Friday, April 11, 2008

Interest Rates, Living Standards & Inflation

Shyam Ponappa / New Delhi June 7, 2007

What the right aims and strategies could do for India's living standards.

We must try to get these few major goals right in India: low interest rates, and a systematic policy framework for basic infrastructure (and systematic approaches to everything, including a simple, low-tax regime).

Low Long-Term Interest Rates

Imagine this scenario: a long spell of low interest rates, initiating a period of domestic expansion with sizeable construction and property development for a decade or more. With low interest rates, this could happen in India. Imagine the corporate champions that could grow exponentially, as companies build their game locally, then expand globally … in banking and financial services, telecommunications, energy, metals, construction, textiles, automotive products, manufacturing, chemicals, leather and fashion … “swashbuckling their way around the world in search of booty”, as the Economist puts it. Wishful thinking? Not entirely. This is what happened in Spain, more or less, over the last 14 years.*
I have taken some liberties, grafting elements of what-might-be for India on to what-has-happened for Spain: Santander in banking, Metrovacesa in property—a subsidiary acquired HSBC’s Canary Wharf headquarters in Britain’s biggest property deal, Ferrovial in construction, Mango and Zara in fashion. India’s special circumstance is that it is entering a phase of manufacturing competence. Manufacturing could be a growth engine if we got basic infrastructure (power, transportation and communications at least, with basic education, healthcare and sanitation, then access to distance education & training …). This may be fanciful, as we display little comprehension of the need for an integrated policy framework, but if it happens, add manufacturing to India’s potential for growth and employment.

We could consider Japan, except that inexplicably, many in India reflect the Western view that Japan is in some doghouse because of the long recession following the property bust over a decade ago. But what a plush doghouse! Look closely, and you will find that Japan has been a member of the OECD, the rich-countries club, all along. It is hard to explain Japan’s living standards to those who have not experienced it…

There’s Korea, the newest member of the OECD. Korea too went through a long period of tremendous growth built on low, stable interest rates. After achieving living standards comparable to OECD countries, there was a partial collapse during the Asian crisis of 1997, followed by structural problems relating to costs and overextended credit. However, that should not obscure the high living standards in Korea today, as is evident from Table 1. The same story applies to China, the US, Australia, Thailand …

Table 1: GDP per capita and final adjusted indicator, 2004

International Comparisons of Living Standards by Equivalent Incomes, Marc Fleurbaey & Guillaume Gaulier, January 2007:

Low interest rates bring the benefits of broad growth that is widely distributed in SMEs and entrepreneurial ventures (provided funding is accessible, not tucked away in government bonds or restricted to blue-chips who don’t need it), as well as in larger enterprises. The resulting lower costs sweep away many ills motivated by high interest rates, e.g., excess liquidity, the Yen carry trade, much of today’s external commercial borrowings (the reverse-rupee-carry-trade), and deals like Japanese leveraged leases (a structure arising from low interest rates with low tax rates), which will disappear with the dismantling of their rationale. Not only will low rates cut off a root cause of excess liquidity, they will help to move the locus of transactions to a local ambit, enabling the development of financial depth and higher-order capabilities in local markets.

Figure 1 shows how GDP varied inversely with lagged real interest rates in the 1990s in the emerging economies of Argentina, Brazil, and Mexico, and the new OECD member Korea.

Figure 1: Real Interest Rates & GDP in Emerging Economies

Source: Business Cycles in Emerging Economies: The Role of Interest Rates, Pablo A. Neumeyer & Fabrizio Perri:

Living Standards

What do we aim for? What living standards should we aspire to, given the option? One measure is GDP per capita, but should we really aim for this, with its implied per capita consumption of, say, 32 kg of aluminium (US) or 6.5 kg (China), or “x” gallons of water, or “y” automobiles? Apart from making our surroundings unlivable, we could surely have more balanced aspirations, just as a life of the mind is worth cultivating despite scores of TV channels spewing inane trivia.

Living standards are measured in various other ways, such as the UN’s Index of Human Development, Osberg & Sharpe’s Index of Economic Well-being, or Bhutan’s Gross National Happiness. Alternatively, GDP per capita can be adjusted to compensate for non-income attributes of a society’s choosing, such as better healthcare, less unemployment or pollution, or more leisure, to arrive at an adjusted “equivalent income”, by determining how much a population is willing to pay for a reference level of a non-income dimension.

Figure 2 from a report by France’s Institute for Research on the International Economy (CEPII) shows GDP per capita for OECD countries, with adjusted “equivalent income” for several factors. According to this, Spain, Japan and Korea enjoy better living standards than their GDP per capita reflects, as do many OECD countries. The lesson for India: define relevant dimensions and desirable levels, then strategise and work to attain them.

Figure 2: Living Standards - GDP per capita ($) Adjusted Equivalent Income, 2004

Source: International Comparisons of Living Standards by Equivalent Incomes, Marc Fleurbaey & Guillaume Gaulier, January 2007:

What should be our “acceptable” inflation rate? The risk in mentioning inflation is that the high priests of one persuasion or the other hijack all discourse, with knee-jerk reactions from anti-inflationary ideologues as well as proponents of inflation-tolerance. Arguments for both sides are entrenched in ideology, preempting understanding and multidisciplinary action for the practical management of such problems.

Consider a question I will address in my next article: what inflation rate should we—and the government and the RBI—wish for?

Before fielding Sukhamoy Chakravarty’s proposed 4 per cent, then RBI Governor Rangarajan’s 5-6 per cent, and FM Chidambaram’s 4-4.5 per cent, please consider:

- At a time of high growth, why nurture high “acceptable inflation”, i.e. expectations of rising prices? Why not 1-2 per cent?

- Do facts contradict the conclusion that high prices follow high interest rates (Thomas Tooke)?**

- How desirable—imperative?—is it to coordinate fiscal and monetary policy (and public-private initiatives) to achieve low interest rates and inflation in an emerging economy?

* See The Economist, May 3, 2007: ‘Conquistadors On The Beach’ and ‘Plain Sailing No Longer’.

** On Interest and Profit: Thomas Tooke’s major legacy to economics, Matthew Smith:

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