Inflation Control Through Structural Reforms

Inflation will persist until supply increases.  Policies must therefore address supply through structural reforms, e.g., in telecom and power.

Shyam Ponappa / Dec 11, 2012

It’s ironic that when our economy finally developed a head of steam after many false starts, the sky fell in, as crony deals like the spectrum and land allocation scandals unravelled. A sizeable transformation of upwardly mobile consumption powered the transition from a laggard to global front runner, despite misgovernance. Now, the legacy of poor infrastructure, scams and an “Indian spring” – with many valid anti-corruption demands but impractical solutions – threatens to derail stability, severely damping productive activity. This jeopardises the very basis of our economic momentum: a burgeoning market. Assorted blunders add to the chaos, eg, judicial rulings that contravene the sanctity of contracts, and misguided institutional action, like the Reserve Bank of India ( RBI) trying to force the government towards fiscal responsibility instead of concentrating on providing stability and support for growth. This is aggravated by a government that does not seem to act in the public interest, and a frustrated Opposition that stalls governance and parliamentary proceedings.

The result is a marked inability, or unwillingness, or both, to act rationally and comprehensively on forward-looking, achievement-oriented plans — except to tide over crises, stay in power somehow, and capture the treasury for opportunistic ends. The Empowered Group of Minister’s ( EGoM’s) decision last week to merely reduce the 1800 MHz spectrum reserve price by 30 per cent where there were no bids is a good example. To see why, compare the end results that would best serve our common interests with the consequences of the government’s approach and actions.

What is the effect on inflation of butterfly wings or a hurricane in telecom? To decipher this, consider the drivers of inflation in India, and how such decisions affect them.

Supply constraints need structural changes in capacity and productivity

Our inflation is driven by increasing fuel and high-technology imports, with rising oil and coal prices and structural constraints on capacity and productivity — aside from expanding demand as purchasing power increases. (There’s also the import of gold, of course, possibly fuelled by lacklustre financial alternatives.) This shows up in a steadily depreciating rupee after August 2011, falling 25 percent from Rs 44 per dollar to Rs 55.

Some economists and foreign exchange advisors consider this as salutary, because India’s goods and services become more competitively priced. A weak currency can be advantageous up to a point, but only if it is exploited through competitive product and service offerings to yield sustainable profit margins. If, however, there is no complementary rise in capacity and productivity to capitalise on market access through the weak rupee, we end as we are today — where the disadvantages of essential imports with a weak currency outweigh the benefits of thin margins in low-productivity labour arbitrage.

Likewise, structural supply constraints remain intractable in the absence of increases in production. Increasing supply involves improving entire process chains: extension services and inputs for agriculture, market organisation and logistics, even changes to cropping methods such as alternatives to flooding rice fields. In other words, deep and sweeping changes in areas where we have not achieved them so far. The requirements for productivity improvement, likewise, are improved infrastructure such as communications services, power supply, storage and delivery including logistics and transportation — again, areas of weakness and inability to deliver that are mired in a policy stalemate, such as in power supply and telecom.

In short, inflation is likely to continue unless supply increases through improvements in production capacity and productivity. Therefore, waiting for inflation to fall before cutting interest rates to stimulate growth is futile. While rate cuts alone are inadequate, as there need to be structural solutions in parallel to build capacity and productivity, it is equally true that without integrated, synchronised initiatives in all these aspects, supply constraints will drive inflation.

Over the last two years, the RBI has shown the inefficacy of raising interest rates to combat inflation. It has only succeeded in slowing growth to a painful rate of under 5.5 per cent, contributing to our social pressures and turmoil. Instead of playing chicken and trying to stare each other down, the government and the RBI need to address growth in tandem, the former by eschewing fiscal irresponsibility and taking bold steps in the public interest, the latter by cutting rates, while introducing real-time systems for selective credit management to minimise misallocation and asset bubbles.

Decisions on spectrum as an example of structural reforms

The EGoM’s decisions on spectrum policy have major implications for productivity and user services for everyone, apart from the operators. Communications services are a basic enabler for effectiveness and efficiency. Increases in supply are facilitated once the infrastructure is in place. For this, we need supportive policies and incentives. Our spectrum allocation approach does not serve these purposes, because the growth in the sector has been largely of voice services and the delivery has been skewed in favour of remunerative urban areas while rural areas have insufficient coverage. This is partly the consequence of allocating narrow bands of spectrum that suffice for voice services but are inadequate for data delivery, and partly because of costs.

Auctions are inappropriate for developing economies like India because (a) they add to infrastructure costs in place of investment in service delivery; and (b) they lead to the fragmentation of spectrum for exclusive use that is contrary to what’s needed for data delivery. Our operators have an average spectrum holding of about 10 MHz, whereas they need at least 2x20 MHz.

Our policy makers seem unaware that new technologies for broadband need much more spectrum. Advanced data services are not possible otherwise, and rural users in nearly two-thirds of India will continue to be deprived of high-speed data access. A radical change in approach by sharing available spectrum will make broadband access much more feasible as well as cost-effective. This is the way to build productivity gains and distributed capacity for supply. The EGoM’s decision has to unleash this sector, instead of merely loosening a revenue-focused stranglehold.

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shyamponappa at gmail dot com 

Super WiFi & Shared Spectrum

A Time to Start Sharing Look into sharing spectrum and 'Super Wi-Fi', instead of auctions, refarming and exclusive allocation.

Shyam Ponappa / Nov 01, 2012

Amidst our preoccupation with internal problems of misgovernance, we’re losing track of long-term technical developments elsewhere.  For instance, there’s a buzz about “Super Wi-Fi” technology in other countries that's missing in India. Yet this could make spectrum abundant, while avoiding the problems of private allocation.  Here’s why India with its floundering, beleaguered telecommunications sector should stay abreast.

Super Wi-Fi using TVWS

The technology for unused TV spectrum bands, or TV White Spaces (TVWS), is referred to as “Super Wi-Fi”, although it doesn’t conform to earlier Wi-Fi standards, nor does it use the 2.4 GHz or 5 GHz licence-exempt spectrum. Super Wi-Fi has its own standards (IEEE 802.22, and 802.11 af in draft form) using 470-810 MHz, the “digital dividend” after conversion from analogue broadcast TV. It can be used for long-range rural broadband, and to improve short-range coverage. In the US, where it was pioneered, access is available without a licence to devices registered with a proximate geolocational database. Like regular Wi-Fi, Super Wi-Fi expands the use of available spectrum by sharing access.

The US is also permitting exploration of shared use in defence and security bands from 1755-1850 MHz, extending the potential for sharing spectrum.1

TVWS trials

Earlier this month, Singapore’s Infocomm Development Authority organised a workshop on TVWS with government and private entities. Organisers included the Institute for Infocomm Research (I²R) and other local participants, with presentations from companies from the US, Europe, Asia, and Africa, including Microsoft, Google, Spectrum Bridge, Adaptrum, Ericsson subsidiary Telcordia, Neul, Japan’s NCIT, and so on.2 Completed or ongoing trials are shown in the diagram below.

Super WiFi Trials

Source: http://www.microsoft.com/en-us/download/details.aspx?id=29678

TVWS and shared spectrum vs refarming

These developments should be of vital interest in India to policy makers, operators and users — not only for TVWS as a shared resource, but as an approach that could be extended to other bands, so that limited spectrum availability doesn’t constrain reasonably priced, high-speed data services. This is a serious limitation in India, unlike in other countries where a few operators have sufficient spectrum; in this sense, the need to share spectrum is much greater in India. For example, sharing could provide a better alternative to refarming of the 900 MHz band, allowing for both 4G and legacy uses.

One difficulty is that dominant operators may oppose sharing because their spectrum holdings provide a competitive advantage: possibly Bharti, Reliance, or an aspirant like Vodafone with access to inexpensive offshore funding. Our collective interests here, however, are likely to be best served not by constraining access through limited, exclusive spectrum, but by making spectrum abundant through sharing, allowing for wide bands (2x20 MHz or 2x40 MHz) that can be aggregated for much higher throughput for data, not just for voice.

For this to happen, (a) the government has to explore spectrum sharing in TVWS as well as in other bands, and (b) stakeholders must be receptive, to co-operate effectively on a workable plan on the lines of revenue sharing after NTP-99, extending to broadband delivery. Everyone will gain: users will get better access, operators can thrive, and the government will collect much more revenue over time. However, dominant operators will need to give up their spectrum for the greater common interest including their own, and for this, they will need compensation — as in production-sharing agreements in the oil sector.

The advantages of spectrum sharing

There are a number of advantages of sharing spectrum. First, and important, it can be non-discriminatory. Second, it avoids private allocation; shared spectrum can be accessed without allocation to private parties. Then there is the fact that capital cost is reduced. There is no deadweight loss from capital tied up in auctions, freeing it all for network development and service delivery. Finally, there’s the general misinformation about auctions, which become academic if spectrum is shared. If spectrum is instead auctioned, the public interest – of users, operators and producers – will be adversely affected. (On producers, while local manufacturing is currently insignificant, there is considerable scope if it is set up right, as telecommunications equipment imports are expected to exceed energy imports in a few years.)

The Supreme Court was misinformed about auction fees exceeding revenue-sharing collections, and not informed of its detriments. As evidenced after NTP-99, networks and services proliferated, resulting in much higher collections than auction fees foregone. The Supreme Court’s opinion on the Presidential Reference clarified that auctions were not mandatory for other resources, but not for spectrum, although the reasoning is the same. This needs rectification if spectrum is not shared, because revenue-share collections and tax revenues on profits from more extensive networks and services are likely to far exceed the estimated auction fees of Rs 40,000 crore over three years, quite apart from the major public benefits of access.

Space for constructive decisions

Another requirement for constructive resolution is that policy makers be given the requisite space to frame solutions that are genuinely in the public interest. These solutions can be premised on abundance if it is possible, rather than artificial scarcity and rationing. At present, the Telecom Regulatory Authority of India, the Department of Telecommunications, and other authorities including the Empowered Group of Ministers are under immense pressure to favour aggressive government collections, instead of what might be genuinely beneficial. This is an odd consequence of the government’s increasing loss of credibility, resulting in the rise of populists, “profit haters”, and ignorant-yet-opinionated sceptics. Uninformed attacks on constructive approaches and alternatives need to be presented and seen in a more balanced way by an informed media, press and public, instead of being fuelled by indiscriminate hype.

Also, we have to learn to distinguish between problems of ideological conviction – those that can be solved through political accommodation – and engineering problems, like network design and service delivery at least cost. Resorting to political accommodation for engineering requirements results in malfunction and/or collapse.

A good way to proceed is to ensure sharing solutions are worked out without incurring exorbitant cost — not only for TVWS but also for legacy operations, such as in the 900 MHz band. These can induce new network build-outs for data services in urban as well as underserved rural areas, and broadband service delivery across the country.

shyamponappa at gmail dot com 


1: Other bands being considered for sharing in the US are:
1695-1710 MHz & 3550-3650 MHz; Unlicensed: 5350-5470 MHz & 5850-5925 MHz.  For details, see: http://news.cnet.com/8301-1035_3-57529959-94/defense-department-pushes-spectrum-sharing-as-solution-to-wireless-crunch/

2: http://whitespace.i2r.a-star.edu.sg/TVWS_Workshop/Programme.html

Details on the UK (Cambridge) trials at: http://www.cambridgewireless.co.uk/docs/Cambridge White Spaces Trial - technical findings-with higher res pics.pdf

The Supreme Court Delivers

Now, the spectrum and licence issues need resolution

On September 27, 2012, the Supreme Court of India delivered the opinion of a bench comprising five Judges on the Presidential Reference regarding the auction of 2G spectrum.

Shyam Ponappa / Oct 04, 2012


The Supreme Court’s opinion on the Presidential reference* dismissed two preposterous claims. One is that it is beyond the ambit of Parliament and the government to formulate economic policies. The second is that the government must allocate resources only through auctions. It’s like the end of a self-destructive nightmare. True, our heedless kleptocracy as a society of rogue politicians, bureaucrats, defence personnel, and complicit citizens, led to this pass. Even so, the anarchic “destructionism” of these claims is as reprehensible as the kleptocracy they seek to tear down. Fortunately, the Supreme Court opinion rose above the populist clamour.

There’s still a mess to clear. The big picture is that the Supreme Court left its decision on spectrum auctions unaddressed. In matters of detail, some points need resolution based on facts. These are discussed below to dispel prevalent myths.

Myth 1: Auctions maximise govt revenues

“Auctions may be the best way of maximising revenue…”: paragraph 116 of the opinion. This contravenes the evidence after the National Telecom Policy -99 (NTP-99), that revenue-sharing maximises government revenues as well as public benefits. It also ignores the many auction failures.

Consider the evidence: auction revenues foregone were estimated at under Rs 20,000 crore for 1999-2007, because the sector was mired in losses and was unable to provide services effectively or pay those dues. By comparison, actual collections from revenue-sharing by March 2007 were more than double, at Rs 40,000 crore. Collections by March 2010 were Rs 80,000 crore. Current annual contributions to government revenues may be about Rs 18,000 crore on Adjusted Gross Revenues estimated at Rs 1,40,000 crore, plus taxes, amounting to perhaps Rs 36,000 crore.

Re public benefits, access to telephony grew from a few million users in 1999 to about 700 million today (excluding around 250 million shadow subscriptions).

An ameliorating caveat in paragraph 12 states: “…if the State arrives at the conclusion … that maximum revenue would be earned by auction of the natural resource in question, then that alone would be the process”, and this is expanded in paragraph 119:

“Where revenue maximisation is not the object of a policy of distribution, the question of auction would not arise. Revenue considerations may assume secondary consideration to developmental considerations.”

This has not prevented erroneous conclusions in the press that auctions are the only valid process, notwithstanding that the conditions stipulated in the order, eg, that government’s actions be “fair, reasonable, non-discriminatory”, were always operative, if not adhered to in instances of abuse, as in the 2G scam.

Myth 2: Maximum govt collections are in the public interest
Government collections as the public interest criterion may work for colonial powers extorting revenues from subject states, or possibly for utopias whose political economy is so balanced that such cross-subsidisation works. Developing economies like India presumably can and should seek the welfare of their people. The same populists crusading for maximum government collections accuse governments of corruption and waste. This doesn’t provide a coherent approach to infrastructure, where each capital-intensive sector is configured to deliver a specific service. For instance, the energy sector has to deliver power, while telecommunications must deliver communications services. Neither can be expected to deliver toilets or water. Yet, many well-intentioned people seem to nurture such irrational expectations.

The spectrum and broadband link

The first prerequisite for broadband is high-speed connectivity. The second is reasonably priced services. Our objectives are, therefore: (a) a broadband network, (b) available anywhere (c) at reasonable prices. Our networks are deficient, however, particularly in rural and semi-urban areas. A host of factors are responsible, ranging from limited public sector network rollout, combined with a private sector focus on the most lucrative urban centres, with incentives skewed to voice telephony. Applications need connectivity based on networks that require spectrum.

Problems and solutions

Consider an application like distance education. The need is for networks and services of high quality (followed by the additional requirement of content). What is apparent is that such applications cannot be effective without the connectivity. So we’re back to the need for networks, of fibre where feasible, and wireless elsewhere. This brings us back to the need for spectrum.

Reviewing facts

As regards the facts relating to the 2G judgment deserving review:
The solution the Supreme Court has not considered is that operators need only to use spectrum, for which they can be charged a fee. The evidence of widely available Wi-fi shows that innovation and usage thrive if spectrum is available. The Supreme Court, the government, and the public need to recognise that allocating spectrum to operators is only one way to use spectrum.

There need be no alienation of spectrum at all, if policies allow open access and charge fees. Then, spectrum could be used like any infrastructure network, eg, airports, highways, or rail, on payment of usage charges. The sharing could be in at least two ways. Operators could pool spectrum for collective use. For this, (i) regulations must allow pooling/active facilities sharing, and (ii) operators must agree on terms and procedures. Another way is for mandatory spectrum sharing using the database-driven systems being implemented in the US by Spectrum Bridge and Telcordia. Similar deployments are planned in the UK, the European Union, and in Singapore. The TV white space is shared because this range is available for sharing, and not because other bands cannot be shared.

There are immense societal costs of duplication in capital investments in multiple networks, including the last-mile spectrum access, of operators using dedicated networks with limited passive facilities sharing (such as towers), compared with the benefits of open-access to common networks, if policies changed. These would employ active facilities sharing (equipment, and not just construction) to reduce capital equipment, construction costs, energy for towers, carbon emissions from a more limited physical network, possibly reduced radiation from a rationalised network with small cells with lower-powered equipment, and the multiplier effect on the finite available spectrum.

Enormous productivity benefits could accrue through ICT applications in infrastructure such as smart grids for energy, transportation, education, healthcare, and government services, as well as many commercial applications.

The Supreme Court could also uphold contractual obligations, by discriminating against actual transgressors in the 2G spectrum allocation, while rehabilitating those who operated within the law.

  
shyam[no space]ponappa at gmail dot com 


* http://supremecourtofindia.nic.in/outtoday/op27092012.pdf  Changed - corrected below

* RE: SPECIAL REFERENCE NO.1 OF 2012

[Under Article 143(1) of the Constitution of India]

SEPTEMBER 27, 2012

[S.H. KAPADIA, CJI, D.K. JAIN, JAGDISH SINGH

KHEHAR, DIPAK MISRA AND RANJAN GOGOI, JJ.]: 

supremecourtofindia.nic.in/pdf/SupremeCourtReport/2012_v9_pii.pdf  Changed - corrected below

https://main.sci.gov.in/judgment/judis/39596.pdf 

Changing Our Game

Adopting 'co-ordination models' like the Stag Hunt instead of pursuing narrow self-interest helps reduce contention and improve outcomes.

Shyam Ponappa / Sep 05, 2012

Consider the handling of irregularities in spectrum allocation and in coal mining rights. Instead of swiftly ring-fencing problem areas where there are allegations of culpability supported by prima facie evidence, then striving for good policies going forward, the ruling coalition and the Opposition are in a war of attrition. What began with the United Progressive Alliance’s turning a blind eye to the spectrum awards has turned into the Bharatiya Janata Party’s heedless flailing to tear down their opponents. Meanwhile, the confusion created by the pronouncements of the Comptroller and Auditor General and previously of the Telecom Regulatory Authority of India has vitiated conditions for constructive reform. Any solution that fails a populist screen is likely to be guillotined in the streets.

Contention versus co-operation


There seems to be quite a contrast between our manifest contentiousness and our apparent friendliness. From our chaotic ways in traffic to dealing with each other and with our surroundings more generally, often, self-centred, short-term opportunism appears to override our better nature. As evidenced in the coalgate stand-off in Parliament, or our inability to establish adequate infrastructure, this cuts across all levels of individuals and groups. The irony is that no one gains, except the perpetrators and supporters of rip-offs and stand-offs. They, too, gain only in the short run, unless they’re not caught out. In the long run, everyone is worse off except the rogues who get away.

How did we get to this self-destructive state, and how might we get out? Insights from game theory could provide some perspective. One stark fact is that our interactions are predominately driven by self-interest that leads to contention, on the lines of a Prisoner’s Dilemma,1 instead of a co-operative group- or common-interest model like the Stag Hunt.2

The two models are described briefly below.  For those who want to skip the description, read on after the next two paragraphs.

Prisoner’s Dilemma

Two men attempting a burglary with a weapon, A and B, are caught, with insufficient incriminating evidence for the burglary. They are questioned separately and not allowed to communicate. If both deny the burglary, they escape a 10-year sentence and will be imprisoned for two years for possession of a weapon. A is told separately that if B pleads guilty and A does not, B will get a reduced sentence of four years, while A will get 10. So A has an incentive to confess and get four years, too. A is also told that if he confesses, he can go free, while B gets 10 years. Therefore, the logical choice for A is to confess. The same logic applies to B. So, both confess and get four years, instead of both denying and getting only two years. The logical trap is that acting in one’s self-interest without communication and co-operation leads to a worse position.

Stag Hunt

A group of hunters agree to wait for a stag in their assigned positions. If one sees a hare and shoots at it, the stag takes flight and the group loses out. The group and individuals gain most if individuals stick with their commitment and get the big prize. However, individuals may be tempted to defect by a less risky, smaller pay-off like a hare.

[The original story implies that hunters must stay in their positions.  If they are tempted to chase after a passing hare, the hunt fails (if the stag comes by their post).]

Logical trap: Self-interest leads to contention and lowest equilibrium

In zero-sum games like cricket, tennis or football, where the total pay-off is the same no matter who wins, one participant gains at the expense of another. In most real-world encounters, however, players can improve their outcomes by co-operation and co-ordination. In other words, many everyday situations can be likened to non-zero-sum games, where one party’s win is not necessarily another’s loss. If individuals (or teams/groups) pursue their self-interest without co-operating and co-ordinating with other players, the pattern is like the Prisoner’s Dilemma, and a logical trap leads to a position of lowest equilibrium (the Nash Equilibrium). This position results from each player/group making the best decision that he/she/they can while taking into account the decisions of the others, and no one can act independently without worsening their position.

Co-ordinating better outcomes

By contrast, if players can (a) co-operate and (b) decide through effective co-ordination, everyone gains. Examples are centrally sponsored projects executed in Opposition-run states – for highways or power, for example – or the backing of political parties for India’s 123 Agreement with America on nuclear co-operation.

Can we escape a logical trap and contention by adopting models that elicit co-operation and co-ordination? Game theory suggests that models based on trust and co-ordination like the Stag Hunt work for a big prize (the stag). The question is whether it is possible to move to a co-ordination model and, if so, how to do it. While there are no simple fixes, the University of Vienna’s evolutionary game theory models hold out some promise through providing insights into how patterns of co-operation can spread in populations.3

There’s also the long, slow haul of structured education and training in collaborative problem solving. The techniques that need incorporation in our curricula from junior school through higher education, vocational training, and at work, are co-operative problem solving as an approach, and project management as a method. The latter starts with a clear definition of goals and objectives, followed by standard operating procedures covering the gamut of the logic of process flow for tasks, setting milestones/sub-objectives, critical paths, and individual and group responsibilities on timelines.

A second aspect where governments have to step in is institutional design — boldly initiating systems and processes after eliciting convergence in each sector from all stakeholders on sound plans in the public interest. Driven by goal-directed project management, this requires systematic action braving populist pressure and distractions.

These initiatives would significantly improve India’s ability to act in the public interest.

---

shyam (no space) ponappa at gmail dot com

1 http://en.wikipedia.org/wiki/Prisoner’s_dilemma

2 “The Stag Hunt and the Evolution of Social Structure”, Brian Skyrms, 2004: http://bilder.buecher.de/zusatz/22/22362/22362426_lese_1.pdf 

3 VirtualLabs, Christoph Hauert: http://www.univie.ac.at/virtuallabs/ 

[Since moved: http://wiki.evoludo.org/index.php?title=Evolutionary_Games_and_Population_Dynamics]

Evolutionary Dynamics – Cooperation and Defection - from the link below:

Cooperators provide a benefit to other individuals at some cost, while defectors attempt to exploit such common resources. This leads to a classic conflict of interest between the individual's and the community performance - and hence the dilemma. The game dynamics then determines the relative frequencies of the different strategies in a population.

 

Decision Analysis for Interest Rates - II

India needs to make practical choices that prioritise growth Shyam Ponappa / Aug 02, 2012 A UN report last June stated: “…the increasing independence of central banks, tighter monetary policy, and inflation-targeting regimes, unnecessarily high — and sometimes, pro-cyclical --policy interest rates were probably one of the most important contributors to the worldwide slowdown in growth...”1 The economy is slowly grinding down as high interest takes its toll. While fear of inflation is understandable, demand-side resolve will not help our supply problems. Surely monetarists also see growth as being dangerously low for India, with its large, explosive, not-so-well-served, -educated, nor -prosperous population? Focusing on anything except growth as the highest priority is a mistake we cannot afford. Everything else depends on it, whether it is feeding people, clothing them, providing livelihood, sanitation, shelter, electricity, social stability, even law and order. My previous column (Business Standard, July 5, 2012) explained how lower interest rates could improve growth by increasing net profits. The purpose was to demonstrate the application of decision analysis through simulation, using financial process-flow logic. The question addressed was: what happens if interest rates are lowered in the present circumstances? Answer: profits would rise, reviving growth through higher income, employee compensation and taxes, with more savings and investment. Consider what might have happened. In March 2012, net profit was 8.8 per cent of total revenues for 2,840 companies.2 This would have risen to 11 per cent by June if interest costs fell 20 per cent per the example. With some reduction in raw-material costs, net profit could have risen further. What actually happened?  The RBI held firm, and net profit stayed about the same at 9.1 per cent (+0.3) for the quarter ended June (711 companies reporting by July 30, roughly 25 per cent). This was despite revenues dropping by about 3 per cent, higher taxes (0.4 per cent), and interest costs rising from 11.1 per cent in March to 17.3 per cent, as expenses dropped by 7 per cent with big cuts in inventories. Commentary Some issues in responses to the earlier article are outlined below, assuming an understanding of finance and awareness of economic history. 1. Straw-man arguments: Zero rate or 100 per cent debt Some readers asked, why not a zero rate? Answer: misallocation and lower productivity. Others asked, why not 100 per cent debt? Answer: bankruptcy risk. Still others suggested that providing support to business was not the only requirement. This is addressed above in growth being the highest priority. Reducing rates from current levels does not mean dropping to zero, nor ignoring prudential norms for debt/equity. Our goal is presumably sustained growth, not volatility with risk. Near-zero rates are known to create problems through misallocation, asset bubbles, and reduced productivity, e.g., in Japan, the USA, and the UK. However, Switzerland used low rates to tackle an overvalued currency in the late 1970s. Low rates induce a propensity to higher debt. This is because of a tendency to misconstrue the Modigliani Miller theorem, viz., that a firm is valued by the earning power of its assets and their risk unrelated to capital structure, to mean that high leverage has no adverse consequences. The lower the rates, the more the temptation to leverage, and the greater the risks. 2. The “correct” interest rate If rates were cut, what figure would be “correct”? Instead of a search for the perfect mathematical step, it is much more important to act in the right direction. Simulation helps to establish an appropriate range. Within that range, the rate is less important than that it’s a significant cut in these circumstances (1 per cent?), while not being too drastic. This is not a theoretical search for a perfect rate, but a pragmatic step to induce growth, for India to regain its investment destination status. The idea of a closed-form point estimate that is “correct” is misplaced, because correctness depends on circumstances, timing, and cultural/emotional/political responses, i.e., animal spirits. Simulation helps in exploring the range of probable outcomes for causal factors. Each factor has its own probability distribution, sometimes contingent on others (a Markov chain), yielding a range of probable outcomes, and not a point estimate. 3. The RBI intended to slow growth One view is that the RBI slowed growth in the hope of containing inflation. Therefore, criticising it for achieving the intended result serves no purpose. Surely the intention was not to slow to this extent? Other critical issues: Processes for growth -  Apart from lower interest rates, certain fundamental processes also need to be addressed with undiluted focus. These are goal setting, prioritisation, and coordination. a) Goal setting: Capital requirements India needs capital to grow, from both domestic and foreign investors. Paradoxically, growth is a critical prerequisite. If this is seen as greed or sophistry, let’s devise a better plan. b) Prioritisation:  Growth is the first requirement, as everything else depends on it. c) Coordination:  Effective coordination is the key to achieving growth. This is exemplified by the current state of electricity distribution, despite the addition of 20,000 Mw of capacity last financial year, mostly stranded, with the supply of coal supposedly being addressed, but without positive results. -  Real interest rates (and growth) In addressing these processes, one problem is conflicting information, for example on real interest rates. Does India have negative rates as some claim? The chart above shows World Bank data until 2011, with India’s generally higher rates. -  Food inflation (and growth) Food inflation is constraining interest rate cuts. The RBI’s statements and some commentators’ remarks lamenting that food inflation prevents rate cuts epitomise a misapprehension about supply and demand that sorely needs resolution. A recent study covering four states (Bihar, Punjab, Uttar Pradesh, West Bengal) suggests that rainfall drives agricultural output in Uttar Pradesh and West Bengal.3  The report concludes that supply side problems primarily affect food prices, not fluctuations in demand.  Add supply constraints from inadequate infrastructure and distribution processes, and it is clear that high interest rates cannot possibly solve the problem of food inflation.

                                                                                       

                                                                                           

                                                                                                        shyamponappa at gmail dot com

1: “The Scorecard on Development, 1960-2010: Closing the Gap?”, Mark Weisbrot and Rebecca Ray, June 2011:http://www.un.org/esa/desa/papers/2011/wp106_2011.pdf 

2: http://www.moneycontrol.com/earnings/ 

3: “The Curious Case of Indian Agriculture”, Nilanjan Banik and Basudeb Biswas, April 28, 2012:http://mpra.ub.unimuenchen.de/38634/1/MPRA_paper_38634.pdf

Comments

Posted by: Srinivasan	August 02 , 2012, 08:54 IST
Looking at just Growth and getting huffed up and puffed up on this single account is very myopic. What if we reduce and make a short-term weak recovery but throw the Indian economy into a tailspin over the long term! So my suggestion - develop stereoscopic vision look intensely at the drawbacks as well. With India having a currency devaluation of almost 15% recently (48 to 55.50), it will be dangerous to reduce rates as suggested by the author. In fact i would like to cry hoarse in return - If you want to save the Indian industry and economy, please raise the rates by 100bips! Now! Posted by: Rajesh August 02 , 2012, 08:38 IST Mr Ponappa says that low rates are risky but lower rates are Ok. He still leaves a cloud hanging over his arguments. Is 25bips acceptable risk and 100bps dangerously risky and 200bips Depressionally risky. It would take a moment to reduce rates but if the implications/harmful side effects are not mapped out precisely and properly we might have to repent at leisure for this hasty action. Serious work should have the look and feel of research and NOT give the impression of desperate policy sloganeering.   Posted by: Rajesh August 02 , 2012, 13:35 IST 1st sentence should read - Mr Ponappa says that, Lowering rates is Ok and in fact desirable, but lowering rates beyond a threshold might become counterproductive and quite risky. Posted by: Akhil August 01 , 2012, 22:56 IST No need to get worked up. This growth decline is the direct result of reduction of crony capitalism because of the pressure of media attention. This is especially true of the mining sector. Govt should focus on reviving crony corrupt capitalism which favors Big Business houses and ignore the people. As soon as the extraction mega profits get logged the growth figures will also start showing a distinct improvement. Handing mines on a platter at no cost provides the great incentive to miners who then extract as fast as possible. Which improves growth even if public assets had been handed out for a pittance. Posted by: Vivek August 01 , 2012, 21:47 IST In view of the currency devaluation should we not instead be raising rates? I think a more sophisticated and comprehensive analysis of the situation should have beeen made by Mr Ponappa. It is not as if the RBI is peopled by dumb no-brainers. They are smart and are aware of all the simplistic arguments advanced by Mr Ponappa. And yet have to balance it with other equally important concerns.

Decision Analysis for Interest Rates

The discipline of systematic evaluation through applying process-flow and decision analysis -- in this example, of financial logic -- can help make reasoned, practical  decisions, whether for interest rates, or for resolving issues in power supply, or in telecommunications, spectrum and broadband.

Shyam Ponappa / Jul 05, 2012


Several analysts applauded the Reserve Bank of India’s (RBI’s) resisting cutting interest rates despite declining growth. Some quoted monetary theory to justify this; others praised the regulator’s standing-up-to-government stance. Meanwhile, the nation groaned, waiting for relief. Is this just the vaunted animal spirits in reverse, that perceive a half-full glass as half-empty? Or is there substance to the frustration of those who function in the real-world marketplace, who deliver products or services and expect rational solutions?


Simulation using financial logic


There is a systematic approach to evaluating alternatives for the cost of money and possible outcomes, using decision analysis and the process-flow logic of finance. Figure 1 shows the quarterly results for 2,840 companies from their income statements on March 31, 2012. The first column shows the amount for 


Figure 1


each item in crores; the second shows each item as a percentage of total revenues including other income. Consider the expense in the interest and net profit columns, shown in the second column as 11.1 per cent and 8.8 per cent of total revenues.

Total revenues for these companies grew about nine per cent from December 2011 to March 2012. Assume conditions remained the same for the next quarter to June 2012, except for one item: the RBI cuts the repo rate by 20 per cent, so interest expense amounts to 8.9 per cent. Revenues grow as in the previous quarter – because conditions are turbid, to say the least – by nine per cent, and the only change in costs is the drop in interest expense to 8.9 per cent. 

The results would look as in Figure 2 for June 2012 (ignoring the change in tax 


Figure 2

for simplicity). Note net profit, which was at 8.8 per cent in March 2012, increases to 11 per cent in June 2012. If nothing else changes for the year, no costs, no animal spirits, net profit in succeeding quarters will be 11 per cent instead of 8.8 per cent of revenues.

Now consider the further effects of the ongoing drop in raw material prices. If raw material costs were to reduce so that expenses fell by, say, five per cent, total expenses would fall from 75.2 per cent to 71.5 per cent of revenues, and net profit would grow from 11 per cent to 14.8 per cent of revenues. In other words, in one quarter, this reduction in interest cost could take net profit from 8.8 per cent to 11 per cent — and, if it were possible to capture the drop in input prices, even to 14.8 per cent of revenues. Figure 3 shows what June 2012 would then look like.

Figure 3

This example involves no hypotheses or theories; just arithmetic. The reality is likely to be different, because there will be changes like the extent of pass-through of a cut in RBI rates, inflation, the extent of labour troubles, seasonal effects on sectors that affect buying, production and so on. The purpose of this example is to show that a reduction in borrowing costs would yield higher profits. These profits could enable companies to muster cash and borrowings to capitalise on falling raw material prices, as they have in the past. To the extent that they can do this, net profits would increase, resulting in increased GDP because of increases in corporate and proprietary income, employee compensation, as well as higher tax collections and increased investment.

Global factors


Another level of complexity arises from global responses to these developments in India, assuming for the moment there are no major negative global events. How are investors likely to respond to higher growth in India in the context of problems with stranded power generation, choked logistics, resurgent populist activism with a weak Centre and assertive states, and uncertain telecommunications reforms? Will a reduction in oil prices translate to lower or higher inflows from foreign institutional investors? And so on. The denouement of developments in Greece, Spain and Italy may affect India significantly. Likewise, developments in America will also have significant effects. The point to consider, quite simply, is this: if profits increase, investment is also likely to increase. Would we rather be dealing with these circumstances from a position of relative strength, or of comparative weakness?


Financial logic: Models

It is not clear whether analysts and practitioners, including the RBI, used planning models based on the process flow of financial logic to test their assertions. For instance, for realistic scenarios based on recent circumstances, what are the likely outcomes of increasing interest rates, holding them steady, or, as in the example above, reducing them? Or are such models considered too simplistic? The logic can be evaluated in the process flow, and the possibilities laid out in a decision tree with likely outcomes. Probabilistic forecasts can be input as distributions linked to probabilities to analyse probability-weighted outcomes instead of simplistic point estimates, before deciding on the appropriate action.

This process of decision analysis can be usefully applied not only for interest rates, but also for resolving problematic issues in electricity supply, or telecommunications, spectrum and broadband policies. A second element that is useful for result-oriented decision making in intractable areas like power supply and telecommunications is participative problem solving, as in the process that led to the successful breakthrough of the New Telecom Policy, 1999. If the government and stakeholders adopt this approach, prospects of a higher growth trend may indeed be realised, despite the doubts being expressed about higher sustainable levels.

                                                                   shyamponappa at gmail dot com




Discussion Board/User Comments

Posted by: Rajesh	July 05 , 2012, 00:53 IST
Hits the nail on the head. But in his timidity the writer stops short. The argument needs to be taken to its logical conclusion. If the Interest Rates are cut by 100% the Net Profit would jump from 8.8 to 20%! The corporates would become extremely successful probably without any cost to anyone else. It is this Greenspanian easy money vision which led to the unparalleled boom of the last decade. Companies would make profits with tremendous ease and then might sit on ash as they continue to do even now in the US. How much of it will get passed on to customers and employers depends on many other competing pressures. After 'Interest', corporates can then concentrate on reducing the other major cost component Taxes Similar "arithmetical" arguments can then be brought on for reduction of Taxes as well.

SP's response @Rajesh:
It helps to study the domain a little before arriving at a conclusion -- e.g., the zero rate regime in Switzerland, and the contrast in Japan, the US, and the UK, versus the approach of Germany (not close to zero, better recovery), etc.  Also about the balance of debt and equity -- the Modigliani-Miller Theorem, which if construed to mean that more debt is better, leads to the abyss, as in the collapse of Long Term Capital Management: http://en.wikipedia.org/wiki/Long-Term_Capital_Management; http://www.nytimes.com/2008/09/07/business/worldbusiness/07iht-07ltcm.15941880.html

	Posted by: Mukul	July 05 , 2012, 13:59 IST
	Good one, Rajesh!
		Posted by: Rohit	July 05 , 2012, 12:13 IST
	How smart! Why stop at zero percent interest rates. Why not go negative. Borrow Rs 100 and return only Rs 50 surely that will provide an even greater fillip to businesses. If providing fillip to businesses was the only concern of this great democracy, and if interest rate reduction has no attached price then we must go steeply negative. Even to the point of saying to businesses borrow Rs 100 and return Re 1, just as a symbollical repayment. Posted by: Akhil July 05 , 2012, 13:43 IST In our debates we should not just be talking about Growth like immature overeager schoolboys. We have to move beyond arithmetic to wisdom and start considering the dreaded possibility of "Collapse" or at least unaddressable "Disaster". One just has to look to US & Europe to understand the horrible danger of emptying one's monetary quivers in good times and being emptyhanded in cyclical downturns. When a desperate obsessive greediness prompts an addict to increase his drug dose in order to increase the intensity of pleasure. Shots start losing effect and increasingly greater doses have to be pumped in to just stay put. At that point the downward slide to hell begins. Posted by: Srinivasan July 06 , 2012, 01:41 IST I was following your last article in the Business Standard "Decision analysis for interest rates" and its Discussion Board/ Reader Comments. As i see it what started out as a very simple "aritmetical" clearcut argument regarding the appropriateness of rate cuts is now getting revealed to be a considerable oversimplification where no easy conclusions are possible. In fact you had to promptly abandon your "aritmetic" and run for shelter to Modigliani-Miller which has stood for long but is now severely critiqued for several reasons among others by Stiglitz. Lots of qualifications and yes-buts have been omitted by you. I sincerely believe that you are a serious scholar and not a Policy cheerleader? Why then were you simplifying arguments so much? To the extent of saying the case for lowering rates is a no-brainer just pure "arithemtic". Intriguing? Maybe if you had just used the metaphor of poison which in the right doses can be a medicine? It wouldn't have been so clearcut as your "aritmetic" metaphor but would have resulted in a closer understanding of the facts? SP's Response @ Srinivasan I think you have misunderstood my article, and my explanation re one comment – by Rajesh – so let me try to explain again. I stick by my simple arithmetic example, by the way, and I do think it makes sense for India to have far lower interest rates now.  Even 8.88% is far too high, in my view, with appropriate selective credit regulation mechanisms in place (which we don’t have yet). As I mentioned, it does help to study/know something about the subject/s before coming to one’s conclusions.  The subjects include the domain of finance (e.g., Modigliani-Miller, the financial logic of P&L -> Balance Sheet -> Cash Flow -> GDP, tax and investment) and economic history, as in the case of Switzerland’s successful use of zero rates to combat an overvalued currency, contrasted with the less successful attempts in Japan, the US, and the UK.  Also the discipline of process flow charts and simulation models, i.e., don’t simply make assertions; show how it works in practice. What you saw as my abandoning my arithmetic example is in fact my trying to explain how complicated it gets if one takes the point simplistically to assert a straw man fallacy, e.g., if a low rate is better, why not reduce rates to zero, or negative?  Why not maximize debt to 100% -- this is where Modigliani-Miller comes in.  Because either choice will end in bankruptcy.  You may be aware of two other Nobel winners, Scholes and Merton, who founded Long Term Capital Management, and because of overleveraging, bankrupted it. Does that mean one must maintain high interest rates in India because of the existing inflation?  I think not, because I think inflation here is driven by inefficient production and supply, not lack of potential for supply.  Therefore, I think the way to contain inflation is to improve productivity to increase supply, not mess with interest rates, money supply, and demand (as has been seen to fail so far here). I also think that at our stage of development, India has to grow a lot (over 6% or more) to just get by.  We have to grow at 8-10 percent for many years together to be able to afford to put in place the systematic infrastructure that we need to be a productive, competitive nation as a whole. I do not subscribe to any economic doctrine, such as monetary theory.  Therefore, I disagree with monetarists who say that the RBI should hold rates or raise rates – like Arvind Subramanian, Rajeev Malik, Ila Patnaik, Ajay Shah -- not because I don’t know the theory or haven’t applied my mind to it, but because I think doctrinaire views do not reflect the facts.  I subscribe to the discipline of systematic analysis of data as in the example, and not the position: ‘don’t confuse me with the facts; this is what the theory says’. Your poison metaphor is apt; anything in excess is a poison, and it applies perfectly to debt (too much) and interest rates (too low).  However, my aim in this article was to show that the discipline of systematic evaluation through applying process-flow and decision analysis -- in this example, of financial logic -- can help make reasoned, practical  decisions, whether for interest rates, or for resolving issues in power supply, or in telecommunications, spectrum and broadband.  In that sense, I am not oversimplifying: I believe the RBI should cut interest rates.