Rx: Start With Consumption, Start Small

The trick to jump-starting the economy might lie in creating demand for basic goods, besides increasing liquidity and other revival measures

IN THE movie Batman & Robin, arch-villain Freeze gate-crashes into an antiquities exhibition and announces: “In this universe, there is only one absolute. Everything…freezes.” Credit markets across the world have frozen over, and though there’s no nasty piece of work yet (at least not on the scale of Freeze), there are no early signs of thawing. Spring may still be far away, but attempts by regulators and governments from across the world to end the economic chill don’t seem to be working. In India too, the government and the central bank, Reserve Bank of India, seem to be working hard to loosen winter’s cold grip over the Indian economy, but with little success.

The RBI has been infusing the economy regularly with large doses of liquidity ever since the system was beset with worries of money drying up. The RBI tried everything in the book — cut cash reserve ratio, freed up part of the statutory liquidity ratio, opened a special lending facility for banks to on-lend to NBFCs, housing finance companies and mutual funds, created a special refinance window from where banks could borrow without providing any collateral. Additional liquidity was pumped in by buying back bonds issued under the market stabilisation scheme. In all, since mid-September, the RBI pumped in Rs 300,000 crore through the sluice gates.

But, even that did not help hydrate the financial system. When banks were swamped with liquidity, they took the cash and dumped it with the RBI for a 6% return, even when lending it to prime borrowers might have fetched better returns. The central bank even cut its benchmark repo rate by 150 basis points (bps) to 7.5% on October 19 in an attempt to get some of that money moving out of the bank vaults. Still no go.

The RBI recently turned up the thermostat once more, this time to prod banks to start lending at reduced interest rates. It cut its benchmark repo and reverse rate by 100 bps. But, again, there’s hardly any movement. The banks are still carting their surplus cash over to the RBI and dumping it there for safe-keeping, for even as a low a return as 5%. Take a look at the money being tipped over at the RBI window.

For the first five days of the month, till the RBI cut the rates, banks plonked Rs 243,310 crore with the Reserve Bank, for a return of only 6%. Then on December 6 — a Saturday — it cut rates again. Over the next three working days, banks again deposited Rs 84,635 crore with the central bank, for a return of just 5%. The total — for just eight days — works out to over Rs 327,000 crore! In fact, the RBI was forced to comment, while announcing the new rate cuts, that the liquidity adjustment facility operated by the central bank, “has largely been in an absorption mode.”

In effect, this means banks are still wary of lending to corporates, despite the sea of liquidity and rate cuts unleashed by the central bank. This also then conveys how banks are still uncertain about the future and that they are doubtful about the ability of their corporate clients to pay up in time. In short, the vital glue of financial system — trust — seems to be missing and the authorities designing the various economic packages are unable to supply it in sufficient quantities.

Here's an example — a public sector unit was able to issue five-year bonds to banks with a coupon of 9.33%. Around the same time, one of the Top five India Inc companies also borrowed three-year money, but at 10.10%. Clearly, banks are willing to take a risk on the government, even if it is a subsumed sovereign guarantee, but not on even AAA-rated private companies. Banks have not forgotten the nightmares of the early 1990s, when bank NPAs ruled around 10-14%. This time, despite the prodding from the government and the central bank, they are unwilling to stick their necks out. The RBI has allowed banks to restructure loans — a euphemism for looking the other way when a loan turns bad — that might in ordinary times have been called for stricter treatment. But, the banks are still not biting.

The problem also seems to be in the system’s liquidity absorption capacity. Whatever steps the government takes at the moment — such as, providing cheap cash to corporates through a variety of refinance windows — not only are banks reluctant to lend, even corporates are loath to load up their balance sheets with fresh debt. Many of them are drawing down their existing credit lines with banks — emboldened somewhat by the new restructuring space — to finish existing projects but are unwilling to bet on new projects. With aggregate demand having fallen, India Inc is also contending with reduced topline and bottom line projections. In such a scenario, they may not be in a mood to pile up additional debt.

Therefore, the key to the current economic impasse might lie on the demand side. The government has tried addressing the issue by spending on infrastructure and by cutting taxes to boost demand. These are also not without their associated problems. Any investment in infrastructure will yield results only after a long lag, and the nature of improved technology does not allow for the higher employment generation that one saw a few years ago. Plus, to get an infrastructure project started is also time-consuming — financial closure in these days of clammy credit markets is a tough call.

Some economists say that the production orientation of the economy has changed in favour of expensive consumer products, a sector that might be slow off the blocks in reviving. In such a situation, reviving demand for wage goods might just do the trick. Even this hypothesis needs to be tested. The occasion might present itself soon — with experts forecasting a better-than-average winter crop, the government should facilitate hassle-free movement of the harvest to the markets and consumables to centres where the ensuing agricultural income can be spent. This may sound simplistic, but sorting the physical, infrastructural infirmities could be one of the first achievable steps on the long road to recovery.

Published as an Op-Ed in The Economic Times (December 15, 2008)

New Bretton Woods Or Globocops?

A new multilateral regulatory structure seems unlikely now, given that the Fed and some central banks would not like to be told what to do. But, there is bound to be greater global coordination between central banks

A FEW days ago, the US Federal Reserve opened swap lines of $120 billion with four countries — Brazil, Mexico, Singapore and South Korea — to keep international liquidity pipelines unclogged. A few days before that, the European Central Bank entered into foreign currency swaps with Iceland and Switzerland, even though they are not part of the Eurozone. A $12-billion swap line was also established with Denmark. ECB also offered Hungary a $6.4-billion loan to tide over its temporary liquidity shortage. The objective of these swap lines is the same — to ensure that the global financial system, especially the countries that are “systemically” important to the US and European economies, do not suffer from a temporary shortage of dollars or euros, leading to a further deepening of the global credit crisis.

Traditionally, this job should have gone to the International Monetary Fund. Conspiracy theory proponents will undoubtedly detect a dishonourable political design here — with developing countries demanding a more egalitarian shareholding structure in the multilateral institute, this is the only way in which both the US and Europe can maintain their sway over the global financial system. But, such extreme hypotheses apart, the IMF normally takes some time to design restructuring packages for distressed economies, while the Fed and ECB are more concerned with overnight and short-term liquidity issues. Plus, here’s the biggest difference — central banks can print money, while IMF has to depend on shareholders’ largesse. So, given the severity of the global financial crisis, both the Fed and the ECB are not leaving anything to chance, or to the IMF’s time-consuming methods.

They are now stepping into a role that is not specified in their mandate. For instance, ECB’s twin-edged mandate is to maintain price stability in the euro command area and to support the general economic policies of the European Community. The Fed’s conventional role, on the other hand, was to ensure full employment, but the oil shock of the 1970s saw US lawmakers adding inflation combat to that traditional mandate. With the current global financial blowout, both the Fed and ECB are now trying to broaden their usual role into some form of “global lenders of last resort”. They are now ready to provide liquidity to liquidity-starved nations in exchange for marketable and non-marketable instruments, even though such paper may be below the normally accepted credit-rating threshold.

This marks a sharp change from the way these central banks have operated over the years and may even provide some clues about how they will conduct their business in the future. The question that arises immediately, therefore, is: are central banks world-over going to morph into something different?

One thing is definite: henceforth, the Fed is sure to get responsibility for ensuring “stability in the financial system”. The Fed’s hands-off policy with regard to Wall Street and its high jinks has not gone down well with millions of US taxpayers who feel burdened with the responsibility of having to bail out errant banks and financial institutions. Academic and quasi-academic literature over the past few weeks is full of references to how central banks must now build efficient radar systems that can detect incipient trends of financial turmoil and head them off before they can grow in size. However, that’s easier said then done. Experts agree unanimously that it’s also very difficult to pinpoint asset-price bubbles early on in the game. Yet, the political impact of the recent experiences is likely to see lawmakers foisting central banks with some accountability.

As a corollary, central banks the world over will now find it difficult to keep monetary policy and bank supervision separate. There are already rumblings that central banks should have oversight over all components of the financial system, especially when recent experiences have shown that it takes no time for the contagion to spread from one segment to the other.

At a recent conference in Chile, Sveriges Riksbank’s deputy governor Lars Nyberg said: “I want to emphasise that monetary policy is perhaps not the most efficient instrument for preventing crises from happening. Even though a too loose monetary policy may contribute to the build-up of a bubble, it is less clear to what extent monetary policy can prevent such a build-up. It is quite likely that substantial interest rate increases, that central banks would find it hard to implement, would be required to achieve this. More moderate rate increases may, of course, still have an effect at the margin, not least as a signal from the central bank that there are certain concerns linked to prevailing developments. But a more capable line of defence to prevent financial crises is to have proper rules and effective supervision in place.”

Transparency is another word that is likely to be heard with increasing frequency in coming months. The demand that central banks lift the veil from their operations is being heeded in degrees, some with a greater extent of openness than some others. And then there are some which operate in a completely secretive environment. Add to this the fact that most financial markets are still opaque and you have a lethal combo. The extreme opacity in the way financial markets created and traded financial instruments is a major reason behind the current crisis. In the days ahead, lawmakers are certain to demand a greater measure of transparency from both central banks (since many commentators have also blamed central banks’ easy money policy for the turmoil) and financial markets.

Finally, will there be new Bretton Woods institutions, responsible for global financial governance, or will central banks become the new globocops? A new multilateral regulatory, institutional structure seems unlikely now, given that some central banks — especially the Fed — would not like to be told what to do. But, there is bound to be greater global coordination and a higher volume of data exchange between central banks. For instance, jointly, both the RBI and Fed should now be able to wring more data out of financial institutions on the sources behind participatory notes.

Published as Op-Ed in The Economic Times (November 14, 2008)

Recapitalising Public Sector Banks

Despite finance minister P Chidambaram’s assertions that all our banks are well capitalised and regulated, the only way to grow in the tough times that lie ahead is to provide banks with additional capital

LAST autumn, when finance minister P Chidambaram was visiting USA with his senior officials, he was apparently invited to lunch by treasury secretary Henry “Hank” Paulson. At the meeting, Paulson reportedly held forth on the benefits of an open financial system and the need for India to loosen its controls. Much as this might sound apocryphal, a news wire also recently carried a dispatch from Beijing, detailing how Paulson harangued the audience at Shanghai Futures Exchange 18 months ago about how “an open, competitive and liberalised financial market” was far more efficient than “governmental intervention”.

Cut to the present. The US government’s attempts to staunch the flow of red ink from its financial sector by stitching together a $700-billion bailout plan has brought its role as a champion of open markets, with minimum “government intervention”, into some question. It has also made the US administration the target for a fair bit of ridicule. But, irrespective of whether the package — called the Troubled Assets Relief Programme, or TARP — is right or not, there are broadly three developments in the US that are worth noting.

* Ban on short selling: Governments across the world, irrespective of their ideological shades or origins, try and influence market outcomes through interventionist policies. Sometimes it works, but its toxic after-effects are felt long after the deed is done. The desire to train markets to deliver what, governments erroneously believe, is beneficial to all market participants is dangerous and essentially short term in nature. These follies include stabs at banning short selling in stock markets. The Indian government has attempted this in the past and the US market regulator is among the latest to succumb to this peculiar affliction.
   The Securities and Exchange Commission, followed by regulators in some other countries, has decided to ban short selling in stocks of financial companies, principally to minimise opportunists (read hedge funds) from aggravating the misfortune of defenceless finance companies. However, the move has instead driven out liquidity from the market and, given the shortage of long-only investors, has turned the markets more volatile. Regulators also do not realise that shorts uncover problems long before they are made public and when they’re past any redemption.

* Return to Keynes?: TARP is probably the Fed and treasury’s way of acknowledging that monetary measures can go only a limited distance in solving some of the endemic problems confronting the US banking sector. The Fed has over the past 12 months tried to keep the financial catastrophe at bay by reducing interest rates and by pumping in huge amounts of liquidity. While this did help the banks somewhat initially, it subsequently failed in averting the bankruptcies and the destruction of balance sheets in other financial institutions outside the Fed’s jurisdiction, such as insurance companies and investment banks. Consequently, the fire-fighters cobbled together TARP, probably encouraged and emboldened by the outcome of the past packages put together during the Depression, or the savings and loan bailout.

TARP, in a sense, can be viewed as a surrogate recapitalisation programme for financial institutions and banks that do not have adequate capital to make up for their damaged assets. So far, so good. But two questions arise here. One, what does this do to USA’s burgeoning budget deficit and will it have the desired effect of providing the kind of fiscal stimulus that the administration hopes for? Two, what happens when a host of other personal loan categories — such as credit card, auto and education loans — also goes toxic, as has been feared for some time now? Will that lead to another bailout deal?

* Sea of liquidity: On Monday, just hours before Republicans in the House of Representatives torpedoed TARP, the Fed decided to flood the global financial system with $630 billion in cash — by increasing its existing currency swaps with other central banks in the world (such as European Central Bank, Bank of England and Bank of Japan, among others) by $330 billion and by enhancing its emergency lending programme by $300 billion. This is over and above all the other rehydrating programmes initiated by the Fed in the past.

While TARP does not technically lead to a flood of fresh liquidity into the system, the additional $630 billion is aimed at de-clogging the credit pipelines and reinstating confidence in the system. But it is also like a time-bomb ticking away in the global financial system whose aftermath will be felt much later. Long after the damage is controlled, this cash is likely to stay around and, much like the legacy Alan Greenspan left behind, impact asset prices across the globe. 

All these have enormous implications for the Indian economy. The biggest danger is that Indian policymakers might also be tempted to pursue wrong policies, primarily out of a misplaced sense of having always pursued the right policies and a desire to thumb one’s nose at all the free market votaries. There is a bit of schadenfreude at work here also. India has its unique set of problems and the only way to really unleash the productive energies of the economy is to keep reforming the different markets. Investors are already expressing their disappointment about the five years wasted by this government without implementing crucial reforms in either labour, or agricultural or infrastructure sectors.

Two critical issues arise here. One, the US government’s $700-billion TARP doesn’t automatically give India the licence to be complacent about its ballooning budget deficit, a large part of which is buried under the illiquid oil and fertiliser bonds. Also, India has to quickly move to recapitalise its public sector banks. Despite finance minister P Chidambaram’s assertions that “all our banks are well capitalised and well regulated”, the only way to grow in the tough times that lie ahead is to provide banks with additional capital. As the global, and the Indian, economy slows down, many Indian banks will need to revisit their capital levels. A solution exists — the government has to dilute part of its holdings in these banks. Supply of quality paper can also provide the market with a booster dose in comatose times.

Published as an Op-Ed in The Economic Times (October 3, 2008)

RBI’s Priorities And Concerns

The pressure on the RBI to cut rates will intensify now because of two immediate reasons — G8 central banks are re-hydrating their economies to keep the credit lines lubricated and China has cut its rates

IN LESS than a week of taking over his new assignment, Reserve Bank governor Duvvuri Subbarao decided to hold a press conference and talk about some macro issues. This is unusual. Typically, a central banker takes some time to settle down before speaking out about the problems of the day. But, given that he chose to address the media so soon after taking over, it is perhaps an indication of the troubled times we live in. Or, perhaps, it’s symptomatic of the confusion roiling the asset markets, making them swing between the two extremes of heightened expectations and mounting uncertainties.

There are signs of ambiguity everywhere — whether it’s in the inflation numbers or growth impulses, whether it’s in the drag effect of a global slowdown or the intense volatility experienced by the markets. Therefore, it was a welcome sign that Subbarao decided to break with convention and spelt out his priorities. While Subbarao has taken to his new role (and its obligatory nuanced statements) with surprising agility, he did outline, rather pointedly, some of the RBI’s concerns and priorities.

But many other concerns remain unspoken and there are any number of surprises (“known unknowns”, as Subbarao calls them) strewn along the central bank’s path to attaining economic growth with price stability. The global sell-off arising out of the collapse of three Wall Street icons — Lehman Brothers, Merrill Lynch and AIG — are the latest “known unknowns”. Much of the advice dished out for the governor so far focuses on obvious concerns, some unfinished agenda and a few minor issues. The obvious ones are: unease over the rate of inflation and speculation over the future course of monetary tightening. The incomplete tasks include financial sector reforms and addressing the capital deficit in PSU banks. The minor issues involve tinkering with products and processes in the currency and interest rate markets. But, Subbarao still has to keep his guard up for a host of wide-ranging issues, including the aftermath of the global credit squeeze.

Elections are round the corner and the governor is bound to be inundated with demands to loosen the monetary taps, some of which were quite presciently tightened by his predecessor. With crude prices having now dipped below $100, the requests to ease interest rates have acquired a new force. Add to that the latest WPI numbers — which dropped to 12.1% for the week ended August 30, from 12.34% the week before — and the clamours for an interest rate cut are already getting louder. Subbarao needs to watch out. Crude prices are still higher than the prices charged by oil marketing companies. But, more importantly, Opec recently decided to undertake a production cut. Although this has so far failed to rattle markets — primarily because of the global economic slowdown — the danger of further production cuts or sudden disruptions in oil production cannot be ruled out.

Also, the slowing down of the inflation rate might be slightly misleading. For one, the inflation index is still growing above the RBI’s comfort levels. But, beyond that, on a disaggregated basis, there are some essential products and manufactured items that are still showing rising prices. There are also two other factors that can’t be overlooked — the base effect might be finally wearing off and, therefore, it is important to look at the week-on-week growth in the index, which clocked 0.2% for August 30, after rising marginally in the previous week. In fact, the September 12 report by the Goldman Sachs Asia economics research team forecasts inflation peaking to 13.5% by November before beginning to cool off. Plus, the rupee’s continuous depreciation against the dollar over the past few days, despite the RBI’s attempts at intervention, could complicate attempts to tamp down inflationary expectations. The rupee will continue to be under pressure as foreign investors rush to sell their equity holdings and buy dollars.

The pressure to cut rates will also intensify now because of two immediate reasons — G-8 central banks are re-hydrating their economies to keep the credit lines lubricated and China has cut its rates. But, developed country banks are caught in an asset blow-out and need additional liquidity to keep their heads above water which Indian banks, thankfully, don’t. Export-driven China, on the other hand, sees large parts of its economy affected by the US developments and has therefore opted to chase growth. India has a strong domestic market and even the consensus growth forecast of 7-7.5% is pretty good by international standards.

The monetary tightening was conducted to squeeze out excess demand, a partial reason for the build-up of inflationary expectations. This is what Subbarao said at his maiden press conference: “The current high level of domestic inflation reflects a combination of supply-side pressures as well as demand-side factors… Though demand is not the main problem, in the absence of further flexibility on the supply side, demand management has to be part of the solution. Dampening demand and anchoring inflation expectations has been the logic behind Reserve Bank’s monetary stance.” One of the methods used was increasing cash reserve ratio (CRR) and the repo rate. This was to ensure a slowdown in the runaway growth in bank credit. Former governor Y V Reddy pressed the panic buttons when credit-deposit ratio crossed 80%, indicating that banks were borrowing short term to finance long-term assets.

Subbarao’s observation about systemic rigidities — “absence of further flexibility…” — is unlikely to be set right any time soon. Plus, as the RBI’s annual report points out, the fisc is expected to come under increasing stress from, among other things, implementation of the sixth pay commission, lower petro-product duties, higher fertiliser subsidies and farm debt waivers. Therefore, perforce, demand-side management will have to remain the focus of the RBI’s strategy. But, the expectations of monetary easing are also unlikely to fade away soon. The market will be looking at the governor pretty closely — to see whether he can indeed walk the lonely path reserved for central bank governors, insulated from the influence of markets and, most importantly, from the fiscal side across the fence.

Publilshed as an Op-Ed in The Economic Times (September 17, 2008)

Good Intention, Bad Outcome

Overseas M&As are providing Indian companies with a new competitive edge. The Competition Act, instead of adding teeth to this new-found competitive advantage, might end up debilitating Indian industry

JUST when you thought India Inc had acquired the muscle to play the global sweepstakes, Indian lawmakers have struck back with attempts to rein in the corporate sector’s worldly ambitions. Prima facie, it seems to be the handiwork of a bunch of people who were nourished on the economic rent built into the licence raj system and are now desperate to restore their cash flows to the pre-reforms era.

They may have just hit upon the perfect system. The new Competition Act — first passed by Parliament in 2002, then amended in 2007 after going through a parliamentary standing committee on finance, but yet to be notified — might be their ticket to the gravy train. As things stand, once the amended Competition Act is notified, industry is scared that this will signal a return to the nightmarish days of Monopolies and Restrictive Trade Practices Act, which required every company, industrial group, entrepreneur to seek approval for every step they took, every move they made. In some ways, it was the MRTP Act of yore which not only stifled competition but also gave birth to the unholy industry-politician-bureaucrat nexus and provided India with a high-ranking berth in the global corruption league tables.

The intentions of the Competition Act are actually honourable. The Act aims to protect citizens from the ill-effects of concentration of power in any company or industrial group and their ability to influence market outcomes, through pricing muscle or market domination. The Act’s opening lines are: “An Act to provide…for the establishment of a Commission to prevent practices having adverse effect on competition, to promote and sustain competition in markets, to protect the interests of consumers and to ensure freedom of trade carried on by other participants in markets, in India…” Every developed country has a similar legislation in some form or the other. But, it is the design and the purport of this Act that promises to incapacitate industry. Here’s an example: had the Act been notified, the Idea-Spice telecom deal might still be languishing in bureaucratic muddle.

The Act has several grey areas, and the purpose behind leaving these gaps in the drafting is anybody’s guess. Given the country’s abysmal judicial and regulatory infrastructure, the first question that arises is whether the country is ready for it. The Competition Commission of India (CCI), a quasi-judicial body entrusted with enforcing the Competition Act, has no wherewithal to adjudicate on any of its mandates. It has a paltry budget, skeletal staff, a crummy office and none of the knowledge base that’s de rigueur for any regulator.

Let’s look at some of the trip-wires left in the Act. First, any M&A deal has to mandatorily notify the CCI. Then, under the Act, CCI gets 210 days to give its assent — a rather long period in today’s competitive environment. Assume the commission feels the deal is not inimical to any of its stated objectives and gives it a green signal. Now comes the fun part — any person can go on appeal to the Appellate Tribunal, which does not have any mandatory time limits. Imagine the scope for mischief. The Act states: “The appeal filed before the Appellate Tribunal…shall be dealt with by it as expeditiously as possible and endeavour shall be made by it to dispose of the appeal within six months from the date of receipt of the appeal.” What if the “endeavour” does not result in a verdict in six months? The Act is silent on the issue. But, that’s not the end. Even if the tribunal overturns the appeal, the appellant can still approach the Supreme Court which will then, in keeping with the tenets of natural justice, need to hear all sides before reaching a verdict. Which M&A deal can wait for so long?

The amended Act also requires all Indian companies bidding for overseas acquisitions to obtain a pre-deal approval first. In fact, all sellers will henceforth require that bidders get all their approvals in place first even before considering their bids. However, many sellers might not be willing to keep the deal in abeyance for 210 days. In addition, there is the issue of confidentiality. Government offices are notorious for leaks — not only to the media but even to business rivals. In comparison, many Indian companies which acquired European targets in the recent past, including some marquee names, not only obtained a pre-deal approval in less than 30 days, but also claim that not a word leaked from the European competition authorities.

Then, there is the threshold level of assets or turnover which is used to decide whether the Act should be made applicable to any company entering into an M&A deal, whether in India or abroad (it will also include two foreign companies merging overseas, if they have operations in India, subject to a threshold level as well). Section 20(3) of the Act requires the government to increase or reduce the threshold levels every two years, on the basis of either the wholesale price index or the foreign exchange rate.

There is a whole range of other contentious issues that is exercising industry, such as the large tracts of ambiguous drafting or the powers granted to the government. For instance, the government has reserved for itself the right of exemption: “The central government may, by notification, exempt from the application of this Act... (a) any class of enterprises if such exemption is necessary in the interest of security of the state or public interest…” While it is strange that the commission, as regulator, has been deprived of this power, the Act also does not include any provisions for exempting “any class of acquisition”, such as creeping acquisitions.

Of the three issues that the Act is expected to tackle, we have touched upon only one here, namely M&As. The other two — preventing cartelisation and abuse of dominant position — also contain enough landmines to trigger off a raft of disputes. But, all this raises one fundamental issue. Overseas M&As were providing Indian companies with a new competitive edge. Legislation, instead of adding teeth to this new-found competitive advantage, might end up debilitating Indian industry.

Published as as an Op-Ed in The Economic Times (August 20, 2008)

Agriculture, The Engine Of Growth

The structural deficiency of the agricultural economy as a whole and the slipover impact from the rise of crude prices on fertiliser prices as well as on transport costs for ferrying food items need to be tackled urgently

THE meeting of heads of state from G-8 and eight other economically important nations (which included Indian Prime Minister Manmohan Singh) in Japan this week got headlines in the Indian media for all the wrong reasons. While the PM’s presence there provided the focal point of all political action in Delhi, the conclave wound up on Wednesday without reaching any meaningful action plan on the two most contentious issues: combating climate change and controlling global inflation caused by rising food and fuel prices. Preoccupied as he might be with all the political drama, Manmohan Singh should also be worried about food security. Especially, since Maharashtra faces a drought-like situation this year.

The greatest disappointment of the G-8 meeting, however, seemed to be the failure of global leaders to come up with a concrete plan to tackle the food crisis. News agency Reuters filed this report: “The G-8 leaders also acknowledged the economic threat from surging oil and food prices…but came up with no fresh initiatives to tackle what they said were complex problems requiring long-term solutions.” What’s strange is the absence of any acknowledgement from the G-8 leaders that the major reason for the rise in food prices is increasing bio-fuels production in the US and, to some extent, in Europe. The rich countries made no promises to remedy this structural issue, which promises to pull another 100 million people below the poverty line this year, but shifted the responsibility to other big emerging countries. Reuters also filed this report: “The G-8…called for countries with sufficient food stocks to make available a part of their surplus for countries in need.”

The World Bank says this upfront in a position paper (Rising Food Prices — Policy Options and World Bank Response): “Concern over oil prices, energy security and climate change have prompted governments to take a more proactive stance towards encouraging production and use of bio-fuels. The has led to increased demand for bio-fuel raw materials, such as wheat, soy, maize and palm oil, and increased competition for cropland…Other developments, such as drought in Australia and poor crops in the EU and Ukraine in 2006 and 2007, were largely offset by good crops and increased exports in other countries and would not, on their own, have had a significant impact on prices. Only a relatively small share of the increase in food production prices (around 15%) is due directly to higher energy and fertiliser costs.” On a more pessimistic note, the World Bank’s note prepared for the G-8 meeting — Double Jeopardy: Responding to High Food and Fuel Prices — states clearly that food prices are likely to remain above the 2004 levels till at least 2015.

All this raises worries about India’s food situation, particularly since repeated studies have shown that any rise in food prices, rather than fuel prices, is seen to have a greater impact on the common man’s inflationary expectations. This assumes greater importance in the case of the urban poor and the rural landless workers, where food has the lion’s share of the total consumption basket, compared to fuel which is either subsidised or almost free. What is likely to exacerbate the situation is the structural deficiency of the agricultural economy as a whole and the slip-over impact from the rise of crude prices on both fertiliser prices as well as on transport costs for ferrying food items from production centres to consumption hubs. Here are some of the urgent issues that need tackling immediately.

THE first anomaly lies at the macro level. Over 60% of the country’s population is today dependent on agriculture, which contributes to only 20% of GDP. This translates into low income per rural family, which then makes most of them vulnerable to debt traps and pushes them into distress every time there is an exogenous shock. The need is to wean away part of each family into skills-based training, without necessarily alienating the entire family from its agricultural roots. The solution is not to provide them with only urban-based jobs, but to create a talent pool for rural industry, whether it is manufacturing or services-based. Such an industrial base, through linkages, has the potential of bringing about qualitative changes in agriculture as well.

• As a result of so many people depending on agriculture for income, land holdings are exceedingly fragmented, leading to falling crop productivity. According to official statistics, close to 60% of all land holdings in the country are marginal holdings (where land ownership is less than 1 hectare). Consequently, the average size of operational holdings is not even half a hectare, or about 1 acre. Average foodgrain yields, therefore, have been almost stagnant.

• Diversion of crop land into non-agricultural use is growing and could be another cause for worry in the long run. New ways should be found of converting non-agricultural land into agricultural land (without actually reducing the forest cover) and employing technology to increase the productivity of these tracts. Antiquated legislation regulating sale and purchase of agricultural land also needs to be updated, with adequate safeguards, to allow for consolidation of farmland.

• A solution for improving the income and the yields would be to introduce contract farming in a big way. This allows a large corporate to tie up with a large number of farmers with contiguous plots. Both win: while the farmer does not lose his homestead and is assured of an income at the end of the harvest, the corporate is ensured a steady supply of output, which takes some of the uncertainties out of his supply chain.

• Finally, the government has no choice but to rise above petty vote-bank politics and take a hard look at all the handouts (such as loan waivers or cheap credit) and the subsidy structure. According to the World Development Report, 2008, 75% of India’s agricultural budget is spent on such private goods, instead of investing in public goods (such as rural roads, or increasing outlays for agricultural R&D).

In short, agriculture has the potential to become the engine for future growth in the economy, but only if the right cards are played now.

Published as an Op-Ed in The Economic Times (July 11, 2008)

Managing Business Cycles

Indian companies bulk up their investment just before the slowdown starts, aggravating the pressure on their bottom lines, rather than being ready with new capacities just when an upswing is taking place 

INDIA became a reluctant devotee of open markets ever since its close brush with bankruptcy. As a result, the country and its policymakers had no choice but to enroll for continuing lessons on the advantages and perils of open markets as well as global linkages. Even Indian businesses had to learn some hard lessons. But, without prejudice to the nature of the economic agency — whether it is the government or the private sector business organisations — the process has been like baptism by fire.

However, the Indian corporate sector has been unable to come to terms with one intrinsic open market phenomena, which is largely episodic in nature but has a close bearing on the future growth prospects of almost all companies. It is called a “business cycle” and impacts bottom lines directly. It is an unavoidable consequence of open markets and free competition. Most developed markets around the world have gathered years of experience about it and have geared many parts of their business activities to forecasting it and then taking action to either minimise its deleterious impact or to capitalise on its salubrious influence. But, most companies in India seem to be getting acquainted with this unique change process only now.

Examples bear out India Inc’s inability to spot this big trend. The Indian corporate sector’s genetic architecture still seems to suffer from a passive disposition to floating along with the tide. Sure, there are some exceptions to this languid and helpless approach, but these are only a handful. Part of the reason for this lassitude lies in history and partly it is also due to structural deficiencies in the market, over which most companies do not have any control.

Here is one example of how companies miss the timing. If one goes by the chronology of business cycles drawn up by Pami Dua and Anirvan Banerji (Business Cycles in India, August 2006), then the period between September 1991 to May 1996 is shown as an expansion period, indicating increases in output, employment, income and sales. But, data shows private sector savings quite placid during the expansionary period (1991-92: 3.1% of GDP, 1992-93: 2.7%, 1993-94: 3.4%, 1994-95: 3.5%), but peaking to 5% only in March 1996, just when the business cycle is about to contract. The story’s the same for private sector gross domestic capital formation, averaging around 13.5% of GDP, but suddenly peaking to 18.4% by April 1996, just as the slowdown begins. Predictably, the savings and the investment rates fell the next year. This seems to indicate that Indian companies bulk up their investment just before the slowdown starts, aggravating the pressure on their bottom lines, rather than being ready with new capacities just when an upswing is taking place.

Research shows that most Indian companies rely largely on external financing to finance expansion (Financial Development & Growth in India: A Growing Tiger in a Cage, Hiroko Oura, IMF, March 2008). The trend is greatly emphasised in firms younger in age and smaller in size. The paper provides pointers to another systemic challenge — dependence on external financing (including equity) is inversely proportionate to a company’s growth prospects. However, Oura also concludes that despite all the shortcomings in the economy, India’s recent growth spurt was largely due to productivity growth. Typically, most firms have two sources of financing — external and internal. Again, external can be divided into domestic and “overseas” finance. If one leaves aside equity, then the sources of financing in the domestic market are characteristically bank funding, trade credit and capital markets (for issuing bonds and a host of other short-tenure instruments, such as commercial paper).

According to studies done over time, it is shown that most Indian companies historically did not generate enough savings. For example, in the ’80s, private sector savings hardly amounted to 2% of GDP — it touched 2% in 1988-89 and reached 2.4% in 1989-90. Given this low rate of savings, the corporate sector had to depend largely on external financing, including equity financing. Over the years, as markets opened up and tax rates came down (diminishing the incentives of high leveraging), the corporate sector’s propensity to invest was then directly related to its ability to generate enough surplus so that a judicious blend of own funds, borrowed funds (which largely meant bank financing) and equity could be used as the optimum, lowrisk combination. However, to generate the kind of internal surplus, most companies had to wait for their savings to touch a critical mass. Ordinarily, by the time most companies could make use of the good times and generate enough bulk on their books, the business cycle would turn. Companies then tended to save their surplus — instead of spending it on capital expenditure — for seeing them through the tight periods.

One alternative could be then to use bank credit for the planned investment expenditure. But, that’s a non-starter given the corporate sector’s inclination to spend only when the cycle starts heading downwards. The April edition of IMF’s World Economic Outlook (aptly titled Housing and Business Cycle) mentions: “Bank credit cycles arise naturally as a result of business cycles. Specifically, bank lending typically rises during an expansion and declines during a contraction. In a downturn, firms’ demand for credit normally declines, reflecting a curtailing of investment plans in response to weaker economic prospects and greater spare capacity...The price of bank credit also varies with the business cycle because it incorporates a risk premium. During a growth slowdown, the risk of insolvency increases in both the corporate and household sectors. Banks typically respond by charging higher risk premiums and tightening lending standards, particularly for riskier borrowers. Hence, expansion of bank credit is typically procyclical, whereas risk premiums and lending standards are countercyclical.”

The only alternative left then is either the equity markets or corporate bond markets. Undoubtedly, the Indian equity markets have reached some degree of global sophistication and efficiency. However, the same cannot be said of the corporate bond market. Also, the efficiencies of the equity market are not enough to compensate for the deficiencies in debt financing. In the end, if we give allowance for the fact that the corporate sector has been maturing over the years, then the only impediment to an efficient corporate sector is the absence of a well-functioning bond market.

Published as an Op-Ed in The Economic Times (June 11, 2008).

Right Fuel For Economic Growth

The government should have devoted a good part of its spending in building infrastructure. This would not only have alleviated pressures on the price line but would have also boosted investment growth

IT IS time that the government steps up to the plate. With the global economy slowing down perceptibly and policy advisers in the government trying to figure out how the ripple-effects will impact India, there is a need for the government to act now, in a meaningful economic manner that provides the right fuel for the economy’s tank. This is not to suggest a return to the old ways of command and control but to provide the right growth impetus to economy. The urgency has got somewhat heightened by the latest inflationary figures.

The government has so far relied on the central bank to sort out some of the large and pressing economic problems, but it’s now time to shoulder some of that responsibility too. Many commentators have been speculating about the action expected from the Reserve Bank on April 29, when it announces its annual monetary and credit policy for 2008-09, and some have even gone to the extent of suggesting what the central bank should be doing. But the onus for squelching inflationary expectations cannot lie with the central bank alone. The reason for that lies in the nature of the problem and the prolonged frailty of the structural deficiencies.

The superior quality of economic growth in the Indian economy for the past 48 months or so has been fired largely by investment in industry. Prior to that, it was consumption that was driving the Indian economy. It is now being increasingly felt that fresh investment by Corporate India into new capacities may slow down, thereby imperilling the very foundation of the sound growth experienced over the past few years. Real investment has grown at an annual average rate of 17% since 2002-03. Or, in other words, investment has been contributing to over 35% of GDP every year. While consumption was earlier the main driver for growth, the contribution of investment to growth over the past four years has been outstripping that made by consumption. However, recent data on investment growth does show some softening from the previous growth levels.

For instance, bank credit to the commercial sector, as reported every fortnight by the Reserve Bank, has been showing a declining trend. Bank credit to the commercial sector (food plus non-food credit) as on June 22, 2007, over March 30 was down 1.7% compared to a growth of 0.9% in the same period in 2006. At the end of the second quarter, bank credit in the first six months was up 5% compared to 10.2% in the first six months of 2006. For the first nine months, bank credit grew only 11.3% compared to 17.2% in 2006. And, finally, bank credit on March 14, 2008, was up 17.8% in 12 months, but far lower than the 24% recorded in the 12 months of 2006-07. It also seems that there is some tapering off of the volume of investments announced as well as the volume of investments implemented.

The government seems to have anticipated this trend. In the budget, the finance minister cut personal income taxes in the hope that some of the resulting increase in disposable income would find its way into additional consumption. Also, the sixth Pay Commission’s recommendations are expected to kick in from the third quarter — the government also seems to be banking heavily on the resulting consumption surge to work some wonders for the economy. Add the additional push from the states, and some economists expect the consumption party to continue till March 2010.

BUT that still does not take care of the deeper problems that are simultaneously plaguing growth as well as stoking the inflationary fires. One of the core issues is the supply-side afflictions. True, part of the push to the WPI has emanated from global food prices. But then the contribution of domestic supply-side problems has neither diminished nor can it be wished away summarily. And, it is here that the government seems to be failing in its role.

Take a look at the capital expenditure (plan plus non-plan) budgeted for 2008-09. Total capital expenditure during 2007-08 amounted to Rs 1,20,787 crore (revised estimates). If the one-time expenditure of Rs 35,531 crore incurred on acquiring the RBI’s stake in State Bank of India is deducted, the comparable figure works out to Rs 85,256 crore. When compared with the actual capital expenditure of Rs 68,778 crore for 2006-07, this is a good 24% higher. But, against the Rs 92,765 crore budgeted for 2008-09, the growth under this head is only about 9% this year.

That is a sharp drop in government’s spending for building assets. One would have expected that in times like these, the government would have devoted a good part of its spending in building infrastructure — such as roads, bridges or power distribution networks in rural areas — to sort out some of the supply-side bottlenecks. This would have then taken care of not only alleviating some of the pressures on the price line but would have also continued to provide the required impulse to investment growth. Two issues arise hereon.

• Prima facie it seems corporate investments into fresh capacities do not seem to be strategic about business cycles. Fresh research might be needed on whether companies wait for sufficient internal accruals before embarking on capacity-creation, primarily because the trust on external sources — particularly the bond markets — could be low. That threatens to then impinge on another acknowledged source of GDP growth — overall productivity growth in the economy.

• Given that the government’s expansionary fiscal measures could be feeding the demand-supply gap for some more time to come, the RBI’s task in managing the price line becomes that much more difficult. The question that arises then is: will the next policy, therefore, follow the predictable path of demand suppression or selectively ease funding of fresh capacities to step up supplies, especially to the rural and SME sectors?

Admittedly, walking the fine line between growth and inflation is becoming increasingly perilous.

Published as an Op-Ed in The Economic Times (April 11, 2008)

Will RBI Join The Give-Away Party?

With a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems counter-intuitive

It’s odd, but somehow the heart goes out to RBI governor Y V Reddy. Yet again, the bill for the party will end up on his desk. Given the pile-up of other issues that require the governor’s full-time attention, the additional cost of reining in the after-effects of finance minister P Chidambaram’s budget jamboree is sure to extract a heavy toll.

Sure, the FM has done what he had to, given the circumstances. Some may even argue that his hand was probably forced to a certain extent by a party diktat. The Rs 60,000-crore farm loan waiver and his petulant response to repeated questions about it betray some of the occupational hazards of framing a budget during election times. But, to his credit, he has still tried to focus on the larger issue at hand — keeping the economy humming and trying to insulate it, as far as possible, from the shock waves of an impending global slowdown. This he has tried to achieve through two measures — trying to ensure that consumption growth in the economy continues apace and that the engine of industrial production does not slow down. At this stage, he is keen to achieve these ends with the help of some fiscal stimulus.

Look at what the FM is up against — the average growth of industrial production has dropped from 11% at the end of the last fiscal year to a monthly average of 9% till November. In December, it was only 7.6% and, if the average industrial production growth rate tends to stay between 5-7% in the second half of the year, the average rate for the year is likely to be below even 9%. That’s a sharp drop from the previous year. The main items dragging the index down have been consumer durables and the auto sector.

The Economic Survey also forecasts that the year is likely to end with an overall real GDP growth of 8.7%, a full 100 basis point lower than the previous year’s 9.7%. Add to this the fear of the unknown — no fix on the extent of the sub-prime damage in the western economies and the resultant economic slowdown, or the degree to which this event will impact the Indian economy.

So, how will the finance minister achieve the twin objectives? For the consumer, he has done two things — made goods cheaper by cutting excise duty and providing them with more spending power by restructuring income tax slabs. With an eye to the industrial production index in particular, he has reduced excise duty on small cars and two-wheelers (sales of which had been hit the hardest). He has also cut the median excise duty rate to spur consumption of daily household items. Given that a large part of the growth impetus during past few months, in the face of slowing down consumption, has been predicated on investment, the FM has introduced some policy changes in the budget to keep the momentum going — removed some long-standing glitches to facilitate higher trading volumes in corporate bonds, promised to develop a bond and currency derivatives market, extended tax breaks for construction of hospitals and hotels.

It’s too early to figure out whether this combination will indeed work in spurring higher consumption levels and therefore keep the industrial shop floors buzzing. But one thing is certain: not addressing the real issues is unlikely to sort out the inflation issue or immediately bring people back into the consumption mode. Take the pressures on the food economy. Is it going to go away with the Rs 60,000-crore farm debt waiver?

Unlikely, since the farmer still has no solutions on sourcing improved inputs (such as seeds or fertilisers) or even an efficient and reliant system for selling his produce. There is also no appreciable investment in improving the infrastructure which delivers agricultural produce from the farm gate to our plates. Therefore, despite the FM’s pious statements about inflation in his budget speech — “Keeping inflation under check is one of the cornerstones of our policy” — food inflation (spurred on to some extent by global factors) is likely to continue to haunt the economy for some more time to come. The Economic Survey observes: “The behaviour of agricultural prices, including essential consumption items, will be critical, given falling poverty and rapidly rising per capita income…Domestic supply management is…critical to stabilising inflation expectations, moderating pressures for upward revision in wages and prices, and containing pressures for cost push inflation through monetary and fiscal accommodation.” 

Second, will lower car and two-wheeler prices (assuming all the auto producers do agree to pass on the duty cuts) really inspire consumers to be liberal with their wallets? Again, doubtful. A careful look at the auto industry sales figures reveals that it was actually lower interest rates that catalysed record sales of the past couple of years. Once rates hardened, sales also dropped. Therefore, to get those motorbikes and tiny cars rolling out of the shop once again, what’s needed is not only a firm control on current inflation, but on expectations of what it’ll be in the future. Since the fiscal design does not explicitly state how it will lower inflationary expectations — and hence interest rates — in the next few months, the efficacy of the entire package is on test.

But, beyond that, the RBI will have its own set of headaches arising out of the budget and other public policy. For one, its authority as an enforcer of credit discipline in the banking system seems to have been undermined once more by a trigger-happy government. Second, the pay commission’s award is surely going to add another little twist to the on-going inflation story.

In addition, the RBI has used monetary policy in the past few months to bludgeon runaway demand and bring inflationary pressures under control. With such a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems   counter-intuitive. Unless, of course, the RBI also decides to join in the pre-election giveaway party.

Published as an Op-Ed in The Economic Times (March 6, 2008)