India's One-Legged Stool

RBI’s lowering of interest rates may not help the economy. Instead, it could tempt the government to borrow more to fund populist schemes, lead savers to save less and weaken the banking system

- Sanjiv Bhatia

RECENTLY, the Reserve Bank of India (RBI) lowered the repo rate to 5.15 percent, the fifth-rate drop this year. This move is not a surprise given the widespread belief among Indian policymakers and their economic advisors that the country’s economic slowdown is cyclical (temporary), and that lowering interest rates will somehow magically fix things. The argument is that lower interest rates make it easier for businesses to borrow and invest money and for consumers to borrow and spend, thereby increasing private consumption and economic growth.

The evidence, however, suggests otherwise. Japan lowered interest rates to zero percent 20 years ago, but its GDP growth over this period has averaged only 0.4 percent per year and has crossed 2 percent only once. In the US, interest rates were lowered to close to zero after the 2008 financial crisis, but GDP growth averaged around 2 percent, which is significantly lower than the long term average of 3.8 percent. The table (facing page) provides the three-year average interest rate (as provided by the 2-year government bond yields) in countries in the Eurozone and the corresponding GDP growth. Even with negative interest rates, GDP in these countries has remained below 1.5 percent.

Why aren’t the economies of these countries with very low interest rates booming? As it turns out, even with interest rates near zero, businesses and consumers are not borrowing more, but instead it is the governments that are loading up on cheap debt. Japanese government debt as a percent of GDP has doubled since rates dropped to zero, while business and household debt have dropped by 23 percent and 8 percent respectively. In the US, government debt has increased by 42 percent, but household debt has fallen by 20 percent.