High Rate Pressure

There has been no other precedent in history when the RBI has acquired the position in the economic framework that it presently enjoys. At this turn, the entire economic drama is being played out in anticipation of what the central banker will do next. This is as applicable globally as it is in the Indian context. From easy monetary policies to fuel growth, to tightening the screws in order to rein the ill-effects of that loose monetary policy, the situation seems to have gone into a spiral of its own. 

Burgeoning deficits on the fiscal and current account sides, the sliding rupee, skyrocketing inflation and to top it all, a shaky geopolitical scenario have all slammed brakes on the growth of the Indian economy, which at one point of time had revved up its engine to such an extent that its ultimate position in the race among the fastest growing economies was assumed to be at the top. 

In the larger debate on what has stalled the economy so badly, one most important point has yet to be discussed or deliberated upon in right earnest – the ever-rising interest rates. This point becomes all the more important considering that the desired impact that higher rates were supposed to create is still nowhere on the horizon. On the contrary, the interest rate burden seems to be creating an impact diametrically opposite to what was intended.

Taming Or Fuelling Inflation? 

The most compelling argument in favour of keeping interest rates on the higher side has been the need control the spiraling inflation. But the irony is that every rate hike results in adding to the inflationary pressures rather than bringing it down. 

Simply put, inflation is a function of wholesale as well as consumer prices. Hiking interest rates is a tool to squeeze liquidity and hence quell demand. But there is now way that consumer prices can be reined in by doing so. Hence, the drumbeating about hiking interest rates to bring down inflation seems to be all bunkum, or at least of seriously limited utility, at least in the present circumstances. 

The one basic factor that can, in fact, bring inflation under control is the rationalisation of supply to demand. In order to achieve that, it is imperative that policymakers help build a business environment that is conducive to fuelling supply rather than curbing demand. Corporate India has been voicing its resentment against higher interest rates all along, claiming that it has a damning impact on the overall business environment. 

But this is being challenged by the high priests of government financing. In a recent interview to a leading financial daily, the Prime Minister’s Economic Advisor, C Rangarajan, hit out at the Indian business fraternity for having criticised the apex bank’s decision of hiking rates. According to him, “Industry seems to feel that the only thing that is relevant is the rate of interest.” 

However, we feel that it would be very important to remind people not taking high interest rates seriously enough that this the single most important factor for any business today. Higher interest rates are holding out multiple fears for the industry. What follows is some more evidence of how industry and industrial output are getting hurt.

Denting Industrial Production 

According to conventional economic wisdom, the interest rate and output (as represented by the Index of Industrial Production) are negatively correlated. Lower interest rate implies lower borrowing costs, which will induce investments and lead to more production. On the other hand, higher interest rates may not encourage investment, and hence, the out- put may not increase. 

Our study of the relation between the change in repo rate and change in IIP from June 2006 to September 2013 confirms the point, albeit with a slight delay. The impact is not immediate, as it takes time for any action on interest rates to get transmitted into the system. Rather, it will be irrational to expect an immediate impact of the hike in interest rates on the output.

On the other hand, there are various instances in our study period where the variables (interest rate and IIP) have behaved contrary to the theory. For example, from September 2008 till January 2009, the repo rates were reduced by 3.5 per cent, but despite this, the IIP growth fell from 10.9 per cent to -5.31 per cent in the same period. Similarly, the interest rates were increased by 75 basis points from April 2011 to June 2011, but the IIP number kept on increasing from 5.32 per cent in the month of April 2011 to 9.45 per cent for June 2011. This shows that there is no immediate relation between the change in interest rates and the IIP number. Nonetheless, it is true that the output gets impacted by a change in interest rates with a lag effect.

So, what is the lag period after which the output gets impacted due to the increase in interest rates? We found that for the first two quarters, there is no negative correlation between both variables. This is corroborated by a study by the RBI, which has estimated that it takes two to three quarters for any change in interest rate to impact the output. As we increase the lag period to three quarters, we found that a negative correlation appears between the hike in interest rate and fall in output (IIP), which is further strengthened when the lag period is increased to four quarters. 

This shows that although there is no immediate impact of a rise in interest rates on industrial production in shorter period, the output is definitely hit when considered over a longer period.

Hardly An Overreaction 

While the Prime Minister’s advisors may or may not be correct in maintaining their stand on the necessity of increasing interest rates to put the economy back in shape, India Inc. has its own reasons, and quite valid ones at that, in crying hoarse against the high interest rate regime. Look at some of the highly leveraged balance sheets. Companies across categories have been facing a problem of higher interest outgo following the higher debt that they carry on their balance sheet. In fact, the loan portfolio of these companies has only gone up over the past five years.

Consider a company like Jaiprakash Associates, whose average secured loans have gone up by 41 per cent and unsecured loans have shot up by an average 43 per cent over the past five years. Adani Power too shows a similar trend. Its secured loans are up 69 per cent, while the unsecured loans shot up by a huge 84 per cent. This holds true of other companies as well, showing how leveraged they are today. The economy has slowed down considerably, and this is creating additional pressures on the operational front. 

Their interest outgo tells of the pressure that these companies are facing. 66 per cent of Jaiprakash Associates’ EBITDA goes into servicing its debt, which is a quarter of its sales figures. The condition of Adani Power is even more precarious, as the company spends beyond its means to service its debts. This is a very clear sign that it would be resorting to borrowings to pay off its interest costs. 

It is not just the Large-Caps that are suffering from this problem. The Mid-Cap space too has been hurt, and in fact even more strongly. In the case of Lanco Infratech, though the interest outgo is only 18 per cent of its sales, as much as 91 per cent of its EBIDTA goes towards servicing the interest costs. GVK Power also suffers from the same ailment. More than a quarter of its revenues and 91 per cent of its EBITDA go towards meeting its interest costs.

Debt Trap & Currency Risks

So overall, it appears as though companies are earning to finance their interest outgo rather than fund further growth. And therein lies the rub. The cascading affect of this high leverage is surely leading us to a point where the high interest rate regime is building a debt bubble for this country. With high interest rates, companies may not be able to service their debt and are beginning to resort to borrowing to repay. If this continues, it could lead to a major debacle. The first indications of how corporate debt is putting balance sheets under strain came in the form of Shree Renuka Sugars trying to sell off a part of its stake to cut on its over Rs 8000 crore of debt.

Another significant oversight on part of the policymakers, who are evidently great fans of resorting to higher interest rates to contain inflation rather than concentrate on the growth aspect, is that companies may be looking at borrowing from over-seas, which may eventually be very risky for our currency.

Striking At The Root

Higher interest rates are creating unforeseen problems for Indian corporates. This is vindicated by the type of companies that have appeared in our list as being highly leveraged. A majority of them belong to the infrastructure sector.

What is happening currently is that most of the lending from banks is going to infra companies. Although there is nothing wrong with this per se, we believe that most of the funds are going into servicing their debts, which will ultimately create a debt crisis. Although in the short term these loans will help banks control their non-performing assets, if the economy does not pick up, it will hurt the lenders and in turn the entire economy in the long term. 

There are two major pitfalls of such lending. First, borrowing money to pay interest does not create any productive assets and hence does little to strengthen the supply side. It also deprives many genuine borrowers, who would have created productive assets that would have led to a higher supply through more production, which would consequently curtail inflation.

Thus, it is actually by moderating the interest rates that the RBI could achieve better growth and stability on the currency front. Of course, interest rates are only a part of the picture, and there is a lot more to be done on the policy front if we are truly to get back on the growth path. Our intent in this story was to point at a core problem that India Inc. is facing today. We will surely bring to our readers the industry players’ concerns on this matter through the medium of our magazine, which we think is the most important to do as of now.