Wednesday, September 7, 2011

Reviving Growth

Reduce interest rates and undertake specific reforms to revive growth

Shyam Ponappa / September 1, 2011

India’s heady economic prospects of a year ago have deteriorated unthinkably. True, the rest of the world is wobbly, too, from America’s unreconstructed and unsustainable headlong decline, to much of Europe’s companion piece. But the possibility of some buffering for India seems to have evaporated. Expectations of better prospects were not so much from decoupling as from our limited dependence on exports, and headroom from activity levels with enormous scope for improvement and expansion — in basic infrastructure, housing, second-order infrastructure like education, sanitation and health care, as well as manufacturing, tourism and retail.

Rising input costs and interest rates started the decline in margins, and self-destructive actions made matters worse, epitomised by the implosion of the scams (2G, the Commonwealth Games, the Karnataka mining scandal, the land scams…). The Reserve Bank of India’s (RBI’s) actions of increasing interest rates when faced with inflation caused by factors beyond its ambit, such as food prices rising because of supply constraints, or energy prices on account of expensive imports, have amplified the negative sentiments.

The Bogey: Growth versus Inflation

The economy is slowing, and earlier estimates of well over nine per cent growth for 2011-2012 have gone overboard. In May, the Federation of Indian Chambers of Commerce and Industry’s estimate was nine per cent; in August, an RBI survey consensus was under eight per cent; Morgan Stanley’s was barely over seven per cent. Yet, policy makers maintain that despite the deleterious effects on growth, raising interest rates to control inflation through monetary policy is paramount.* In absolute terms, the need for controlling inflation is incontestable, but societal needs provide an exigent imperative for making the trade-off in favour of growth. The consideration now needs to be of steps that could alleviate the slowdown, and the likely effects of such actions not only on inflation, but also in collateral damage to economic activity.

Consider India’s shortcomings, namely, insufficient food production and associated storage and distribution, inadequate agricultural extension support services, expensive oil and coal imports, and lack of educational and vocational training facilities for a burgeoning, youth-dominated population. Add another level of inadequacy arising from our continuing lack of infrastructure, from basic sanitation, water and health care, extending through energy, transportation and communications (broadband). These structural bottlenecks exacerbate the negative aspects of our predicament.

The government’s recalcitrance in acting against blatant corruption, until the scams erupted, had already unsettled markets. Even salutary developments like Anna Hazare’s anti-corruption movement have added to the destabilisation, through attacks on parliamentary processes and the prospect of a breakdown in law and order.

Against this backdrop, we have a slowing economy, now threatened by a global slowdown. In the quarter ending March 2011, a third of the Sensex companies had missed their earnings estimates, while in the last quarter ending June 2011, nearly half of them were below estimates. With offshore revenues estimated to contribute nearly a third of FY12 profits, the threat of a global slowdown is ominous.

Inappropriate Rate Hikes

From this perspective, raising interest rates to combat inflation appears decidedly ill-advised. As expected, interest rate increases have not reduced inflation. The reduction can happen only when economic activity slows so much that demand for essentials falls, a horrific prospect. As for attracting foreign investment, rate hikes do little to induce confidence in foreign investors in skittish times, because they look to India and emerging markets for growth, not for stability. To be a safe haven, India has to be perceived not as a developing economy, but as an equivalent of the Organisation for Economic Co-operation and Development — a long way and many years ahead.

The economy, therefore, needs shoring up. Can the RBI and the government take steps to reverse the decline? Consider the following corrective actions:

(i) Reduce rates to revive growth

In these circumstances, the priority has to be growth. Otherwise, apart from minimal foreign investment, domestic investment also is likely to be curtailed further, and social instability triggered by economic pressures could grab centre stage to devastating effect. International commodity prices are outside India’s control, but the RBI can reduce interest rates. Cutting rates can raise margins and revive consumer demand.

The central bank needs to reverse its repressive stance on rates, no matter what the textbooks say, so that enterprise profits recover to a high-growth trajectory.

An immediate cut in borrowing rates, together with a concerted move to reset positive expectations and sentiments, is an urgent requirement.

(ii) Selective credit controls for asset bubbles

Further, the RBI has avoided instituting selective credit controls to avoid asset bubbles, perhaps because of legacy reasons concerning commodity pricing and the potential for interference in markets. With smart e-governance at hand, this nettle must be grasped in place of the blunt instrument of overall rate increases, to use real-time, targeted additional margins, cash reserves and rate increases to defuse incipient asset

(iii) Reforms to build momentum

In tandem, we need reforms to rebuild economic momentum. All sectors need reform, e.g., energy, communications, transport, sanitation/water/health and education. For instance, the energy/power sector sorely needs drastic reforms, but it is so complex, with so many layers that need disentangling, that while initiatives are necessary, they are unlikely to revive growth in a reasonable period. The need, therefore, is to focus on what is practicable with the likelihood of achieving results.

In practical terms, we have to prioritise, and focusing now on communications, specifically broadband, could yield results. Mobile communications grew phenomenally over the last decade. The meteoric rise stalled for a variety of reasons: excessive competition, ultra-low tariffs, saturation in urban markets, limited access to spectrum, no incentives for broadband, restrictive actions against BSNL and MTNL, scandals and policy uncertainties. Yet, if the government initiates appropriate reforms in spectrum policies with incentives for broadband delivery, prospects could revive. If the government can (a) formulate major reforms with a New Telecom Policy 2011 that achieves growth, while(b) resolving problems relating to past irregularities through sound legal processes and judgment, communications could go through another meteoric rise, becoming the growth engine for the economy.

* “The policy dilemma”, C. Rangarajan, Business Standard, August 22, 2011: