Reviving Growth

Reduce interest rates and undertake specific reforms to revive growth

Shyam Ponappa / September 1, 2011

India’s heady economic prospects of a year ago have deteriorated unthinkably. True, the rest of the world is wobbly, too, from America’s unreconstructed and unsustainable headlong decline, to much of Europe’s companion piece. But the possibility of some buffering for India seems to have evaporated. Expectations of better prospects were not so much from decoupling as from our limited dependence on exports, and headroom from activity levels with enormous scope for improvement and expansion — in basic infrastructure, housing, second-order infrastructure like education, sanitation and health care, as well as manufacturing, tourism and retail.

Rising input costs and interest rates started the decline in margins, and self-destructive actions made matters worse, epitomised by the implosion of the scams (2G, the Commonwealth Games, the Karnataka mining scandal, the land scams…). The Reserve Bank of India’s (RBI’s) actions of increasing interest rates when faced with inflation caused by factors beyond its ambit, such as food prices rising because of supply constraints, or energy prices on account of expensive imports, have amplified the negative sentiments.

The Bogey: Growth versus Inflation

The economy is slowing, and earlier estimates of well over nine per cent growth for 2011-2012 have gone overboard. In May, the Federation of Indian Chambers of Commerce and Industry’s estimate was nine per cent; in August, an RBI survey consensus was under eight per cent; Morgan Stanley’s was barely over seven per cent. Yet, policy makers maintain that despite the deleterious effects on growth, raising interest rates to control inflation through monetary policy is paramount.* In absolute terms, the need for controlling inflation is incontestable, but societal needs provide an exigent imperative for making the trade-off in favour of growth. The consideration now needs to be of steps that could alleviate the slowdown, and the likely effects of such actions not only on inflation, but also in collateral damage to economic activity.

Consider India’s shortcomings, namely, insufficient food production and associated storage and distribution, inadequate agricultural extension support services, expensive oil and coal imports, and lack of educational and vocational training facilities for a burgeoning, youth-dominated population. Add another level of inadequacy arising from our continuing lack of infrastructure, from basic sanitation, water and health care, extending through energy, transportation and communications (broadband). These structural bottlenecks exacerbate the negative aspects of our predicament.

The government’s recalcitrance in acting against blatant corruption until the scams erupted had already unsettled markets. Even salutary developments like Anna Hazare’s anti-corruption movement have added to the destabilisation, through attacks on parliamentary processes and the prospect of a breakdown in law and order.

Against this backdrop, we have a slowing economy, now threatened by a global slowdown. In the quarter ending March 2011, a third of the Sensex companies had missed their earnings estimates, while in the last quarter ending June 2011, nearly half of them were below estimates. With offshore revenues estimated to contribute nearly a third of FY12 profits, the threat of a global slowdown is ominous.

Inappropriate Rate Hikes

From this perspective, raising interest rates to combat inflation appears decidedly ill-advised. As expected, interest rate increases have not reduced inflation. The reduction can happen only when economic activity slows so much that demand for essentials falls, a horrific prospect. As for attracting foreign investment, rate hikes do little to induce confidence in foreign investors in skittish times, because they look to India and emerging markets for growth, not for stability. To be a safe haven, India has to be perceived not as a developing economy, but as an equivalent of the Organisation for Economic Co-operation and Development — a long way and many years ahead.

The economy, therefore, needs shoring up. Can the RBI and the government take steps to reverse the decline? Consider the following corrective actions:

(i) Reduce rates to revive growth

In these circumstances, the priority has to be growth. Otherwise, apart from minimal foreign investment, domestic investment also is likely to be curtailed further, and social instability triggered by economic pressures could grab centre stage to devastating effect. International commodity prices are outside India’s control, but the RBI can reduce interest rates. Cutting rates can raise margins and revive consumer demand.

The central bank needs to reverse its repressive stance on rates, no matter what the textbooks say, so that enterprise profits recover to a high-growth trajectory.

An immediate cut in borrowing rates, together with a concerted move to reset positive expectations and sentiments, is an urgent requirement.

(ii) Selective credit controls for asset bubbles

Further, the RBI has avoided instituting selective credit controls to avoid asset bubbles, perhaps because of legacy reasons concerning commodity pricing and the potential for interference in markets. With smart e-governance at hand, this nettle must be grasped in place of the blunt instrument of overall rate increases, to use real-time, targeted additional margins, cash reserves and rate increases to defuse incipient asset bubbles.

(iii) Reforms to build momentum

In tandem, we need reforms to rebuild economic momentum. All sectors need reform, e.g., energy, communications, transport, sanitation/water/health and education. For instance, the energy/power sector sorely needs drastic reforms, but it is so complex, with so many layers that need disentangling, that while initiatives are necessary, they are unlikely to revive growth in a reasonable period. The need, therefore, is to focus on what is practicable with the likelihood of achieving results.

In practical terms, we have to prioritise, and focusing now on communications, specifically broadband, could yield results. Mobile communications grew phenomenally over the last decade. The meteoric rise stalled for a variety of reasons: excessive competition, ultra-low tariffs, saturation in urban markets, limited access to spectrum, no incentives for broadband, restrictive actions against BSNL and MTNL, scandals and policy uncertainties. Yet, if the government initiates appropriate reforms in spectrum policies with incentives for broadband delivery, prospects could revive. If the government can (a) formulate major reforms with a New Telecom Policy 2011 that achieves growth, while(b) resolving problems relating to past irregularities through sound legal processes and judgment, communications could go through another meteoric rise, becoming the growth engine for the economy.

Shyam (no space) Ponappa at gmail dot com

* “The policy dilemma”, C. Rangarajan, Business Standard, August 22, 2011: http://www.business-standard.com/india/news/c-rangarajanpolicy-dilemma/446531/

'Containing Inflation' - A Myth

Shyam Ponappa / New Delhi August 7, 2008

We need problem-solving, not confused rhetoric or misguided action

It’s as if there’s a conspiracy to beat India’s growth surge to pulp, making sure the economy is hamstrung in the months and years ahead. Those of us seeking rational signals in the economy have watched incredulously as the cost inflation from edible oil, food and energy was misconstrued as overheating from 2006, leading to a series of misguided, self-destructive steps. Moreover, there has been a baffling obscurantism spread by many different quarters — the RBI, the Finance Ministry, and many economists including from the private sector, the media and press — spouting irrational sophistry about the need for the sledgehammer of rising interest rates “to contain inflationary pressures".

Mutterings about the pass-through of international energy prices are of a piece. The effect of pass-throughs is to increase inflation further, and unlikely to reduce short-term demand (i.e. control inflation), unless the increase is so large that the economy slumps because of a drop in demand.

The build-up with the convoluted explications started with the RBI’s nagging suspicion [sic] in October 2006 that there “could be elements of overheating in the Indian economy”. This led to the hike of the repo rate from 7 per cent to 7.25 per cent, making financing more expensive in the Indian economy. By December 2006, the RBI raised the cash reserve ratio (CRR) by 50 basis points to reduce inflationary pressures, and by the end of January 2007, raised the repo rate to 7.5 per cent citing the demand-supply mismatch in food. By March 2007, the repo rate was raised to 7.75 per cent and the CRR by 50 basis points to 6 per cent citing continuing inflationary pressure. In June, the repo rate was raised to 8 per cent.

The benefit of hindsight makes it evident to all of us including the RBI and the government that these measures have done nothing to improve the supply of food or edible oil, or for the surge in petroleum prices. Inflationary pressures are expected to continue into 2009 despite these actions that have slowed the economy. So, what is the purpose, other than reducing growth precipitously? All that increasing rates and financing costs will do is to kill India’s growth story. This shows clearly in the figure in the slowdown from 2007 in GDP growth and in the Index of Industrial Production.

Increasing rates can only curb inflation by reducing growth so much that demand is curtailed for those whose ability to buy food increases because of higher earnings. That’s what the obfuscatory talk of “containing demand” boils down to: forcing the economy to slow so that some people can afford to buy less food. It is also clear that by increasing demand through the loan waiver and NREGS without addressing supply constraints, the government’s actions increased inflationary pressures. Likewise if the Pay Commission recommendations are implemented now instead of delayed for a year.

What rising financial costs have done to the Indian economy is to vaporise all prospects of high growth and profits. Further aggravated by the global slowdown and the repercussions of the continuing meltdown of home loans and overleveraged US consumers, this has reduced the prospects of currency inflows that have so far provided a ballast to India’s dream investment run.

Corrective Actions Require Substance, Less Form

The government and RBI could take a constructive, problem-solving approach to growth, inflation, interest and exchange rates, provided their purpose is solution-oriented and not a preoccupation with appearing to take action. These involve (a) avoiding gamesmanship — loan waivers, NREGS, the imperfections of the PDS — and addressing more effectively (b) fuel taxes and pricing, and (c) supply and distribution.
The first step may be to acknowledge that in the short term, there is little that can be done to ameliorate high food prices with one exception, while taking measures to improve supply over the medium and long term. The exception is interim steps to help the poor through food coupons that enable direct subsidies through existing retail systems.

Over the medium term, a system using smart cards needs to be planned and implemented through the retail network that provides direct subsidies for food and fuel to lower-income users. On fuel, there has to be a concerted move to reduce taxes and remove anomalies in petrol and diesel pricing (i.e. subsidising private vehicle owners, inappropriately encouraging the growth of small diesel vehicle manufacture and sales).

Increasing Supply

Equally important, we have to learn to take the good examples of applied research and extension to make them more of a reality. It’s as simple or as difficult as getting good applied research work done in the field, and providing convincing extension support to local farmers. I had the opportunity recently to review an excellent instance of applied research, combined with sound extension practices that ensure supplies of fresh vegetables wholesale, organised and channelled flawlessly.

Of course, unique aspects make this not easy to replicate. The first is a well-managed farmers’ cooperative. This was organised in Ladakh by the late Rigzin Namgyal Kalon of Leh with great foresight, integrity and ability some 40 years ago. Mr Kalon had the ability to see how farmers could prosper by organising themselves for supplying farm produce to the sizeable army presence in Ladakh. When Mr Kalon passed away in 2002, his peers had the good sense to appeal to his family to continue to lead their effort. The second is a wholesale buyer (the Army). The third is the presence of an institute engaged in effective applied research in agriculture, horticulture and animal husbandry in Ladakh. Started as the Field Research Laboratory under the Defence Research and Development Organisation, this is now the Defence Institute of High Altitude Research. This combination of elements provides the ingredients for a winning formula for the farmers of Ladakh.

Here are object lessons for those who see the potential for cooperatives, but think it cannot work in India. After all, there is Anand (the Gujarat Cooperative Milk Marketing Federation Ltd) and its extension to the National Dairy Development Board to prove that it can be done. We have to stop thinking of shortcuts, learn to replicate these ways, and teach ourselves to collaborate.

shyamponappa@gmail.com

The Burden of High Interest

Shyam Ponappa / New Delhi March 6, 2008

We need low interest rates for many years of double-digit growth in India.

I first saw ‘Whack-the-Gopher’ years ago at Billy Bob’s in Fort Worth, Texas. This place, famous for country entertainment, has a pro bull riding arena, a huge dance floor, many bars, and a Texas BBQ. It also has Whack-the-Gopher. Stand with a mallet in front of a raised ‘yard’ with a number of gopher holes. As the varmints pop out, whack them back in.

RBI’s Nostrum: Whack the Gopher

The RBI has its own variation. Every time the economy picks up, whack it with high interest rates, talk about inflationary risks to fuel uncertainty — and watch it fall back.

If anyone is chuffed at 8.7 per cent growth, stop to consider what kind of sufficiency leaves growing swathes of the country subject to violent attacks by extremist rebels, while most of it has no basic amenities (sanitation-water-health-education). In contrast, China apparently defines a growth rate at which employment fails to keep up with new entrants into the labour market as “economic stagnation”.* What will it take for India to plan and achieve the rising tide that, starting from Japan in the 50s, many countries have had the sense to figure out and make happen? Everyone including the Left must realise we can only aspire to any decent living standards after coordinated efforts to get 10 per cent growth for at least 10 years or more.

The RBI’s charter needs to be redefined, stressing growth and employment primarily, and inflation control secondarily, instead of the other way around. We would do well to remember that while countries that grew fast experienced occasional crises, they still grew faster than countries with smooth credit conditions.**

Interest & Profits

The chart shows Interest Expense as a percentage of Revenues, Expenses, and Net Profits from FY2000 to FY2007 on the left vertical axis, and the minimum Prime Lending Rate from FY2000 to date on the right vertical axis.

Interest costs amounted to as much as or more than net profits from 2000 to 2002, then dropped to around 20 per cent by 2007. From the way costs varied with rates, we know what will happen to profits. A study of quarterly interest rates and GDP growth in India for 2000-2006 corroborates this, as does an IMF study of other emerging economies I have cited earlier.#

Investment and planning are driven by perceptions of growth and profits. If revenues and profits (and expectations of them) grow at near 20 per cent, companies will continue to invest, and investors will keep buying stocks at high valuations. More enterprises will come on stream and do well, with additional growth in employment (i.e. further increases in output and employment). This is a virtuous circle for India with its demographics and headroom, because a large proportion of the population has room for appreciable improvement to attain reasonable living standards. This provides

massive scope for additional housing, transportation, energy and other infrastructure, durables and consumer products, as well as services. And it can only happen if enterprises and individuals continue to invest and act with optimism, buoyed by the prospects of growth and profits. Remember how years ago, good multinationals had consistent PE multiples of 25 when the market was at 15? This is why. And yes, there are reasons to justify such valuations for good Indian companies for the foreseeable future, provided our monsters don’t all rise.

Defenders of the Faith

A theoretical argument for high interest rates is that they can’t be lower than inflation. However, consider the examples in the table for India, China, Malaysia and Thailand:

Inflation in these countries is in fact higher than their interest rates, while borrowing costs in India are double these countries. A one per cent lower rate in India in 2007 would have resulted in increased net profits of about 3.5 per cent (based on a sample of companies). So, if Indian companies paid 3 per cent less for debt, their profits would increase by 10 per cent.

Of course, you might say: what about more profits that could accrue from a rationalisation of taxes, of better infrastructure, e.g. lower power costs and no standby requirements, better transport with improved logistics, government services provided efficiently over the Internet, and so on? You would be right. This is why there is potential for growth in profits of 20 per cent plus for many years together as all these kick in, provided we do what it takes to realise the potential.



Actionable Steps



What can the government do?



- Get the RBI to focus primarily on growth and employment, with a secondary emphasis on inflation.



- Take equivalent steps starting in the finance ministry on fiscal discipline, extending to all ministries and states; avoid populist giveaways.



- Set clear goals and coordinate all policies and actions across ministries and states and between the government and the RBI to achieve them, e.g.:



a) Lower expectations of inflation by:

- Cutting and rationalising taxes;

- Building policies and practices to deliver additional supplies of foodgrain, pulses, and edible oil as in the next paragraph.



b) Develop and execute sector-specific supply strategies, e.g. for foodgrains, pulses and edible oil: acquire additional stocks with better pricing; formulate strategies for additional production through better analysed and managed cultivation, i.e. better scientific inputs, extension and practices, and strategies such as offshore joint ventures.



c) Maintain a lower interest rate structure. Avoid inappropriate rate increases when limited supplies cause prices to rise; instead, coordinate fiscal and monetary policies (macro plus sector-specific) to improve supplies.



d) Develop and deploy systems and procedures at the operating level to facilitate lending on a sound basis to sectors such as construction, housing, durables, transportation and automotive products, i.e. more emphasis on the RBI’s banking operations charter. Good systems and procedures for sound credit will accelerate productivity, growth, and employment. As cited in an earlier article, the IMF found that it is indiscriminate lending without proper credit evaluation and/or repayment projections that lead to crises.@ This is important for an economy that relies heavily on bank credit, and does not have a well-developed bond market.



Such steps will help many of the gophers get up and away.




_________________________________________________________


shyamponappa@gmail.com



* ‘Harsh winter raises specter of “Chinese stagflation”’, Simon Rabinovitch, Reuters, January 20, 2008: http://www.reuters.com/article/ousiv/idUSPEK7570420080130

** ‘Crises and Growth: A Re-Evaluation’, Romain Rancière, Aaron Tornell, and Frank Westermann: http://www.nber.org/papers/W10073

# ‘Exploring the inflation, interest rate, growth nexus’, A. Vasudevan (former RBI Executive Director heading Research), (http://www.thehindubusinessline.com/2006/08/03/stories/2006080300201000.htm), and “Business Cycles in Emerging Economies: The Role of Interest Rates”, Pablo A. Neumeyer & Fabrizio Perri, cited in the BS June 7, 2007: http://business-standard.com/search/storypage_new.php?leftnm=4&leftindx=4&subLeft=1&autono=286882


@ Cited in the BS September 11, 2007: ‘Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies’, July 2005(www.imf.org/external/pubs/ft/wp/2005/wp05151.pdf), see http://business-standard.com/search/storypage_new.php?leftnm=4&leftindx=4&subLeft=1&autono=297545

'Ideal' Inflation & Exchange Rates for India

Shyam Ponappa / New Delhi July 05, 2007

What India needs and how to get there.

My last article addressed how strategic use of low interest rates could help achieve better living standards (http://organizing-india.blogspot.com/2008/04/ideal-inflation-exchange-rates-for.html). This one explores what the “right” inflation and exchange rates might be, and suggests next steps.

Inflation

What is the desirable inflation rate? We must think beyond fixed mindsets to address circumstances as they are, and determine what we can do. Otherwise, we have the ludicrous situation of self-inflicted damage that threatens to hobble growth yet again. How ironical that delegations scour the globe soliciting investment; and yet, when larger capital flows occur, they induce a state of near-hysteria against inflation. The RBI raises rates, to a chorus of approving groans. Thus, perversely, positive developments become the very impediments to progress. This must change for India to grow at a sustained 9-10 per cent or more.

Do we want those capital inflows, or not? Do we want to grow around 10 per cent a year, or not?

An inescapable consequence of growth is that there will be increasing foreign investment. If we avoid moving quickly to full convertibility, we escape some of the volatility associated with it. In my opinion, this market is simply not ready for high volatility (translation: we will not be able to stomach the carnage, so the detriments will overwhelm the benefits). It will be when a preponderance of attributes moves it out of the “emerging markets” category. Meanwhile, incentives can influence flows towards FDI rather than secondary markets or asset bubbles, reducing inflationary pressures. But some of the supply pressure for inflation and overvaluation needs to be channelled into profitable, liquid offshore investments. On inflation, Dr Rangarajan’s view* is that the “threshold” of 5-6 per cent he suggested years ago was for that time, and the ideal rate for India “…depends on what the rest of the world is doing. If the rest of the world is gearing towards… 2-2.5 per cent, we cannot have an inflation rate well above that rate. Therefore, about 3 to 4 per cent is an acceptable inflation rate for the medium term. For now we should be gearing towards 4 per cent...” Paraphrasing, 2-2.5 per cent is desirable but unrealistic, hence a near-term 4 per cent (the WPI is nearly there), with a lower medium-term goal.

Apart from interest/growth-related reasons, inflation hurts the poorest the most. With high prevailing growth, we need the lowest inflation achievable (1-2 per cent?), facilitating low interest and strong growth across a broad front.

Supply Pressures & Export-Friendly Exchange Rates

Some appreciation of the rupee is inevitable with a strengthening economy, while undervaluation benefits many exporters. Net benefits to the economy, however, vary with a number of factors, e.g., energy prices, as a stronger rupee is beneficial for energy imports and import-dependent exports, while a weaker or undervalued rupee benefits those using local products and services. That said, there are compelling reasons for assisting growth engines (IT/KPO, etc.), despite all the counter-arguments. The same holds for manufacturing, while this sector builds quality and volume. System responses, therefore, need careful evaluation.

What Rate?

Should India try to manage the Nominal Exchange Rate, the Real Effective Exchange Rate, or something else? CRISIL has an index described in a recent article by Radhika Anand and Subir Gokarn called, rather infelicitously, the “Parameter of Competitiveness” (PARC).** This compares the rupee with the export-weighted and inflation-adjusted currencies of India’s competitors for exports. It shows the rupee has been appreciating against competitor currencies since the end of 2005. The RBI has every reason to use this, or a similar measure, as a criterion for evaluating exchange intervention.

Strategy & Execution

Recognising that we cannot say “no” to inflows and must say “yes” to growth, what should we do differently?

Set growth objectives—10%+: Goal-oriented planning begins with clear objectives. This means accepting one or a few non-contradictory, overriding objective/s. Then, coordinating responses to achieve it/them. Confused yearnings, fears or wish-lists are not a good starting point.

Analyse dispassionately: For instance, stop viewing trade deficits with lingering fears of scarcity: if a significant deficit arises from increases in imports for growth, this is quite different from, say, a preponderance of oil imports. Growth-oriented imports mean that we are importing capital, exactly as we must.

Coordinate fiscal & monetary policy: The conventional wisdom is that the benefits of an independent Central Bank accrue at no cost to the economy. A report in the European Journal of Political Economy, however, finds that when monetary and fiscal authorities pursue their goals independently, conflicts arise that render both sets of goals less achievable.*** This happens: “because unrestrained competition between independent policy makers creates conflicts in which one policy has to be used (in part) to neutralise the other.” The upshot is that goals are subverted, and cannot be achieved efficiently. The more populist a government’s actions, the more the Central Bank becomes inflation-averse.

Strategy and coordination can help achieve the next three items.

Keep inflation and interest rates low: This is detailed in my previous article (http://interestrates-gdp.blogspot.com/) and in the next paragraphs.

Invest foreign exchange reserves abroad: The RBI knows it can invest reserves abroad in remunerative ways. Yet, our culture of crucifying those who achieve breakthroughs ensures that first-movers will suffer if there is a misstep. Therefore, this decision must be a multi-partisan and empowered-Group-of-Ministers’ initiative.Those who think China began creatively investing its reserves with Blackstone in 2007 should be aware it was investing—whether from reserves or from another account—in strategic enterprises such as phosphoric acid in America, or real estate in Thailand—nearly 20 years ago. Time to wake up and act! $5 billion in an offshore infrastructure investment vehicle is one thing. $50 billion in liquid funds with returns of possibly over 20 per cent and much more is what we must do immediately. Then, $100 billion.

Structural solutions for chronic shortages: Formulate long-term, systematic, strategic initiatives for energy, pulses, food grains, sugar… instead of repetitively dealing with periodic crises. Instances are: strategic alliances/investments for oil and gas (as begun), appropriate support prices combined with distribution systems that work better for food grains, and a long-term pulses strategy.

Conclusion

It is time to think and act strategically and systematically, in concert, to build a virtuous cycle on low interest, inflation, and exchange rates.

shyamponappa@gmail.com

* “There is no growth-inflation tradeoff”, interview with BS: http://business-standard.com/search/storypage_new.php?leftnm=4&leftindx=4&subLeft=1&autono=288715

** “Rupee impact is large, but not the only one”: http://www.rediff.com/money/2007/jun/11rupee.htm

*** “An independent Central Bank faced with elected governments,” Demertzis, Hallett & Viegi: http://econpapers.repec.org/article/eeepoleco/v_3A20_3Ay_3A2004_3Ai_3A4_3Ap_3A907-922.htm