Racy Cases 23 Interest(ing) Investments

V Pattabhi Ram and A V Vedpuriswar

Chatshow eyed the 120 odd students in his class. They were an extremely talented lot. Someone from this group would one day become India’s finance minister, he thought. And one of them would surely go on to become the governor of the RBI he told himself. With those thoughts that made his eyes a shade misty, Chatshow decided that he would explain the link between interest rates and investments. After all, future finance ministers and future RBI honchos need to understand the link to manage the economy!

Chatshow got into his famous “ask question-offer-logic” mode. He began: “What happens if lending rates fall? Well, profits improve. What happens if earnings grow? Well, cash flows improve. What happens if cash flows improve? Well, the urge to expand improves.” The girl in the middle row supplemented, “If lending rates fall, businessmen either expand capacity or set up new facilities. This leads to growth.” Chatshow agreed. And remarked, “That is why central banks, the world over, cut interest rates to boost growth.” Flowers asked, “Sir, would that apply to India?”

“Ha, there you are,” said the professor, apparently impressed by the question. He flipped in his OHP sheet that showed how interest rates in India had dropped dramatically since 1991. A backbencher remarked, “Sir, despite the sharp decline in interest rates, bank lending to industrial clients hasn’t perked up, and investments haven’t happened.” With a majestic swish of his mane Chatshow said, “Yup.” And asked: “Any reasons?”

“Loanable funds theory” hissed Flowers. Boka, picking the cue, said, “The interest rate is the price of capital. When more people are willing to lend (sell capital) than borrow (buy capital), interest rates should go down.” The girl in the middle row (GITMR) added, “When more people are willing to borrow than lend, interest rates should go up”. Flowers closed out, “Hence, interest rates should be low in countries that enjoy a capital surplus should be high in countries that suffer a capital deficit.” The professor nodded.

It was then that Chatshow got into his famous act; comparing Japan with India. “In Japan”, he said, “Interest rates have been close to zero for many years. Avenues for heavy capital investment, such as infrastructure, have been exhausted. Hence, the demand for capital is less than the supply of capital.” He paused. And then added, “But India, which is weak on infrastructure, is short of capital”. Flowers thought, no roads, no telecom, no power and no water. Leading software companies like Wipro are constantly complaining about the inadequate infrastructure in India’s software capital, Bangalore. Chatshow delivered his knockout punch, “So logically, interest rates in India should be much higher!”

The class was beginning to scent the fact that the professor was resenting the low-interest rates in India. If proof was needed, it came in immediately. Chatshow said, “No product should ever be underpriced”. The girl in the middle row nodded. “If you under-price a commodity, people don’t realize its worth.” Flowers wisecracked, “Come Easy, Go Easy;” recalling a Hadley Chase book that he had read in school. Chatshow brought the discussion back to where it should be.
“The Asian currency crisis happened because the region was privy to cheap capital. Consequently, projects with low rates of return got approved. As long as the government pegged its currency to the dollar, the party continued. But once the peg broke, the effective cost of borrowing, i.e., the currency depreciation plus the interest rate on foreign borrowings, proved to be too much of a burden for the domestic financial system.” Impressed by his flow of words, Chatshow asked “Any questions?”

Flowers volunteered. “Sir, who benefits from low-interest rates? Chatshow turned around and cooed, “Any answers?” Boka remarked, “Two entities benefit from these drops. One, ‘large companies’ and two ‘the government’. Blue chip companies have never had any problem accessing funds. Such companies are now able to do so at even lower rates. And the government, which is burdened with a huge fiscal deficit, gains.”

Chatshow was impressed. “Good. That is why these two parties seek a reduction in interest rates. Meanwhile, the small sector, a key driver of growth in any economy, has been starved of funds. Even in the past, when interest rates were higher, this sector struggled to get funds. Now, in a lower interest rate scenario, getting funds has become harder”. A backbencher remarked, “Sir, we cannot blame banks for refusing to lend in the current scenario. When interest rates are low, banks have little incentive to lend to risky projects. It makes more sense for banks to put their funds in government securities and blue-chip bonds and earn smaller spreads without taking any risk”. He had hit pay dirt. The class roared in approval. Even Chatshow smiled.

The professor then wondered aloud, “How has the government reduced the interest rate so much?” Flowers volunteered: “The reduction has come through administrative diktats issued by the government and Reserve Bank and not by increasing the availability of capital, in relation to the demand”. Chatshow asked, “Is there a better way of reducing interest rates?”

Boka jutted in, “We need to increase the supply of money. For that, we must do three things. One, we must reduce the Non Performing Assets in banks. To do that we need better bankruptcy laws. Disputes relating to defaults must be resolved quickly so that capital that is locked up will be released. Two, we must improve capital productivity in public sector enterprises so that resources can be freed for infrastructure investments. And three, we should cut the huge budget deficit to reduce the demand for capital.” Phew.

Chatshow summed up: “Interest rates should compensate the lenders for the risk they take We seem to think that reducing interest rates will cut costs and overnight make our companies competitive. This is wrong. Competitiveness can come only through innovation, not artificial props. In Germany and Japan exports did not crash when their currencies appreciated against the US Dollar. That is because the two countries are globally more competitive than anyone else in the world in a range of industries. They make goods that no one else can make,either in terms of cost or quality or both.”

The gong went. And Flowers asked, “Would it mean that for success we need to become competitive courtesy innovation than through dropped interest rates.” Chatshow waved, “Yup.”


About Pattabhi Ram

A chartered accountant by profession, a writer by passion and a teacher by accidental choice.
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2 Responses to Racy Cases 23 Interest(ing) Investments

  1. A very informative case interestingly presented. One different dimension is that the RBI now believes that the risk of lower interest pushing up inflation via increased aggregate demand is low because capital utilisation is around 70% only as of now. If this view is correct, following consequences follow: 1) Interest is lower. So, consumers borrow more. 2) Consumption demand increases. This increase is met by higher utilisation of existing capital. Hence, prices instead of increasing may actually come down.3) Profits increase because of higher volume. Wages and dividends are marked up. 4) Consumption demand increases further. Thus, at least, in the short run, a virtuous cycle of increased business activity is in place.

    In this possible scenario, fresh capital formation need not and may not happen. NPAs should hopefully start performing again.

  2. Ranjan says:

    After all it has met a larger goal. It profess as the thought of the Chatshow that “every great man starts as just a man”. Today’s passenger on “the impact of interest rate on economy” bus is tomorrows Driver.

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