Shyam Ponappa / New Delhi October 28, 2008
Focus on profit margins through loans at lower rates, and rationalised taxes
Now, unlike in the Great Depression, central banks and finance ministries know it’s better to run deficits and print money than to suffer massive losses of output and jobs —Niall Ferguson (Harvard Business School)
Really? Well, let’s just hope this is true of India… To be fair, the finance ministry and RBI acted with alacrity, recognising that irrational panic causes devastation and must be stopped immediately. Now, however, they need to do more — much, much more. Let’s examine what they should do, and why.
The headlines sum up the situation: delays in expansion plans for steel and real estate development, plummeting stocks in aluminium, banks, oil, cement… airlines collapsing, equity issues even for solid companies like Hindalco devolving on the underwriters, and the Baltic Dry Index (which tracks shipping rates for bulk cargo such as iron ore) dropping to the lowest level since February 2003 after peaking in May. Consumer spending is drying up, with the stock markets in free fall. The auguries are not good for The Great India Story. What we need now is decisive action, with no half-measures.
What should be India’s policy objective? Get the travel and leisure services sector to flourish, thereby keeping our air and other travel services surging at a healthy clip? Or kill off the boom in travel and airlines with all their attendant multiplier effects that provide an excellent and practical way to capture our demographic dividend, making use of our cultural and natural features? There is no doubt about what is best for the public interest: build travel and leisure services as fast and as well as we can. If the government accepts this objective, the policy actions needed are clear: one aspect of the problem is attributable to inappropriate taxation that makes ATF for aircraft more expensive than most places in the world. Therefore, rationalise ATF prices so that the cost structure supports travel growth, and ensure the availability of credit assessed on sound criteria at low rates.
Keep enterprising developers and their projects scudding along, if on a more realistic asset-price trajectory? Or let them perish by the wayside, stalled projects gaping in the economic wilderness we wreak for ourselves? Again, there is little doubt that the public interest is in keeping the momentum going, although the crossover points for balancing construction momentum with sustainable asset and input prices are a complex problem with a knife-edge solution we must find and then traverse.
While our monetary and fiscal authorities have understood and responded to the need for liquidity, it seems less well-understood that too-little can be as damaging as too-late, and that we are now at the too-little stage. A key requirement is that this liquidity results in credit access for individuals and businesses, and that bankers don’t “tuck their money under their mattresses,” so to speak. That’s with regard to cash for maintaining — just maintaining, at a slower pace — momentum in the real economy. So, this is the first need: a lower Cash Reserve Ratio and much more liquidity.
+ Lower Interest Rates…
Liquidity alone will not improve depressed profit margins, which have dropped from 20 per cent-plus to 10 per cent. Morgan Stanley apparently expects profits to be at 15 per cent going forward, with trend growth for GDP at 7-7.5 per cent; let’s hope that happens, although it seems very doubtful. Therefore, there is a two-fold need right now: (a) high liquidity, combined with (b) low interest rates. Without the first, it will all be too late. Without the second it will still be too late, because reduced profit margins will not sustain growth momentum. Improved profit margins will not only help growth, they will also stem the slide in stock prices, which will derail India’s otherwise sound prospects based on its large domestic market.
= Profit Margins
Other things being constant, the RBI’s and finance ministry’s aim should be to protect profit margins, so that growth is maintained and stock markets stabilise. This may help retain FII investments, possibly even attracting further investments, as well as obviating redemptions on over $150 billion of foreign currency convertible borrowings (FCCBs) from next year. If FIIs continue to sell on every uptick and if these FCCBs are redeemed, there will be continuing undue pressure on profit margins and on the rupee.
A good way to anchor profit margins is for enterprises and individuals to have ready access to credit to run their operations. Better yet, if credit is available at lower rates, profit margins will improve — as much as 30 per cent for every 10 per cent reduction in borrowing costs, by one estimate in better times. This requires more liquidity at much lower rates, with the oversight to ensure that bankers make sound loans across the board, and that loans are not squandered on asset bubbles.
As former RBI Governor and ex-Finance Secretary S Venkitaramanan puts it*, if the RBI adopts the way the rest of the world measures inflation, that is:
a) on the basis of changes in consumer prices as against wholesale prices (the CPI rather than the WPI),
b) calculated from month-to-month with adjustments for seasonal variations, instead of a point-to-point comparison with a 12-month interval, that is, ‘year-on-year’,‘headline’ inflation will be much lower, nearer 7 instead of 11 per cent. This in itself justifies interest rates being 4-5 per cent lower. Several others support the user price index: Ila Patnaik of the National Institute of Public Finance and Policy writes that Indian economists have been advocating using seasonally adjusted monthly inflation data for years, giving instances of how the RBI’s year-on-year measure has led to inappropriate actions; V Sridhar details why the WPI, a producer price index, is inappropriate, and elucidates why the consumer indices currently misrepresent the facts; Surjit Bhalla has written in this newspaper about seasonally adjusted monthly consumer prices.**
There is absolutely no logic in curtailing our prospects with high interest rates, now that the bogey of inflation experienced recently is recognised as having happened for reasons other than domestic interest rates. On the contrary, there is good reason to capitalise on India’s fundamentals to boost economic activity and jobs when few places in the world show comparable prospects. We have the domestic markets to get our beleaguered construction, metals, automotive and airline sectors moving, provided other corrective steps such as rationalising taxes on ATF for aircraft are also addressed together with cheaper credit.
So, we need big cuts in the CRR to increase liquidity, and in the repo rate, the rate at which banks borrow from the RBI, to lower borrowing costs. A reduction of 3-4 per cent in interest rates could double profits.
Simultaneously, there is a need to redefine and expand the scope of ‘priority sector’ loans, currently 40 per cent of bank lending. To make this work, an essential adjunct is the design and deployment of an effective regulatory system for online monitoring and timely action and redress, including incentives, disincentives and penalties. For best effect, this needs to be done by a multidisciplinary group, and not by the RBI alone.
Focus on Profit Margins
India’s authorities need a singular focus on profit margins. Higher margins can be achieved through more credit at lower rates, well-applied and properly channelled. This will revive growth and help attract more investment in a virtuous circle.
* ‘Global financial crisis: reflections on its impact on India’, S Venkitaramanan: http://www.hindu.com/2008/10/18/stories/2008101851380900.htm
‘Mismeasuring inflation’, V Sridhar: http://www.hinduonnet.com/2008/05/05/05hdline.htm