Thursday, February 5, 2009

'Haircuts' for All

Reducing the 'prices' of assets, finances and taxes can revive earnings and growth

...The entire platform of inflated interest, tax rates and input costs needs to come down, facilitating lower prices and a revival of consumer sentiment, together with growth and productivity...

'“As far as the interest rates are concerned, the Reserve Bank of India has to take a call. It is desirable to bring down the rates. It is desirable to bring down the reverse repo rate,” said Suresh Tendulkar, chairman of Prime Minister’s Economic Advisory Council.'***

Shyam Ponappa / New Delhi February 5, 2009

State Bank of India moved boldly last Monday, reducing home loan rates, and introducing an SME initiative. However, to revive growth, comparable actions are required from developers, RBI and the government. Developers have to reduce asset prices, marking the runaway increases in real estate; the RBI needs to cut rates; and the government needs to rationalize and reduce taxes. Everyone has to ‘cut prices’, ie, asset prices, interest rates and taxes; banks have to cut rates, while producers cut product prices. This will get earnings to grow and markets to revive, thereby attracting investment.

Once this principle is understood and accepted, coordinated action can revive construction and capital projects, and reverse consumer sentiments. Banks can devise creative solutions for stalled projects, as the reduced prices of assets, finances and taxes change the economics of projects. Otherwise sound projects that are unviable at 16 per cent can be profitable at 7-8 per cent, and more so with tax reduction.

For instance, developers who obtained funds without a price correction are grimly hanging on, with few deals. Projects that are halfway or nearly complete are stuck because of the exorbitant cost of funds. Banks, meanwhile, are putting their money into government securities. These are not only safe, but also appreciate as interest rates decrease. Banks are also parking funds with the RBI. If only policymakers heeded HDFC Chairman Deepak Parekh’s observation in early November 2008 to bring the reverse repo rate down to 2 to 3 per cent for some period. The RBI’s repeated mantra of standing ready to act — inject liquidity, reduce rates — is not of much use after a collapse. Action needs to be taken now, without waiting for more contraction in construction, manufacturing and new jobs.

The entire platform of inflated interest, tax rates and input costs needs to come down, facilitating lower prices and a revival of consumer sentiment, together with growth and productivity.

Fiscal action may be the most effective through tax cuts, given the dilatory nature of government expenditure and risk of misappropriation.* For specific suggestions, see ‘Cut income tax to avoid deflation’ (BS February 2, 2009), and ‘Making the stimulus package work’ (BS February 4, 2009). Unfortunately, December’s excise cut was squandered, as it was unaccompanied by significant interest rate cuts, limits on bank investments in government securities, and reduced asset prices.

What can be done at this late stage, as rates, taxes and prices were not cut months ago?** Start with interest rate cuts, because while inflation has dropped from 13 per cent to zero in eight months, rates have not been reduced enough.

Cut the CRR by 2-3 per cent (from 5 per cent)

A cut in the Cash Reserve Ratio by 2 per cent would make money available effectively at no cost to banks. The whinging about the cost of funds will be neutralized as ‘free’ funds to the extent of the cut will be available, ending the circular argument of lower-cost funds for lower-priced loans. Existing deposits at high cost need separate handling, as discussed in the conclusion.

Not having cut the CRR by 2 per cent last December, the opportunity for getting the same results by an incremental 1 per cent cut (ie, a cumulative 2 per cent) has been lost. After a couple of months, even these steps may fail.

Cut the repo and reverse repo by 2 per cent (from 5.5 per cent and 4 per cent to 3.5 per cent and 2 per cent, respectively)

Again, the opportunity for reversing sentiment has been vitiated by inaction and gradualism, by doing nothing or by cuts that were too small. While an all-or-nothing action calls for really drastic cuts, the coordinated strategy advocated here is likely to reverse sentiments, altering buying behaviour, enterprises earnings and markets. Some sectors like exports are going to be hit by external circumstances, but the domestic market has considerable room for growth in many sectors. This has to be exploited as world markets continue to spiral down.

Cut the bank rate/discount rate (currently 6 per cent)

This rate, used by the RBI to signal medium-term rates, has been at this level since 2003. With inflationary expectations dropping, and interest rates lower in most of the world, there is no rationale for this signal. Detailed calculations may indicate 4 per cent or less.

Allow banks to set savings rate with a floor (3 per cent?)

In keeping with the lowering of the interest rate table, the RBI could set a low floor on savings bank rates, while allowing banks to set their own rates.

Limit bank investments in government securities

Banks have to invest up to the statutory liquidity ratio in government securities; but the RBI should limit excess investment.

Small savings (Post Office) and PF rates

These rates need to be addressed at some point as part of the rate schedule.


Cutting rates, prices and taxes simultaneously will address several issues:

The chicken-and-egg issue of what comes down first — deposit rates or loan rates — will fix itself when (a) the opportunity cost of holding money rises for banks with a low reverse repo rate, and (b) there are limits on investment in government securities.

Banks should also be encouraged to develop creative solutions, like a conditional offer of financing to a real estate developer with a good programme except for over-the-top pricing. The offer could be like a variant of the facetiously termed ‘Saturday Night Special’, ie, a financing offer at a low rate valid for a limited period, conditional on an asset-price cut. The reduction in asset valuation could be whatever is estimated to make the project viable (eg, 30-40 per cent).

This implies ‘price cuts’ by the bank/s as well on their spread on high-cost deposits. Banks may find the higher volumes with lower net interest margins quite attractive. Across-the-board rate cuts will result in equitable allocation of credit, while protecting bank margins.

The risk of asset bubbles from overeager investors will be reduced, although the RBI needs to institute controls and disincentives, like increased margin requirements and higher rates for additional properties/projects.

Demand and growth are likely to revive with lower costs and prices, yielding higher earnings for enterprises, and higher government revenues.

* For instance, see: ‘Roads to nowhere’, India Today, January 30, 2009:§ionid=36&Itemid=1&issueid=91

** ‘The Burden of High Interest’, BS March 6, 2008:

'Factory output falls most in 15 yrs', BS February 13, 2009.