Friday, October 31, 2008

Urgent: Bank Credit At Lower Rates

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.

Desperate Straits

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.

Required Steps

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:

** ‘The Thursday syndrome’, Ila Patnaik:
‘Mismeasuring inflation’, V Sridhar:

Thursday, October 2, 2008

Changing Mindsets: The Economy & Financial Turmoil

Shyam Ponappa / New Delhi October 2, 2008

There is a way India can seize the moment and make the most of the present circumstances

How will India weather the global meltdown? It depends, because there is a way India could make the most of the present circumstances. It would require congruent action by policymakers on factors they have some control over and can manage. Clarity and prioritisation in objectives is the first step, while effective execution is the next.

High Profitability

The single most important aim should be to ensure that enterprise profits continue to grow healthily. This, in turn, implies (requires) continuing growth in investments in infrastructure and projects, and in consumer spending.

To elaborate:

  • The continued profitability of enterprises is all-important — for all legitimate enterprises operating in India, publicly- or privately-owned, in every sector. As for foreign-owned enterprises, there is a second-order benefit when they improve the quality of products and services, capacity, and efficiency in production, logistics and service delivery in ways that are beyond the ability of locally-owned enterprises. These improvements can act like a rising tide, making for better human resources and systems.

  • Ensuring the implementation of projects in progress is a major driver of continued profit growth. This applies as much to infrastructure as it does to new projects and expansion, because it is when projects are completed that output and profits grow, whether directly in specific entities, or indirectly by the facilitating increase in infrastructural capacity, supply and efficiency.

  • Another significant driver of profit growth is consumer spending (within reasonable limits) to absorb the existing and additional capacity and growth. This implies, crucially, to a continuation of high savings, which then fuels further investment.

Paradoxically, if consumer spending is restrained, it will not only hamper growth directly, it will also constrain project implementation and plans for future investments.

Why Profits?

High profits result from robust, productive economy activity. As it happens, the economy is well-positioned for this after several good years, resulting in investment plans that are in the process of being executed. Investments in infrastructure in the next three to five years are expected to create assets amounting to almost as much as the total asset stock built in the last 60 years (Figure 1).*

Figure 1: Capacity Addition Planned 3-5 Years

The importance of profits to owners is clear: cash flows, access to inexpensive capital for equity and debt, and the ability to attract talent. There seems to be
less appreciation, however, of just how important profits are to the government. We get a sense of that if we consider the enormous (government) investment needed in infrastructure, the effect of robust tax collections on the government’s ability to invest, and the likely effect of a slowdown.

A large and growing domestic market offers opportunities in this time of global turmoil. Strong continued growth in profits will elicit capital inflows reversing the weakness of the rupee, and help offset the increased costs of imported oil. The combination of profits and capital inflows will instil confidence in domestic and foreign investors to continue to invest.

If this happens apace, the rupee will strengthen. There should be clarity on the net benefits of the rupee’s strength or weakness: overall, it is most beneficial and equitable if we have a stable, strong rupee based on fundamentals and confidence in the economy, perhaps while seeking the benefits for some years of an undervalued currency through exchange rate management — that is, subsidising exporters at everyone else’s expense — to the extent possible.

Prospects For Profits

A year ago, analysts were expecting corporate profits to grow through 2009 at 18-20 per cent. Since then, there have been steep declines, and for June 2008, 1,638 companies reported profit growth of 10.6 per cent (Figure 2).

Figure 2

Prospects for profit growth are ominous because both the drivers, project implementation as well as consumer spending, are declining. Project implementation declined as a percentage of projects announced from 53 per cent in December 2006 to 45 per cent in June 2008. Power projects slowed from 50 per cent in December 2006 to 40 per cent, transport services from 62 to 45 per cent, and mining from 50 to 37 per cent. Meanwhile, consumer loans also declined steadily (Figure 3).*

Figure 3

Rejuvenating Profits

For profits to accelerate, (a) project implementation needs to improve, and (b) consumer spending has to grow.

Interest rates affect both. Financing costs within a range are policy choices affected by perception, mindset and execution. The benefits from a reduction in borrowing costs have been estimated as a 30 per cent increase in profits-before-tax for every 10 per cent fall in interest rates, or an increase of Rs 25,000 crore in profits for a 1 per cent reduction in interest rates. Also, lower rates will help to increase consumer loans and therefore spending, provided credit is available. An improvement in both factors is likely to have a positive impact on project implementation.

Therefore, steps need to be taken immediately to accelerate enterprise profits by:

  • Reducing interest rates for enterprises targeted for working capital and project investment with prudential norms, with close oversight.

  • Restarting consumer spending by reducing interest rates for targeted retail lending (say, for specific categories of consumer loans such as first houses, vehicles, consumer durables and commercial projects with high equity participation and sound drivers), while anchoring lower inflationary expectations as is being done.

  • Making credit available for productive use, rather than repressing bank credit growth. This is especially important when conventional credit is overstated because of oil bonds and loans to oil companies to cover losses from administered prices.

  • Rationalising processes so that projects can be executed and not held up by convoluted regulatory and procedural impediments. This needs a focused ‘detoxification’ exercise for clearances, so that projects are not stalled.

Such changes mean a redesign of the RBI’s reporting and monitoring processes and systems, integrated with IT and communications, as well as in project clearances. They have the potential, if managed successfully, for major improvements in India’s approach to managing its economy, and for sustaining high GDP growth.

*Source: ICICI Prudential;