Monday, November 10, 2008

Ambivalence Adds To Uncertainty

Shyam Ponappa / New Delhi November 06, 2008

We need decisive action on credit and interest rates.

The rate cuts together with steps like the RBI giving enterprises access to foreign exchange are welcome initial steps. They are too tentative, however, and more urgent action is required.

The present developments are like a less severe precursor. After a total loss of economic momentum, remedial actions will have less effect. The economy is staggering under a liquidity crisis from inappropriate tightening and high interest rates, leading to stalled projects and spending, with businesses floundering on the brink of distress sales, bankruptcy and layoffs. How can India’s domestic market-driven economy with its fundamentally sound banks be revived?

Simple Arithmetic

The logic is simple: banks lend to enterprises only when they see profits and expect to recover loans. Profits have tanked, and must be revived. Profits will rise with adequate liquidity, low interest rates and strong disincentives not to lend (ie, a low reverse-repo rate — which banks earn for deposits with the RBI), together with rationalized taxes as for ATF for aircraft provided revenues can be maintained. Revenues will sustain and grow only if there is confidence; otherwise, there will be no spending. Hence the urgency for the government to orchestrate its actions with the RBI, banks, businesses and industries, to apply a concerted strategy for building profits.

At present, the strength of our economy built in the good years in healthcare and pharmaceuticals, airlines, hotels, banks and financial services, metals and manufacturing…is being squandered in battling a recessionary spiral. What’s worse, that spiral was induced and is now aggravated by self-inflicted high funding costs (global rates are lower) and tight credit. This is why enterprises sought external borrowings, and are now suffering with the depreciation of the rupee.

Reversing The Downward Spiral

The negative trend can be reversed by addressing four drivers of the present economic crisis: confidence, liquidity and its sibling, credit, and interest rates, ie, costs. Instead of dithering with half-measures — small rate cuts, ambivalence between keeping rates high to attract remittances, or low to promote growth — the RBI and the government need to act decisively to make India a high-growth market and attractive investment destination. Radically increased liquidity and decreased interest rates (and rationalized taxes) can improve profits dramatically. While global cues will affect foreign investment, convergent action could temper this. These steps are needed urgently, before there is irreparable damage.

* Confidence: All or Nothing

In a crisis, confidence is an all-or-nothing holding action. Tweaking a few props is like putting some timber in the path of a massive flood: it cannot avert the damage. Therefore, instead of business-as-usual, there must be well-orchestrated actions affecting liquidity, credit and interest rates, together with a resolute stance, such as assured access to foreign exchange (as has been done). The restoration of confidence is needed before there is further damage from stalled projects, distress sales of assets, bankruptcies, and massive layoffs.

* Liquidity

A goal-oriented approach is advisable, taking cognizance of the facts, with objectives defined to converge. In the case of liquidity, the issue is the extent of shortage. An assessment of needs must cover the events leading up to the crisis, including the strangulation of liquidity and credit to enterprises because of escalating CRRs and interest rates over the last two years and early this year, coupled with high government and PSU borrowings, eg, the oil and fertilizer subsidies through banks. This ‘backlog’ is one component of liquidity needs. The disappearance of international trade credit is another. Funding needs for enterprise activities and projects is the third, FIIs repatriating when stock prices rise is the fourth, and a revival of consumer spending the fifth. This is the demand for which the RBI should provide. The order of magnitude required may be two to three times what was done last week, achievable by a further cut of 2 per cent in the CRR (presently 5.5 per cent), to signal a ‘liquidity bank’.

* Credit Availability

Once there is liquidity, banks must be encouraged to lend based on acceptable criteria. This needs more than admonitions from the Finance Minister. The most direct signal is a disincentive: a low reverse-repo rate, so that banks cannot simply park funds profitably with the RBI (they may still opt for government bonds for safe returns, for which other disincentives need to be devised to discourage excess). True, given our risk-averse bias, there are many reasons for bankers to hesitate in making lending decisions according to their business judgment. This bias will take time to grow out of, but the process needs to be helped along by structuring systemic support that rewards productive lending over unduly risk-averse behaviour. Unfortunately, that isn’t all: structural support also needs to be devised to guard against arm-twisting by predatory politicians, and to protect bankers from them.

* Cost of Funds

To rid ourselves of unnecessary, self-imposed constraints, we need a further cut of at least 2 per cent in the repo rate. There is no conceivable reason for imposing high costs for money. As for attracting foreign remittances, their incentive is the spread between offshore deposit rates (low in many places) and Indian rates. Some economists argue that high demand for funds keeps India’s rates high, but finance professionals — finance and economics are different domains — will tell you that the demand for funds is always high in an active economy, while a major component of the cost of funds is a regulatory construct. It is bankers who ration supply on the basis of their criteria, unless compelled to do otherwise.

Also, high rates inflate India’s cost structure unduly, as the cost of money has an input multiplier effect on other prices, ie, interest costs as a percentage of revenues, or of total costs, understates the detrimental effects of high interest rates.

With lower interest costs, Indian enterprises will earn higher profits. If growth is nearer potential, enterprises will attract more from investors, including foreign investors, as was the case in the last few years. This is why the RBI and the government must act decisively on building confidence, liquidity and credit, and cut interest rates.

For recent views that support these measures, see:

'There's no need for irrational pessimism', Deepak Parekh
interviewed by Shobhana Subramanian:

However, Dr. Rangarajan says the RBI has done enough:

'The financial crisis and its ramifications', C. Rangarajan:

Added later (November 11, 2008): As a matter of fact, it turns out that the government has again done too little in cutting duties and taxes on ATF. A piece in the Business Standard titled, 'Taxes, costing methods make Indian ATF prices highest in Asia-Pacific', by Rakteem Katakey shows that despite a 36 percent cut, prices in India at Delhi and Mumbai are 60 percent higher than in Singapore and Kuala Lumpur.

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