This article appeared in Feb 2012 edition of Wealth Insight - Surprisingly still relevant :)
The author tells us why the real reform in India would be reducing the size of government expenditure & not raising user prices
Economic
growth requires savings (investment) and savings need positive real
interest rates. Industry and markets have been quick to lay the blame of
a recent fall in economic growth at the door of the RBI. RBI had, since
February 2010, increased the repo rate from 4.75 per cent to the
current 8.5 per cent in the face of persistent high inflation levels.
This has fuelled fears of an economic slowdown, something that the
policy makers want to avoid in an election heavy year.
Has the RBI really been "hawkish"?
The graph below tells a different story.
Post the economic meltdown in 2008, RBI moved quickly to drop interest rates. The same alacrity was missing on the way up. Inflation started to rise by November 2009. RBI took corrective steps only in March 2010, that too in very small steps allowing inflationary expectations to build. Real interest rates (=interest rate - inflation) which measures the payment a saver receives for postponing consumption has been negative since November 2009 - and continued to be so till now.
How does negative real interest penalize the saver? Let's assume movie tickets last year cost Rs 100. With interest rates of 10 per cent, a bank fixed deposit (FD) of Rs 1000 yielded Rs 100 in interest - you could use it to watch a movie. This year, price of movie tickets increased to Rs 112. If interest rates remained unchanged, you would now have to dip into your FD to watch a movie. In other words, you would have been penalized for saving (postponing consumption).
The Indian economy witnessed a sharp recovery in 2009-10. The justification of negative real interest rate did not exist - but did either industry or market participants complain? Monetary policy is supposed to be counter-cyclical. It has to provide stimulus when the economy slows, and "take away the punch bowl" when the economy is over-heating. The latter is always difficult if the stimulus stays for too long. Borrowers get addicted!
But isn't it obvious that higher interest rates will slow the economy?
The relationship between growth and inflation has been the subject of much research. Evidence is mixed - but in general, it appears that low rates of inflation may help growth, while sustained high levels inflation harm long term growth rates.
In the Indian context, "threshold inflation" below which inflation is assumed benign has been variously estimated at between 4 per cent and 7 per cent. A RBI working paper published in September 2011 suggests the relationship as in the graph below. Inflation as measured by WPI becomes damaging as is rises beyond 7 per cent.
Other studies, e.g. Prasanna and Gopakumar, (IGIDR) conclude unequivocally "that any increase in inflation from the previous period negatively affects growth". In any case, not curbing inflationary expectations when the inflation rate is near double digits would mean that the RBI is not performing its key task - that of maintaining price stability.
In short, while the near-term growth prospects may seem subdued, failure to curb inflation would hamper longer term growth in the economy. Don't shoot the messenger!
Domestic saving and growth
Why is it necessary that savers receive positive "real returns"? Growth requires investment. In India, it requires Rs 4.5 of investment to generate Rs 1 of income per year going forward. This rate is referred to as ICOR (Incremental capital output ratio). ICOR is a measure of the efficacy of use of capital. ICOR has averaged between 4 and 4.5 for the past two decades.
Over the past few years, domestic savings have averaged around 33 per cent of GDP. Current account funds another 1-3 per cent. Overall, assuming that the ICOR remains at 4.5, India should be able to sustain a growth rate of 8 per cent (= {33%+3%}/4.5) on an average. To increase this to 9%-10% however, one of two factors must change - either savings rate has to move to 40 per cent, or ICOR has to drop to nearer 4. Offering negative real interest rates to savers (as has been the case for the past 3 years) is not likely to move savings rate to 40 per cent.
Efficient use of capital too requires that poor capital allocation decisions be avoided. When interest rates are low, borrowers are encouraged to take risks - often leading to mis-allocation of capital - and increasing ICOR. The real estate asset bubble of the US is a case in point. In capital deficient India, this would be unacceptable.
Reducing ICOR requires policy initiatives
Post liberalization (1991), the Indian economy used capital judiciously as witnessed by an ICOR of 4. India is now entering a period of infrastructure building. This is more capital intensive, with returns that are often back-ended. ICOR will rise.
Another factor is the increasing dependence on government decision making. While the early 90's marked the removal of the need for government approvals, many industries now are again dependent on licensing and allocation of public resources (e.g. telecom, mining, power). Once again, industry looks to government policy to grow. Lack of policy initiatives will drop growth not RBI.
All policies are not equal
Post the polls in UP, markets expect several policy changes - indicating government's willingness to address the concerns of investors. It's likely that there will be a slew of announcements.
When examining announcements, keep a "framework" in mind. Ask if a policy announced allows industry to make better capital allocation decisions over the long term. Ad hoc exemptions and tax rate changes may provide temporary relief, but not sustainable growth. Investment requires a stable policy environment. Fickle decision making does not work - not even favourable decisions.
Foreign investment may receive favours. Policy makers would do well to remember that foreign savings make up less than 10 per cent of the total saving in the country. Undue focus on international capital flows while neglecting domestic markets does not make sense. Money has the same color - irrespective of its origin.
Real reform for India would be reducing the size of government expenditure and not by raising user prices. The government has created a list of entitlements and threatens to create more without debating. How these will be paid for.? Last year, the finance minister promised not to have costs off the "balance sheet". He failed. Let's wish for a better year ahead. Else, the Indian growth story will remain the best potential play - only the potential will take another decade to realize.
The author tells us why the real reform in India would be reducing the size of government expenditure & not raising user prices
By Anand Tandon | Apr 14, 2012
Has the RBI really been "hawkish"?
The graph below tells a different story.
Post the economic meltdown in 2008, RBI moved quickly to drop interest rates. The same alacrity was missing on the way up. Inflation started to rise by November 2009. RBI took corrective steps only in March 2010, that too in very small steps allowing inflationary expectations to build. Real interest rates (=interest rate - inflation) which measures the payment a saver receives for postponing consumption has been negative since November 2009 - and continued to be so till now.
How does negative real interest penalize the saver? Let's assume movie tickets last year cost Rs 100. With interest rates of 10 per cent, a bank fixed deposit (FD) of Rs 1000 yielded Rs 100 in interest - you could use it to watch a movie. This year, price of movie tickets increased to Rs 112. If interest rates remained unchanged, you would now have to dip into your FD to watch a movie. In other words, you would have been penalized for saving (postponing consumption).
The Indian economy witnessed a sharp recovery in 2009-10. The justification of negative real interest rate did not exist - but did either industry or market participants complain? Monetary policy is supposed to be counter-cyclical. It has to provide stimulus when the economy slows, and "take away the punch bowl" when the economy is over-heating. The latter is always difficult if the stimulus stays for too long. Borrowers get addicted!
But isn't it obvious that higher interest rates will slow the economy?
The relationship between growth and inflation has been the subject of much research. Evidence is mixed - but in general, it appears that low rates of inflation may help growth, while sustained high levels inflation harm long term growth rates.
In the Indian context, "threshold inflation" below which inflation is assumed benign has been variously estimated at between 4 per cent and 7 per cent. A RBI working paper published in September 2011 suggests the relationship as in the graph below. Inflation as measured by WPI becomes damaging as is rises beyond 7 per cent.
Other studies, e.g. Prasanna and Gopakumar, (IGIDR) conclude unequivocally "that any increase in inflation from the previous period negatively affects growth". In any case, not curbing inflationary expectations when the inflation rate is near double digits would mean that the RBI is not performing its key task - that of maintaining price stability.
In short, while the near-term growth prospects may seem subdued, failure to curb inflation would hamper longer term growth in the economy. Don't shoot the messenger!
Domestic saving and growth
Why is it necessary that savers receive positive "real returns"? Growth requires investment. In India, it requires Rs 4.5 of investment to generate Rs 1 of income per year going forward. This rate is referred to as ICOR (Incremental capital output ratio). ICOR is a measure of the efficacy of use of capital. ICOR has averaged between 4 and 4.5 for the past two decades.
Over the past few years, domestic savings have averaged around 33 per cent of GDP. Current account funds another 1-3 per cent. Overall, assuming that the ICOR remains at 4.5, India should be able to sustain a growth rate of 8 per cent (= {33%+3%}/4.5) on an average. To increase this to 9%-10% however, one of two factors must change - either savings rate has to move to 40 per cent, or ICOR has to drop to nearer 4. Offering negative real interest rates to savers (as has been the case for the past 3 years) is not likely to move savings rate to 40 per cent.
Efficient use of capital too requires that poor capital allocation decisions be avoided. When interest rates are low, borrowers are encouraged to take risks - often leading to mis-allocation of capital - and increasing ICOR. The real estate asset bubble of the US is a case in point. In capital deficient India, this would be unacceptable.
Reducing ICOR requires policy initiatives
Post liberalization (1991), the Indian economy used capital judiciously as witnessed by an ICOR of 4. India is now entering a period of infrastructure building. This is more capital intensive, with returns that are often back-ended. ICOR will rise.
Another factor is the increasing dependence on government decision making. While the early 90's marked the removal of the need for government approvals, many industries now are again dependent on licensing and allocation of public resources (e.g. telecom, mining, power). Once again, industry looks to government policy to grow. Lack of policy initiatives will drop growth not RBI.
All policies are not equal
Post the polls in UP, markets expect several policy changes - indicating government's willingness to address the concerns of investors. It's likely that there will be a slew of announcements.
When examining announcements, keep a "framework" in mind. Ask if a policy announced allows industry to make better capital allocation decisions over the long term. Ad hoc exemptions and tax rate changes may provide temporary relief, but not sustainable growth. Investment requires a stable policy environment. Fickle decision making does not work - not even favourable decisions.
Foreign investment may receive favours. Policy makers would do well to remember that foreign savings make up less than 10 per cent of the total saving in the country. Undue focus on international capital flows while neglecting domestic markets does not make sense. Money has the same color - irrespective of its origin.
Real reform for India would be reducing the size of government expenditure and not by raising user prices. The government has created a list of entitlements and threatens to create more without debating. How these will be paid for.? Last year, the finance minister promised not to have costs off the "balance sheet". He failed. Let's wish for a better year ahead. Else, the Indian growth story will remain the best potential play - only the potential will take another decade to realize.
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