India's High Cost of Capital: A Macroeconomic Challenge, Not a Financial Flaw
India's persistently high cost of capital is increasingly recognized as a macroeconomic outcome rather than a flaw within the financial sector. Borrowing remains expensive not due to market malfunctions, but primarily because the economy saves too little and depends heavily on foreign capital to bridge its investment gap.
The Root Causes: Savings Deficit and Foreign Reliance
Persistent current account deficits compel India to pay a significant risk premium to global investors. This premium is subsequently embedded in domestic interest rates and equity returns, creating a cost of capital that effectively acts as a tax on economic growth. For the first time, the blame for high interest rates is being placed squarely outside the financial system.
As highlighted in recent economic surveys, empirical analysis reveals that improving the Current Account Balance (CAB) is nearly twice as effective in lowering long-run interest rates compared to simple financial deepening, such as increasing private credit to GDP. This underscores that external balance matters more than mere credit expansion in determining capital costs.
Fiscal Pressures and State-Level Discipline
The fiscal structure further reinforces this economic pressure. Weak fiscal discipline at the state level, driven by revenue deficits and unconditional cash transfers, adversely affects sovereign borrowing costs. Investors are increasingly assessing consolidated general-government finances, which pushes up the risk premium across the entire economy.
Key implications include:- Higher borrowing costs for businesses and individuals.
- Increased pressure on public finances.
- Reduced attractiveness for long-term investments.
Impact on Industrial Behavior and Competitiveness
High capital costs significantly shape industrial behavior within India. Capital-intensive upstream sectors, such as manufacturing and infrastructure, struggle to scale efficiently. This economic environment nudges firms towards seeking protection and policy shelter rather than focusing on productivity gains and innovation.
When capital becomes prohibitively costly, efficiency often gives way to negotiation and lobbying efforts. Companies tend to seek resilience through insulation and regulatory support instead of enhancing competitiveness in the global market. This dynamic can hinder long-term economic growth and structural transformation.
Addressing these macroeconomic fundamentals is crucial for reducing India's cost of capital and fostering a more competitive, growth-oriented economy.
