November 2014

CRISIL Insight

INTEREST
RATES

REGULATORY
HURDLES

Will a rate cut spur investments? Not really

CRISIL Insight

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Will a rate cut spur investments? Not really

CRISIL Research study shows investments have slowed in times of lower 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 average
rate 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.

CRISIL Insight

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 among 189 countries.

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

Fixed investment growth, y-o-y

%
20.0
15.0
10.0
5.0
0.0
-5.0

2014-15F

2013-14

2012-13

2011-12

2010-11

2009-10

2008-09

2007-08

2006-07

2005-06

-10.0

Note: Nominal repo rate at the fiscal year -end minus average CPI inflation, F=Forecast
Source: RBI, Central Statistical Office, CRISIL Research

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.
1

Our findings resonate with recent research on corporate investment behaviour by Kothari et al 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 database have 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.

The 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 Economic
Research), and Jerold B Warner (Simon Graduate School of Business, University of Rochester)

CRISIL Insight
Chart 2: Real cost of borrowing and return on investments
Real lending rate (adjusted for inflation)

ROA

10.0
8.0
6.0
4.0
2.0

2013-14

2012-13

2011-12

2010-11

2009-10

2008-09

2007-08

2006-07

2005-06

2004-05

-2.0

2003-04

0.0

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).

Table 1: No downforce on lending rates

Average CPI**

Change in
Change in
repo rate 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

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 Bak er, 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, rather
than 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 policy
logjam was captured through the Economic Policy 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

CRISIL Insight

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).
Table 2: Slowdown in investment growth explained
by rise in policy uncertainty and high lending rates

GFCF growth (%)

FY06-FY11

FY12-FY14

11.4

4.6

Which can be explained by:

External demand growth

Table 3: Slowdown in investment growth not

due to monetary policy

GFCF growth (%)

FY06-FY11

FY12-FY14

11.4

4.6

2.4

2.8

-4.3

-7.4

0.7

0.5

10.2

7.8

Which can be explained by:

2.5

2.8

External demand growth

Policy uncertainty

-4.1

-7.0

Policy uncertainty

Real lending rate

-2.3

-3.2

Real repo rate

Domestic demand

10.1

7.7

Domestic demand

Constant

4.9

4.9

Constant

1.9

1.9

Other factors

0.4

-0.7

Other factors

0.6

-1.0

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).

Box: Regression Analysis

%, y-o-y

Actual GFCF growth

Fitted GFCF growth (w/repo rate)

Fitted GFCF growth (w/lending rate)

30.0
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
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

-15.0

Source: CSO, CRISIL Research

Table 4: Regression results with repo rate

Table 5: Regression results with lending rate

Dependant variable: Real investment Growth

Dependant variable: Real investment Growth

(Real GFCF Growth)

(Real GFCF Growth)

Coefficient

P>|t|

1.8005

0.001

External demand growth

Policy uncertainty

-0.0487

0.011

Real repo rate

External demand growth

Coefficient

P>|t|

1.8321

Policy uncertainty

-0.0462

0.013

-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
R-squared

36
0.6011

Number of observations
R-squared

36
0.6191

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

CRISIL Insight

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 influencing
demand. 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

Sectoral interest rates on auto finance
16.0
12.0
8.0
4.0
0.0

Cars & UVs

Nominal lending rate

Source: CRISIL Research estimates

Commercial vehicles
Real lending rate

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

FY06

FY05

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

FY06

FY05

-4.0

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

Loans disbursements

2007-08 = 100

Sales

210
190
170
150
130
110
90
70
50
FY08

FY09

FY10

FY11

FY12

Cars & Utility Vehicles

FY13

FY14

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Commercial vehicles

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.

CRISIL Insight
Chart 5: High leverage and deceleration in sales growth
Interest cost / Operating income (%)

Operating income growth (%yoy)

Gearing (times)
28

19
16

15
13.2
10.7
8.6

6.8
4.7
1.1
2009-10

1.3
2010-11

1.9

2011-12

2.2

2012-13

2.3

2013-14

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

In a nutshell

10

Investment 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.

Annexure
Chart A.1: Returns on bank deposits are lower than alternative saving options
Average real rate of return (2008-09 to 2012-13)
14.7

3.3
1.2

-1.5
-1.8
Bank deposits Claims on
Provident and
government pension funds
(investment in
govt debt)
-2.4

Real estate

Shares and
debentures

Gold

Note: Returns are adjusted for CPI inflation

Source: CRISIL Research

Chart A.2: Household savings in bank deposits have come down sharply
% y-o-y
23.8
22.4
19.9
17.2
15.9
13.5

2006-07

2007-08

2008-09

2009-10

2010-11

2011-12

14.2

2012-13

14.1

2013-14

Source: RBI

11

CRISIL Insight
Chart A.3: Government borrowings lord over bank credit to corporates
% y-o-y average
37.4

26.7

28.0

16.8

2003-04 to 2007-08
Govt Borrowings

2008-09 to 2013-14
Bank credit

Source: Ministry of Finance, RBI

Analytical Contacts:
Dharmakirti Joshi

Vidya Mahambare

Chief Economist, CRISIL Research

Principal Economist, CRISIL Research

Email: dharmakirti.joshi@crisil.com

Email: Vidya.mahambare@crisil.com

Dipti Deshpande

Neha Duggar Saraf

Senior Economist, CRISIL Research

Email: dipti.saletore@crisil.com

Economist, CRISIL Research

Email: neha.saraf@crisil.com

Media Contacts:

12

Tanuja Abhinandan

Jyoti Parmar

Communications and Brand Management

Email: tanuja.abhinandan@crisil.com
Phone: +91 22 3342 1818

Communications and Brand Management

Email: jyoti.parmar@crisil.com
Phone: +91 22 334 21835

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Phone: +91 44 2854 6205/06
+91 44 2854 6093
Fax: + 91 44 2854 7531

Pune
1187/17, Ghole Road
Shivaji Nagar
Pune - 411 005, India
Phone: +91 20 2553 9064/67
Fax: +91 20 4018 1930

Gurgaon
Plot No. 46
Sector 44
Opp. PF Office
Gurgaon - 122 003, India
Phone: +91 124 672 2000

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CRISIL Limited
CRISIL House, Central Avenue
Hiranandani Business Park, Powai, Mumbai - 400 076. India
Phone: +91 22 3342 3000 | Fax: +91 22 3342 8088
www.crisil.com
CRISIL Ltd is a Standard & Poor's company