Regrouping for Growth - Interest Rates - III

Aside from muddling along, the choices are to try to grow and retain capital to staunch the gap temporarily, or to settle for low growth and capital flight.

Shyam Ponappa  September 5, 2013

What are possible ameliorative steps for India's economy? Taking stock, are we overreacting to our economic woes? Second, do our problems have global origins? To the extent they are home-grown, what were the missteps? How can they be corrected?

The answers to the first and third (overreaction, policy errors) depend on whether one takes a "static" or "dynamic" view. Static views compare measures at points in time to arrive at an assessment of better or worse. Dynamic views, by contrast, emphasise system-wide flows and consequences, as in financial simulation models, with the focus on outcomes. The real question is whether we can grow sufficiently so that foreign and domestic funds cover imports and build manufacturing, or shrink and risk a deluge.

Risk assessment

From a static perspective, the present situation is nowhere near the dangers of 1991. Flows, however, highlight the potential for danger of slow growth: a demographic bulge with high aspirations and low opportunities; and a large, low-skilled population. What's worse is that foreign investment-fuelled growth rode a wave of imports without sufficient development in direct manufacturing. This imbalance is heightened by the stoppage of iron ore exports and the slump in coal production because of mining scandals, aggravated by high coal and gold imports. The problems - in telecom, mining, aggressive environmentalism, retrograde tax impositions, inadequate manufacturing - are all self-generated except for oil prices and the Syrian crisis. They stem from abdication of governance, overreach, or greed, compounded by judicial and citizen backlash. Only the triggers are external - from capital flowing in to the signal of a cutback.

Policy missteps 1: Interest and profits

The left side of the chart below shows interest expenses and profits for several thousand listed companies over the last four quarters. In terms of flows, higher interest rates curtailed demand as intended, so lower revenues and higher costs reduced profits - all while supply-constrained inflation continued.

Some experts maintain that rate cuts won't affect growth, citing the lack of a clear correlation; or the insignificant share of interest in total costs (reportedly three per cent); or that rates drive savings or consumption, but not investment. Clear correlations are unavailable because credible research must cover all major variables and interrelationships; simplifying them can distort conclusions. The research must also include how the effects of changes vary for rising or falling, large or small economies at different stages of development. The other reasons appear to ignore aspects of flows like momentum and turbulence - or even the data. And aggregates and averages can be misleading, as detailed below.

• Interest costs in 850 non-financial companies went up by 40 per cent as a share of earnings before interest, taxes, depreciation and amortisation over three years. While Ebitda roughly doubled, interest costs nearly tripled(http://articles.economictimes.indiatimes.com/2012-10-25/news/34729789_1_inflation-control-potential-growth-rate-capital-formation).
   
• Interest costs in 2,242 companies reportedly doubled from 2.3 per cent to 4.2 per cent of revenues over two years. Costs two years earlier were 16 per cent of Ebitda, whereas in the quarter ending December 2012, costs were 34 per cent of Ebitda. Analysts attributed this to low demand, and expect worse in 2013-14 unless demand improves (http://articles.economictimes.indiatimes.com/2013-02-18/news/37160258_1_interest-outgo-rise-in-interest-expenses-interest-cost).
   
• In July 2013, earnings of 85 out of 600 listed non-financial companies did not cover interest payments, up from 61 the year before; another 43 were at risk compared with 36 a year earlier, and non-performing loans were increasing (http://www.thehindubusinessline.com/companies/debt-traps-india-inc-as-profits-fail-to-cover-interest-outgo/article4889184.ece).
   
• Aggregate costs and averages sometimes conceal problems. Credit Suisse reports that the aggregate interest cover for 10 large, overleveraged industrial groups has dropped from 1.6 last year (borderline) to 1.4 (inadequate). For four of these groups, interest costs exceed profits. Rejoicing in the woes of "profligates" is inadvisable, however, because a collapse affects everyone.

Policy missteps 2: Sustainable profits and stability


Profits are essential for savings, investment, stability and order. This is why sustained profitability is of paramount importance for India. Provided industrial relations are harmonious and demand is resilient, that is, momentum is positive, lower interest costs within reason can sustain positive sentiment, resulting in higher profits up to a point (see chart - right). This has been a matter of incomprehension or denial for government (central and states), the Reserve Bank of India, the judiciary, and many citizens.

Instead, we have populist handouts to capture treasuries, and irresponsibility in replenishing them. What started with cheap rice in the 1980s has degenerated into a free-for-all, promising a distribution from the treasury contingent on capturing it for aspirants, or recapturing it for incumbents: vote us in, and you'll get these spoils.

Plausible remedies

• Lower rates: A number of experts in India and abroad recommend a reversal of monetary tightening and reduced interest rates. Some aver that the biggest risk is stifling growth by raising rates, eg, Paul Krugman and Ryan Avent (http://krugman.blogs.nytimes.com/2013/08/22/generation-b-for-bubble/). Others, unfortunately, suggest confusing strategies, including raising rates to contain inflation, despite this not having worked and been shown to be detrimental.
   
• Fiscal responsibility: A second requirement is fiscal responsibility in trade-offs for resources, betrayed by all parties in the impractical Bills on food security and land acquisition. This is a crucial requirement from both the government and the Opposition. For example, an effective step would be to raise diesel prices by Rs 5 a month for three months (which the government could evaluate using simulations).
   
• Manufacturing: Another requirement is action supporting manufacturing. A National Manufacturing Plan has been mentioned for years, but only coherent action will change the perception of yet another plan on the shelf. For instance, the government has resiled on the preferential marketing access for telecom equipment, which will increase imports.
   
• Stalled projects: There have been future-oriented announcements, eg, on fuel supply for power projects, but no demonstrable actions and results.

In sum, a rate cut combined with consistent actions on fiscal responsibility, disentangling projects, manufacturing, and stop-gap measures like swap facilities for oil companies and "stretching" imported coal may provide a breather. These could have a stabilising effect on the rupee, improve sentiment, and re-establish India's growth potential.

---

shyamponappa@gmail.com

Comments

Anand Tandon

1. Interest costs did not go up because of "high rates". Over FY07-13, interest costs for approx 750 companies with a market cap of >$1bn increased at 30% CAGR, while net debt increased at 31% CAGR. Comparing with revenues mis-states the problem. Yes, there is an economic slowdown, but it is NOT caused by interest rates. In fact, over this entire period, real interest rates have been NEGATIVE. 2. Krugman et al are operating in an environment where interest rates are zero, and there is little inflation. There the attempt is to INCREASE inflation, so that the economy can be given a stimulus through a negative interest rate ! India suffers from extremely HIGH inflation, and out of control revenue expenditure of the government - an entirely different problem 3. The weak rupee, in part caused by a low real interest rate and high consumption demand,has already led to a tightening in the near end of the interest rate curve. This could have been avoided if as Dr Subbarao mentioned in his outgoing speech, the RBI has been faster in the tightening cycle.

SP Replies

“…over this entire period [FY07-13?], real interest rates have been negative.”

Data for Real Lending Rates according to (a) the RBI and (b) the World Bank (from TadingEconomics.com)

Real Lending Rate – RBI  1992-93 to 2009-10

Measures of Nominal and Real Effective Lending Rates of Banks in India

Deepak Mohanty, A.B. Chakraborty and S. Gangadaran

May 2012

http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14236

a) RBI - Real Lending Rates & Growth

Real Lending Rates - 1992-93 - 2009-10

Real Lending Rates & GDP Growth

b) The World Bank

http://www.tradingeconomics.com/india/real-interest-rate-percent-wb-data.html

REAL INTEREST RATE (%) IN INDIA

The Real interest rate (%) in India was last reported at 2.01 in 2011, according to a World Bank report published in 2012. Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.This page includes a historical data chart, news and forecasts for Real interest rate (%) in India.

“2. Krugman et al…  India suffers from extremely HIGH inflation, and out of control revenue expenditure of the government - an entirely different problem.”

Reply

They are writing about India (http://krugman.blogs.nytimes.com/2013/08/22/generation-b-for-bubble/).

"The emerging-market squeeze, short version"

Ryan Avent   Aug 21st 2013

http://www.economist.com/blogs/freeexchange/2013/08/global-economy-0

"My conclusion was that the big risk is a policy overreaction in affected economies. Governments or central bankers worried about depreciation or its effect on inflation will be tempted to move monetary policy in an inappropriately tight direction."

Srinivasan

Shyam Ponappa has exceeded himself in this columns. Brilliant stuff. "Rejoicing in the woes of "profligates" is inadvisable, however, because a collapse affects everyone." Nobody could have given a better argument to silence the liberals who have been crying hoarse about 'Moral Hazard'. I think this eliminates Moral Hazard as a category worthy of consideration because losers should not lose in capitalism as it will bring everyone down. Effectively, those who are on top should not be tested. Even if they lose they should be reinstalled back through subsidies for the Rich. And there goes Schumpter and his Creative Destruction. If we are going to have to pay the price of Destruction, we dont need Creativity itself. It is nothing short of revolutionary stuff for Ponappa to keep insisting on stopping all this Churn business. Society really does not need new innovaters to be well rewarded, continuation with old failures is the way to go. That will The basic framework of economic policy should save the well-entrenched and keep out the troublesome unsettling new aspirants. That will keep society stable as well. Everybody will know their place and learn to stay put. Along similar lines, he has also excelled in returning to his pet topic of lowering Interest Rates as the preeminent route to save the corporates which are failing. The 850 or 2000 corporates which are failing need to be subsidised through the lower interest rate mechanism, no matter what price the rest of the Economy has to pay for it. Head of PM's Council of Eco Advisers has said on 3 Sep that the country was suffering from very high inflation for an extended period and so the rupee adjustment was only to be expected. Does he mean to say that the inflation targeting should have been done through higher interest rates. The rupee drop has no link to prior inflation and low inflation rates. Isnt it so Ponappa? Ponappa based on this clear simplemindedness has been crying oarse in his columns for a 300bps drop for interest rates even before DV Subbaro raised it by 300bps. To drop them to around 200bps! Brilliant assumption - There is no price to pay for economic policy failures. 

SP Replies

The Real Effective Exchange rates, according to the Reserve Bank of India (RBI):

http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/36T_CB080813.pdf

The statement that reduced interest costs will increase profits if other factors are constant is a truism.  It would be true if any cost is reduced with other factors unchanged. 

Should this be done?  Or should the “850 or 2000 corporates which are failing” (Srinivasan) [be allowed to fail].

As written, I think the choice is to tide over the difficult situation we are in by retaining foreign and domestic capital, or risk a serious, prolonged downturn with capital flight.  Whether this is justifiable or not depends on the facts of our economic situation and what our objectives are. 

In my opinion, we are at a juncture where employment opportunities must be improved somehow.  I think the way to do so is to improve the profitability of sound enterprises, and not consign all overleveraged companies to mass bankruptcy, because it will be too disruptive to our political economy.  A mass bankruptcy would destabilize our banking system and jeopardize what is most important for employment and for the future, the development of infrastructure.

There are distinct areas in which decisions have to be made: exchange rates, interest rates, and economic policies in areas other than exchange and interest.  I am suggesting that action on interest rates and on other economic aspects can strengthen the economy, so that the currency becomes more stable.

Srinivasan

Srinivasan replies - Choice 1 is To try to maximise working within an illiberal non-market-based system which i) rewards crony Big Business without any reason through interest rates (but that is a model which can be followed only for so many years before currency has to be devalued) and ii) helps them out when they take wrong decisions, and iii) when the above disastrous decisions stretch the system beyond the limit, and systemic risks emerge, they are addressed by spreading the pain to all sectors of the economy. Choice 2 - have a market based system which rewards innovation and energy and efficiency. Those who fail, no matter how much their clout - they Fail. Those who do well the market rewards them amply. These basic incentive mechanisms are not tampered with. The full potential of the People gets unleashed. As Ruchir Sharma of Morgan Stanley point out since UPA-I the Churn within the Top Twenty-Hundred-Thousand has stopped. Most of those who were in the Top Twenty in 1991, had dropped out and been replaced by fresh entrants by 2001. But in the next 10 years there has been hardly any change in the Top Twenty. These new entrants have grabbed control over the policy structure in Delhi to close the door to any further new entrants. The choice - Choice 1 or Choice 2 - is up to us. Think short-term and save and exalt a corrupt Big Business system in which SMEs and common people languish in the absence of right incentives. Or, Think long-term and over-haul it to empower people to excel and outperform. Brilliant assumption by SP - There is no price to pay for economic policy failures. There will be two mega-benefits. No penalty to Big corporates for their erroneous decisions, and no penalty to the Nation for erroneous policies.

05-09-2013

Growth, India's Highest Priority

The government must focus on reviving corporate profits and, hence, growth

“…people are starting to question the long-term Indian story… For the time being, people are just giving up on it” — a Moody’s analyst Shyam Ponappa / Jun 07, 2012

With growth in the fourth quarter of 2011-12 at 5.3 per cent, India’s economy is on the brink. If higher growth is not addressed as a priority, we will all lose enormous upside potential. We cannot afford disunity on this issue — neither the government’s arbitrary action nor inaction, nor stalling by the United Progressive Alliance allies, nor the irresponsibility of the Opposition. Continuing discord carries the risk of precipitating our own Greek tragedy.

We need to agree on what the biggest problems are, and how to remedy them. Here is the case for focusing on growth above all, and acting to enable it.

Symptom: Rupee Depreciation

The depreciation of the rupee is the acute symptom. Why has the rupee fallen so precipitously, and why might it get worse? Because of foreign currency outflows. Why the outflows? Declining corporate profits, as explained below.

The drop of over 27 per cent against the dollar since August 2011 is crushing for companies with foreign currency convertible bonds (FCCBs) and external commercial borrowings (ECBs). Estimates of redemptions this year range from $5.5 billion to $7 billion. With growing euro problems and global risk aversion, renewing external debt is possible only for the strongest companies. This problem has to be dealt with, despite the temptation to say, “Let them stew”. That works only if we are not all cooking in the same pot — which we are.

Some counter that an overvalued rupee needed depreciation to help exports. In depressed markets, growing market share is less likely. Some object to actions that protect companies with ECBs as “socialising losses”. While policies can have multiple effects, it is net benefits that matter most: whether losses in energy imports outweigh the export advantage in a global downturn, or companies that escaped high domestic interest rates will create more turmoil if they fail compared with bailing them out. These judgement calls need the objective use (to the extent possible) of financial models, balancing the resistance to creating moral hazard.

Declining Profits

We now face a problem of shrinking profits. With weakening global cues, a slowing economy, and lower capital flows, everyone – policy makers, enterprises and citizens – must seek to alleviate what will otherwise be a slow, difficult recovery. Collectively, concerted efforts are needed to improve profits.

High Interest Costs

Lower revenue growth in 2011-12 with higher raw material costs resulted in lower profit margins. In the fourth quarter, higher interest costs were 31 per cent of net profits, compared with 22 per cent for the previous quarter for 1,066 companies, excluding banks and financial entities. Interest costs for over 2,000 companies rose 38 per cent, following increases in the previous three quarters of 42-50 per cent. High interest costs and an unreconstructed budget triggered a downward spiral in profits. This was made worse by negative sentiment because of government ineffectiveness and capriciousness, epitomised by the Vodafone tax case: attempts to seize what the Supreme Court had annulled.

Foreign outflows triggered by decreasing profits were aggravated by a declining rupee — because of high imports with rising prices, particularly for oil and gold, but also for coal imports, because of local supply shortfalls. The consequent fall in stock prices and unstable tax policies combined to reinforce outflows, increasing downward pressure on the rupee.
There were, of course, other reasons:

• Mismatches between growing demand and constrained supply, leading to persistent inflation. The Reserve Bank of India’s (RBI’s) raising interest rates to tackle this has only compounded the problem of reduced profits and investments, made worse by central and state government failures to augment supply.
• Capriciousness in policies which, like Brazil’s missteps of the ’70s, began with distributing entitlements before assuring growth. Capriciousness now manifests in decisions like the Vodafone tax case.
• Paralysis/incapacity, typified by the failure in the coal supply chain to power plants, unviable electricity distribution agreements and tariffs, new power plants running far below capacity, the unwillingness to take constructive decisions on spectrum and telecom policies fearing populist reactions, or the rollback of foreign direct investment in retail. This is compounded by the rise of populists, many of whom act as if good intentions obviate the need for domain knowledge, competence, organisation, or even simple arithmetic.

Solutions

Two salutary steps are possible immediately. 

- First, cut interest rates, although economists are divided on the merits. What should the RBI do? A big rate cut – 150-200 basis points – can improve profits, capitalising on softening input costs, as well as boost sentiments. Interest as a percentage of profits must be reduced, and sentiment improved to enable increasing investment. Interest rate increases as some suggest, on the other hand, will deplete profits further, accentuating lower growth and exacerbating the decline.

- Second, the government should signal an immediate end to arbitrary tax moves.  

Thereafter, systematic steps are needed to address difficult issues like telecom policy, fuel supplies and land acquisition. Telecom and spectrum reforms are overdue, as are energy reforms addressing the fuel supply-power generation and distribution-sustainable tariffs chain. Then there are all the structural elements affecting productivity – a big mouthful – that can only be addressed in phases.

In terms of sequence, the next significant effort could focus on the poster boy in trouble, the telecom sector. The empowered group of ministers (EGoM) can decisively abandon short-term government revenues in favour of user benefits, leading in time to even more government revenues. A persuasive case needs to be made, for example, to those who favour goals other than functional objectives — like government collections for purposes extraneous to the sector, such as for sanitation or for food. Such confusion in objectives arises from misinformation or incorrect reasoning, because (a) the primary objectives of a sector are its functional purposes; and (b) government collections increase with the prosperity of enterprises paying reasonable taxes. For this iconic sector, including its spectrum and broadband issues, the EGoM should be made aware of the recent report to the US President’s Council of Advisors on Science and Technology on sharing spectrum.*

                                                                                                                  shyamponappa at gmail dot com

* "Presidential Panel Urges More Flexible Use of Spectrum", John Markoff, May 25, 2012, The New York Times:

http://www.nytimes.com/2012/05/26/technology/presidential-panel-urges-better-use-of-spectrum.html?_r=1

Report available at: op.bna.com/der.nsf/r?Open=sbay-8umrn7.ppt

Discussion Board/User Comments (8)

Posted by: Rajesh	June 08 , 2012, 16:39 IST
Sir, when you have identified the right solution ? a big rate cut, why aim for a limited and timid 200 bips rate drop. Why not go the whole hog? This is a time for action and boldness. We must set things right and revive the market. The aim should be to completely unburden the industry from the yoke of the interest burden. Let us follow the West and Japan and bring interest rates in the 0 to 1% range. This restructuring of interest rates will solve a long standing structural problem and unshackle the industry.

  Posted by: SP June 11 , 2012, 17:53 IST
@ Rajesh: 
It's true that we have comparatively much higher borrowing rates. After they try a first cut of 2% and see the benefits, they can move to a bolder balance to maintain NRI remittances...

Posted by: Vivek	June 08 , 2012, 16:11 IST
Are Outflows the result of Declining corporate profits Mr Ponuppa? Outflows and Inflows are determined far more by the Liquidity position in the West than anything which India does. Greece and halting-faltering US recovery decide our "Inflow" fate. Those who benefit from sops, will ofcourse try to use the excuse of a "broken India story" to extract Endless "Inflow" sops, but the wise will realize and flow with the Global Macro context. Grin and wait for the next liquidity cycle.

Posted by: SP June 11 , 2012, 17:56 IST

@Vivek:

True, liquidity is the primary source. But it's exogenous, and we have no control over it, other than taking indirect steps to make investing here more attractive. That's what profits do -- foreigners invest in India for growth, not for safety.

Posted by: Calling a Spade	June 08 , 2012, 15:28 IST
Nature of Subsidies - This world is not an island. Subsidies to the poor also help corporates by increasing their buying power and generating demand. Subsidies to the rich corporates (fiscal stimulus export subsidies debt restructuring tax cuts, etc)may trickle down to the poor in the form of cheaper products and employment. However, there is no guarantee of that!! But the greedy selfishness of the corporates can be turned from a social hazard into a social virtue and result in public good! Not through regulation but ONLY if competitive pressures balance this greed and direct vast entrepreneurial energies into customer service. Witness the benefits of low rates which have accrued to customers in telecom sector. It is not spectrum subsidies but the new entrants and greater market competition which has created the telecom revolution.

       Posted by: SP    June 12, 2012,  11:03 IST

@Calling a Spade:

Infrastructure sectors such as telecommunications/broadband have attributes of network economics and cannot sustain unlimited competition, because of  problems arising from an "empty core" (game theory).  Please see article titled, "Competition, open skies ...and bust?", August 4, 2005 (http://organizing-india.blogspot.com/2008/04/competition-open-skies-and-bust.html).  The article is about airlines, but the same principles apply to communications.

The likely consequence of unregulated competition is "robber baron" outcomes of the Gilded Age.  

Posted by: Gopi	June 07 , 2012, 07:54 IST
Sir, opposition, esp BJP, has been accused of being irresponsible / destructive by Cong's bhompus in our media - eg, edit pages of BS, IE, Telegraph, HT, ToI, ET etc as also many leading commentators - for last 8 years. So, my question to you, sir, is: how did we achieve high growth rate during first 6+ years of UPA Raj?

  Posted by: SP June 11 , 2012, 18:02 IST

@Gopi: 

There's no doubt the NDA prepared a good platform for growth. But as mentioned in the article, this was squandered by premature giveaways, restrictive monetary policy, and -- what is not mentioned, but is perhaps most important -- lack of constructive leadership in championing growth. However, the fact is that the Opposition and allies appear to be equally heedless and opportunistic.

Posted by: ashok	June 06 , 2012, 22:45 IST
New private power projects should be allowed ( compelled ? ), making use of open access, to sell directly to consumers, bypassing the broke SEBs completely. No need for competitive bidding, leading to unviable tariffs, dodgy allotments of captive coal mines and leaning on Coal India to help out. This will also have the effect of fracking the SEBs, whose reform is long overdue.