Rate-cut is not viable; cut only to cheer mood: Experts

Hello and welcome to this edition of CNBC-TV18's Indianomics. With just a couple of days to go before the RBI announces the credit policy, the finance ministry, Indian industry, bankers and the equity markets have begun to increasingly clamour for a cut-rate by the RBI.

A select panel of experts comprising Chetan Ahya, chief economist and managing director, Morgan Stanley, SS Mundra, executive director, Union Bank, Sanjay Nayar, country-head, KKR India and Ajit Ranade, chief economist, AV Birla Group agree that a cut in interest rate by the RBI would not boost growth and called for a small reduction to cheer market sentiment. CNBC-TV18 also announced the conclusions of an exclusive poll of on what the financial markets have priced in. Below is an edited transcript of the conclusions of the poll and the discussion on  CNBC-TV18.
There is almost a war cry out there for a rate cut.  A CNBC-TV 18 poll indicates that 80 percent of the market expects a CRR cut of and of this, 20 percent expects a 50-basis point cut.
On the repo rates, the market is divided with 50 percent calling for a repo rate cut.  Importantly, 40 percent of the bankers, economists and fund managers polled expect RBI to cut both CRR and repo on October 30 when the RBI announces its credit  policy.
For the full fiscal year, the majority expect further cuts in repo rate after the announcement policy on Tuesday. Around 75 percent expect another round of reduction of 25-50 bps in repo rates after October 30, while only 25 percent expect no cut or expect RBI to stop with a 25-bps cut on Tuesday.
On CRR too, the market expects a further round of cuts. Around 40 percent expect a total cut of 50 bps in CRR including a cut on Tuesday, 10 percent expect a 75-bps cut, 20 percent expect a 100-bps cut and a miniscule 5 percent expect a CRR cut by as much as 150 bps.
Growth is likely to grab the RBI's attention for the rest of the year and the majority expect the RBI to sound more dovish on growth than before, shifting focus away from inflation. That explains why close to 70 percent of the respondents expect RBI to revise its GDP growth forecast downwards to below-6.5 percent and only 30 percent expect GDP forecast to be retained at 6.5 percent.
On inflation, the market remains divided whether RBI will revise its inflation forecast from the current 7 percent. Q: You represent a big business group which along with vendor and suppliers, almost constitutes a mini-economy. What is your opinion? Are the rates so high that industry is actually not able to produce? Ranade: The logic behind tightening rates lies in its use a means to control inflation. If you look at last three years, the growth rate of GDP has come down from 8.5 percent to 6.5 percent and perhaps this year it is 5.5 percent. Whereas, the average inflation rate for the WPI base has come down from 9.6 percent to 8.8 percent and 8 percent, which means that the tightening has had a much more disproportionate impact on GDP than on inflation. So, that's fact number one.
Secondly, the economy is dangerously close to a situation where the productive capacity is being significantly reduced by these so-called supply bottlenecks which also include tightened rates and a slowing GDP. So the very tightening of rates has slowed down the process of capacity-creation.
Gross fixed capital formation, which is an indicator of capacity-creation, has really rapidly come down and of course, private-sector investment spending is down to very, very low levels. Add to this, the cost of interest as a proportion of EBITDA or profitability, has increased significantly. In fact, in three years when interest rates were tightened by roughly 170 percent, interest outgo was up by almost 300 percent. So therefore the tightening has been considerable.
Please remember that ultimately, the mandate is not a single mandate, it is a balance between growth and inflation. One does recognize that there are inflationary concerns, but I think there a virtuous cycle could be triggered. A cut now will induce inflows which will make the rupee stronger like the announcement of reforms in September. Finally, there is the impact of interest rates on deficit as interest constitutes a large part of deficit. Q: You publicly stated that inflation was led by demand. Would you agree with the view that rates have reached a level where it has started to actually choke supply? Ahya: There is no free lunch in a macro-economy. If real interest rates are negative then you do not incentivise the households and the system to save enough. The current account deficit is almost close to 4 percent of GDP. So, there is increased pressure from the market to loosen interest rates. If real interest rates turn negative when expectations on inflation are high, it will only fan the inflation expectations further.
So I think, great care should  be taken before deciding on the solution rather than just using the typical remedy which has worked in the past in India. But whenever growth has slowed in the past, there has been a big decline in inflation and the cuts in interest rates made perfect sense.
But in the current situation when the slowdown in growth has not had the resultant effect on inflation, a cut in interest rates is not the solution. The key is to independently implement measures which augment supplies. I think all participants in the economy forget that the component, about 20 percent CAGR, of very high rural wages over the last three-and-a-half years is playing an independent role in impacting inflation.
Similarly, the fiscal deficit of 9 percent of consolidated GDP has resulted in the transfer into the hands of households which, in many cases, is less productive. So I think there is a need to formulate a comprehensive solution independently from tightening interest rates.
_PAGEBREAK_ Q: If deposit rates fall, will the banking system have face a situation where low deposit rates will further impact deposit growth? Mundra: I think the percentage of interest expenses as a ratio to net sales is probably overstated. According data I have collected on the capex of large manufacturing companies, in December 2008 the ratio was 14.8 percent and in June 2012 it was 12.9 percent. So this percentage in the whole manufacturing cost during these two cycles of crisis, has come down rather than going up. So, I think that must keep in mind. Of course I agree that when discussing the impact of interest-rate cuts, one cannot generalise too much.
Negative returns to depositors would certainly have a dampening impact on the economy. In the last one year, the process of mobilsation of deposits has not been able to keep pace with the growth in credit and will certainly impact on interest rates, which cannot be generalised.  Q: To what extent is interest an important component for additional incremental investment such as capex? Would the component of interest be an important factor while making these decisions? Nayar: It definitely will be an important factor. I do not think that a cut in interest rates is going to result in a dramatic increase in capex or investment spending. Indian businesses are not increasing capital expenditure due to bottlenecks. So yes, new investment decisions will obviously take the cost of interest into consideration. But where are the projects? Growth has to be primarily be driven by the public sector and to an extent, by the private sector.
If people feel confident in investing into real assets and there is a bit of fiscal prudence- that is a much better solution than raising a war cry for rate-cuts. The cut in rates will only fuel a lot of sentiment which will lure some more hot money and asset inflation will rise again. Q: Will that asset inflation be of a help in raising equity? Will an intermediate fall in rates improve a few balance-sheets laden with debt and provide relief to a few SMEs? Nayar: But it still will not create real assets and supply and that is the source of the whole bottleneck problem today.
_PAGEBREAK_ Q: Do you think that if rates were cut, there would be some lasting negative impact on the fiscal deficit and current account deficit for the simple reason that it fuels more consumption? Do you think the cut in rates could perhaps harm the current account deficit?
Ahya: Using a rate-cut to revive growth, in my view, is a delivering the wrong medicine based on wrong diagnosis. It will be possible to control inflation, current account deficit and improve overall macro-economic stability only by cutting fiscal deficit, bringing down the rural wages and working on reforms. Q: Ultimately the RBI governor and the finance minister have to address the real problems of serious business downturn and a fall in sentiment. As an economist do you think that the governor has to just play along and not seriously increase liquidity? Ranade: No, certainly not. The whole process is one of reciprocity. The RBI governor in his statement in April said that the RBI was ready to reciprocate. The central bank has to look ahead with the expectation of negative inflation data six months from now and take into consideration the fall in global commodity prices.
Secondly, there has to be no underestimation of the impact of a trigger like a cut in interest rates. Though the cooperation between the RBI and the government in boosting economic growth is at an ebb, a little trigger like a rate-cut could kick-start a virtuous cycle of events that could be beneficial to the stock markets, the process of disinvestment and the fiscal situation.
Interest is paid out of EBITDA and constitutes a significant a proportion of quarterly earnings. So any relief will go a long way in a global scenario with huge supply and excess capacities which only allow for 7-percent profit margin. So, even a 5-percent relief in interest cost will go a long way. Nayar (in response to Ranade) : How many big businesses do you think cannot get competitive financing if they had a project and wanted to invest? That is the question. I think real investments have to come from big businesses in India who can actually afford to get the most competitive pricing through local or foreign commercial borrowings. Q: Do you think a rate-cut might ameliorate the NPL situation for the SME sector? Mundra: I agree to the extent that the impact of interest rates in the case of SMEs is certainly more pronounced in the case of large borrowers. The cost of capex and the project capital is spread over a period of time and I don’t that it is relevant to consider the rate of interest at the beginning of a project or during the conduct of the project.
Banks will only clear projects with a minimum debt service coverage ratio (DSCR) level of 1.5 percent. So projects with a DSCR of 2 percent should be able absorb a hike in rate of interest without complaints of the hike jeopardising the completion of the project or hampering capacity -creation.
In my experience, I have found that it is illogical to link interest rates to project-completion. Within the SME spectrum, the only segment found to be affected by a hike in interest rates were companies with a turnover of less than Rs 50 crore per annum.