If MPC Is Concerned About Unequal Access To Capital, Increasing Rates Is Not Exactly A Solution

The minutes of the previous meeting of the Monetary Policy Committee (MPC) were released earlier and just as the minutes were released, we saw a renewed interest.

This renewed interest was an outcome of the keen focus with which we are viewing the developments in the Indian economy.

But before answering that, we need to understand what constitutes a 'recession'. Let us look at the National Bureau of Economic Research (NBER) for a definition. The NBER defines a recession as follows:

By this definition, India is not yet in a recession, given the Q2 GDP print on a Q-o-Q basis provided a significant increase.

No, I am not celebrating the current state of the Indian economy, which continues to be vulnerable, but I am simply stating the need to have a sense of clarity with which we approach the problem that the country faces.

This is important, as a pandemic is fundamentally different from a standard economic crisis. The economics of a crisis and the economics of a pandemic differ because the economics of a crisis focusses solely on addressing demand, and supply sentiments.

In contrast, economics of pandemics are complicated as we are required to deal with challenges on the public health, society and economic front.

Thus, as stated several times in previous articles, the Q1 GDP contraction did not come as a surprise, given that the economy was in a lockdown and what it meant was that economy lost a good part of its annual income during these few months.

The subsequent months were supposed to be better, as economic activity normalised, but there was a permanent income that was lost. At the peak of the pandemic, there were various estimates around the extent of the permanent damage that we may witness.

However, we now know that the impact will be far less than what was originally feared.

It is important to give this background before we look into some of the issues that have been raised by many since the minutes were made public. It is interesting to note that the members of the MPC do not sound like their other central bank counterparts as even though they appear to be accommodative.

This was honestly puzzling even as we saw references to headlines and core inflation being considered, while growth contraction was still something that was given a higher priority by the central bank.

The interesting observation, however, came from Professor JR Varma that low rates were benefiting oligarchs as they had access to capital by using commercial paper.

The comments further mentioned the prospects of them exercising pricing power, which could further benefit them from consolidating their position. There is a problem with the way many have interpreted the issue as they seem to believe that low rates are the problem — and thus, hiking rates could be a solution.

The question here is not so much to do with interest rates, but with the unequal access to credit and its impact on the distribution of the different rates to different companies.

Therefore, the problem is not of low rates, but of inadequate focus on fixing the problem of access to cheap credit to our small and medium enterprises, which can provide them with much-needed growth capital.

Consider an alternative scenario that was a reality till recently — but under this scenario that India has extremely high real rates of interest.

The small and medium enterprises which largely resort to domestic capital predominantly in the form of bank credits end up facing a high cost of capital.

Large companies, in contrast, can borrow from abroad using different instruments — and the rates across the world are lower than in India.

Therefore, the difference between the capital cost for the large and the small/medium enterprises would widen significantly.

Now, if the domestic rates were to be lowered, the small business owners would be able to reduce their cost of capital and the difference in cost of capital between small and large businesses would be narrower.

The point that unfortunately has to be spelt out here is that low rates helping oligarchs has more to do with the inequitable access to credit than to with the prevalence of low rates itself.

Thus, increasing rates will not solve the situation, but will only compound the problem.

It was well recognised that recovery from the pandemic-induced recession would be different across sectors and that it would pose a challenge to major sectors.

It was also regarded that SMEs will be hit hard, while SMEs in the contact services industry were hit the hardest by the crisis. Therefore, the developments over the last few months and the minutes of the MPC meeting does not come as a surprise, but only reinforces the fact that the economics of a pandemic is different from the economics of a crisis.