A strong balance sheet needs reasonable profits and, therefore, reasonable interest rates.
Shyam Ponappa |
October 3, 2013
Several analysts lauded the Reserve Bank of India (RBI) governor's announcements on interest rates on September 20. Others rued the lost opportunity to capitalise on sentiment, especially after his dramatic entry statement stopped the collapsing rupee and markets in their tracks with what seemed like a magical swish of his cape.
Is sentiment all that important? And are these merely differences in subjective perceptions, or are there objective reasons that explain these differences? Analysing this quote on easy money tapering may provide some answers: "We must use this time to create a bullet-proof national balance sheet and growth agenda...."
Reasonable profits are a prerequisite
How are balance sheets strengthened? Barring external events like third-party equity investments, strengthening happens through building assets of good quality, or reducing liabilities and debts. To do this, profits are essential from activities in the "P&L", or statement of profit and loss; these give rise to the flow through the balance sheet to the cash-flow statement. Only profits (up to a reasonable level) in the ordinary course can make the balance sheet strong - although there can be productivity gains from other means, such as speeding up receivables or reducing inventory/debt. Extraordinary gains from selling assets or intangibles could also help.
Our excess of imports over exports also makes us vulnerable. This is aggravated by events like the mining crisis, which lowered power generation and exports, while increasing coal imports. This is why the timing of cash movement is critical. When foreign investments slow, excess imports become unfunded, and the rupee weakens. Other off-balance sheet actions also strengthen or weaken our balance sheet position - for example, the currency swap with Japan expanded from $15 billion to $50 billion. Conversely, investments in unproductive assets that immobilise capital, like gold, worsen it.
The essential fact is that India is short of capital, and has to rely on foreign investment. This is why higher price-earnings (PE) multiples and investments by foreign institutional investors (FIIs) are preferable to a more conservative approach, and why we need more locally manufactured high-quality products.
The growth agenda
It is the central and state governments that have a great deal to do to remove obstacles to investing and functioning here, as spelt out by the Damodaran Committee recently (http://www.mca.gov.in/Ministry/annual_reports/DamodaranCommitteeReport.pdf). It will take much more than governments, however, because a major reason for our inability to act in concert is our fractious, adversarial approach that extends to corporate interests as much as to our politics.
There is one important aspect to which the RBI can make a real difference: perceptions and sentiment. It can lift sentiment and facilitate performance. Better returns are required for higher domestic investment. According to an RBI report, returns also have a positive influence on foreign institutional investment ("QE-II and FII inflows into India - Is there a Connection?", Anand Shankar: http://rbi.org.in/scripts/PublicationsView.aspx?id=13973).
In our circumstances, functioning below capacity with high interest rates (State Bank of India's prime lending rate is 14.55 per cent), lower interest rates can help close the output gap in the short term, although major structural changes have to be addressed for the medium and long term. Some opine that high inflation prevents this; others cite India's supposedly negative real rates. Consider these facts before reaching your conclusion:
- According to the RBI, real lending rates were positive over the last two decades, as shown in the graph.
- The RBI apparently didn't reduce the repo rate because the inflation based on the wholesale price index (WPI) rose to over six per cent in August. This happened because onion prices rose 244.6 per cent. Higher rates have not reduced food inflation so far, as the problems, mostly in vegetables, are supply-related. It couldn't possibly bring down onion prices or overall food inflation, but it destroyed positive sentiment. Instead, it would help if the RBI could be persuaded to act on inflation when it is appropriate, as in the case of interest-rate-fuelled asset bubbles. It could institute policy-driven, real-time sectoral dampers to deflate funds diversion and excessive speculation, and leave supply problems, as in the case of vegetables, to the government.
- After the rate increase, sectors like banking, real estate and automobiles fell sharply because of anticipated lower earnings. Bank securities holdings fell immediately, marked to market at lower prices.
- Some think that higher rates make bonds attractive to FIIs. Typically, if there's high uncertainty, FIIs don't look to emerging market bonds for returns, whereas they may consider this if they perceive less risk. In the last 12 months, FII bond holdings went down by Rs 18,000 crore, while holdings in equities increased by about Rs 1.48 lakh crore. There will be far higher investment in stocks if profits improve.
The opportunity: Our markets
India's economy is near a chasm because of a convergence. This convergence gave India a rising economic tide, and feeds the aspirations of an increasingly larger number of people. Together with this, demographics over the next decade will create the largest proportion of working-age population in India's history. To the extent that they can be educated, trained, absorbed and productively employed, India is likely to flourish. The alternative - if their potential is squandered through actions leading to economic stagnation and societal disorder - is simply unthinkable. We face an enormous threat which, if we get across successfully, will turn into a tremendous opportunity. Yet, large sections of the political leadership including of the ruling party, and of the press and media, seem oblivious of how close we are to real danger.
Our markets are also our greatest attraction, ranging from being large but potentially weak, if we do badly, to large and strong, if we do well. This is why investors put up with our obstacles; why Japan Inc, for instance, is struggling to replicate the success of Maruti-Suzuki. This is a strength that we can use to achieve more of our potential, with a judicious combination of governance, positive sentiment and monetary policy, instead of being bypassed as we are now.
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Figure 1 shows how GDP varied inversely with lagged real interest rates in the 1990s in the emerging economies of Argentina, Brazil, and Mexico, and the new OECD member Korea.
Figure 1: Real Interest Rates & GDP in Emerging Economies
Source: Business Cycles in Emerging Economies: The Role of Interest Rates, Pablo A. Neumeyer & Fabrizio Perri: http://www.nber.org/papers/W10387
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