The Burden of High Interest Rates

The Burden of High Interest
Shyam Ponappa / New Delhi March 6, 2008

We need low interest rates for many years of double-digit growth.

I first saw ‘Whack-the-Gopher’ years ago at Billy Bob’s in Fort Worth, Texas. This place, famous for country entertainment, has a pro bull riding arena, a huge dance floor, many bars, and a Texas BBQ. It also has Whack-the-Gopher. Stand with a mallet in front of a raised ‘yard’ with a number of gopher holes. As the varmints pop out, whack them back in.

RBI’s Nostrum: Whack the Gopher

The RBI has its own variation. Every time the economy picks up, whack it with high interest rates, talk about inflationary risks to fuel uncertainty — and watch it fall back.

If anyone is chuffed at 8.7 per cent growth, stop to consider what kind of sufficiency leaves growing swathes of the country subject to violent attacks by extremist rebels, while most of it has no basic amenities (sanitation-water-health-education). In contrast, China apparently defines a growth rate at which employment fails to keep up with new entrants into the labour market as “economic stagnation”.* What will it take for India to plan and achieve the rising tide that, starting from Japan in the 50s, many countries have had the sense to figure out and make happen? Everyone including the Left must realise we can only aspire to any decent living standards after coordinated efforts to get 10 per cent growth for at least 10 years or more.

The RBI’s charter needs to be redefined, stressing growth and employment primarily, and inflation control secondarily, instead of the other way around. We would do well to remember that while countries that grew fast experienced occasional crises, they still grew faster than countries with smooth credit conditions.**

Interest & Profits

The chart shows Interest Expense as a percentage of Revenues, Expenses, and Net Profits from FY2000 to FY2007 on the left vertical axis, and the minimum Prime Lending Rate from FY2000 to date on the right vertical axis.

Interest costs amounted to as much as or more than net profits from 2000 to 2002, then dropped to around 20 per cent by 2007. From the way costs varied with rates, we know what will happen to profits. A study of quarterly interest rates and GDP growth in India for 2000-2006 corroborates this, as does an IMF study of other emerging economies I have cited earlier.#

Investment and planning are driven by perceptions of growth and profits. If revenues and profits (and expectations of them) grow at near 20 per cent, companies will continue to invest, and investors will keep buying stocks at high valuations. More enterprises will come on stream and do well, with additional growth in employment (i.e. further increases in output and employment). This is a virtuous circle for India with its demographics and headroom, because a large proportion of the population has room for appreciable improvement to attain reasonable living standards. This provides massive scope for additional housing, transportation, energy and other infrastructure, durables and consumer products, as well as services. And it can only happen if enterprises and individuals continue to invest and act with optimism, buoyed by the prospects of growth and profits. Remember how years ago, good multinationals had consistent PE multiples of 25 when the market was at 15? This is why. And yes, there are reasons to justify such valuations for good Indian companies for the foreseeable future, provided our monsters don’t all rise.

Defenders of the Faith

A theoretical argument for high interest rates is that they can’t be lower than inflation. However, consider the examples in the Table for India, China, Malaysia and Thailand:

Inflation in these countries is in fact higher than their interest rates, while borrowing costs in India are double these countries. A one per cent lower rate in India in 2007 would have resulted in increased net profits of about 3.5 per cent (based on a sample of companies). So, if Indian companies paid 3 per cent less for debt, their profits would increase by 10 per cent.

Of course, you might say: what about more profits that could accrue from a rationalisation of taxes, of better infrastructure, e.g. lower power costs and no standby requirements, better transport with improved logistics, government services provided efficiently over the Internet, and so on? You would be right. This is why there is potential for growth in profits of 20 per cent plus for many years together as all these kick in, provided we do what it takes to realise the potential.

Actionable Steps

What can the government do?

- Get the RBI to focus primarily on growth and employment, with a secondary emphasis on inflation.

- Take equivalent steps starting in the finance ministry on fiscal discipline, extending to all ministries and states; avoid populist giveaways.

- Set clear goals and coordinate all policies and actions across ministries and states and between the government and the RBI to achieve them, e.g.:

a) Lower expectations of inflation by:

Cutting and rationalising taxes;

Building policies and practices to deliver additional supplies of foodgrain, pulses, and edible oil as in the next paragraph.

b) Develop and execute sector-specific supply strategies, e.g. for foodgrains, pulses and edible oil: acquire additional stocks with better pricing; formulate strategies for additional production through better analysed and managed cultivation, i.e. better scientific inputs, extension and practices, and strategies such as offshore joint ventures.

c) Maintain a lower interest rate structure. Avoid inappropriate rate increases when limited supplies cause prices to rise; instead, coordinate fiscal and monetary policies (macro plus sector-specific) to improve supplies.

d) Develop and deploy systems and procedures at the operating level to facilitate lending on a sound basis to sectors such as construction, housing, durables, transportation and automotive products, i.e. more emphasis on the RBI’s banking operations charter. Good systems and procedures for sound credit will accelerate productivity, growth, and employment. As cited in an earlier article, the IMF found that it is indiscriminate lending without proper credit evaluation and/or repayment projections that lead to crises.@ This is important for an economy that relies heavily on bank credit, and does not have a well-developed bond market.

Such steps will help many of the gophers get up and away.

shyamponappa@gmail.com

* ‘Harsh winter raises specter of “Chinese stagflation”’, Simon Rabinovitch, Reuters, January 20, 2008: http://www.reuters.com/article/ousiv/idUSPEK7570420080130

** ‘Crises and Growth: A Re-Evaluation’, Romain Rancière, Aaron Tornell, and Frank Westermann: http://www.nber.org/papers/W10073

# ‘Exploring the inflation, interest rate, growth nexus’, A. Vasudevan (former RBI Executive Director heading Research), (http://www.thehindubusinessline.com/2006/08/03/stories/2006080300201000.htm), and “Business Cycles in Emerging Economies: The Role of Interest Rates”, Pablo A. Neumeyer & Fabrizio Perri, cited in the BS June 7, 2007: http://business-standard.com/search/storypage_new.php?leftnm=4&leftindx=4&subLeft=1&autono=286882

@ Cited in the BS September 11, 2007: ‘Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies’, July 2005(www.imf.org/external/pubs/ft/wp/2005/wp05151.pdf), see http://business-standard.com/search/storypage_new.php?leftnm=4&leftindx=4&subLeft=1&autono=297545

Bank Credit for Growth

Shyam Ponappa / New Delhi September 11, 2007
India needs continuing rapid bank credit for this phase of growth.

One issue that deserves RBI and Finance Ministry review for action is the rate of bank credit growth. A perverse outcome of the capital inflows we seek — and have for once succeeded in getting — is that credit is less accessible and more expensive because of the RBI’s actions to curb bank credit as India enters its most promising phase of growth. While steps must be taken to contain liquidity, the point at issue is the objective of reducing bank credit growth. Perhaps this is because orthodoxy demands that when bank credit grows rapidly, it should be reduced by curtailing availability and increasing interest rates, to avoid excesses.

Let us consider the relevant facts in India’s current unprecedented growth phase. While bank credit has been growing over the last few years at around 30 per cent, rising to 35 per cent in July 2006 before dropping to 22 per cent in June 2007, it is instructive to view it in a comprehensive context. The factors to be considered are GDP levels, bond markets as an alternative source of funds for growth, and levels of saving, investment, private consumption, household debt, and housing finance. Considering some of these attributes in emerging economies as well as in mature markets helps to round out the picture.

Bank Credit & GDP

In 1970, bank credit to the private sector in India was at about 19 per cent of GDP. The UK was at 29 per cent, Brazil at approximately 48 per cent, and China at about 52 per cent, while the USA was already over 115 per cent. By the mid-90s, India reached 29 per cent. The UK had crossed 110 per cent while Brazil was at 60 per cent, and China over 90 per cent. By 2005, India reached 37 per cent, or twice its 1970 level. Meanwhile, emerging Asian economies were at 100 per cent or more; only Brazil’s level had dropped back to about the same as India.

Chart 1 shows the average rate of growth of bank credit to the private sector from 2002 to 2005, and bank credit as a percentage of GDP. This indicates there is considerable room for expansion. However, this must be evaluated together with bond markets to make a better assessment, after considering their roles in India compared with their roles in mature economies as well as emerging economies.

http://www.banque-france.fr/gb/publications/telechar/rsf/2006/etud2_1206.pdf

Role of Bank Credit

The role of bank credit in India is very different from its character in mature markets. Bond markets in developed economies are deep and liquid, and have broad participation from institutions as well as individuals. Consequently, these markets have significant disintermediation, with banks being much less important as a source of funds for growth. In contrast, in India as in emerging Asia, banks are the primary source of funds. Bond markets have not yet developed sufficient depth and liquidity, and so cannot serve as an effective alternative source of growth funds as in mature markets. In this light, high bank credit growth of good quality is precisely what India needs for maintaining economic momentum.

Bond Markets

Table 1 shows India’s bond markets together with other Asian local currency and US dollar bond markets excluding Japan. Asian economies in general have relatively underdeveloped bond markets. The figures show that India has a relatively less developed local currency market than Korea, China, or Taiwan, and an even less developed US dollar bond market. Considered in combination with the predominant role of bank credit, it becomes evident how essential the latter is for India’s economic growth.

Table 1: Bond Markets in Asia

Source: Fitch Presentation: May 8, 2007: http://www.apec-melbournefincen.org.au/latest/BMFforum/docs/PS1-Goyal.pdf

Savings, Investment & Private Consumption

Next are trends in saving, investment and consumption. For the period 1999-2005, domestic saving was 32 per cent of GDP and rising, household saving steady at over 22 per cent, capital formation rising at over 32 percent, and private consumption trending down below 60 per cent since 2004. This looks good … but for the self-inflicted damage we could incur, by (a) curtailing access to credit, and (b) making credit more expensive.

Household Debt

The level of household debt in India is low compared not only to the US and Europe, but to other Asian countries as well, e.g., Thailand, Taiwan, and Malaysia (Figure 2). Average household debt in Emerging Europe was 12.1 per cent of GDP, 27.5 per cent in Emerging Asia — well over India’s 9 per cent in 2005 (perhaps 12 per cent now?), 9.2 per cent in Latin America, and 58 per cent in Mature Markets. Without advocating extravagant consumerism, household debt levels in India have room for considerable growth.

Figure 2: Household Debt 2005

Source: http://www.imf.org/external/pubs/ft/GFSR/2006/02/pdf/chap2.pdf

Housing Loans

The penetration of housing loans as a percentage of GDP is very low in India (7.25 per cent at the end of 2005). This compares with 10 per cent in China, and 61.3 per cent in Singapore. Figures for 2002 for the EU were 42.6 per cent, and for the US 79.6 per cent. The huge demand for housing combined with the relative safety of housing loans suggests that this area requires action to increase the availability of finance at reduced rates.

Consumer Debt & Productivity

Finally, an insight attributed to Jagmohan Raju of Wharton is that many Indian consumers take on debt for productivity-boosting utility products, rather than for consumption or entertainment.* This deserves serious scrutiny; if true, it is a powerful reason in itself against constraining consumer credit and/or making it more expensive.

Lending Booms & Financial Deepening

The IMF cites examples of lending booms in developing economies without subsequent crises in Egypt, Lebanon, and Indonesia.# Driven essentially by the financing needs of a large investment and consumption expansion because of structural reforms, these countries experienced a permanent financial deepening. Other examples cited are euro-convergence countries like Ireland and Spain, and the developed economies of Australia and the UK. The IMF report also draws attention to where and what sort of corrective action is necessary: in systems and training for institutions with substandard credit evaluation procedures, and/or with unrealistic projections of repayment capacity.

Therefore, unless the data and analysis are wrong, the RBI and the government should consider:

1. Accepting that during rapid development, credit will grow faster than output, and provide for it by inducting systems and corrective measures for lax enterprises, with the emphasis on minimising misuse and asset bubbles.

2. Taking all reasonable steps to assure availability of loans at low interest rates as a sound enabler for growth, especially of infrastructure.


* ‘Despite Growing Debt, the Indian Consumer Banks on Tomorrow’, October 31, 2006: http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4105&CFID=32583999&CFTOKEN=56310536&jsessionid=a830583bfa34026567e3

# ‘Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies’, July 2005: www.imf.org/external/pubs/ft/wp/2005/wp05151.pdf

shyamponappa@gmail.com

'Ideal' Inflation & Exchange Rates For India

Thursday,Jul 05,2007

Shyam Ponappa / New Delhi July 05, 2007
What India needs and how we get there.

My last article addressed how strategic use of low interest rates could help achieve better living standards (http://interestrates-gdp.blogspot.com/). This one explores what the “right” inflation and exchange rates might be, and suggests next steps.

Inflation
What is the desirable inflation rate? We must think beyond fixed mindsets to address circumstances as they are, and determine what we can do. Otherwise, we have the ludicrous situation of self-inflicted damage that threatens to hobble growth yet again. How ironical that delegations scour the globe soliciting investment; and yet, when larger capital flows occur, they induce a state of near-hysteria against inflation. The RBI raises rates, to a chorus of approving groans. Thus, perversely, positive developments become the very impediments to progress.

This must change for India to grow at a sustained 9-10 per cent or more. Do we want those capital inflows, or not? Do we want to grow around 10 per cent a year, or not?

An inescapable consequence of growth is that there will be increasing foreign investment. If we avoid moving quickly to full convertibility, we escape some of the volatility associated with it. This market is simply not ready for high volatility (translation: we will not be able to stomach the carnage, so the detriments will overwhelm the benefits). It will be when a preponderance of attributes moves it out of the “emerging markets” category. Meanwhile, incentives can influence flows towards FDI rather than secondary markets or asset bubbles, reducing inflationary pressures. But some of the supply pressure for inflation and overvaluation needs to be channelled into profitable, liquid offshore investments.

On inflation, Dr Rangarajan’s view* is that the “threshold” of 5-6 per cent he suggested years ago was for then, and the ideal rate for India “…depends on what the rest of the world is doing. If the rest of the world is gearing towards… 2-2.5 per cent, we cannot have an inflation rate well above that rate. Therefore, about 3 to 4 per cent is an acceptable inflation rate for the medium term. For now we should be gearing towards 4 per cent...” Paraphrasing, 2-2.5 per cent is desirable but unrealistic, hence a near-term 4 per cent (the WPI is nearly there), with a lower medium-term goal.

Apart from interest/growth-related reasons, inflation hurts the poorest the most. With high prevailing growth, we need the lowest inflation achievable (1-2 per cent?), facilitating low interest and strong growth across a broad front.

Supply pressures & export-friendly exchange rates
Some appreciation of the rupee is inevitable with a strengthening economy, while undervaluation benefits many exporters. Net benefits to the economy, however, vary with a number of factors, e.g. energy prices, as a stronger rupee is beneficial for energy imports and import-dependent exports, while a weaker or undervalued rupee benefits those using local products and services. That said, there are compelling reasons for assisting growth engines (IT/KPO, etc.), despite all the counter-arguments. The same holds for manufacturing, while this sector builds quality and volume. System responses, therefore, need careful evaluation.

What rate?
Should India try to manage the Nominal Exchange Rate, the Real Effective Exchange Rate, or something else?

CRISIL has an index described in a recent article by Radhika Anand and Subir Gokarn called, rather infelicitously, the “Parameter of Competitiveness” (PARC).** This compares the rupee with the export-weighted and inflation-adjusted currencies of India’s competitors for exports. It shows the rupee has been appreciating against competitor currencies since the end of 2005. The RBI has every reason to use this, or a similar measure, as a criterion for evaluating exchange intervention.

Strategy & execution
Recognising that we cannot say “no” to inflows and must say “yes” to growth, what should we do differently?

Set growth objectives—10%+: Goal-oriented planning begins with clear objectives. This means accepting one or a few non-contradictory, overriding objective/s. Then, coordinating responses to achieve it/them. Confused yearnings, fears or wish-lists are not a good starting point.

Analyse dispassionately: For instance, stop viewing trade deficits with lingering fears of scarcity: if a significant deficit arises from increases in imports for growth, this is quite different from, say, a preponderance of oil imports. Growth-oriented imports mean that we are importing capital, exactly as we must.

Coordinate fiscal & monetary policy: The conventional wisdom is that the benefits of an independent Central Bank accrue at no cost to the economy. A report in the European Journal of Political Economy, however, finds that when monetary and fiscal authorities pursue their goals independently, conflicts arise that render both sets of goals less achievable.*** This happens “because unrestrained competition between independent policy makers creates conflicts in which one policy has to be used (in part) to neutralise the other.” The upshot is that goals are subverted, and cannot be achieved efficiently. The more populist a government’s actions, the more the Central Bank becomes inflation-averse.

Strategy and coordination can help achieve the next three items.

Keep inflation and interest rates low: This is detailed in my previous article (http://interestrates-gdp.blogspot.com/) and in the next paragraphs.

Invest foreign exchange reserves abroad: The RBI knows it can invest reserves abroad in remunerative ways. Yet, our culture of crucifying those who achieve breakthroughs ensures that first-movers will suffer if there is a misstep. Therefore, this decision must be a multi-partisan and empowered-Group-of-Ministers’ initiative.

Those who think China began creatively investing its reserves with Blackstone in 2007 should be aware it was investing—whether from reserves or from another account—in strategic enterprises such as phosphoric acid in America, or real estate in Thailand—nearly 20 years ago. Time to wake up and act!

$5 billion in an offshore infrastructure investment vehicle is one thing. $50 billion in liquid funds with returns of possibly over 20 per cent and much more is what we must do immediately. Then, $100 billion.

Structural solutions for chronic shortages: Formulate long-term, systematic, strategic initiatives for energy, pulses, food grains, sugar… instead of repetitively dealing with periodic crises. Instances are: strategic alliances/investments for oil and gas (as begun), appropriate support prices combined with distribution systems that work better for food grains, and a long-term pulses strategy.

Conclusion
It is time to think and act strategically and systematically, in concert, to build a virtuous cycle on low interest, inflation, and exchange rates.

shyamponappa@gmail.com
* “There is no growth-inflation tradeoff”, interview with BS: http://business-standard.com/search/storypage_new.php?leftnm=4&leftindx=4&subLeft=1&autono=288715
** “Rupee impact is large, but not the only one”: http://www.rediff.com/money/2007/jun/11rupee.htm
*** “An independent Central Bank faced with elected governments,” Demertzis, Hallett & Viegi: http://econpapers.repec.org/article/eeepoleco/v_3A20_3Ay_3A2004_3Ai_3A4_3Ap_3A907-922.htm