“People are starting to question the long-term Indian story… For the time being, people are just giving up….”
— a Moody’s analyst
With growth in the fourth quarter of 2011-12 at 5.3 per cent, India’s economy is on the brink. If higher growth is not addressed as a priority, we will all lose enormous upside potential. We cannot afford disunity on this issue — neither the government’s arbitrary action nor inaction, nor stalling by the United Progressive Alliance allies, nor the irresponsibility of the Opposition. Continuing discord carries the risk of precipitating our own Greek tragedy.
We need to agree on what the biggest problems are, and how to remedy them. Here is the case for focusing on growth above all, and acting to enable it.
The depreciation of the rupee is the acute symptom. Why has the rupee fallen so precipitously, and why might it get worse? Because of foreign currency outflows. Why the outflows? Declining corporate profits, as explained below.
The drop of over 27 per cent against the dollar since August 2011 is crushing for companies with foreign currency convertible bonds (FCCBs) and external commercial borrowings (ECBs). Estimates of redemptions this year range from $5.5 billion to $7 billion. With growing euro problems and global risk aversion, renewing external debt is possible only for the strongest companies. This problem has to be dealt with, despite the temptation to say, “Let them stew”. That works only if we are not all cooking in the same pot — which we are.
Some counter that an overvalued rupee needed depreciation to help exports. In depressed markets, growing market share is less likely. Some object to actions that protect companies with ECBs as “socialising losses”. While policies can have multiple effects, it is net benefits that matter most: whether losses in energy imports outweigh the export advantage in a global downturn, or companies that escaped high domestic interest rates will create more turmoil if they fail compared with bailing them out. These judgement calls need the objective use (to the extent possible) of financial models, balancing the resistance to creating moral hazard.
We now face a problem of shrinking profits. With weakening global cues, a slowing economy, and lower capital flows, everyone – policy makers, enterprises and citizens – must seek to alleviate what will otherwise be a slow, difficult recovery. Collectively, concerted efforts are needed to improve profits.
Lower revenue growth in 2011-12 with higher raw material costs resulted in lower profit margins. In the fourth quarter, higher interest costs were 31 per cent of net profits, compared with 22 per cent for the previous quarter for 1,066 companies, excluding banks and financial entities. Interest costs for over 2,000 companies rose 38 per cent, following increases in the previous three quarters of 42-50 per cent. High interest costs and an unreconstructed budget triggered a downward spiral in profits. This was made worse by negative sentiment because of government ineffectiveness and capriciousness, epitomised by the Vodafone tax case: attempts to seize what the Supreme Court had annulled.
Foreign outflows triggered by decreasing profits were aggravated by a declining rupee — because of high imports with rising prices, particularly for oil and gold, but also for coal imports, because of local supply shortfalls. The consequent fall in stock prices and unstable tax policies combined to reinforce outflows, increasing downward pressure on the rupee.
There were, of course, other reasons:
- Mismatches between growing demand and constrained supply, leading to persistent inflation. The Reserve Bank of India’s (RBI’s) raising interest rates to tackle this has only compounded the problem of reduced profits and investments, made worse by central and state government failures to augment supply.
- Capriciousness in policies which, like Brazil’s missteps of the ’70s, began with distributing entitlements before assuring growth. Capriciousness now manifests in decisions like the Vodafone tax case.
- Paralysis/incapacity, typified by the failure in the coal supply chain to power plants, unviable electricity distribution agreements and tariffs, new power plants running far below capacity, the unwillingness to take constructive decisions on spectrum and telecom policies fearing populist reactions, or the rollback of foreign direct investment in retail. This is compounded by the rise of populists, many of whom act as if good intentions obviate the need for domain knowledge, competence, organisation, or even simple arithmetic.
Two salutary steps are possible immediately. First, cut interest rates, although economists are divided on the merits. What should the RBI do? A big rate cut – 150-200 basis points – can improve profits, capitalising on softening input costs, as well as boost sentiments. Interest as a percentage of profits must be reduced, and sentiment improved to enable increasing investment. Interest rate increases as some suggest, on the other hand, will deplete profits further, accentuating lower growth and exacerbating the decline.
Second, the government should signal an immediate end to arbitrary tax moves.
Thereafter, systematic steps are needed to address difficult issues like telecom policy, fuel supplies and land acquisition. Telecom and spectrum reforms are overdue, as are energy reforms addressing the fuel supply-power generation and distribution-sustainable tariffs chain. Then there are all the structural elements affecting productivity – a big mouthful – that can only be addressed in phases.
In terms of sequence, the next significant effort could focus on the poster boy in trouble, the telecom sector. The empowered group of ministers (EGoM) can decisively abandon short-term government revenues in favour of user benefits, leading in time to even more government revenues. A persuasive case needs to be made, for example, to those who favour goals other than functional objectives — like government collections for purposes extraneous to the sector, such as for sanitation or for food. Such confusion in objectives arises from misinformation or incorrect reasoning, because (a) the primary objectives of a sector are its functional purposes; and (b) government collections increase with the prosperity of enterprises paying reasonable taxes. For this iconic sector, including its spectrum and broadband issues, the EGoM should be made aware of the recent report to the US President’s Council of Advisors on Science and Technology on sharing spectrum.