Business needs capital. Most commonly it comes in 2 forms - Equity and Debt. Mostly companies use a combination of both. The manufacturing and infrastructure sectors are mostly heavily loaded towards the debt. Therefore the cost of debt has a deep impact on the cost of capital. Interested readers can go here to read more about calculation of Cost of Capital.
The regulatory framework in India directly controls the cost of capital. RBI sets the Base Rate. This rate dictates the rate at which banks raise capital to give out loans. Add to this overheads and operational costs, and the rate at which the bank gives money to the businesses is a good 3%-5% higher than this.
The direct impact of capital on a business is therefore, easily understood. What most people do not look at is the indirect impact of this factor. For example, a construction company is constructing an office building. It takes a loan from the bank to meet some of it's costs. In a competitive supplier market, the cement vendor gives it a 6 month line of credit, which means that the vendor takes a short loan from the bank for the same. Obviously this also is built into the cost of cement to be borne by the construction company (this explains cash buyer's discount). Therefore cost of goods and services acquired for a project through every vendor as well as direct investments are all impacted by lending rates.
The finished good, in this case an office or a house, is also purchased via the finance route. In case it is a small product like toothpaste, the stockist uses financing to maintain supply.
The same goods end up getting financed more than once, therefore on a project, the cost of capital goes up, even beyond the interest rate from the bank.
Why is the RBI keeping the lending rates high then, you may ask. It definitely seems to be a driver of inflation if it can raise the cost of getting the toothpaste to your toothbrush. Even our Finance Minister has more than once asked him to lower it. The answer, ironically, is inflation itself (though personally I think Mr. Rajan's intentions need to be questioned)! The prevailing wisdom is that inflation can be brought down by increasing rates. If you ask me, it's silly. and the Chinese agree with me. Below are graphs showing the Prime Lending Rates vs Inflation rates in China and India over the last 1 year. You can see that the Chinese have drastically lowered their rates in order to boost their economy. India seems to be napping. Dont ask my why, ask UPA appointed, imported from America, RBI governor Mr. Raghuram Rajan.
A high interest rate regime might work in an economy like North Korea, but it kills anyone in the present world. The first thought might be that it impacts the exporters. They will have to compete with the Chinese (much lower interest cost) and others with a business handicap (explains shrinking manufacturing sector in India). Good observation. But it also impacts manufacturing activities means for internal consumption. Here's how.
Governments usually levy an import duty on goods to protect the local industry. In rare cases outright anti-dumping duties are also levied. These trade barriers are hotly contested by other economies, and many times retaliatory duties from the other side impact some other industry. So there is a limit to protection one can get. A country with a lower cost of capital, therefore can not only kill India's export competitiveness, but also it's internal consumption manufacturing.
Established companies with existing manufacturing bases can still compete somehow with short term discounting, as well as leveraging reputation and relationships. But any entrepreneurs can kiss their chances of establishing themselves goodbye.
The big picture: The biggest impediment to our new government's Make In India plan is the reserve bank of India itself!
I hope the government is able to get the RBI to come around to a saner view and give the economy a chance to reflect the confidence the people have shown in the new team that they have elected with such a resounding mandate.
By the way, here is a nifty tool from Harvard Business School that lets you plug in rates and calculate cost of capital for your business
The regulatory framework in India directly controls the cost of capital. RBI sets the Base Rate. This rate dictates the rate at which banks raise capital to give out loans. Add to this overheads and operational costs, and the rate at which the bank gives money to the businesses is a good 3%-5% higher than this.
The direct impact of capital on a business is therefore, easily understood. What most people do not look at is the indirect impact of this factor. For example, a construction company is constructing an office building. It takes a loan from the bank to meet some of it's costs. In a competitive supplier market, the cement vendor gives it a 6 month line of credit, which means that the vendor takes a short loan from the bank for the same. Obviously this also is built into the cost of cement to be borne by the construction company (this explains cash buyer's discount). Therefore cost of goods and services acquired for a project through every vendor as well as direct investments are all impacted by lending rates.
The finished good, in this case an office or a house, is also purchased via the finance route. In case it is a small product like toothpaste, the stockist uses financing to maintain supply.
The same goods end up getting financed more than once, therefore on a project, the cost of capital goes up, even beyond the interest rate from the bank.
Why is the RBI keeping the lending rates high then, you may ask. It definitely seems to be a driver of inflation if it can raise the cost of getting the toothpaste to your toothbrush. Even our Finance Minister has more than once asked him to lower it. The answer, ironically, is inflation itself (though personally I think Mr. Rajan's intentions need to be questioned)! The prevailing wisdom is that inflation can be brought down by increasing rates. If you ask me, it's silly. and the Chinese agree with me. Below are graphs showing the Prime Lending Rates vs Inflation rates in China and India over the last 1 year. You can see that the Chinese have drastically lowered their rates in order to boost their economy. India seems to be napping. Dont ask my why, ask UPA appointed, imported from America, RBI governor Mr. Raghuram Rajan.
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| Source: http://www.tradingeconomics.com/ |
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| Source: http://www.tradingeconomics.com/ |
A high interest rate regime might work in an economy like North Korea, but it kills anyone in the present world. The first thought might be that it impacts the exporters. They will have to compete with the Chinese (much lower interest cost) and others with a business handicap (explains shrinking manufacturing sector in India). Good observation. But it also impacts manufacturing activities means for internal consumption. Here's how.
Governments usually levy an import duty on goods to protect the local industry. In rare cases outright anti-dumping duties are also levied. These trade barriers are hotly contested by other economies, and many times retaliatory duties from the other side impact some other industry. So there is a limit to protection one can get. A country with a lower cost of capital, therefore can not only kill India's export competitiveness, but also it's internal consumption manufacturing.
Established companies with existing manufacturing bases can still compete somehow with short term discounting, as well as leveraging reputation and relationships. But any entrepreneurs can kiss their chances of establishing themselves goodbye.
The big picture: The biggest impediment to our new government's Make In India plan is the reserve bank of India itself!
I hope the government is able to get the RBI to come around to a saner view and give the economy a chance to reflect the confidence the people have shown in the new team that they have elected with such a resounding mandate.
By the way, here is a nifty tool from Harvard Business School that lets you plug in rates and calculate cost of capital for your business
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