Cut Interest Rates To Revive Growth

Shyam Ponappa / New Delhi January 1, 2009

Significant interest rate cuts can deliver price cuts and revive growth.

...Avoid calibrated loosening of a noose, giving remedial finance to enterprises after they are half-dead...

...excise cuts, without significant interest rate cuts and sufficient liquidity, are like one-handed clapping: Simply not very effective...

India managed 8.8 percent growth annually for five years. “If it could keep this up, India would be transformed, as China has been,” says The Economist.* Alas, ICRIER’s estimates indicate possibly under 6 percent growth for 2008-09, and under 4 percent for 2009-10.** Perhaps 2 percent below potential (reduced to 8 percent?) by March 2009 and 3-4 percent by March 2010.

The fall in the Index of Industrial Production leaves policymakers no room for false optimism (see diagram).


Source: The Economist

Add dismal advance tax collections in December, a limp stock market as FIIs pull out and local demand stalls, unresponsive consumers, new hires plummeting, and funds raised through public offers at a five-year low. The airline sector dying again and with it, prospects for tourism gains. Airlines will be gutted unless taxes are cut to reduce our inordinately expensive aviation fuel (ATF), enabling price cuts. Lower pricing is more critical for ATF than for petrol for cars, because capital-intensive airlines cannot simply cut back on travel as individuals can, and capital costs will compel failure if the cost structure is unviable.

This is a hard landing for India. Growth so far short of potential means huge opportunity losses for very many people. The spillover in social consequences is another cost with devastating effects, from deteriorating law and order to divisive short-term realpolitik. Time to stop tinkering and take big steps.

Bungled Policies: One-Handed Clapping

Responses from the RBI and the government have been mixed. After a good start, there’s been a letdown. A solid excise cut in the first week of December from 14 percent to 10 percent, after-trial 1 percent cuts in the repo and reverse-repo rates, and reclassification of some real estate lending as priority sector. Markets stirred warily, and banks strove to devise creative solutions, restructuring and lowering rates on some home loans. And then? Nothing — fooled again.

Have the RBI and the government done enough? Consider:

• Consumer demand revived only slightly. This is to be expected with a rate cut of only 1 percent. Interest rates are very high in India, affecting prices, consumer finance, and sentiment (a negative wealth effect — see next item).

• Despite good fundamentals, the Sensex is volatile around 10,000. Some think a forward P/E multiple of 10 is reasonable. But with India’s upside potential, the Sensex could be at much higher multiples with strong foreign and domestic investments, if it were not constrained. These constraints are: Depressed earnings because of expensive or unavailable finance and sagging demand, negative sentiment, and uncertainty. Remedial measures can increase earnings, critical for investment, and revive sentiments. Otherwise, growth will be constrained by limited bank finances, further circumscribed by concerns about excessive credit growth (which aggravated the liquidity constraints to begin with).

• The RBI says there is adequate liquidity, but banks have deposits of around Rs 29,000 crore at the risk-free reverse-repo rate. Meanwhile, trade credit has dried up and the securities markets are dead, with funds raised from the public at a little over a third of the previous year, at Rs 16,927 crore in 2008 against Rs 45,137 crore.

• Additionally, contradictory moves, eg, a railway freight hike, resulted in cement companies not reducing prices sufficiently, crippling revival possibilities.

With India’s potential, why isn’t growth higher? Because excise cuts, without significant interest rate cuts and sufficient liquidity, are like one-handed clapping: Simply not very effective.


Reviving Growth

The ‘solutions’ are straightforward:

Liquidity: Abundant liquidity, with signals of continued availability — not calibrated loosening of a noose, giving remedial finance to enterprises after they are half-dead — will convince lenders that funds are available, and businesses that they can realistically consider investments. The need is for a further CRR cut of 2 percent.

Repo Rate Cut To 4.5 percent: The cost of funds must fall for lending rates to drop. One way to induce this is a sharp reduction in the repo rate — the rate at which banks borrow from the RBI — by 2 percent, to 4.5 percent, combined with a reverse-repo cut (next item).

Reverse-Repo Rate Cut To 3 per cent: A simultaneous cut in the risk-free rate of investment for banks by 2 percent will encourage lending. Also, these cuts will change the economics of many good enterprise activities and projects, making them viable, providing opportunities for banks to lend. Initially, banks short of funds will borrow to lend at lower rates. Call rates will drop with adequate liquidity, ensuring a significant fall in lending rates.

Limits on Investment in Government Securities: There need to be limits on banks’ investments in government securities to discourage this risk-free alternative.

NRI Remittances: NRI remittances require a level of safety, and thereafter, returns. Returns are driven by FCNR rates, which can be set separately from other policy rates, as has been done before.

FII Investment in Debt: As of October 15, 2008, FIIs had invested $2.4 billion in corporate bonds and about $3.25 billion in government bonds. Some argue that if India’s interest rates fall, these investments will pull out. While foreign investors do seek higher returns, one issue is the limited extent of these investments, as India is not viewed as a true safe haven (having recently made it to investment grade, and now in danger of slipping). Another is the relative merits of strong growth with low interest rates, with two associated developments:

• A strengthening currency, and

• provided there are the right policy initiatives, a strong debt market.

Benefits from these developments are likely to far exceed a weak position ‘defended’ with higher rates. A third factor is low returns elsewhere.


Real-Time Management: The RBI also needs to implement a loan monitoring system covering: (1) Priority sector loans and rates, (2) Capital-intensive manufacturing and services such as airlines with domestic market potential, and (3) Higher margin requirements and provisioning for activities such as second-and-subsequent property loans, to discourage asset bubbles.


Cutting rates is easily practicable. If there are doubts, sound out bankers who understand cash flows, and have a sense of actual supply and demand. If there are problems, raising rates will correct for many of them.


shyamponappa@gmail.com

* ‘An elephant, not a tiger’, The Economist, December 13, 2008.

** ‘The global crisis and India’s growth rate’, BS December 3, 2008: http://www.business-standard.com/india/news/the-global-crisisindias-growth-rate/16/13/342081/





See:

Do more than you think is needed: Bimal Jalan

STATE OF THE ECONOMY (A TURN-OF-THE-YEAR SERIES)

BS Reporter / New Delhi January 01, 2009

An Investment Fund for India

Shyam Ponappa / New Delhi September 07, 2006

We must build a GIC-type fund for investment.

A General Reserve …

There are at least four reasons for India to create a general reserve fund without any further delay. The first is the motivation for other country funds: diversified investments with good returns and reasonable safety are much better than government bonds with low returns—especially when they are bonds in America or some other country. There is one exception based on regional self-interest, and that is an investment such as in Asian bonds, if they were to develop as a viable alternative. Why provide cheap capital to others, instead of applying the lessons of well-run national funds over the last 30 years and profiting thereby?

The second is the rationalisation of the government’s holdings in public sector undertakings (PSUs), and distancing the government from direct management. Aggregating state holdings in an investment fund will facilitate less day-to-day political interference in PSUs as various committees have recommended, most recently the Arjun Sengupta Committee on Public Sector Enterprises. Although not strictly necessary, this could encourage a more public-interest oriented policy perspective for government, allowing for a broader, non-partisan approach. This would enable the strengthening of state-owned enterprises on conventional business lines, if possible.

… And an Investment Fund

Third, some of our burgeoning currency reserves (and future surpluses?!) could be channelled into an investment fund. Just 10 per cent of India’s foreign currency reserves will make for a $16 billion corpus. All we need thereafter are judicious investment decisions (!), the returns from which could finance development and infrastructure. Financing infrastructure with primary reserves, however, is definitely not advisable (see “FX Reserves & Infrastructure”, Business Standard, June 16, 2005).

These returns can be sizeable. Singapore’s Government Investment Corporation has funds about the same as our currency reserves. Under the chairmanship of Lee Kuan Yew, it earns 9.5 per cent, well over returns on our reserves, and has been doing so for 25 years. In 2005-06, the RBI had average foreign currency reserves of Rs 629,067 crore ($136 billion), and earned Rs. 25,569 crore (just over 4 per cent). Another 5.5 per cent would have added over Rs 34,000 crore.

With Low Inflation and Interest Rates

The fourth reason has major implications for domestic investment: investing overseas would reduce our excess liquidity if the RBI took appropriate measures. If it could lower inflation through fine-tuning reserve ratios, jawboning, and well-applied lending norms (easily said, but so very difficult to do!), this would enable lowering interest rates. With that, we could ride the magic carpet of cheap capital, as Japan has done.

We have to make several critical choices though, once we choose this path. For instance, if inflation dropped but interest rates were not reduced, there would be no magic carpet ... Another decision is whether to make “strategic investments”, like the Kuwait Investment Authority or Singapore’s GIC, or to decide that national interests should not influence investments, or to use a combination of financial and policy considerations. Alternatives include diversified investments on commercial considerations, as with Norway’s Pension Fund, or encouraging private sector investments overseas as an adjunct to foreign policy, as with America’s Overseas Private Investment Corporation. While a recent editorial in this newspaper referred to OPIC having a minor role in US FDI, OPIC’s facilitation of $164 billion in 35 years would be significant for India. A related choice is whether to manage by legislative committee as in Alberta’s Heritage Fund, or through financial managers as in Norway’s Pension Fund.

These dilemmas should not dissuade us from grasping the nettle in our best interests. In a way, this calls for a future orientation that we have long bucked against. Witness our preoccupation with building to meet historical capacity and always falling short, whether in energy and power, or in transportation or in communications, schools, sanitation … It is the same when we wrangle over sectarian rights for more of a share of what is available, reflecting a rationing-and-shortage mindset, instead of concentrating our efforts on creating more.

A strategic approach demands nurturing a long view, a capacity for deferred gratification, and, most of all, non-partisan collaboration for common goals. Equally, it requires the application of Deming’s “right knowledge”, as against the naïve assumption that good intentions will do. That is, we need to adopt a multi-disciplinary, collegial approach, with robust project management from goal setting to execution. Further, let us not be carried away by free-market rhetoric and naïve disregard for the realpolitik of public-private partnerships in world markets. This shows in suggestions that the World Bank’s Multilateral Investment Guarantee Agency already supports investments by smaller companies, or that our government should not champion national interests in investments. Ask yourself, why does the US have a national fund to promote private sector investment (OPIC)? Recognise that governments support national interests.

Alberta’s and Norway’s Funds

It is instructive to consider the different approaches of some funds and their results. Two examples of similar size of capital sources and time frame are Alberta and Norway.

Created in 1976, Alberta’s Heritage Fund was set up with an overlay of political decision making. The plan was to allocate 30 per cent of annual energy royalties. An economic slump in the 80s led to this being cut to 15 per cent, with the balance going to fiscal expenditure. As the economy worsened, the allocation was cut altogether, with all the capital being used to develop infrastructure, provide incentives to the energy sector, and keep taxes low (including maintaining zero sales tax). The Heritage Fund, now a little over Canadian $14 billion, has averaged returns of 5.7 per cent annually, somewhat under half that of more successful Canadian pension funds such as the Ontario Teachers’ Fund.

Like Alberta, Norway initially spent its oil royalties on social programs and economic stimulation. There were sometimes mixed results, because the kroner appreciated, depressing Norwegian exports. About 10 years ago, Norway changed its stance, setting up the Petroleum Fund, later renamed the Pension Fund, which invests with geographic and sectoral diversification being key criteria. It is now Canadian $165 billion, with average returns of around 4 percent because of its conservatism. While governments still withdraw funds for expenditure, there is a (tough) formal process, and responsible governments limit withdrawals to no more than the returns. Norway’s strategy of putting everything into the fund and living off the returns is working.

shyamponappa@gmail.com