In his foreword to the Reserve Bank of India’s (RBI) annual report, the outgoing governor Raghuram Rajan seems to offer an explanation to Union Commerce Minister Nirmala Sitharaman's demand just last week — that the RBI should go for nothing less than a 200 basis points rate cut to help tiny entrepreneurs. Rajan explains why the interest rate lobby is wrong in assuming that a massive RBI rate cut will translate into lower loan rates, prompt banks to lend more and, thus, benefit small entrepreneurs.
Let’s look at this issue in detail.
Rajan says in the foreword: “The willingness of banks to cut lending rates is muted; not only does weak corporate investment reduces the volume of new profitable loans, their stressed assets have tightened capital positions, which may prevent them from lending freely.”
“Certainly, the reluctance to lend to industry and small businesses is more visible among the more stressed public sector banks compared to the private sector banks,” the governor said.
Also, the former IMF chief economist rules out any rate cuts, forget 200 bps, in the near future anyway due to high inflation. “Inflation projections are still at the upper limits of RBI’s inflation objective. With the Reserve Bank needing to balance savers’ desire for positive real interest rates with corporate investors’ and retail borrowers’ need for low nominal borrowing rates, the room to cut policy rates can emerge only if inflation is projected to fall further.”
In simple words, expect no rate cuts from RBI until inflation is controlled fully and brought down to the central bank’s comfort zone, which isn't the case now.
Already, the July CPI (consumer price index) inflation at 6.07 percent crossed the 6 percent upper band (2 percent on the lower side) agreed between the central bank and the government. Though there is a likelihood that consumer inflation will ease post September backed by a good monsoon (thus lower food prices, the key driver of inflation) received this year, the upside pulls on the food inflation continue to pose major risks to the central bank’s early 2017 target of 5 percent. Under the agreement between the RBI and government, the central bank has been given a retail inflation target of 4 percent (plus/minus 2 percent) by the government until 2021. The central bank’s first target is 5 percent by March 2017.
Recently, Sitharaman’s demand for 200 basis points (One bps is one hundredth of a percentage point) had hogged headlines. Rajan, in his foreword, essentially gives two messages. One, it’s not easy for the central bank to go for a rate cut at this stage. Secondly, even if the central bank cut rates, it isn't necessary that such an action will help small firms. That's because reasons for banks not lending to small firms are primarily high bad loans and lackluster investments. The governor explains that (more than high interest rates), the weak investment scenario that results in poor credit recovery and capital constrains arising out of high non-performing asset (NPA) situation, make lending to small companies difficult. So far, banks' experience from lending to small firms hasn't been very good in terms of asset quality. Most lenders, especially state-run banks, have seen substantial chunk of their bad loans emerging from this segment, which are hit hard in an economic downturn. Hence, it isn’t hard to understand why banks are reluctant to take further exposure to small firms.
In a recent article, Firstpost had argued why Sitharaman’s demand for a 200 bps rate cut isn’t a feasible idea in the backdrop of high inflation.
“I would want the entire banking system of this country to please be a bit more caring about the industry... it is time now for the Indian economy to have a breath of fresh air. The competitiveness of smaller companies is affected purely because of rate of credit," Sitharaman had said.
But, as noted earlier, the fact is that even if RBI goes for a 200 bps rate cut it would have severely hurt the depositors who park their money in banks. Because, banks don’t cut lending rates alone, they will have to first reduce the deposit rates to manage their costs. This will mean that the common depositors, including the senior citizens, will have to suffer with even lower returns. This was, anyway, a hypothetical scenario because banks, in the fist place, are not going to cut their lending rate even if the RBI cuts rate because of huge NPAs on their books (currently the stressed assets of Indian banks are well above 11 percent of their total loans). Here again, a major reason for NPAs on the books of banks is absence of fresh investments in stalled or delayed projects that has impacted the repayment ability of companies.
To be fair to Sitharaman, the minister raised a valid issue. Small firms are indeed passing through a tough phase. There has been hardly any bank lending to these firms in the recent years. Bank lending significantly contracted to small firms between 2015 and 2016 till May, with loan growth registering at negative 12.7 percent to medium-sized companies and negative 6.5 percent to micro and small companies. Unlike large top-rated companies, these firms also do not have the capacity to tap the money markets to raise funds. But, the government will have to innovate other ways to help these small firms instead of merely relying on banking sector.
The point here is this this: Sitharaman is bang on identifying and highlighting an important issue--the sad state of small entrepreneurs in India, but the solution she offers (massive RBI rate cuts that’ll translate to lower bank lending rates to MSMEs) is far from a realistic scenario. Rajan explains the issue well in his last major RBI report.