Friday, September 6, 2013

Regrouping for Growth - Interest Rates - III

Aside from muddling along, the choices are to try to grow and retain capital to staunch the gap temporarily, or to settle for low growth and capital flight.

Shyam Ponappa  September 5, 2013

What are possible ameliorative steps for India's economy? Taking stock, are we overreacting to our economic woes? Second, do our problems have global origins? To the extent they are home-grown, what were the missteps? How can they be corrected?

The answers to the first and third (overreaction, policy errors) depend on whether one takes a "static" or "dynamic" view. Static views compare measures at points in time to arrive at an assessment of better or worse. Dynamic views, by contrast, emphasise system-wide flows and consequences, as in financial simulation models, with the focus on outcomes. The real question is whether we can grow sufficiently so that foreign and domestic funds cover imports and build manufacturing, or shrink and risk a deluge.

Risk assessment
From a static perspective, the present situation is nowhere near the dangers of 1991. Flows, however, highlight the potential for danger of slow growth: a demographic bulge with high aspirations and low opportunities; and a large, low-skilled population. What's worse is that foreign investment-fuelled growth rode a wave of imports without sufficient development in direct manufacturing. This imbalance is heightened by the stoppage of iron ore exports and the slump in coal production because of mining scandals, aggravated by high coal and gold imports. The problems - in telecom, mining, aggressive environmentalism, retrograde tax impositions, inadequate manufacturing - are all self-generated except for oil prices and the Syrian crisis. They stem from abdication of governance, overreach, or greed, compounded by judicial and citizen backlash. Only the triggers are external - from capital flowing in to the signal of a cutback.

Policy missteps 1: Interest and profits

The left side of the chart below shows interest expenses and profits for several thousand listed companies over the last four quarters. In terms of flows, higher interest rates curtailed demand as intended, so lower revenues and higher costs reduced profits - all while supply-constrained inflation continued.

Some experts maintain that rate cuts won't affect growth, citing the lack of a clear correlation; or the insignificant share of interest in total costs (reportedly three per cent); or that rates drive savings or consumption, but not investment. Clear correlations are unavailable because credible research must cover all major variables and interrelationships; simplifying them can distort conclusions. The research must also include how the effects of changes vary for rising or falling, large or small economies at different stages of development. The other reasons appear to ignore aspects of flows like momentum and turbulence - or even the data. And aggregates and averages can be misleading, as detailed below.

Policy missteps 2: Sustainable profits and stability

Profits are essential for savings, investment, stability and order. This is why sustained profitability is of paramount importance for India. Provided industrial relations are harmonious and demand is resilient, that is, momentum is positive, lower interest costs within reason can sustain positive sentiment, resulting in higher profits up to a point (see chart - right). This has been a matter of incomprehension or denial for government (central and states), the Reserve Bank of India, the judiciary, and many citizens.

Instead, we have populist handouts to capture treasuries, and irresponsibility in replenishing them. What started with cheap rice in the 1980s has degenerated into a free-for-all, promising a distribution from the treasury contingent on capturing it for aspirants, or recapturing it for incumbents: vote us in, and you'll get these spoils.

Plausible remedies

  • Lower rates: A number of experts in India and abroad recommend a reversal of monetary tightening and reduced interest rates. Some aver that the biggest risk is stifling growth by raising rates, eg, Paul Krugman and Ryan Avent ( Others, unfortunately, suggest confusing strategies, including raising rates to contain inflation, despite this not having worked and been shown to be detrimental.
  • Fiscal responsibility: A second requirement is fiscal responsibility in trade-offs for resources, betrayed by all parties in the impractical Bills on food security and land acquisition. This is a crucial requirement from both the government and the Opposition. For example, an effective step would be to raise diesel prices by Rs 5 a month for three months (which the government could evaluate using simulations).
  • Manufacturing: Another requirement is action supporting manufacturing. A National Manufacturing Plan has been mentioned for years, but only coherent action will change the perception of yet another plan on the shelf. For instance, the government has resiled on the preferential marketing access for telecom equipment, which will increase imports.
  • Stalled projects: There have been future-oriented announcements, eg, on fuel supply for power projects, but no demonstrable actions and results.

In sum, a rate cut combined with consistent actions on fiscal responsibility, disentangling projects, manufacturing, and stop-gap measures like swap facilities for oil companies and "stretching" imported coal may provide a breather. These could have a stabilising effect on the rupee, improve sentiment, and re-establish India's growth potential.

Anand Tandon
1. Interest costs did not go up because of "high rates". Over FY07-13, interest costs for approx 750 companies with a market cap of >$1bn increased at 30% CAGR, while net debt increased at 31% CAGR. Comparing with revenues mis-states the problem. Yes, there is an economic slowdown, but it is NOT caused by interest rates. In fact, over this entire period, real interest rates have been NEGATIVE. 2. Krugman et al are operating in an environment where interest rates are zero, and there is little inflation. There the attempt is to INCREASE inflation, so that the economy can be given a stimulus through a negative interest rate ! India suffers from extremely HIGH inflation, and out of control revenue expenditure of the government - an entirely different problem 3. The weak rupee, in part caused by a low real interest rate and high consumption demand,has already led to a tightening in the near end of the interest rate curve. This could have been avoided if as Dr Subbarao mentioned in his outgoing speech, the RBI has been faster in the tightening cycle.

SP Replies

“…over this entire period [FY07-13?], real interest rates have been negative.”

Data for Real Lending Rates according to (a) the RBI and (b) the World Bank (from
Real Lending Rate – RBI  1992-93 to 2009-10
Measures of Nominal and Real Effective Lending Rates of Banks in India
Deepak Mohanty, A.B. Chakraborty and S. Gangadaran
May 2012

a) RBI - Real Lending Rates & Growth

Real Lending Rates - 1992-93 - 2009-10

Real Lending Rates & GDP Growth

b) The World Bank
The Real interest rate (%) in India was last reported at 2.01 in 2011, according to a World Bank report published in 2012. Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.This page includes a historical data chart, news and forecasts for Real interest rate (%) in India.

“2. Krugman et al…  India suffers from extremely HIGH inflation, and out of control revenue expenditure of the government - an entirely different problem.”


"The emerging-market squeeze, short version"
Ryan Avent   Aug 21st 2013
"My conclusion was that the big risk is a policy overreaction in affected economies. Governments or central bankers worried about depreciation or its effect on inflation will be tempted to move monetary policy in an inappropriately tight direction."

Shyam Ponappa has exceeded himself in this columns. Brilliant stuff. "Rejoicing in the woes of "profligates" is inadvisable, however, because a collapse affects everyone." Nobody could have given a better argument to silence the liberals who have been crying hoarse about 'Moral Hazard'. I think this eliminates Moral Hazard as a category worthy of consideration because losers should not lose in capitalism as it will bring everyone down. Effectively, those who are on top should not be tested. Even if they lose they should be reinstalled back through subsidies for the Rich. And there goes Schumpter and his Creative Destruction. If we are going to have to pay the price of Destruction, we dont need Creativity itself. It is nothing short of revolutionary stuff for Ponappa to keep insisting on stopping all this Churn business. Society really does not need new innovaters to be well rewarded, continuation with old failures is the way to go. That will The basic framework of economic policy should save the well-entrenched and keep out the troublesome unsettling new aspirants. That will keep society stable as well. Everybody will know their place and learn to stay put. Along similar lines, he has also excelled in returning to his pet topic of lowering Interest Rates as the preeminent route to save the corporates which are failing. The 850 or 2000 corporates which are failing need to be subsidised through the lower interest rate mechanism, no matter what price the rest of the Economy has to pay for it. Head of PM's Council of Eco Advisers has said on 3 Sep that the country was suffering from very high inflation for an extended period and so the rupee adjustment was only to be expected. Does he mean to say that the inflation targeting should have been done through higher interest rates. The rupee drop has no link to prior inflation and low inflation rates. Isnt it so Ponappa? Ponappa based on this clear simplemindedness has been crying oarse in his columns for a 300bps drop for interest rates even before DV Subbaro raised it by 300bps. To drop them to around 200bps! Brilliant assumption - There is no price to pay for economic policy failures. 

SP Replies

The Real Effective Exchange rates, according to the Reserve Bank of India (RBI):

The statement that reduced interest costs will increase profits if other factors are constant is a truism.  It would be true if any cost is reduced with other factors unchanged. 

Should this be done?  Or should the “850 or 2000 corporates which are failing” (Srinivasan) [be allowed to fail].
As written, I think the choice is to tide over the difficult situation we are in by retaining foreign and domestic capital, or risk a serious, prolonged downturn with capital flight.  Whether this is justifiable or not depends on the facts of our economic situation and what our objectives are. 

In my opinion, we are at a juncture where employment opportunities must be improved somehow.  I think the way to do so is to improve the profitability of sound enterprises, and not consign all overleveraged companies to mass bankruptcy, because it will be too disruptive to our political economy.  A mass bankruptcy would destabilize our banking system and jeopardize what is most important for employment and for the future, the development of infrastructure.

There are distinct areas in which decisions have to be made: exchange rates, interest rates, and economic policies in areas other than exchange and interest.  I am suggesting that action on interest rates and on other economic aspects can strengthen the economy, so that the currency becomes more stable.

Srinivasan replies - Choice 1 is To try to maximise working within an illiberal non-market-based system which i) rewards crony Big Business without any reason through interest rates (but that is a model which can be followed only for so many years before currency has to be devalued) and ii) helps them out when they take wrong decisions, and iii) when the above disastrous decisions stretch the system beyond the limit, and systemic risks emerge, they are addressed by spreading the pain to all sectors of the economy. Choice 2 - have a market based system which rewards innovation and energy and efficiency. Those who fail, no matter how much their clout - they Fail. Those who do well the market rewards them amply. These basic incentive mechanisms are not tampered with. The full potential of the People gets unleashed. As Ruchir Sharma of Morgan Stanley point out since UPA-I the Churn within the Top Twenty-Hundred-Thousand has stopped. Most of those who were in the Top Twenty in 1991, had dropped out and been replaced by fresh entrants by 2001. But in the next 10 years there has been hardly any change in the Top Twenty. These new entrants have grabbed control over the policy structure in Delhi to close the door to any further new entrants. The choice - Choice 1 or Choice 2 - is up to us. Think short-term and save and exalt a corrupt Big Business system in which SMEs and common people languish in the absence of right incentives. Or, Think long-term and over-haul it to empower people to excel and outperform. Brilliant assumption by SP - There is no price to pay for economic policy failures. There will be two mega-benefits. No penalty to Big corporates for their erroneous decisions, and no penalty to the Nation for erroneous policies.