Thursday, April 17, 2008

The Burden of High Interest

Shyam Ponappa / New Delhi March 6, 2008

We need low interest rates for many years of double-digit growth in India.

I first saw ‘Whack-the-Gopher’ years ago at Billy Bob’s in Fort Worth, Texas. This place, famous for country entertainment, has a pro bull riding arena, a huge dance floor, many bars, and a Texas BBQ. It also has Whack-the-Gopher. Stand with a mallet in front of a raised ‘yard’ with a number of gopher holes. As the varmints pop out, whack them back in.

RBI’s Nostrum: Whack the Gopher
The RBI has its own variation. Every time the economy picks up, whack it with high interest rates, talk about inflationary risks to fuel uncertainty — and watch it fall back.

If anyone is chuffed at 8.7 per cent growth, stop to consider what kind of sufficiency leaves growing swathes of the country subject to violent attacks by extremist rebels, while most of it has no basic amenities (sanitation-water-health-education). In contrast, China apparently defines a growth rate at which employment fails to keep up with new entrants into the labour market as “economic stagnation”.* What will it take for India to plan and achieve the rising tide that, starting from Japan in the 50s, many countries have had the sense to figure out and make happen? Everyone including the Left must realise we can only aspire to any decent living standards after coordinated efforts to get 10 per cent growth for at least 10 years or more.

The RBI’s charter needs to be redefined, stressing growth and employment primarily, and inflation control secondarily, instead of the other way around. We would do well to remember that while countries that grew fast experienced occasional crises, they still grew faster than countries with smooth credit conditions.**

Interest & Profits
The chart shows Interest Expense as a percentage of Revenues, Expenses, and Net Profits from FY2000 to FY2007 on the left vertical axis, and the minimum Prime Lending Rate from FY2000 to date on the right vertical axis.

Interest costs amounted to as much as or more than net profits from 2000 to 2002, then dropped to around 20 per cent by 2007. From the way costs varied with rates, we know what will happen to profits. A study of quarterly interest rates and GDP growth in India for 2000-2006 corroborates this, as does an IMF study of other emerging economies I have cited earlier.#

Investment and planning are driven by perceptions of growth and profits. If revenues and profits (and expectations of them) grow at near 20 per cent, companies will continue to invest, and investors will keep buying stocks at high valuations. More enterprises will come on stream and do well, with additional growth in employment (i.e. further increases in output and employment). This is a virtuous circle for India with its demographics and headroom, because a large proportion of the population has room for appreciable improvement to attain reasonable living standards. This provides

massive scope for additional housing, transportation, energy and other infrastructure, durables and consumer products, as well as services. And it can only happen if enterprises and individuals continue to invest and act with optimism, buoyed by the prospects of growth and profits. Remember how years ago, good multinationals had consistent PE multiples of 25 when the market was at 15? This is why. And yes, there are reasons to justify such valuations for good Indian companies for the foreseeable future, provided our monsters don’t all rise.

Defenders of the Faith

A theoretical argument for high interest rates is that they can’t be lower than inflation. However, consider the examples in the table for India, China, Malaysia and Thailand:

Inflation in these countries is in fact higher than their interest rates, while borrowing costs in India are double these countries. A one per cent lower rate in India in 2007 would have resulted in increased net profits of about 3.5 per cent (based on a sample of companies). So, if Indian companies paid 3 per cent less for debt, their profits would increase by 10 per cent.

Of course, you might say: what about more profits that could accrue from a rationalisation of taxes, of better infrastructure, e.g. lower power costs and no standby requirements, better transport with improved logistics, government services provided efficiently over the Internet, and so on? You would be right. This is why there is potential for growth in profits of 20 per cent plus for many years together as all these kick in, provided we do what it takes to realise the potential.

Actionable Steps

What can the government do?

- Get the RBI to focus primarily on growth and employment, with a secondary emphasis on inflation.

- Take equivalent steps starting in the finance ministry on fiscal discipline, extending to all ministries and states; avoid populist giveaways.

- Set clear goals and coordinate all policies and actions across ministries and states and between the government and the RBI to achieve them, e.g.:

a) Lower expectations of inflation by:

- Cutting and rationalising taxes;

- Building policies and practices to deliver additional supplies of foodgrain, pulses, and edible oil as in the next paragraph.

b) Develop and execute sector-specific supply strategies, e.g. for foodgrains, pulses and edible oil: acquire additional stocks with better pricing; formulate strategies for additional production through better analysed and managed cultivation, i.e. better scientific inputs, extension and practices, and strategies such as offshore joint ventures.

c) Maintain a lower interest rate structure. Avoid inappropriate rate increases when limited supplies cause prices to rise; instead, coordinate fiscal and monetary policies (macro plus sector-specific) to improve supplies.

d) Develop and deploy systems and procedures at the operating level to facilitate lending on a sound basis to sectors such as construction, housing, durables, transportation and automotive products, i.e. more emphasis on the RBI’s banking operations charter. Good systems and procedures for sound credit will accelerate productivity, growth, and employment. As cited in an earlier article, the IMF found that it is indiscriminate lending without proper credit evaluation and/or repayment projections that lead to crises.@ This is important for an economy that relies heavily on bank credit, and does not have a well-developed bond market.

Such steps will help many of the gophers get up and away.


* ‘Harsh winter raises specter of “Chinese stagflation”’, Simon Rabinovitch, Reuters, January 20, 2008:

** ‘Crises and Growth: A Re-Evaluation’, Romain Rancière, Aaron Tornell, and Frank Westermann:

# ‘Exploring the inflation, interest rate, growth nexus’, A. Vasudevan (former RBI Executive Director heading Research), (, and “Business Cycles in Emerging Economies: The Role of Interest Rates”, Pablo A. Neumeyer & Fabrizio Perri, cited in the BS June 7, 2007:

@ Cited in the BS September 11, 2007: ‘Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies’, July 2005(, see

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