Central Bank of Sri Lanka recently announced that “in nominal terms, most market interest rates are at historic lows, although there is further room for these rates to reduce in relation to the low inflation environment”. However, it is a well-known fact that reductions in policy interest rates have not stimulated private sector activities (investments supported by bank borrowings). Various parties have highlighted a number of reasons for holding back the growth of credit to private sector. One among them is the low rate of returns on investment though it is not tested in the context of Sri Lanka.

Following essay, published in The Economist 0n 16^th Oct. 2014, provides evidence that lack of returns could hold back investment even under a low interest rate regime.

Monetary Policy:  Tight, Loose, and Irrelevant

If central bankers want to spur economic activity, they cut interest rates. If they want to dampen it, they raise them. The assumption is that, as it becomes cheaper or more expensive for businesses and households to borrow, they will adjust their spending accordingly. But for businesses in America, at least, a new study* suggests that the accepted wisdom on monetary policy is broadly (but not entirely) wrong.

Using data stretching back to 1952, the paper concludes that market interest rates, which central banks aim to influence when they set their policy rates, play some role in how much firms invest, but not much. Other factors—most notably how profitable a firm is and how well its shares do—are far more important (see chart). A government that wants to pep up the economy, says S.P. Kothari of the Sloan School of Management, one of the authors, would have more luck with other measures, such as lower taxes or less onerous regulation.

Establishing what drives business investment is difficult, not least because it expands and contracts far more dramatically than the economy as a whole. These shifts were particularly manic in the late 1950s (both up and down), mid-1960s (up), and 2000s (down, up, then down again). Overall, investment has been in slight decline since the early 1980s.

Having sifted through decades of data, however, the authors conclude that neither volatility in the financial markets nor credit-default swaps, a measure of corporate credit risk that tends to influence the rates firms pay, has much impact. In fact, investment often rises when interest rates go up and volatility increases.

Investment grows most quickly, though, in response to a surge in profits and drops with bad news. These ups and downs suggest shifts in investment go too far and are often ill-timed. At any rate, they do little good: big cuts can substantially boost profits, but only briefly; big increases in investment slightly decrease profits.

Companies, Mr Kothari says, tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.

* “The behaviour of aggregate corporate investment”, S.P. Kothari, Jonathan Lewellen, Jerold Warner