The Modi government needs to take swift action to bring down interest rates drastically if it wants to kick start an economic recovery
June is around the corner and the second bi-monthly policy review of the Reserve Bank for 2016-17 is imminent. If times were normal we would at most have expected another quarter percent reduction in the interest rate with a few other small changes to tweak the economy into going in the desired direction. But times are anything but normal.
The Modi government swept to power on the explicit promise that it would bring ‘Acche Din’ back again. But two years have passed and the economy has only sunk steadily lower. Today more and more people are beginning to fear that it simply does not know what to do. It now has three years in which to redeem its promise. If it fails, it faces a defeat in 2019 from which it may never recover.
Where should the government start? The answer has been staring us in the face for the past four , if not five, years: It is to end the obsession with combating inflation and start consciously planning for growth again. This is what two governors of the RBI have adamantly refused to do ever since 2011. More inexplicably, this is what two governments, one packed with world class economists, have allowed them to do.
When inflation, measured then by the wholesale price index, touched double digits in March 2010 the RBI reversed an 18-month easy money policy and began to raise interest rates every two months till the borrowing rate for medium-sized, sound, companies touched 14 percent. That policy was misbegotten even then because a large part of the domestic price rise had been caused not by a surge in domestic demand but in global commodity prices triggered by runaway investment in China under its Fiscal Stimulus programme.
Whatever shred of justification had remained for such a high rate in 2010 and 2011 disappeared when China’s fiscal stimulus programme ended, world commodity prices slumped, and wholesale price inflation in India began to drop. By mid-2012 WPI inflation had halved and everyone expected the RBI to start lowering interest rates once more. But instead it perversely switched its measure of inflation from the WPI to a newly constructed Consumer Price Index( CPI) that gave far greater weightage to items such as health, housing, fuel, transport and education, where the price rise was driven by the Indian State’s systemic neglect of these sectors.
When, despite this, the CPI-based inflation rate too fell to five percent at the end of 2014 (and the WPI index of inflation became negative) the RBI, now under Raghuram Rajan, switched horses once again and began harping on the need to control ‘inflationary expectations’, to keep its policy rates unchanged. The market lending rates therefore remained at 12 percent to 15 percent. With inflation having fallen below zero, and inflation measured by both the WPI and the GDP deflator at or below zero this gave India the highest real rates of interest in the world.
Side by side with this has gone a near complete disregard for the effect of its policies on economic growth. In July 2010 and 2011 the RBI’s annual reports took continued high growth for granted, and assumed that high interest rates would only dampen inflation. When industrial growth fell from 8.2 percent in 2010-11 to 2.8 percent in 2011-12, it still took credit for having ‘moderated’ growth and thereby successfully curbed ‘inflationary expectations’.
When growth did not revive in 2014 even after inflation disappeared the RBI began to put the blame on infrastructure shortages, too much red tape, litigation over land and delays in obtaining environmental clearances. Only ignorance, or rank intellectual dishonesty can explain why it overlooked what was obvious to any economist, that while these hurdles could inhibit investment in new, ‘green field’, mines and factories they were no obstacle to increasing production from existing mines and factories. Capacity utilisation in industry had fallen from the high eighties before the onset of global recession to seventy percent by 2013 and more precipitously to 60 percent last year. The cause was not any shortage of raw materials or power, but of demand. That was the curse that the RBI had bestowed upon the Indian economy.
But the RBI remained unrelenting. In 2013, when company after company began to succumb to the debt burden created by high interest rates and low demand, Rajan shifted the blame for industry’s failure onto the greed, ambition and lack of scruple of Indian entrepreneurs, who had taken huge loans in preference to issuing more share capital, in order to monopolise profits and avoid diluting control of management. A year later, as the bad debt of banks began to choke their capacity to lend he also began to accuse bank managers of cronyism and incompetence in the sanction of loans.
What the RBI has never asked itself is whether its own policies might be to blame. The very same bank managers and entrepreneurs whom it is blaming now were responsible for the eighteen-year spurt in growth that began in 1993. Then as now, some had been visionary and far-sighted, while others had been venal and incompetent. India’s business environment, too, had been as unwelcoming then as it is now. So what had changed to bring about such a sharp reversal of industrial growth?
The answer is the real rate of interest. Despite Rajan’s niggling rate cuts over the past year, the lending rates of the commercial banks for all but a handful of ‘prime’ borrowers, are still above 12 percent. At this rate the cost of any project, be it building a power station or acquiring a flat screen TV, doubles every six years. This single fact explains both the abandonment of Rs.880,000 crores worth of infrastructure and heavy projects, and the four-year slump in the sale of consumer durables. It also explains why Industrial growth has averaged less than three percent since 2011.
Above all, it explains why employment has all but stopped growing. Until chief economic adviser Arvind Subramaniam raised the issue in the 2014-15 Economic Survey, there had been a virtual conspiracy of silence in North Block over this issue because successive governments simply did not want to face it. As a result India had remained one of a handful of countries that did not have annual employment data, and did not even attempt to set annual targets for employment growth.
However , extrapolating from the quarterly data for employment growth in eight labour intensive industries that the Ministry of labour has been tracking since 2008, the annual growth of employment in the economy as a whole has fallen from over seven million in 2008-9 to under one million in 2015-6.
Where are the jobs?
In sum, six million young men and women who would have found work if growth had continued at the pace attained in 2003-2011, have found themselves without a future in this one year alone. Theirs is the desperation that is fuelling the Patidar and Jat agitations for job reservation in government today. And this is only the beginning of the troubles in store for the Indian State in coming years.
Worst of all, with every day that interest rates have stayed at their present, crippling, level they have further eroded the capacity of the economy to bounce back from recession. For every month of delay has added to the burden of interest payments and eaten into the net worth of indebted companies till there is nothing left to revive.
The Indian economy is close to this point of no return. The RBI’s own study of the non-financial corporate sector in India in the first half of 2015-16, showed that 25 percent of the more than 2,800 companies sampled had accumulated debt in excess of their net worth or in excess of three times their equity capital, and were unable to repay their loans. Their only hope of survival as functioning units is to sell off some of their companies to other cash-rich companies in order to reduce their debt and hope for better times. This is already happening. Kingfisher was forced into bankruptcy and dissolution, but Suzlon and Jet airways found foreign buyers for a controlling portion of their shares.
GMR , with Rs.43,000 crores of debt is selling 30 percent of its equity in GMR energy to Malaysia’s largest power utility. Jaypee, among the most ambitious and visionary infrastructure companies in the country, had a debt of 57,000 crores in 2013. Two years later, despite having sold off a fifth of its assets, its debt had climbed to Rs. 61,285 crores. And even some of the buyers are now in trouble. Jindal energy, which bought the two hydro-power plants from Jaypee, is having to be bailed out by elder brother-owned Jindal steel.
The plain truth is that mergers and acquisitions work when failures are individual, caused by poor planning, foresight or unforeseen changes of technology or taste. But they don’t when the cause of failure is systemic and simultaneously affects entire swathes of industry. India’s prohibitive interest rates are causing the latter type of failure, and the longer the gestation period of a company’s investment, the more complete has been the failure.
This is the reason for the difficulties that the commercial banks’ restructuring of stressed companies by converting a part of their corporate debt into a controlling share of their equity has run into. For since there has been no change for the better in the environment within which the re-structured companies have to operate, more and more of these are also meeting the same fate as their predecessors.
The catalytic change that will allow re-structured companies to make a fresh start will only come about when the government forces the RBI to lower interest rates not marginally but drastically. But instead of doing this the Modi government is concentrating on making the death of the Indian corporate sector easier by changing the country’s bankruptcy laws. If all goes well Indian companies will now take only one year to die instead of four.
Two stark choices
The Modi government now faces two stark choices: it can allow the real rate of interest to borrowers to stay in the 10-12% range, and keep blaming corrupt investors, complaisant bank managers and the ‘global downturn’ for India’s woes. Or it can bring lending rates down very, very sharply to a level that will revive consumer goods sales, allow debt ridden firms to cut down their interest burden drastically by refinancing their loans, and then allow the most heavily indebted among them to re-structure their debt by issuing controlling shares to their creditor banks.
The first will inexorably lead to massive sell-outs to foreign companies at bargain basement prices, and will wipe out of a large section of the Indian entrepreneurial class. The second will not only save the economy but also the Indian entrepreneurial class. But it will require Narendra Modi and Arun Jaitley to decide that it is the responsibility of the government to determine interest rates, in line with its economic priorities, and not that of the RBI.
If they take the latter route they will still have to decide by how much interest rates should come down. Contrary to what Rajan has been trying to impress upon the government, there is no econometric model that can tell them what the interest rate should be. On the contrary, as Kaushik Basu, Rajan’s predecessor as chief economic adviser in North Block, has stressed in his recent book, ´An Economist in the Real World: The Art of Policy Making in India” the first step must be to accept how limited is our understanding of how economies actually work, and therefore how much policy making has to be based upon learning by the bootstrap, and from past experience.
One guideline is provided by the economic recovery that was engineered by the Vajpayee government between 1998 and 2003. During this period the nominal prime lending rate was brought down from 16.5 to 10.5 percent, but inflation ranged from five to six percent. Thus the real rate of interest was halved to five percent. Today the Prime lending rate is 9.7 percent, but with inflation by its most comprehensive measure, the GDP deflator, at zero, this is also the real rate of interest.
Given the much greater depth of the recession today, the average lending rate needs to be brought down by at least five percent, to be reasonably sure of sparking an economic recovery. Such a sharp reduction will need to be carefully managed , in order to anticipate, and deal, with side effects such as a rise in imports and the financing of the government’s fiscal deficit in the year or two that will elapse before tax revenues rise sufficiently to bring the budget back into equilibrium.
But the alternative, of pretending that India is the fastest growing country in the world and needs to do nothing except tweak interest rates for the good days to return, is a sure road to political suicide.