Macro Imbalance and the need for a new framework agreement

My article in Businessline today.

The chorus for reduction of Real interest rates as the panacea for the current economic stall is getting louder. From commentators to administrators to economists that seems the only item in the menu these days.

Interest rates (nominal and real), Inflation, Forex rates and Reserves, Investments, Capital Account convertibility and Foreign Investment Flows (all from the input or causative side) and Growth, Output and Employment on the resultant side are all intricately interconnected. There seems a need to look at things comprehensively and evolve a framework agreement between RBI and the Government reflecting this reality.

Illustration of Inter connectedness and imbalance

People buy things in advance if either it is likely to be costlier in the future when they need it or for de-risking (like Gold and Real estate). But what if the realized prices later consistently prove to be less? Would people still buy upfront or would it indicate some discrepancy? Lets see it in the context of forex rates.

The actual rates post facto have consistently been lower (far lower) than the Forward rates (rates quoted today for $ that will be delivered say 3, 6 months later).

The first one is determined based on the difference in inflation rates and the second one based on difference in nominal interest rates. If the Real Interest Rates are deducted from nominal, then the movement in both should be determined by difference in inflation. This should hold but for changes in outlook and situational factors and the policy induced difference in Real interest rates.

The persistence of actual rate being way less than Forward rate represents a serious imbalance and causes plenty of problems in domestic competitiveness, flow of foreign currency, investment absorptive capacity, etc. For example, if apples (representative of a basket of goods) are selling at Rs 50 in India and $1 overseas, then exchange rate should be ideally 1$ = Rs 50. Say, next year Indian apples have suffered an inflation of 10 per cent and have gone up to Rs 55. But apples overseas have suffered an inflation of 2 per cent and gone up to $1.02. Then the exchange rate should be Rs 55/1.02 = 53.93. But if the exchange rate is kept at say Rs 51, then the Indian exporter will get 1.02$ X 51 = 52.02 Rs /apple while he is able to get Rs 55 selling it domestically. Why would he export? To overcome this, we should allow the Re to correct. This will happen if we match the $ supplies into India with its net imports

Contours of a new framework agreement 

The framework agreement between the Government and RBI should cover all the essential variables not just one or two in isolation. Such an agreement should cover the following.

Limits on Forex Inflows: The inflows should be calibrated to match the absorptive capacity of the economy and its investment needs.  While Capital account convertibility can remain, RBI has to limit the quantum either at total levels or under each major sources of inflow. Reserves are a costly loss making insurance asset (much like Gold in individuals’ hands) whose cost are far more than the difference between interest earned and paid. It has effect on the real economy. The limits can be +/- 1-2% of what is required to plug the CAD or 6 months imports +/- 2 weeks.

Maintenance of Competitiveness: Competitiveness comprises two elements – the physical and the currency. Physical competitiveness comes from technology, scale, skills, IPRs, and natural resource endowments over which neither RBI nor Government may have control. Currency needs to stay competitive which can be achieved only if it floats freely to reflect the inflation differential.

Forex rates: RBI should be mandated to maintain the REER values within 2/3% of Re’s REER value after correcting the massive divergence now on a one-time basis.

Recalibrating REER Values: Again instead of using the general inflation numbers of the countries it should be the inflation of major input costs (including interest costs) of goods and services traded between India and its major trading partners. This basket may keep changing but there are real dangers of monolithic baskets or even currencies as a whole which are governed by many factors other than what determines competitiveness.

Real interest rates – Real interest rates should be mandated to be within 5-10 bps spread over interest rates in competing countries and those investing into India. High real interest rates and overvalued currency may encourage debt flows more than investments in real assets and FDIs.

Inflation: Divergence between estimated actuals and realized actuals after the end of period is difficult to control even for items like Forex rates where almost all participants are educated, trained and hence rational. It becomes even more hazardous in inflationary expectation. It’s time we move on to inflation targets for 3-4 major groups. Food inflation is far more politically sensitive and socially damaging than perhaps white goods or real estate.

Stability of Laws:  The last 4-5 years have seen sudden sharp changes in rules governing provisioning, NPAs, default status, etc. and levels of support to distressed assets even those which are clean but facing stretched cash flows. Changes should factor in reasonable adjustment period.

Quid Pro Quo

If these are corrected, governments should undertake to do the following:

  • To stay within the 3-4% fiscal deficit targets,
  • To smoothen MSP increases based on fundamentals rather than subject to political whims and fancies,
  • To curtail interest declared on mandated savings like PF, PPF etc.,and
  • Not to announce arbitrary minimum wages.

The current economic impasse is arising out of highly overvalued currency, uncompetitive real interest rates, inflows far in excess of absorptive capacity and inflation which looks more western and 1st world’s. The entire burden of causing growth and employment hence falls on the elected Government which has to substitute for the private sector which has been rendered uncompetitive due to these imbalances.

A comprehensive agreement on the above lines would go very far in kick starting growth and employment once again.

Flexibility and Agility are Virtues

Ironically almost a century ago, as the noted economist Irving Fisher in his The Money Illusion quotes Reginald McKenna, Chancellor of Ex-chequer UK as follows: “Since the War, central bank reforms have been instituted in Albania, Austria, Chile, Colombia, Germany, Hungary, …India, Russia, South Africa. In all these countries, except India, not one central bank has copied the Bank Act of England; but with that exception, all have adopted some system which is similar to the Federal Reserve Act” which provides for an ‘elastic currency’… the greater elasticity of the Federal Reserve System (is) the main reason for the higher prosperity of America”.

What was true then of America is true today of China which has proved far more nimble footed and what was true of Bank of England is true of RBI, which treats cast in stone monolithic approach as a virtue.

(The writer is the author of Making Growth Happen in India, Sage Publications).

 

A Contrarian Monetary Policy

Indian industry has been sluggish for a fairly long time, and all our orthodox monetary policies have not been able to make it come alive, grow and deliver employment of any great proportion. Democracy does not seem to be the villain, as much as unimaginative policies. Opportunity costs for experimenting with an alternative policy are very low now, as never before.
The key cornerstones of such a policy would be as follows:

  •  No FDI/FPI or FII targets: Just maintain the rupee within -4%/+1% of REER values. This will be pre-fixed with a one-time readjustment to correct the current overvaluation.
  • No inflation targeting: Target industry/economic activity-specific interest rates based on supply gaps or potential. Debunk general purpose credit measures.
  • Switch from price-based (repo and bank rate) money volumes to volumes-based price (interest rate) discovery.
  • These monetary measures have to be garnished with two fiscal actions—bringing petroleum under the ambit of GST (28%), and aligning all export incentives with the ‘best of ASEAN’ incentive package.

Let’s see how these contrarian measures are better suited to kick-start industrial revival and help in the creation of employment. First, a recapture of changes in business behaviour especially with respect to the main policy tool, i.e. interest rates.

Interest on working capital should count as variable cash costs (marginal cost to economists). An increase across the board for all players would only push up the supply curve and result in inflated prices—quite contrary to the effect desired. In any case, due to advances in communication, payment systems, ‘as and when needed door delivered’ systems, optimisation algorithms in stock keeping, etc, businesses are working with a lot less working capital and some enterprises even on negative working capital.

The ability of long-term interest rates to influence investment decisions is fast dwindling over time. Most of the new economy is funded by equity capital and sweat equity. In conventional manufacturing, gone are the days of 4 or 3:1 debt equity structures. Credit rating agencies frown at 1.5X debt levels now. Investments in new economy areas like Google, Ola, Paytm, IPL, casinos, Reliance Jio and space travel are more an outcome of guts and vision, rather than RoI and IRR-based like automotive sector, consumer products and street corner restaurants. And the new economy’s share in investments is overshadowing that of the traditional economy’s. These have reduced the potency of some of the monetary tools. More savings are also finding their bypass route to investments than through conventional banks and financial institutions, i.e. through private equity, VC, HNI, PMS systems, etc. Interest can affect consumer demand and have some effect on savers conduct, and this could be used for maximum impact.

The Indian context
The general capacity utilisation in industries is stuck at less than 75%—a level that will hardly inspire any investments. A great proportion of consumption growth has been met through imports from more cost-competitive nations. A few relatively better cost-competitive players have seen their capacity utilisation grow to fuller levels.

There are some industries (such as telecom) that have seen investment, but these are largely in the nature of ‘overtaking’ investments, i.e. fresh investments with superior offerings, driving customers away from existing players, thus rendering already standing investments to lower capacity utilisation levels. Some such industries (such as modern retail and banking) have also destroyed jobs through the use of technology.

A contrarian approach
Working capital interest rates for manufacturers with fuller utilisation should discourage stocking. Credit flow for downstream distribution and trade for such industries may be either curtailed using physical norms or prohibitive interest rates. But long-term interest rates should be kept lower to encourage quick capacity additions. Industries which see low capacity utilisation need lower working capital and export-facilitating interest rates, but long-term loan rates should ideally dissuade fresh capacity additions.

Overtaking investments should be mandated to raise a greater proportion of funds through own or equity funds. Besides being risky themselves, they also create systemic risks for all the existing players and their financing banks, and hence the whole industry should be charged risk premiums and far tighter debt/equity targets (<0.5 maybe), which would slow down such investments.

The above clearly indicates a need to junk the current general purpose credit policies and adoption of a sector-specific approach, with working capital and capacity addition loans being priced differently—risk premiums on one end and incentives on the other.

The 2008 meltdown could, in large measure, have been avoided by controlling just one industry—construction and mortgage-backed securitisation. Industry-focused approach produces results faster, is focused on the causes, and avoids unnecessary spillages and unintended harmful side-effects on other industries.

Sticking to the REER corridor of -4%/+1% on a yearly basis will help in competitive (to the rest of the world) inflation anchoring (of traded/tradable goods and services and thus overall), unless, of course, we import a large portion from the Venezuelas of the world. A 4% undervaluation will somewhat neutralise the loss/lack of competitiveness due to our infrastructural bottlenecks, substandard scales and bureaucratic bottlenecks. Such REER targeting will also determine levels of FPI/FII targets and portfolio investments.

Even if we want to anchor inflation, 6% makes sense, but giving the same width on the underside at 2% does not make sense. Any growing economy needs higher inflation and the corridor for an anchor of 4% may even be 4-6%, instead of 2-6%. Or even just 6% maximum, like highway speed limits.

Inflation, interest rates and volume of credit all have their influence on economic activity with varying degrees, with inflation being the least direct and perhaps most loose, and the volume of credit most direct and perhaps more immediate. Moderating through a more direct tool can be more effective. Interest rates can be the resultant, than being a determinant.
Fuel oil has the largest influence for a single item and should perhaps be under the central control of the GST Council, rather than be a matter of political Centre-state slugfest. Proper control of a few such items could moderate inflation to the desired levels. Indian incentives as well infrastructure are way too uncompetitive, and even as physical infrastructure takes time, one can work with export incentives.

Monetary policies increasingly look like wet blankets to suppress high fever. Without redressing the causes, we will only reap the harmful side-effects. Monetary policies do not seem to have rediscovered themselves in the last several decades with advances in behavioural economics, not even business behaviour.

Way to kick start economy – Currency Devaluation or Fiscal Stimulus?

An edited version has appeared in Financial Express on 13 Oct 2017

Currency Correction or Fiscal Stimulus?

V Kumaraswamy

The feeling of sluggishness is palpable everywhere. There are talks of stimulating the economy by fiscal incentives etc. This can be a very innocuous medicine for reasons of (i) dosage, (ii) potency, and (iii) long lead time.

First the dosage. The government may throw Rs 50-60K crores as fiscal stimulus. This is about 0.4% of our GDP. Given the current moribund state of economy with 25-30% underutilised capacities it is too tiny to have any impact. The current closure of capacities or lack of investments have not become so for 1-2% poorer realisations or profitability. While the figures vary for different industries, it is substantial – more in the range of 10-20%. We need a correction of this magnitude. The gaps in our competitiveness with countries exporting to us like China, ASEAN and Korea is 10-15%; not a 1-2% pittance.

Next the potency and wastage. Any incentive will reach both Units operating at full capacity and units with low utilisation and poor profitability. Units which are closed or NPA currently could hardly be revived with a small ‘spread thin’ incentive. The incentives reaching units operating at full capacity will neither create incremental growth nor new employment. There will be a lot of wasted (applying where not needed) efforts.

Finally, the lead time. If stimulus is by way of Income Tax rebates, it will be a year or many quarters before the recipient feels it and reckons it in his decisions. If it is by way of Indirect tax cuts, the recipient knows that it is for a limited period and will not motivate him for taking a long term investment decision. We need some immediate actions and most fiscal measures take a long lead time to get results. It may be well beyond 2019 that one would see perceptible results.

The current problem

The economy is stuck at a low and unresponsive equilibrium.  The current economic impasse is born out of 3 main factors (i) high internal value of currency (low inflation targets resulting in high real interest rates), (ii) may be partially from it, high external value of Rupee and high real interest rates attracting too much forex flows which are beyond the capacity of economy to absorb and (iii) free trade with ASEAN which kicked in from Jan 2014 in full.

ASEAN FTA did increase supplies and kept prices under check. It made import parity as the main basis of price determination for many manufactured goods. But it also eroded domestic industry’s profitability since manufacturing prices have hardly risen to cover inflation of inputs in wages and inputs from agriculture. It delivered customer stable or reduced prices but took away their jobs. India’s growth is creating Jobs but in other countries!

Somehow inflation control has become the focal point of our monetary management in recent years just like fiscal deficit is for our Union Budgets. While the fiscal deficit control is understandable, in an open globalised economy when product of every description could be freely imported, supply shortfall induced inflation is out of question. From Pulses and rice, to apparels, to electronics and Ganesha and Navrathra idols everything can be imported these days. So supply constraint induced inflation is the least that RBI or the Government needs to worry about.

Ways to correct imbalances

The main contributory reason for our lack of competitiveness with other regional players is the high external value of our currency. The sooner it is corrected the better, either by devaluation or dis-incentivising inflows.   But devaluation can cause inflation. As is reasoned out below inflation can be phantom enemy if things are calibrated well.

The first thing is to reduce debt limits available to overseas investors and strictly adhere to such limits. There is nopoint accumulating reserves to earn 1-2% returns by paying 4-5% overseas as interest in $ terms.

Secondly, there could be a temporary tax on overseas investments into India. This can be even for ECBs, investments into government debt and all inflows which are not required for physical imports. Taxing interest on GOI bonds will lower their yields and contain inward flows. There could be a surcharge on inflows till the related imports also take place. These could be used for re-capitalising our banks.

As a corollary, Government can mandate that fresh foreign investments can only be in new government bonds issued, on which the GOI can offer much less interest rate. Such an exercise will help the GOI as well. Such issuances can be allowed for secondary trades may be a separate bond segment with lower interest will develop as a result.

Containing Resultant Inflation 

The Government should bite the bullet like it did with GST and correct the near 22% over valuation in one substantial go. It can reset $=Re at Rs 71-72, which is 11% correction.

Monsoon is good throughout the country and agricultural inflation may not be a risk. If in fact there is excess production, a good forex rate might help evacuate some surplus so that domestic prices don’t crash due to oversupply.

In the long term, a 11% devaluation is about $ 40 billion in added inflation. This on a GDP of approx. $ 2400 is about 1.6% – may not be unbearable. But it’s the short temr effect on imported products and their immediate derivatives and next level products.

Oil is the largest at 25% of import bill.  Government (state and Central) should put a price cap. Their duties (customs, Excise and VAT together) account for a third of final price. There can be a freeze for 12-18 months in Re-terms on these. Oil marketing companies which have expanded their margins in the last few months can be told to absorb a third and the rest can be passed on. An additional 3.7% inflation on oil will amount to about a 1% on final inflation. Gold and Diamonds are next. We should not bother with Gold (the costlier it is, the better) and Diamond is largely for processing and hence related exports will make up for the input inflation.

That will confine inflation largely to manufactured goods. Most prices today in manufacturing sector are determined by import parity prices. A 10-11% correction would most likely translate into a similar uptick in their prices, which could help several factories (most especially textiles) to start chugging again. In any case, buyers of manufactured goods have had it too good for the last 5-6 years without much inflation.

Protecting the pensioners and interest earners needs to be balanced with the interest of freshers in the job market. The total interest paid on all bank deposits and Small savings and MFs is less than 5.5% of GDP. If we remove the government pensioners and those who have not yet retired from this, it would not be more than 1-2%. The number of those entering the job market and finding themselves without jobs will far outnumber those surviving solely on interest.

Currency correction will also solve a lot of NPA issue. A 10-12% increase in industrial realisations will turn many industrial units from potential NPAs to preforming ones.

Superiority over fiscal stimulus

Currency correction will hit the problem where it is. The dosage at 11% on the total value of trade (both imports and exports) is huge. It will alter the domestic profitability substantially and have an immediate impact – from the following day morning.

Sure forex borrowers will suffer. But those who have covered their exposure need not worry. For those who have not covered or partially covered, they have made good gains for the last 12 years on the trot. Why should not they not be made a pay some back now?

An equilibrium cannot be corrected by fiscal stimulus which will be better for rectifying confidence issues.

(The writer is the author of Making Growth Happen in India, Sage Publications).

Exchange rates — REER logic may be unsustainable

The Hindu Businessline

Perhaps the most sustainable `pricing policy for dollars’ (to rename exchange rate policy) will be that based on `transaction cost’ adjusted PPP. `Transaction costs’ here include the transport and insurance costs, costs of inventory, hidden costs of differential controls and restrictions, labour law and other legal rigidities, lax administration and infrastructure, and, of course, the inertia of the people to migrate, or change their consumption habits. Maybe it is time we moved away from managed pegs and managed REERs.

http://www.thehindubusinessline.com/bline/2003/02/21/stories/2003022100030800.htm