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.
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
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
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.
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.
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