How high Real Interest Rates can trip Modi in 2019

this artcile of mine has appeared in Financial express today (29/sept, 2017). Link below.

http://www.financialexpress.com/opinion/here-is-what-can-trip-narendra-modi-in-general-elections-2019/875051/

Unedited Version:

RBI’s Interest Rates can trip Modi in 2019

V Kumaraswamy 

Ask any shop keeper, or the lonely looking private security guards, unemployed youth in urban slums or interior towns, or the taxi drivers as to what their main issue today is and pat comes the reply: be rozgari

Not many expected Vajpayee to lose 2004 with the groundswell of national passion over Kargil, Golden Quadrilateral, relative peace and quiet in domestic scenario, great government finances and the political networking he cultivated.  Yet he lost.

The voter at the booth is not going to be thankful for how much wholesale corruption has come down (retail is still alive and throbbing), degree of digitisation India has achieved, how benign inflation is, etc. These are at best hygiene factors which can easily be washed away if joblessness persists. Without a job, a stable one at that, he can’t proposer.

High Manufacturing Real Interest Rates (RIRs).

If more people have to be converted from being losers during the on-going reforms to gainers, we need rapid job creation. Services sector (IT, BPOs, Call Centres, and Telecom) created jobs by the buckets till about 2011-12 but have reached stagnation now and have even started becoming uncompetitive now threatening imminent job losses.  Agri sector is just incapable of creating further jobs; rather it would release lots that need to be absorbed.

Employment should come from only manufacturing and here is where the real interest rates facing Indian industry is proving an insurmountable barrier not just a hurdle. The accompanying chart compares the Real Interest Rates (RIRs) between China and RIRs facing Indian manufacturing.  Manufacturing RIRs are  derived by deducting manufacturing inflation from the nominal interests facing manufacturing sector. For the last over a decade Indian Mfg RIR is about 7.21% versus China’s 2.92% – (i.e 4.29% over China’s) a huge hole for anyone to be interested in investing in Indian manufacturing.

It is a mistake to compare the general RIR which is just 2.04% over China, the country with which we have maximum non-oil trade deficit. The General inflation is contaminated by Fuel oil, Food which have no bearing whatsoever for studying manufacturing investment competitiveness.

Why has it become important now?

Just but for one year, Indian Manufacturing RIRs have been higher than China since 1991. So why has it started affecting investment sentiments now. Starting Jan 2014, duties for imports from ASEAN has become Zero virtually (S Korea is not far behind) making India’s trade borders completely open. China (even with import duties) has cost structures lower than ASEAN for several commodities.

India’s capital account has also been steadily opening up and for practical purposes it is completely open. Even the per annum limits on debt are periodically reviewed and enhanced without even waiting for the year turns.

With open trade and capital flows one has to be more sharply competitive. Added to this is the 25-30% overall surplus capacity in Industry. Who would dare to invest with a huge handicap on interest rates and surplus capacities. It is better to source goods from China or set up facilities there and sell in India, which exports jobs.

Sources of competitiveness

As mentioned earlier, agriculture and services look spent forces as far as employment creation goes.  It rests on manufacturing to create jobs, for which it needs to be competitive, which has to come from any of the 4 factors of production or natural resource endowments (part of Land).

India has tied itself up in knots where land is concerned.  Our socialistic mindset has made a grand backdoor re-entry through LARR and a plethora of court rulings, restriction on land transfer and change in usage, etc. Any acquisition takes 5 years – far beyond the patience time for an entrepreneur to keeping waiting with his ideas.  India has 375 people per sqkm where China has 142 (2015), increasing the pressure on land. So land as a source of competitive strength is ruled out.

Labour can be a source of strength given the wage levels now. But for that to happen we need to repurpose our education. Instead of (or perhaps alongwith)  BE(Mechanical) and B Tech (Chemical) we need 8th Std (textile printing), 10th std (BPO assistant), 12th std (Source coders), etc. i.e. fit for purpose specialisation kicking in at far younger ages. This can perhaps reduce capital invested for turning an unemployed into productive force as well supply the skills that would increase productivity. Such increased productivity can make the labour cheap per output unit.

That leaves Interest rates. Even enterprise is a function of interest rates beyond a point, where it translates entrepreneurism into investments. With excess capacities and high RIRs in Manufacturing, no one will feel tempted to invest in India.

High real interest rates (when the whole of rest of world is underperforming) and an increasingly politically stable India is attracting excess of $s, that cannot be absorbed by a stalling investment economy. Oversupply / unutilised $s in the forex market causes its prices to decrease. With it, it brings down import prices and makes our exports un-remunerative. This causes imports to flare up. Sure we are also gaining in petrol, prices of Chinese goods, goods from ASEAN, etc. But then the jobs in making them is happening overseas. What’s more important now  – employment or lower inflation? People who are gloating at low inflation are looking at just one side of the equation

In the last 6-7 years our Monetary economists have been failing their equilibrium mathematics exams, with their highly out of context imported monetary theories. But the political student to be detained may be Modi’s Government in 2019.

(The writer is the Author of Making Growth Happen in India (Sage Publications))

 

 

 

 

 

 

 

 

Demonetisation Lessons from Brazil

An edited version of this article appeared in Financial Express today. Link: http://www.financialexpress.com/opinion/note-ban-lesson-from-brazil-best-way-to-demonetise-is-not-to-have-one/472432/

Public policies are best when a lot of reason goes into their formulation and passion into their implementation.Those looking for an effective recipe for formulation could learn a lot from Brazil. It has demonetised its currency 8 times since 1942 and thrice simply knocked off the last 3 digits of its currency overnight i.e. like a 10,000 Cruzeiro (then Brazilian currency) will be 10 Cruzeiro from next day morning.

Lessons from 1830s to 1942.

Even before from 1830s it has been compelled to experiment with its currency due to evolving politics. The early experiments are to do with metallic convertible bases like silver and gold, metallic copper coins, birth of parallel paper money,  etc.

In early 1830s in order to stabilise the external value of Mil-Reis (then currency), the centre starved supply of currencies reducing the circulation of copper coins in the provinces. The provinces responded by issuing their own notes to neutralise demonetisation. Promissory Notes issued by Commercial banks valid for 15 days by law began to be accepted far beyond their due dates. (Source: Page 39-43,  Monetary Statecraft in Brazil: 1808–2014, Kurt Mettenheim)

Some other time commercial banks were allowed to issue bank notes (like in Hong Kong where currencies were issued by Standard Chartered and HSBC till accession). This led to loss of control of central authority and dilution of monetary policies.

Brazil through its history has clearly proved that no one can ‘starve’ the people of currency for far too long.

1942-1994

This period was mostly about high government expenditure, unbridled fiscal gaps and high inflation. Brazil demonetised 8 times before the last one in 1994.

It has had to change its currency, the ultimate form of demonetization for every conceivable reason – to tackle black money (Indian objective), to tackle hyper inflation, tackle daily cumulating interest rates of 3% (which is nearly 50,000% p.a.), base erosion, commodity price volatilities especially in Copper or just to avoid confusion (if Brazil had retained its currency same as in 1942, it would be 1 US $ =  2750 followed by 18 zeros, a nightmare for the accountants). They have been far deeper than t he Indian type demonetisation – the entire spectrum was replaced and the currency itself renamed.

The last in 1994.

The most recent in 1994 seemed Quixotic. It was aimed more at breaking the psychology of inflation. With 100% inflation consistently for 14 preceding  years (in 4 years over 1000%), shops had to revise prices 3 times everyday. That is when the government decided to use two currencies simultaneously – one virtual for counting the real value of currency and another for payments and settlement – and every shop having to display its prices in both and revise it 3 times a day.

But unexpectedly, people started anchoring their values against the real value (which was set near 1 Real Value unit = 1 US$).  Within a quarter or so, it was clear people were not rushing any longer to shops to avoid their currency buying less than when they started from home. Inflation abated and the real value became the Real the official unit. It was perhaps one of its most successful experiments that has lasted till date.

Lessons from Brazil

People will seek ways to settle transactions in the most cost and effort efficient ways. For many transactions in much of India, using currencies across the counter is still the most efficient option. In 1970s and 80s, when there was a coin shortage of sorts,  Chintamani co-operative superstore in Coimbatore used to issue their own tokens. These slowly gained acceptance with public so much so that even government owned busses and offices used them.

The parallel systems will start issuing notes and IOUs which will be strictly ‘enforced’ amongst its members through extra legal authorities.

One thing Brazil has always got right (between 1942-1994) is to have the 1,2,5,10,20,50,100 note sequence – considered the most friendly from transaction settlement point of view.

Currencies are as much about psychology and convenience as values for accounting and transaction, as the 1994 experiment so decisively proved.

The best way to demonetise is not to have one – avoid inflation, avoid unjustifiable or un-implementable tax systems, and not to issue too much of it anyway. Brazil has about 3% as currency/GDP whereas India’s is11-12%. Government should have incentivised and reduced it by 1% every year rather than force it in one lump.

A parade of demonetisations has not exactly curbed either parallel economy or corruption in Brazil. Corruption and black money is so rampant, their President was recently impeached for corruption, their biggest real estate tycoon is behind bars and may have to spend the rest of life there if not politically rescued.

Why black money or parallel economy, there is a near parallel administration being run by the mafia through drugs, extortion, violent thefts (one murder every 10 minutes i.e 140 a day, down of course from 600 a day not so long ago), etc. none of which will be happening through tax paid cheque money transfers.

Conclusion

In summary Brazil offers 3 ground rules (perhaps not with successful examples as much as negative narratives):

  • the way to tame inflation is not periodic demonetisations but curb state populism,
  • the way to curb black money and illegal economy is not starving people of cash but well thought out tax policies and effective punishments, and
  • the way to protect free trade from causing domestic unemployment problems is to maintain the external value of the currency which in turn is achieved by restricting external capital inflows to just what is required for financing current account deficits. (Donald V Coes, Macro Economic Policies and Growth in Brazil, 1964-90)

One would definitely give credit to both the government and RBI for curbing state populism within FRBMs. But given the levels of corruption in tax collection systems itself, black money curbing through demonetisation seems an ill fitting solution. Unemployment is rampant and growing due perhaps to highly overvalued Rupee and extra terrestrial real interest rates.

The daily dose of RBI circulars does indicate that someone is extremely alert at the wheel but whether he knows the destination and if it will deliver enough gains for the pains people are experiencing, time alone will tell.

The writer is CFO and author of ‘Making Growth Happen in India’ (Sage Publications)

Demystifying GDP numbers – as articulate a statistician as you will ever find

Demystifying the confusion around GDP figures

Attended an address today by Dr Pronab Sen, former Chief Statistician of India and Chairman National Statistical Commission. I must admit despite his slightly absent minded looks, he is the most articulate economist I have heard in a long time. Some excerpts. He threw a lot of light of issues generating lots of heat in the press nowadays. (Errors in figures if any is entirely mine).

Should we believe the new GDP growth rates reported

People confuse output for income. GDP is not the sum of turnover but income. A consumption good may be traded at 4-5 intermediate stages before it reaches the final consumer. Then GDP is not the summation of the turnover of the 4 intermediate trades but just the income (Value added) at each of these stages. Example: if an auto mfgr imports components of Rs 30, assembles and sells the car at Rs 55, the dealer to retail showroom at Rs 70, and the retailer to customer at Rs 80… the GDP will be Rs 50 (25+15+10) not Rs 235 (30+55+70+80) or Rs 205 (55+70+80).

Thus GDP is not summation of  Value of Outputs (VO) but summation of Value added (VA) at each stage.

GDP = ∑VA  or = ∑VO * (VA/VO). i.e output into Value Added ratio at each respective stage.

In India the long term average (1950-1998) VA ratio was 16% for manufacturing industries. Between 1998 & 2003 it increased to 18%. By 2011-15 this has increased to 22.5%. Thus a lot more value addition is taking place in our output than anytime in the past. Even if our output may not have grown at higher rates, the value added component in that output has gone up … giving higher GDP numbers. This is what is being witnessed now.

2             Typically in a downturn, industries invest in efficiency improvements rather than investments in physical assets. In Boom time they invest in physical assets (may be indiscriminately). During 2 crunch times of 1998-2003 credit squeeze and 2011-2015, India has invested and become far more efficient and is achieving higher VA in its output. We are lot more competitive globally today than 10 years back.

3             China also invested heavily in physical assets during boom years. Their VA/VO ratio was also fortunately high in mid-20s which has fallen and stands over the last decade to 19% now, less than India’s in several sectors – a sign of over investment. They are now investing in efficiencies and technologies. The World average (long term) is 18-19%. India is well placed now on cost competitiveness and more industries should identify their strengths and grow; they should not worry too much about our size being 1/5th or 1/10th of China’s in their industry.

Why corporate profitability is low in spite of higher value added

4             The VA  has 2 large components – (i) what is paid out as wages and salaries (WS) and (ii) other operating surplus(OS) (paid out as interest, dividend, retained surplus, etc.). In the last 5 years the average rate of growth in WS for India as a whole is 17% p.a. meaning far more is paid out as salaries and wages and the share of OS is 10% p.a. of which the share of interest has been high. Dividend payout has also increased dramatically affecting Corporate profitability and retained surpluses. Wages and salaries in rural India has risen faster than in urban areas/industries.

Shift in manufacturing profile

5             The share of unlisted firms is growing faster than listed companies. Unlisted firms are growing at 12% CAGR while listed firms output is growing at 7% CAGR. The share of informal sector has quietly reached 40% today.

India is becoming more entrepreneurial. It would not be surprising to see that in the next 5/10 years, the top 20 of the 40 construction companies will be totally new and unheard of now.

6             Black money distorts asset allocation.  Most of it is kept in black assets – gold and real estate. Now that there is drive against black money, real estate is suffering.

On Why IIP numbers (index of Industrial production)  don’t reflect our higher growth    

7             IIP numbers are constructed from select industries. Those mfg industries/product which contribute at least 2% of total is selected first. Some of these may have 8% some 5% and so on. 14 such products contribute 80%.

For these products/ industries, just the top 6 firms (turnover wise) are selected. Their rate of growth is taken and averaged and reported as IIP numbers. The index we are using has a base 2004.

During the last 10 years between 2004/5 and now, the small and medium scale sector in these industries have grown far faster (at 14% p.a) than the corporate sector (7% p.a) and the sample 6 have grown even slower. The share of small firms have grown from 30% to 50% in the last 10 years – a fact not captured by the index.

Construction of any index is a time consuming and costly exercise based on extensive surveys. Thats why they are not done frequently. A new series with base 2011 is in the offing, which might set right the anomaly between GDP and IIP numbers.

Why Indian industry is not investing even if it is growing

7             Informal sector which is growing the maximum does not have much savings – it is squeezed out by the money lenders – their main source of finance.

More is paid out as wages and salaries, who may not have the same investment urges as retained earnings.

and of course the High interest rates (see below)

Interest rates

8             Indian interest rates are very high. It attracts a lot of portfolio flows which come in and keeps Rupee artificially high and un-competitive. The way to correct it is to let the interest rates fall which will enable the industries to invest and absorb these flows. If the flows are properly absorbed the currency will find proper level ($ may be Rs 72/75 instead of being Rs 67-68) and portfolio flows will be moderated. This has not been allowed to happen and our real interest rates have been kept artificially high.  We are just accumulating reserves instead of putting it to productive use.

9             Indian industry is crying hoarse on high real interest rates. What they should be screaming at is the differential interest rates. Between 2008 and now these have moved significantly against India.

Our corporate interest rates were 9% average towards end of last decade when the global interest rates were 4.5 % – a gap of 4.5%. Today our interest rates are 10.5% when the global interest rates are kept at 1.5% a gap of 9%. Not an ideal situation for investments. It is better to invest overseas, even if to supply to India.

Thus Indian industry is caught between artificially high interest rates and artificially high forex rates which does not enable them to raise prices in line with costs.

Difference between Planning Commission and the current NITI AAYOG.

10           The previous planning commission had a 15 year, 5 year and 1 year plans/horizons.

15 years – There was a broad perspective plan which was not generally well known or publicized.

5 years – Better known as 5 year Plans. This was an approach paper.

1 year – laid out the expenditure for various programmes.

The NITI AAYOG has a 15, 7, 3 year cycles.

15 year. Vision document – the Government has asked the Niti Aayog to come up with this.

7 year – plans and programmes.

3 year – implementation plans for the above.

NPAs

11           The current NPA is entirely that of Corporate sector. The priority sector NPAs have remained at their usual 1.5%.

12           From financing just working capital needs from retail savings our Banks are now financing long term loans from the retail savings. More than 50% of lending today is for long term loans.  This is inherent mismatch. Our commercial Banks are not just designed to deal with NPAs.

13           It is not that we were without NPAs earlier. The long term loans were earlier met by DFIs (IDBI, ICICIs, IFCIs) which financed themselves with long term Bonds (15 year types) and were far better able to deal with temporary fluctuations in business and time taken to rectify/reconstruct even bad decisions. It is simply not feasible to deal with them on a quarterly basis, which is what the banks are expected to do now.

Responsible Recovery of NPAs

Treating all debtors the same, including those with scope for turnaround, is bad for banks and the economy

There can be no doubt that banks need to go after the non-performing assets (NPA) vigorously so that the moral hazard of wilful default does not get hard-coded into the DNA of borrowers.

Banking thrives on the delicate psychological infrastructure of public confidence. One should also bear in mind that one of the most essential ingredient of growth is risk-taking capacity and entrepreneurial zeal.

The current hysteria being created by media and the sudden near-choking actions of the RBI towards NPA recovery seem to overlook the fact that we need a balanced approach to recovery even while preserving the above two.

Reasons for bad loans

The current stock of NPAs is the result of court actions of cancellation of licences, government not keeping its word on contractual obligations, global commodity price movements, low equity base in India, irrational exuberance in sanctions and a lackadaisical approach in the past, free-trade agreements (FTA), a sudden sinking of the growth table from 8-9 per cent to 6-7 per cent with services taking a greater share, etc.

Of these, the Asean FTAs have played a large part in pushing many units to involuntary defaults. According to one estimate, when all ASEAN countries implement their FTA commitments with India, India’s exports to them are supposed to increase by 21 per cent while India’s imports from them was slated to increase by 59 per cent (C.Sikdar and B. Nag, 2011,Impact of India-ASEAN FTA).

Surprisingly, Asean FTA, effective January 2010, remained largely unnoticed till the last leg. When the import duties on many end products became zero per cent from 2.5 per cent in 2014, it became a tipping point for the media, traders, and even the overseas exporters.

The cumulative lag in its impact weighed in heavily all too suddenly. This put the domestic manufacturing industry’s prices on import parity and several industries became uncompetitive or saw their margins shrink. In any case their ability to pass on input cost inflation became restricted. Due to this, the growth rate in several Indian manufacturing sector has sharply come down from 7-9 per cent to 3-4 per cent. This has elongated the pay back of several projects from 6-7 years to 10-12 years.

A moderated approach

Banks should carefully segregate stressed credits into (a) where Return on Capital Employed (ROCE) is still more than Cost of Capital (COC). This would indicate that the credit is still viable but less liquid than earlier planned, and (b) where ROCE is less than COC, where the feasibility itself in question.

In case of (a) the RBI should allow one-time re-scheduling of loans in line with the revised economic assumptions and the elongated paybacks, with adjustments in credit spreads, but without strangulating either the clients or banks by provisioning.

Such cases should not be reckoned as NPA in view of the general objective of maintaining a conducive atmosphere for investment. They should not be allowed to erode the confidence in our banking system and preserve the capital base of banks.

Most of current stipulations seem more appropriate for Type (b) cases. The combined might of the legal system (with its slothful, apologetic approach) and existing regulations is the weakest in cases involving immoral and wilful defaults. Immediately after the crisis of 2008, it was found that the CEOs and traders of investment banks had appropriated for themselves huge bonuses from questionable practices and structures.

The Swiss and the Swedish authorities, instead of protracted legal battles, arm twisted them to pay up a substantial part of their ill gotten gains, threatening them with the might of the State which yielded optimum and quick results.

Given that the top 60-70 cases would cover nearly 80-85 per cent of our current NPAs, the regulator, the government and the banks might do well to take lessons from such an approach and jointly ‘arm twist’ a settlement.

This approach might involve transfer of ownership in Type (b) cases to others in the industry who have competitive strengths in manufacturing, technology or distribution to make a less viable unit to fully viable one. Central Banker should have ideally asked for easy exit norms including the court procedures, automatic transfer of licences and permits instead of just concentrating on provisioning alone.

Banks should also agree on norms for lending for takeovers and mergers which is taboo as of now at least for cases involving share purchase, even if the acquirer has to pay for liabilities simultaneously.

Overly cautious approach

The contrasting approaches of the Fed to 2008 crisis as against the current scene in India is interesting. The 2008 crisis was caused by individual excesses and born of instruments created by outlandish models.

Professional excesses were writ all over and unjustified transfers of wealth humongous. Yet their approach was to save the system and public confidence and many of the sins were forgiven or forgotten, despite the effectiveness of their legal system.

Our strangulating approach of ‘one prescription whatever the diagnosis’ seems destined to manufacture a crisis out of what is at worst a matter of serious concern. This, when an accommodative monetary policy is the need of the hour, with the bulk of the economy and manufacturing sector struggling and growth and employment addition far below potential.

The excesses of strangulation can be gauged in the light of the equity that RBI holds in relation to its total balance sheet size. RBI’s ratio in this regard is the second highest in the World at 32 per cent (next only to Norway at more than 40 per cent).

The same stands at a mere 2 per cent for the US and UK. There is a clear case for a more nuanced and segmented approach, appropriate solutions for each class of cases, besides of course a re-look at the real interest rates which are at historic highs for many sectors, stubbing out any entrepreneurial spurs in the affected sectors. The high equity component in the balance sheet should be a source of comfort and assurance of the system; unfortunately RBI does not seem to know its strengths.

An edited version of this was published on March 28, 2016 in The Hindu Businessline. Link: http://www.thehindubusinessline.com/opinion/going-overboard-on-npa-recovery/article8406146.ece

 

 

Why not a safety net for the moneylender

May 9, 2006

The Hindu BusinessLine

Money-lenders perform an essential service. Commercial banks will never supplant them. Take the money-lender out of the rural areas, the rate of suicides and the degree of despair will only rise, not abate. The structure of their pricing (interest rates) is the irritant

http://www.thehindubusinessline.com/todays-paper/tp-opinion/why-not-a-safety-net-for-the-moneylender/article1733146.ece

Unlocking Forex reserves to fund infrastructure

Aug 10, 2005

The Hindu BusinessLine

A model that involves the participation of intermediaries such as the World Bank/IMF, the International Finance Corporation, or the Asian Development Bank, could be the key to convincing the Reserve Bank of India to use forex reserves to fund infrastructure projects.

http://www.thehindubusinessline.com/todays-paper/tp-opinion/article2185844.ece

Lets Democratise Monetary Policy Making

The Hindu Businessline

There’s an irony here. Elected representatives such as the Prime Minister in India or President in the US who are vested with the responsibility to deliver employment and growth, and control prices face so many constraints — constitution, parliament, aggressive opposition and ex-post scrutiny by the CAG, PAC, CBI, etc. But there no such fetters for the unelected monetary monarchs — be it the head of the US Fed or the RBI.

http://www.thehindubusinessline.com/opinion/lets-democratise-monetary-policymaking/article6665493.ece