Interest Rates Are Low. But Are They Low Enough?
Purely from a growth lens, it may be easy to argue that policy & market rates should be lower than those that exist today.
It has been argued that interest rates have fallen to a decadal low in India which should help growth recover and allow the government to fund its borrowing at a cheaper cost in a non-disruptive manner.
While it is true that market rates have fallen sharply, are today’s market rates low enough in the context of the prevailing growth environment compared to that of a decade earlier?
The answer is a clear no.
Growth Now And Then
Let’s first compare growth conditions today to those that prevailed during the global financial crisis of 2008 when interest rates had fallen to similar lows.
In October-December 2008, just after the Lehman bankruptcy, real GDP growth moderated to 5.8% year-on-year from 8.5% and 9.8% in the previous two quarters. It slowed further to 3.5% in January-March 2009 period, which marked the bottom of growth in that cycle.
Nominal GDP growth had moderated to 10.9% in October-December 2008, from 18.7% and 18.4% in the previous two quarters and also bottomed in January-March 2009 at 5.5%. Full year real GDP growth in FY09 fell to 6.9% from 9.3% a year ago, while nominal GDP growth fell to 13.4% from 16.2 in FY08.
As the RBI started to cut the repo rate from the pre-crisis level of 9% to 4.75% by April 2009, 10-year government bond yields hit a low 5.25% at the end of December. The reverse repo rate, which was then the operative rate in surplus liquidity times, had been dropped from 6% to 3.25%.
That was then.
The Covid-19 shock in 2020 has been far more severe than the shock posed by the 2008-09 crisis. Real GDP growth for FY21 is likely to contract anywhere between 8-10% and nominal GDP growth is likely to decline by 5-7% compared to last year.
In response, the repo rate has been cut to 4%, below the previous low of 4.75% but the current reverse repo rate at 3.35% is still higher than the previous lows of 3.25%. In response, the yield on the benchmark 10-year bond fell to a low of 5.75% on May 22, 2020, when India’s MPC last cut rates. It is now hovering around the 6% mark, higher than the lows seen after the 2008-crisis, despite growth being significantly lower compared to the financial crisis period.
Beyond Growth
Purely from a growth lens, it may be easy to argue that policy and market rates should be lower than those that exist today. But there are other factors in the mix.
Inflation being prime among them.
We note that prices of key vegetables have increased sharply in the last few weeks and the average increase in tomato, onion and potato is up 21.5% month-on-month in September versus a 2.6% increase in August. This can lead to a 1-1.5% month-on-month increase in CPI food prices, which will push up CPI inflation close to 7% or higher in September.
Deutsche Bank is projecting CPI inflation to average 5.7% in FY21 and then moderate to 4.0% in FY22. But given the current high inflation prints and the RBI’s inflation-targeting mandate, expectations have dimmed about the prospect of future rate cuts.
Back in the October-December 2008 period, when the RBI had cut interest rates aggressively in the aftermath of the Lehman bankruptcy, CPI inflation had averaged 10.2%. It was at 9.1% and 12.3% in FY09 and FY10 respectively. At that time the RBI used to focus on wholesale price inflation (which was lower than retail) and there was no inflation targeting framework, which allowed the central bank to cut rates aggressively.
There are other differences between the global financial crisis period and now, which would support the case for even lower rates.
For instance, credit growth was much stronger back then than it is now.
Bank credit growth went from 22.6% in October-December 2008 to 17% by March 2009 and 16% in March 2010. In the current cycle, scheduled banks’ credit growth has fallen to 5.3% year-on-year in September. If one were to add the credit offtake of NBFCs and HFCs—these two sectors finance almost 30% of total credit in the economy—total credit growth will be flat to negative.
This credit growth profile supports the argument for market interest rates to be lower than current levels.
Further analysis of monetary conditions suggests that money supply and the money multiplier, adjusted for bank liquidity, indicates a lower-than-trend velocity of money.
The final factor is public debt.
Despite a sharp increase in general government deficit (to 9.3% of GDP in FY10, from 4% of GDP in FY08) in the aftermath of the financial crisis, public sector debt/GDP moderated to 75.5% in FY10 from 77.7% in FY08. This was possible as nominal GDP growth remained significantly higher than nominal interest rate throughout the 2008-09 crisis period, thereby helping the debt/GDP trajectory to remain on a declining path.
In the current cycle, the Covid-19 shock is likely to push up the general budget deficit to 13% of GDP, from 8% in FY20. However, debt/GDP is expected to rise above 85% of GDP in FY21, from about 72% in FY20, as nominal GDP growth will be significantly lower than nominal interest rates.
While market interest rates have fallen to a decadal low, it pales in comparison to the drop in nominal GDP growth, resulting in the adverse debt/GDP dynamic.
But Can We Get Lower Rates?
While there may be enough arguments in support of lower market rates, another 25-50bps cut in the policy rates will do little good. Also, rate cuts amidst high inflation could hamper the MPC’s inflation-targeting credibility over the medium-term.
With no further expectation of rate cuts, market yields will have a natural tendency to move up, given the concerns on the fiscal front and the consequent negative demand-supply dynamic in the bond market.
How then do we keep market rates low and attempt to bring them down further?
In our view, given the prevailing environment, more proactive bond purchases will be required over a longer period of time to provide support to the bond market and the overall economy. Bank credit growth is expected to rise in the coming quarters even though NBFCs are likely to stay in consolidation mode. Banks are unlikely to be able to support both private credit demand and higher borrowings simultaneously. In this backdrop, the RBI needs to step in proactively to buy bonds and keep longer duration yields from inching higher.
There is one more step the MPC can take, which it hasn’t in the past.
In the aftermath of the GFC, the RBI maintained a pause of about 10 months from the trough of the rate cut cycle in April 2009 before starting to hike rates gradually from March 2010.
In the current cycle, the exit from lower rates should be triggered after a longer pause to give sufficient time to the economy to recoup from the massive shock. Surely, real GDP growth would be in double digits during the April-June of 2021 period because of a favourable base, but that should not lead the MPC to start thinking of reversing the accommodative stance pre-emptively.
Kaushik Das is India Chief Economist, Deutsche Bank AG.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.