It’s Make or Break Time for the Indian Economy

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RBI governor Raghuram Rajan needs to halve India’s lending rates and allow companies to get out of debt in order to revive growth and undo five years of flawed policymaking

Fie photo of Finance Minister Arun Jaitley with RBI Governor Raghuram Rajan. Credit: IANS

File photo of Finance Minister Arun Jaitley with RBI Governor Raghuram Rajan. Credit: IANS

India’s tottering economy has reached a fork in the road.

On April 5, the Reserve Bank of India (RBI) will announce its policy for the next quarter. What it decides will determine whether the economy will recover or die.

For five years, since mid-2011, industry has been begging the government for a cut in interest rates, but the Reserve Bank of India has been adamant about keeping them up. As a result, the corporate giants have migrated to more benign pastures abroad, taking close to a hundred billion dollars with them. Indian industry has therefore languished, growing at rates below 3% a year – the lowest the country has ever known.

This dark epoch may at last be coming to an end.

It is now a foregone conclusion that the RBI will bring interest rates down. Earlier this week, finance minister Arun Jaitley told the media that what he wants is what everyone wants—a cut in rates. “I have done everything that [the RBI] wanted me to do. I have held the deficit at 3.9%. And I have brought down the deposit rates on provident funds and small savings. This will make it possible for the commercial banks to bring down their lending rates, without losing deposits to small savings accounts.”

RBI governor Raghuram Rajan has also indirectly signalled a rate cut by admitting that official estimates of GDP growth are almost certainly too high.

The question on everyone’s mind is how much the lending rates will be brought down. The markets have assumed a cut of 50 basis points, i.e, half a percent, in key policy interest rates. If commercial banks pass this, and earlier cuts, down fully, the lending rates could come down by more than one percent. In expectation of this, the Sensex has already re-crossed the 25,000 mark, and will doubtless rise further.

But will a 1%, or even 1.5%, cut in lending rates suffice to re-ignite economic growth?

The blunt answer is “No.” Indian enterprises are so deeply mired in debt that all this will do is prolong their death throes.

Where we are now

To understand why this is the case let us take a quick look at where the country stands:

A year ago there were Rs. 880,000 crores worth of “stalled” investment projects – which is just a polite way of describing projects that the investors had abandoned because they felt that carrying on was throwing good money away. Only a handful of these projects have been revived in the past year, and others have joined their number.

Not surprisingly, therefore, by the end of 2015, public sector and private banks had piled up a total of Rs. 400,000 crores of bad debt.

A lot more debt was on its way to “going bad,” for 415 out of 2300 large companies, heavily invested in infrastructure, were not making enough profit to pay the interest on their debt.

Today nine out of India’s dozen steel plants are insolvent and outstanding. Companies like Jaypee and Gammon India have piled up debts in excess of Rs. 33,000 and Rs. 15,000 crores respectively that they are unable to repay.

One by one, companies that had become brand ambassadors for India in the fiercely competitive global market have begun to fail.

Kingfisher Airlines, which had set a new standard of comfort and service in economy class flying, was the first to go, and it has gone all the way to the bankruptcy court. It was followed by Suzlon, which saved itself only by selling out to a foreign competitor and, in effect, ceasing to be Indian.

Jet Airways has done the same and become a subsidiary of Etihad airlines. Today, United Breweries (rechristened United Spirits), which had made its Kingfisher brand of beer synonymous with international cricket, is going the same way.

Unitech, one of India’s largest construction companies, has gone broke and its owners have spent time in jail before being bailed out. Behind Unitech is a queue of other construction companies inching towards a similar fate.

So far, like a caring undertaker, the Modi government has done everything it can to make these companies’ passage to the other world less painful. Loans have been ‘re-structured’ – a euphemism for having repayment conditions eased on a case-by-case basis – and laws have been changed to make the dissolution of bankrupt companies easier and quicker.

But since the Modi government has done nothing to change the basic conditions in the market that have driven these companies into crisis, the re-structured loans are also speedily souring.

The first step to economic revival

Can this economy be revived?

There is nothing magical or secret about what needs to be done.

The first step is to halve India’s brutally high lending rates from the present 11 to 15%, and allow all companies with a positive operating surplus, i.e, a higher current revenue than operating cost, to refinance their loans at the new rates of interest. For a very large number of companies, this will suffice to make them solvent once more.

To those who have uncritically accepted the quarter percent rate cuts that Governor Raghuram Rajan has been willing to concede so far, this cure may sound too radical.

But it isn’t. In 1999, the interest rate I was receiving on my five year bank deposits was 13.5%. By 2003, Finance Minister Yashwant Sinha and RBI Governor Bimal Jalan had brought it down to 6.5%. But the economy did not suffer because the economy was growing at an 8.2% (genuine) rate of growth. And I did not suffer because I had shifted my money into equity shares and multiplied my capital by 220 percent.

So where is the downside in this solution?

Today’s financial pundits never tire of reminding us that this makes for the revival of “inflationary expectations.” The surge in demand that will follow a sharp lowering of interest rates will, they fear, cause the economy to “overheat” and push up not only prices but also India’s balance of payments deficit. “Real” interest rates, they maintain, must therefore always be “positive,” i.e, above the rate of inflation. With the cost of living still rising at 5% and the REPO – the rate the RBI charges commercial banks that borrow from it – at 6.75% there is only limited room for a further cut.

This reasoning is, to put it bluntly, pure gobbledegook. To investors it is not the REPO but the borrowing rate that matters. Today, the prime lending rate of the commercial banks is 3% higher than the REPO rate, and the average borrowing rate is 4 to 4.5% higher. So, there is plenty of room for a sharp cut.

Waiting for something to grow. Credit: Shome Basu

Waiting for something to grow. Credit: Shome Basu

Misplaced theories

In any case, why must the real interest rate be positive?

China has financed its explosive growth for thirty years by paying negative real rates of interest on bank deposits. The downside of this – a huge excess of capacity in infrastructure and heavy industry – is only surfacing now, but has any Chinese person said, or written, that he or she wishes the growth had not taken place?

By the same token, for more than three decades, South Korea systematically used a variety of financial instruments, including negative real rates of interest, to foster the growth of private and state owned enterprises that it felt had the capacity to take on the European, American and Japanese multi-nationals that dominated the world market.

The truth is that “inflation targeting” and “positive real rates” are products of the neo-liberal dogma spawned by Milton Friedman and the Chicago school. These ideas have gained their popularity because they have served to legitimise the dominance of finance capital over industry in the de-industrialising western world. But they are, in the end, only dogma. And in India, they have been misapplied and have caused us to lose a crucial decade of economic growth – a decade that we may never recover.

Kaushik Basu, who was Rajan’s predecessor as Chief Economic Adviser in the ministry of finance, has summed up the worthlessness of dogma in his latest book An Economist in the Real World, as follows:

“One thing that experts know and non-experts do not, is that experts know less than non-experts think they do. Take for instance monetary and fiscal policies. Decades of careful research have given us important insights into these. But on many large questions we have little more than rules of thumb: if there is stagnation lower interest rates and inject liquidity; if there is inflation raise policy rates and the cash reserve ratios of the banks….

The reason these …work, at least tolerably…is evolution. Over time the wrong moves get penalised and their users either learn by watching others, or disappear themselves. In brief we get our monetary and fiscal policies right …in the same way as birds get their nest building right.”

Basu’s simile sums up everything that has gone wrong in policymaking during the past five years.

Rajan and his predecessor, Subba Rao, abandoned the wholesale price index and switched to using the cost of living index as a measure of excess demand, and imposed a high interest rate regime on the economy. However, what the cost of living index was measuring was not an excess of demand, but shortages of supply caused by the growing failure of the state to provide essential services like health, housing and education, and state government-administered increases in the price of foodstuffs, agricultural raw materials, transport fuels and power.

Today, every index of inflation – wholesale prices, the GDP deflator and the core rate of inflation – is zero or negative. So, either the RBI governor must learn from his mistakes and bring the interest rate down to half the present level over the next six to nine months, or he must “disappear.”

The second step towards revival

Sharply lowering the interest rate is only the first step towards revival.

The second step is for the government to help companies that are deeply mired in debt to be saved, in this way: convert a sufficient part of their debt into equity and then itself buy enough of the shares to instil confidence in the market that it does not intend to let the company in question fail. Here Jaitley could follow Basu’s second dictum – learn by watching others.

The shining example of success is President Obama’s rescue of General Motors (GM).

In 2009, when GM and Chrysler were about to declare bankruptcy, the US treasury spent $49.5 billion to purchase 500 million shares of GM, $1.5 billion to bail out some key ancillaries, and $3 billion in subsidies to make Americans replace old cars with new fuel efficient ones.

Not only was GM saved but three years later, the treasury was able to sell the 500 million shares to the public for $39 billion. What is more, it saved 1.2 million jobs and also earned $39.4 billion in taxes.

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  • Joji Cherian

    “the corporate giants have migrated to more benign pastures abroad, taking close to a hundred billion dollars with them”

    And see what is happening to Tata Steel which acquired Chorus with much fanfare.. By reducing the interest rate you can delay the corporate default rate for a while.FOR A WHILE. Then it will be back at Junk in Trunk economy.As what we see in America where the interest rate is held at ridiculously low rate,unchanged for the past 10 years. It is curious how Wall Street surged to almost the all time high these days on Jannet Yellen’s comment that interest rate could not be raised. Why? Yellen said the economic outlook is deteriorating.The share markets hit highs when economic conditions are deteriorating.
    Mr Jha is a highly erudite person and me a nobody.Still I can not understand his logic.

  • Sagnik Chakraborty

    That would constitute the making of another crisis-that caused by rapid currency depreciation.
    That’s what hit Thailand and Indonesia in the early 2000’s and they are still struggling to cope up. When Foreign capital comes in, people are irresponsible.
    But when it goes out, it leads to a hangover like situation because the currency falls.
    Raghuram Rajan’s book (Fault lines) is a good read to get the basics of this.

  • piyush

    do not reward people who have goofed up by taking huge loan and not able to pay back.Solution should be to reduce interest for all.This will make sure only those who took right choices during good times survive bad time. Let companies who made wrong investment die or be taken over by others companies/ government and good one flourish. This will make sure no one repeat those mistakes. If you want to bail out. Bail out farmers and people who are in distress and they will create more demand for economy and cause growth.

  • Sowhat

    Dr Om, that is bad banking and economics. Several companies that feel the pain today, are simply because they are not efficient. They ‘invested’ too much to create too little. It does not make sense to throw good money after bad.

  • satish

    The present RBI governor is the worst India has ever had. For most ignorant people, they only look at his armour of degrees. The results of Rajan’s actions speaks for itself: Indian economy on the death bed badly needing blood and Rajan preaching about perfect digestion. It is so easy to see he is working for US interests: a high interest rate regime and chase for dollar reserves is a must for other countries to not create hyperinflation in the US due to excessive QE. The medicine that was used by US works only if no one else uses it. The IMF puppet will ensure this. After his term is over, he will leave India for US or IMF. The Genius of Rajan is in building reserves of US Dollars. He comes from US, will go back to US. If you have any doubt, just look at the increasing number of NPAs across industries, high and growing unemployment, collapsing rupee (self induced), highest interest rates for any growing economy (in fact, it will destroy the economy). The Indian industry is in a tailspin and any talk of firing Rajan makes the US vested interests nervous as hell. They need Rajan, more than India ever does or cares. The game of geopolitics and American hegemony is not for the layman to understand. The time to act is already past. Indians are doomed with the fatal combination of Modi and Rajan. Indians will for a long time rue Rajan’s actions who has made RBI itself the biggest Non Performing Asset!

    • Sowhat

      If the corporates are in pain mainly because of high interest rates, shouldn’t you direct your ire at commercial banks which have transmitted less than half the RBI’s rate cuts. The truth is real interest rates are currently barely 1.5%, which is not high. You cannot simply look at nominal rates and judge if rates are high; it is just like the fact that foreigners will not invest in India because interest rates are high..because high inflation will erode the purchasing power of the Rupee leaving no benefit in foreign currency terms. Actually RBI is trying to put more in your pocket in real terms and most people (the silent majority) understand that.

      • satish

        You can defend RR to death; the fact of the matter is that RR has nothing to lose if he is wrong! And he is wrong. Just look at the economy under his reign. RBI has itself become NPA. RR does not have the will nor the vision to turn around the economy. His actions are causing the Great Depression in India similar to the one faced by US in 1929! And by the way, if the RBI has no control over the commercial banks, then why does RBI exist at all? RBI is fully cooperating with the commercial banks in not passing on the puny rate cuts because it does not want the economy to take off! RR is an American stooge who is hell bent on destroying the Indian economy and he is doing a very good job of it.

    • Veer Bharat

      LoL I mean you surely need treatment, if you blame rajan for problems in banking,corporate sector, their loot,cronyism,inefficiency.We shdn’t be blame ills of other sector to pragmatic RBI head Rahguram rajan.

  • S.Thiyagarajan

    The article makes funny reading. The author assumes, albeit wrongly that interest difference of 1% or 2% will make the industries roaring back to pink of helath and reap in rich dividends for the country. These people are unashamedly chamchas of industrialists. Interest rates make only a low percentage of the input and the industries are not going down becuase of present interest rates. Surely Kingfisher has not suffered because of interet rates but because of one man’s over ambition and extravagance. If the author wants to halve the present interest rates, how much will the deposit holders suffer because of the erosion in their returns? Mr. SubbaRao has suggested that RBI is consulting everybody about the policy rates except the backbone of the banking system, the poor depositors. Already the bank deposits are making a negative return after provisioning for tax and inflation. If you reduce the deposit rate further, who will put the money in the banks and what the banks will do for funds? Simple logic and thinking eludes the so-called elite economists. The FM willingly or unknowingly following the advice of this elite economists and pitching for further and further rate cuts. If the deposit rates are cut any further, the depositors will flee from the banking system and the banks will have to depend on the govt. hand outs. for their survival. The govt. will be financing the extravagant industrialists indirectly thro banks. Further many banks which are tottering on the brinks will go under and the banking system will be under seize. For heavens sake, donot listen to these so-called elite, high flying, foreign educated economists who are advocating disaster for the banking industry. The FM has got a duty to safeguard the interest of the poor depositors, many of them are retired pensioners depending on the interest return s for their livelihood. The industry is suffering because of extravagance and masmanagement. Depositors cannot be made to bear the burden for the affluent industrialists. They are sponging on the banking system and when things go wrong, they will flee the country and live blissfully in anotheer country making fun of the entire banking, legal and governace. The banking system will make a monkey out itself if it follows the ill advice of this high flying economists. The very base of the BJP, the salaried middle class will be destroyed by this ill ove. Please avoiud any further rate cuts.

  • Veer Bharat

    Wow problems of economy like cronyism,inefficiency, corruption, flawed price realization of projects,loot,supply side constraints,shady banking transaction,lendings is blamed on RBI interest rates, very far sighted of you.
    I think such quick policiy fixes is just creating islands of prosperity and islands of destitute in India. Which our cities,rural India or every public sphere displays with very high contrast.