Go slow on rate hikes: Make capital accessible and affordable to drive investment and job creation

We have entered a golden age of Indian entrepreneurship. The number of active companies has risen by more than half a million in 3 years, from 1.6 mn to 2.2 mn.

Many of these are new companies. At the same time, several are likely informal businesses registering formally as companies. For decades, surveys showed that barriers to formalisation were mainly a high regulatory burden (high formalisation costs), particularly for smaller firms, and limited gains from formalisation because cost and access to capital were challenges. This is changing.

Irrespective of whether these are new businesses or existing businesses registering themselves, the underlying drivers are 2: easing regulations and falling cost of capital. We still need to do much more on both, and it would be unwise to assume these changes come without costs.


While meaningful risks from potentially excessive deregulation may be some time away, some side effects of the falling cost of capital are visible and need to be dealt with quickly.

Underlying the reduction in India's cost of capital is GoI's progress in fiscal consolidation. India is among the rare major economies where general government fiscal deficit is near pre-Covid levels. Once adjusted for the off-budget spending in that era, the actual deficit is much lower today.

This comes at a cost. A shrinking deficit constrains growth. India's output remains a year behind its pre-pandemic path - better than in most economies, but still signalling slack in the job market. The shortfall is equivalent to a year's new workforce going without jobs. While rapid growth creates jobs, the larger pool of under- and unemployed workers keeps real wage growth weak for many, preventing them from feeling the benefits of growth in their standard of living. This has political implications.

The wise, if unstated, policy choice has been to let the private sector fill the economic slack, using cheaper capital to build businesses and create jobs. The surge in company creation and capital formation suggests this is underway. The cost and availability of both debt and equity capital are among the most favourable ever.

Despite global disruptions, and in particular the surge in energy prices, home loan rates are still near 7%. Increasingly sophisticated financial firms, leveraging DPI, are also making credit available to a wider swathe of smaller businesses.

For equity capital, while the high price-to-earnings ratio is and should be a concern for investors, it signals low cost of equity for entrepreneurs. They are acting on this signal: stock sales by companies and promoters could be nearly ₹6 tn this year.

While private equity firms booking gains and repatriating seems to be a loss to the economy, these profitable exits encourage them to raise new funds to invest in new startups and young companies. The proliferation of foreign and increasingly local VC and private equity firms also means that more entrepreneurs have access to equity capital.

Some side effects are emerging. A simple way to understand capital flows is to compare them to water, which flows downhill with the speed determined by the slope. If Indian bond yields are 8% and US yields - a proxy for the global cost of capital - are 2%, capital flows rapidly into India in pursuit of higher returns. But if Indian yields fall to 7.3% while US yields rise to 5.3%, the flow slows and may even reverse in some pockets.

As India needs more capital to accelerate growth, could domestic savings start flowing to firms abroad? The risk is limited because India does not have a fully open capital account: not all pipes allow free two-way flows. Indian financial firms, for instance, cannot lend to foreign borrowers. But investors must be free to repatriate their capital, or they may hesitate to invest in India. This also means some segments permit unchecked capital outflows.

This has meant that India, which at one point sought to maintain CAD between 2-3% of GDP is now struggling to finance a much smaller CAD.

Given entrenched fiscal challenges, global rates are unlikely to fall unless there is a sharp growth slowdown. So, should Indian interest rates be raised further? The lazy narrative in bond and currency markets is that they should mirror global rates. Some investors also question fiscal prudence when there is slack in the economy, in effect asserting that fiscal works better than monetary.

Prudence, instead, would be in acting on two fronts:

• Open so-far-blocked/impeded channels of capital inflows (like with the recent relaxation for bond investors) and make foreign capital more welcome and prospects more attractive. Simplification of tax laws, a direct approach to global firms that drive value-chains, and a relentless easing of regulations can help. Deregulation would also help domestic firms.
• Raise demand for capital. The welcome surge in new issuances, including by the government, is important to absorb the massive inflows into public markets without creating valuation distortions. This capital can then be deployed for growth. We may also need to take more policy risks to channel capital from pension and insurance funds to be deployed more actively for growth.