowdown in industry and a ban on mining activities that

affected demand. Similarly, sluggish income prospects are likely to have impacted the demand for cars and

utility vehicles, albeit to a lesser extent. High inflation and low income visibility trimmed the discretionary

spending capability of households and severely impacted their affordability. Overall, it suggests that factors

other than interest rate have played a bigger role in driving down automobile demand in recent years.

Chart 3: Lending rates in the automobile sector

Source: CRISIL Research estimates

-4.0

0.0

4.0

8.0

12.0

16.0

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Cars & UVs Commercial vehicles

Sectoral interest rates on auto finance

Nominal lending rate Real lending rate


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Chart 4: Trend in loan disbursements and sales in the automobile sector

Source: CRISIL Research estimates

Infrastructure: The ratio of interest cost to operating income for infrastructure companies has increased

sharply in recent years from 4.7% in fiscal 2010 to 13.2% in 2014. However, the analysis suggests that this

worsening had more to do with high indebtedness of infrastructure companies than elevated interest rate.

In infrastructure (especially for companies engaged in road and power-generation projects, accumulated debt

is so high that the interest cost has ballooned (Chart 5). In addition, policy uncertainty and a high proportion of

non-performing / stressed assets mean risk of lending is very high, which has further pushed up the risk

premium on lending rate. If that werent enough, with regulatory hurdles impeding growth, operating income

has declined, aggravating the pain.

Given this, additional investments have been hard to come by. Growth in infrastructure investment fell sharply

to 5.2% average during fiscals 2012 and 2013, compared with 8.6% during 2009 and 2011, and 22% in 2004

to 2008. Corporate investment decisions are driven by the internal rate of return (IRR) accrued on projects.

Data show IRRs on road projects have fallen to nearly 8-14% from 16-18% in 2008 and 2009. However, this

has not been because of high lending rates. The culprit is cost overrun (nearly 23%) spawned by delays in

project clearances by the government and problems in land acquisition.

50

70

90

110

130

150

170

190

210

FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Cars & Utility Vehicles Commercial vehicles

Loans disbursements Sales2007-08 = 100


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CRISILInsight

Chart 5: High leverage and deceleration in sales growth

Note: Data is for infrastructure companies engaged in roads, power generation and diversified.

Source: CRISIL Research

In a nutshellInvestment growth has slowed down sharply in the last two years even though policy rates have been

negative in real terms and real lending rates have averaged less than 3%. The primary reason for this

is the sharp fall in the expected return on investments.

The RBI now needs to maintain a positive real repo rate to firmly anchor inflation expectations,

especially when upside risks to its CPI inflation target of 6% by January 2016 continue. Further, a

new monetary framework will be implemented from April 2015. So till such time there is clarity on the

inflation target given therein, reducing the repo rate would be premature.

Recent evidence suggests that any flare-up in inflation due to lowering of interest rate at this stage

could hurt consumption demand further, lower Indias export-price competitiveness, and raise input

costs -- all of which will reduce corporate profitability even more.

There is, therefore, a case for the RBI to hold the repo rate at the current level.

4.7

6.88.6

10.7

13.2

16

19

28

15

8

1.1 1.31.9 2.2 2.3

2009-10 2010-11 2011-12 2012-13 2013-14

Interest cost / Operating income (%) Operating income growth (%yoy)

Gearing (times)


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Annexure

Chart A.1: Returns on bank deposits are lower than alternative saving options

Note: Returns are adjusted for CPI inflation

Source: CRISIL Research

Chart A.2: Household savings in bank deposits have come down sharply

Source: RBI

-2.4 -1.8-1.5

1.2

3.3

14.7

Bank deposits Claims on

government(investment in

govt debt)

Provident and

pension funds

Real estate Shares and

debentures

Gold

Average real rate of return (2008-09 to 2012-13)

23.822.4

19.9

17.2 15.9

13.514.2 14.1

2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14

% y-o-y


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CRISILInsight

Chart A.3: Government borrowings lord over bank credit to corporates

Source: Ministry of Finance, RBI

37.4

28.026.7

16.8

2003-04 to 2007-08 2008-09 to 2013-14

% y-o-y average

Govt Borrowings Bank credit

Analytical Contacts:

Dharmakirti Joshi Vidya Mahambare

Chief Economist, CRISIL Research Principal Economist, CRISIL Research

Email: [email protected] Email: [email protected]

Dipti Deshpande Neha Duggar SarafSenior Economist, CRISIL Research Economist, CRISIL Research

Email: [email protected] Email: [email protected]

Media Contacts:

Tanuja Abhinandan Jyoti Parmar

Communications and Brand Management Communications and Brand Management

Email:[email protected] Email: [email protected]

Phone: +91 22 3342 1818 Phone: +91 22 334 21835
mailto:[email protected]:[email protected]


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CRISIL Insight - Will a Rate Cut Spur Investments (1)