Shyam Ponappa: Cut Interest Rates To Revive Growth

Significant interest rate cuts can deliver price cuts and revive growth.

India managed 8.8 percent growth annually for five years. “If it could keep this up, India would be transformed, as China has been,” says The Economist.* Alas, ICRIER’s estimates indicate possibly under 6 percent growth for 2008-09, and under 4 percent for 2009-10.** Perhaps 2 percent below potential (reduced to 8 percent?) by March 2009 and 3-4 percent by March 2010.

The fall in the Index of Industrial Production leaves policymakers no room for false optimism. Add dismal advance tax collections in December, a limp stock market as FIIs pull out and local demand stalls, unresponsive consumers, new hires plummeting, and funds raised through public offers at a five-year low. The airline sector dying again and with it, prospects for tourism gains. Airlines will be gutted unless taxes are cut to reduce our inordinately expensive aviation fuel (ATF), enabling price cuts. Lower pricing is more critical for ATF than for petrol for cars, because capital-intensive airlines cannot simply cut back on travel as individuals can, and capital costs will compel failure if the cost structure is unviable.

This is a hard landing for India. Growth so far short of potential means huge opportunity losses for very many people. The spillover in social consequences is another cost with devastating effects, from deteriorating law and order to divisive short-term realpolitik. Time to stop tinkering and take big steps.

Bungled Policies: One-Handed Clapping
Responses from the RBI and the government have been mixed. After a good start, there’s been a letdown. A solid excise cut in the first week of December from 14 percent to 10 percent, after-trial 1 percent cuts in the repo and reverse-repo rates, and reclassification of some real estate lending as priority sector. Markets stirred warily, and banks strove to devise creative solutions, restructuring and lowering rates on some home loans. And then? Nothing — fooled again.

Have the RBI and the government done enough? Consider:

 

 

Consumer demand revived only slightly. This is to be expected with a rate cut of only 1 percent. Interest rates are very high in India, affecting prices, consumer finance, and sentiment (a negative wealth effect — see next item). 
 

Despite good fundamentals, the Sensex is volatile around 10,000. Some think a forward P/E multiple of 10 is reasonable. But with India’s upside potential, the Sensex could be at much higher multiples with strong foreign and domestic investments, if it were not constrained. These constraints are: Depressed earnings because of expensive or unavailable finance and sagging demand, negative sentiment, and uncertainty. Remedial measures can increase earnings, critical for investment, and revive sentiments. Otherwise, growth will be constrained by limited bank finances, further circumscribed by concerns about excessive credit growth (which aggravated the liquidity constraints to begin with). 
 

The RBI says there is adequate liquidity, but banks have deposits of around Rs 29,000 crore at the risk-free reverse-repo rate. Meanwhile, trade credit has dried up and the securities markets are dead, with funds raised from the public at a little over a third of the previous year, at Rs 16,927 crore in 2008 against Rs 45,137 crore. 
 

Additionally, contradictory moves, eg, a railway freight hike, resulted in cement companies not reducing prices sufficiently, crippling revival possibilities.

With India’s potential, why isn’t growth higher? Because excise cuts, without significant interest rate cuts and sufficient liquidity, are like one-handed clapping: Simply not very effective.

Reviving Growth
The ‘solutions’ are straightforward:

Liquidity: Abundant liquidity, with signals of continued availability — not calibrated loosening of a noose, giving remedial finance to enterprises after they are half-dead — will convince lenders that funds are available, and businesses that they can realistically consider investments. The need is for a further CRR cut of 2 percent. 
 

Repo Rate Cut To 4.5 percent: The cost of funds must fall for lending rates to drop. One way to induce this is a sharp reduction in the repo rate — the rate at which banks borrow from the RBI — by 2 percent, to 4.5 percent, combined with a reverse-repo cut (next item). 
 

Reverse-Repo Rate Cut To 3 per cent: A simultaneous cut in the risk-free rate of investment for banks by 2 percent will encourage lending. Also, these cuts will change the economics of many good enterprise activities and projects, making them viable, providing opportunities for banks to lend. Initially, banks short of funds will borrow to lend at lower rates. Call rates will drop with adequate liquidity, ensuring a significant fall in lending rates. 
 

Limits on Investment in Government Securities: There need to be limits on banks’ investments in government securities to discourage this risk-free alternative. 
 

NRI Remittances: NRI remittances require a level of safety, and thereafter, returns. Returns are driven by FCNR rates, which can be set separately from other policy rates, as has been done before. 
 

FII Investment in Debt: As of October 15, 2008, FIIs had invested $2.4 billion in corporate bonds and about $3.25 billion in government bonds.

Some argue that if India’s interest rates fall, these investments will pull out. While foreign investors do seek higher returns, one issue is the limited extent of these investments, as India is not viewed as a true safe haven (having recently made it to investment grade, and now in danger of slipping). Another is the relative merits of strong growth with low interest rates, with two associated developments: A strengthening currency, and provided there are the right policy initiatives, a strong debt market.

Benefits from these developments are likely to far exceed a weak position ‘defended’ with higher rates. A third factor is low returns elsewhere. 

Real-Time Management: The RBI also needs to implement a loan monitoring system covering: (1) Priority sector loans and rates, (2) Capital-intensive manufacturing and services such as airlines with domestic market potential, and (3) Higher margin requirements and provisioning for activities such as second-and-subsequent property loans, to discourage asset bubbles.

Cutting rates is easily practicable. If there are doubts, sound out bankers who understand cash flows, and have a sense of actual supply and demand. If there are problems, raising rates will correct for many of them.

* ‘An elephant, not a tiger’, The Economist, December 13, 2008.
** ‘The global crisis and India’s growth rate’, BS December 3, 2008:
https://www.business-standard.com/india/news/the-global-crisisindias-growth-rate/16/13/342081/  
shyamponappa@gmail.com