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There are demands from various quarters for pruning interest rates to spur the economy.But how effective is a rate cut in the Indian context? In 1999-2000, the RBI floored the gas-

pedal -- the bank rate -- to one of its lowest levels at 8 per cent (Apri l 29, 1999 throughMarch 2, 2000). Shockingly, recent CSO data reveal that growth in private corporate sector

fixed capital formation in fiscal 2000 actually fell 1.3 per cent. The CMIE estimated a fall of18 per cent in government capital expenditure in the same period. How do we make sense

of this seemingly puzzling result? Let us work it through.

INTEREST rate is essentially a nominal variable. Does it have any impact on the real

economy? If it were a panacea to our problems, would it not have been abysmally low bynow, with the economy booming? But that is not the case. A cut in the interest rat e is

expected to expand output through increased investment. Interest rates make for arelatively convenient policy variable and growth -- a noble goal in macroeconomics.

Therefore, the true expansionary effect of interest rate cuts has gone largely unqu estioned.While the theory underlying this relationship is fairly sound, in the Indian context, its

relevance could be overemphasised.

First, the government (read the Finance Ministry) can at best tinker with the rate at which it

can borrow. Small savings (which includes Kisan Vikas Patra, Indira Vikas Patra, National

Savings Certificate, and so on) is the government's little piggy-bank . A cut in these ratesimmediately renders government borrowing cheaper. This shows a notional cut in

expenditure. Directly, other government spending decisions become more profligate andreckless. This affects the fisc's health, dousing sentiment. And r ightly so, as government

spending is largely revenue (read unproductive) in nature.

Second, the interest rate structure is not smoothly interlinked. Does a rate cut have a

positive fallout on the cost of funds for private investment? First, rapid asset marketadjustment assumes almost no time-lag for interest rates to change across the board. This

is not necessarily true. A cut in the EPF, GPF rates last fiscal did not see commercial banks

scramble to reduce their PLRs. However, in the upward direction, the response is moreencouraging. (Also we must remember that only the blue-chip co rporates can borrow at

rates close to the PLR.)

Now, let us assume that the RBI cuts the bank rate, a closer proxy for interest rates as ithas a greater bearing on the PLR. The bank rate is the rate at which the RBI refinancesbanks. Suppose one bank bells the cat and cuts its PLR, while all others f ollow suit. (Banks

in India are not altogether fond of lending. With the provisioning norms getting stricter andtheir being saddled with huge NPAs, banks cannot but exercise over-cautiousness in lending

decisions.) Theory would have us believe that this cut would spur private investment (byfirms). The logic is sound. But, in practice, most bank borrowings by corporates are for

short-term working capital purposes.

Strictly speaking, short-term funds cannot be employed to enhance productive capacity.

This is largely funded by debentures and corporate bond floats, which are long-termfinancial instruments. As an aside, we must remember that a change in interest rate s does

not alter the total supply of money. It only results in a reallocation of assets within

portfolios. Elementary economics tells us that a rate cut triggers the demand for corporatebonds and, consequently, bond prices harden. This encourages fresh bond floats.

Does this necessarily imply new investment demand because capital becomes cheaper?

Typically, in a recession mode (usually, that is when rate cuts are prompted), thebenchmark rate is cut and corporates are seen to retire high-cost debt by borrowing at p

revailing cheaper rates. There is only a change in the maturity and yield on paper, while theunderlying asset remains the same. There is no real fresh investment demand, as one might

hope.

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The argument can be extended to long-term funding. For instance, if, in response to a ratecut, corporations fund expansion through tapping the primary market -- debt or equity. For

a greenfield project, typically, the process from the feasibility study to arranging for a leadbank, to the stage of allotment (when the proceeds can be used) takes a typical MNC a little

more than a year.

If the homework has already been done, from the time of the board decision on an issue till

the allotment stage takes an average of three months. Considering that interest rate isoften used as a remote control to manage the rupee, it is anybody's guess what changes it

may go through in response to the very volatile forex market. This unpredictability takesaway most of the punch of rate-cut announcements. This is one reason why it loses

relevance with long-term funding decisions. Another perspective is as follows:

Corporate investment demand is a function of various parameters: End-product demand,

competition in industry, terms of the technology tie-ups and the availability of capital goods.Interest rate is just one of them. Assuming that the particular capital g ood required needs

to be imported, a cut in interest rates might make credit cheaper.

But in the forex market, the narrowing of the interest rate differential may cause a capital

outflow. This makes the rupee weaker, rendering the imports, in fact, more expensive -- aclassic Catch-22 situation! In fiscal 1999, India imported 71 per cent of its capital goods

requirement, while in the estimate for fiscal 2000, imports constitute as much as 76 per

cent of the total value of capital goods.

So far, the discussion has centred on the organised sector. A look at what happens in theunorganised sector shows that it is even more shocking. Imagine a farmer borrowing from a

moneylender at 24 per cent. When interest on PPF drops 100 basis points fr om 12 per cent

to 11 per cent, his indifference is not misplaced. Rate cuts in these unreachable areas arefutile.

To sum up, first, interest rate cuts help the government book lower expenditure and delude

us with notional savings. Second, they do not exactly result in cheaper finance for the

private sector due to glitches in the market mechanism. Third, cheaper cred it is offset bydearer imports. And, finally, interest rate changes are only temporal in nature, as it is like

one stone trying to hit too many birds.We must keep in mind that real interest is but a function of capital. A cut in it can boost

demand, but the oft-overlooked supply curve in our context is considerably inelastic. At theend of the day, India's economy is still capital-scarce. Thus, a cut in interest rates can at

best be illusory, and it ultimately seeks its level of equilibrium. Only in the long run can thissituation can be corrected by encouraging R&D, protecting IPRs and freeing all barriers on

FDI, to attract capital and lift the pro duction function.