Will higher interest rates lower growth?

May 12, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The Reserve Bank of India (RBI) increased the repo rate by 50 bps on May 3 and there was an outburst of opinions that the rate of GDP growth will drop. The consensus seemed to be that it would drop to 8 pct, a 100 bps less than what we had been used to.

Of course, May 3 was the first time in two years that the RBI raised the repo rate by a hefty 50 bps. In the earlier eight installments, the increase was only 25 bps.

Nevertheless, cumulatively that adds up to 200 bps. That had no impact on inflation and no impact on growth. Why should the additional 25 bps cause so much anxiety?

Most opinions did not contain explanations. It is relevant to ask why should an increase in repo rate hit GDP growth. How does the higher rate impact major sectors of the economy? How long does it take for the full impact to work itself out? These questions remain unanswered except for the assumed trade-off between inflation and growth.

The repo rate raises the cost for commercial banks of borrowing from the RBI. That in turn raises the cost of lending by commercial banks to their creditors with an effect on other interest rates, mainly short term.

The two classes of borrowers that are important are home buyers and  industry.

Banks have been quick to increase the BPLR on loans for purchase of homes. Since investment in homes is a long-term investment, an increase in interest rates makes considerable difference to the monthly installment. Would that affect demand for homes?

It would have if the buyer was left high and dry. That is not the case in India. We have a DA system which ensures that the income of the home buyer will increase automatically with inflation. Hence the higher installment payment will be taken care of by the higher income. There should not therefore be any significant fall in demand for homes and consequently in construction activity which is one of the important determinants of GDP growth.

What about industry? Surely the cost of bank borrowing will shoot up. But investment is funded from equity and long-term borrowing, the cost of which has not significantly increased. Besides, interest payments are a small part of the cost of production, less than 5 pct.

Even if the increase in repo by 50 bps is fully passed on to industry, it will increase the cost of production by only 0.25 pct which can be most easily passed on to the consumer. It is therefore unlikely that projects on the drawing board will be abandoned because the repo is up. The only projects that can be delayed are capital heavy projects funded largely from borrowing.

It appears unlikely that the higher repo rate announced by the RBI is going to slice off growth to 8 pct. It is more likely the economy will tolerate high inflation with high interest rate and high growth.

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