Government must quickly restore credibility of monetary policy. (Representative Image – File Photo)
Theoretical economics tell us any reduction in interest rates has two-fold impact on the economy – One, it shifts consumption from future to present and two, shifts savings from deposits in banks to stock markets. In contra any increase in interest rates shifts present consumption to future [antidote to inflation] and from stock market into bank deposits.
As the clamour for reduction in interest rates gets shriller by the day, we need to put this theory to greater scrutiny, more so from the Indian perspective.
But first some facts on the state of economy:
India’s gross fiscal deficit reached 99 per cent of the annual Budget estimates by end November 2014. This was primarily on account of revenue slippages accentuated by expenditures overshooting budgetary estimates.
On a year-on-year basis, non-food bank credit increased by 11 percent in November 2014 as compared with an increase of 14.7 percent in November 2013. That implied further slowdown in economy. Consequently, credit to industry increased by a mere 7.3 percent in November 2014 as compared with an increase of 13.7 percent in November 2013. Deceleration in credit growth to industry was observed in all major sub-sectors, barring construction, beverages, tobacco, mining & quarrying.
As at end of September 2014, India’s total external debt stood at USD 455.9 billion, recording an increase of USD 13.7 billion over the level recorded at end-March 2014. India’s foreign exchange reserves provided a cover of a mere 69 percent to the total external debt stock at end-September 2014.
A sharp rise ingold imports and a fall in export growth pushed India’s current account deficit [CAD] to approximately USD 10 billon [2.1 percent of GDP] in the second quarter of this financial year, ending September, compared to USD 5.2 billion (1.2 percent of GDP) for July-September 2013.
In short, there fiscal deficit is spiralling out of control, external debt is piling up while there is pressure on the Rupee on account of widening CAD. All this, experts tell us can be cured by simply reducing lending rates by half a percent! How puerile can we get?
A half-percent solution?
In my previous column [Budget 2015 – Micromanaging the economy], I had dealt with issues raised by the mid-term review of the economy carried out by the Finance Ministry. Based on the said review I had pointed out that approximately Rs 18 Lac Crores of project are stalled across the country for a variety of reasons.
One such project was that of my client. Naturally, his company was unable to repay banks which had lent significant sums. Worried of the possibility of this company going belly up and consequently paranoid of this account becoming bad the bankers summoned my client only to give piece of their mind.
My client was bombarded with logical questions by his Bankers. And the most pertinent of them being – when will he repay the entire amount back to Banks? At-least when would he service the outstanding interest? My client was unfazed. After all, to him, such meetings were “routine.”
According to my client all that the bankers spoke was filibuster! And the threats [including designating him as a wilful defaulter and seizing his assets] held out by Bankers were empty; impossible to be effectuated.
Gathering his wits instantly he retorted: “I have not diverted any money from my project. Importantly, as Indian economy chocked during the UPA regime my project could not achieve more than 30 percent capacity utilisation. And that turned a wonderful landmark visionary project into a non-performing one.”
Crucially, he put forth a profound question: “What is my fault? If I am guilty of exaggerating revenue flows from my project, so were bankers who carried out due-diligence on the same before lending to me.” What followed is not for public consumption.
It was indeed an acrimonious war of words between the borrower and lender banks. Yet there is something that strangely unites the two warring sides – reduction in rates! My client, as well as his bankers unanimously concluded the meeting that the only solution is in reduction of rates.
And this half percent rate cut is supposed to at-least double the capacity utilisation of his project from present low levels, bring instant revenues and lead to increased cash flows that would in turn facilitate paying of [outstanding] interest as well as repayment of loans! How silly can we get?
It is in this connection the Midterm Review of the economy states, “For nearly six years (2007 third quarter to 2013 third quarter), India lost monetary policy credibility, reflected in the fact that real policy interest rates were consistently negative at a time when inflation was persistently in the double-digit territory.”
These policy distortions were caused by a fixation of the previous dispensation to a lower rate regime and thereby sustain stock markets. And despite such distortions Indians invested predominantly in Banks, not stock markets.
Nevertheless, this distortion paved way for easy-cheap money and built-up of asset bubbles which in turn explain why my client and his banker recklessly embarked on building huge capacities. These capacities were disproportionate to the need of Indian economy, more so as it was hit by a downturn since 2010.
The economy, banker and my client are all attempting to pay now for sins committed through a half percent rate reduction!
Missing woods for the trees
In one of my previous column Budget 2015 – Micromanaging the Economy I had pointed out that the consumer durables and consumer non-durables have recorded a growth of (-) 35 per cent and (-) 4.3 per cent respectively during October 2014 when compared to October 2013. These are alarming indicators of retail demand having completely dried up.
The dramatic collapse of demand in consumer durable indicates the loss of confidence by consumers in India. The reason for the same is not far to seek. Demand, especially at the retail level, is a product of confidence. Remember that confidence at the retail level is rooted to aggregate of all policy of Government.
Put pithily, benign interest rates of the past years ended up creating asset bubbles, robbed consumer of their confidence and did not divert Indian savings into stock markets – contrary to what the experts and economists had predicted. Thus, there is a quintessential problem of both demand [as exemplified by this data mentioned above] and supply [as my client story demonstrates].
And both cannot be cured by a rate cut!
Unless consumer confidence is restored and demand picks up at retail level, recovery is a far cry. The Government must realise that the only way to do so is to quickly restore credibility of monetary policy.
Those championing reduction of interest rates are genuinely hoping to revive investment – a non-starter. The reason for the same is not far to seek as most corporates who probably could borrow are already in the red, like my client! Moreover, several sectors are facing capacity overhang caused by a loose monetary policy of yesteryears. Either way banks [having learnt the lesson the hard way] have very less risk appetite.
But what about borrowings by retailers on account lower interest rates? Will it not fuel demand? Will it not trigger growth? The answer to this question is cultural and psychological and hence beyond theoretical economics – Indian retail demand is not credit driven as it is in several other countries. Hence triggering retail demand through rate cuts too is a non-starter.
Unless inflation is controlled and real interest rates turns positive ordinary Indians will not have any faith in the Government. To restore confidence, Government has to cut fiscal deficit and demonstrate that it can walk the budget talk. Also it needs to remove through effective governance all supply side constraints to address inflation spikes.
Moreover a positive deposit rate is an elixir for restoring retail demand as it would ultimately result in more money in hands of consumer. Remember India has in excess of Rs eighty lac crores as deposit in banks. These are not only savers; they are also consumers.
For the past six years this group – the households – have been short charged on account of a lax monetary policy.
But pink papers and armchair economists, because of vested interests, fancy a rate reduction without an economic rationale. Crucially, the Foreign Investors who have invested in India’s stock markets too want to offload. But in the absence of retail investors are finding it difficult to exit from India. Cut or no cut, when it comes to investment in stock markets it is a classical case of once bitten twice shy for Indians!
To conclude, lower interest rates have failed to persuade Indian to shift invest their investment into stock markets. Neither has it shifted future consumption to present. Indian households by their sheer doggedness and persistent savings outwitted theoretical economists. Yet experts parrot the same rate cut mantra!
Will Budget 2015 sidestep advice of experts to artificially reduce rates? Will it slay the monster of inflation? Will it significantly lower fiscal deficit? Crucially, will it make India an efficient economy and hence an attractive investment destination?