Vivek Kaul
So P Chidambaram’s at it again, trying to bully the Reserve Bank of India (RBI) to cut interest rates. “In our view, the government and monetary authority must point in the same direction and walk in the same direction. As we take steps on the fiscal side, RBI should take steps on the monetary side,” the Union Finance Minister told the Economic Times.
Economic theory suggests that when interest rates are low, consumers and businesses tend to borrow more. When consumers borrow and spend money businesses benefit. When businesses benefit they tend to expand their operations by borrowing money. And this benefits the entire economy and it grows at a much faster rate.
But then economics is no science and so theory and practice do not always go together. If they did the world we live would be a much better place. As John Kenneth Galbraith points out in The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand..The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life… Business firms borrow when they can make money and not because interest rates are low.”
While India is not in a recession exactly, economic growth has slowed down considerably this year. And this has led to businesses not borrowing. As a story in theBusiness Standard points out “At a recent meeting with the Reserve Bank of India (RBI), 10 of the country’s top bankers said companies were still keeping expansion plans on hold, as business growth continued to be slow in an uncertain economic environment. Nine of 10 bankers who attended the meeting admitted their sanctioned loan pipeline was shrinking fast due to tepid demand.”
This is borne out even by RBI data. The incremental credit deposit ratio for scheduled commercial banks between March 30, 2012 and September7, 2012, stood at 14.4%. This meant that for every Rs 100 that bank raised as deposits during this period they only lent out Rs 14.4 as loans. Hence, businesses are not borrowing to expand neither are consumers borrowing to buy flats, cars, motorcycles and consumer durables.
One reason for this lack of borrowing is high interest rates. But just cutting interest rates won’t ensure that the borrowing will pick up. As Galbraith aptly puts it business firms borrow when they can make money. But that doesn’t seem to be the case right now. Take the case of the infrastructure sector which was one of the most hyped sectors in 2007. As Swaminathan Aiyar points out in the Times of India “The government claims India is a global leader in public-private partnerships in infrastructure. The private sector financed 36% of infrastructure in the 11th Plan (2007-12 ),and is expected to finance fully 50% in the 12th Plan. This is now a pie in the sky. Corporations that charged into this sector have suffered heavy losses. They expected a gold mine, but found only quicksand. They have been hit by financially disastrous time and cost overruns.”
Clearly these firms are not in a state to borrow. Several other business sectors are in a mess. Airlines are not going anywhere. The big Indian companies that got into organised retail have lost a lot of money. The telecom sector is bleeding. So just because interest rates are low it doesn’t automatically follow that businesses will borrow money.
“If you take a poll of the top 100 companies in the country, you will find them saying nothing has changed despite the reforms. Confidence will return only if things start happening on the ground,” a Chief Executive of a leading foreign bank in India was quoted as saying in the Business Standard.
Confidence on the ground can only come back once businesses start feeling that this business is committed to genuine economic reform, there is lesser corruption, more transparency, so and so forth. These things cannot happen overnight.
Consumers are also feeling the heat with salary increments having been low this year and the consumer price inflation remaining higher than 10%. Borrowing doesn’t exactly make sense in an environment like this, when just trying to make ends meet has become more and more difficult.
Given these reasons why has Chidambaram been after the RBI to try and get it to cut interest rates? The thing is that the finance minister is not so concerned about consumers and businesses, but what he is concerned about is the stock market.
With interest rates on fixed income investments like bank fixed deposits, corporate fixed deposits, debentures, etc, being close to 10%, there is very little incentive for the Indian investor to channelise his money into the stock market.
Since the beginning of the year the domestic institutional investors have taken out Rs 38,000.5 crore from the stock market. If the RBI does cut interest rates as Chidambaram wants it to, then investing in fixed income investments will become less lucrative and this might just get Indian investors interested in the stock market.
The lucky thing is that even though Indian investors have been selling out of the stock market, the foreign investors have been buying. Since the beginning of the year the foreign institutional investors have bought stocks worth Rs 72,065.2 crore. This has ensured that stock market has not fallen despite the Indian investors selling out.
If the RBI does cut interest rates and that leads Indian investors getting back into the stock market there might be several other positive things that can happen. If Indian investors turn net buyers and the stock market goes up, more foreign money will come in. This will push up the stock market even further up.
The other thing that will happen with the foreign money coming in is that the rupee will appreciate against the dollar. When foreigners bring dollars into India they have to sell those dollars and buy rupees. This increases the demand for the rupee and it gains value against the dollar.
An appreciating rupee will also spruce up returns for foreign investors. Let us say a foreign investor gets $1million to invest in Indian stocks when one dollar is worth Rs 55. He converts the dollars into rupees and invests Rs 5.5 crore ($1million x Rs 55) into the Indian market. He invests for a period of one year and makes a return of 10%. His investment is now worth Rs 6.05 crore. One dollar is now worth Rs 50. When he converts the investors ends up with $1.21million or a return of 21% in dollar terms. An appreciating rupee thus spruces up his returns. This prospect of making more money in dollar terms is likely to get more and more foreign investors into India, which will lead to the rupee appreciating further. So the cycle will feeds on itself.
In the month of September 2012, foreign investors have bought stocks worth Rs 20,807.8 crore. Correspondingly, the rupee has gained in value against the dollar. On September 1, 2012, one dollar was worth Rs 55.42. Currently it quotes at around Rs 52.8. This means that the rupee has appreciated against the dollar by 4.72%.
An immediate impact of the appreciating rupee is that it brings down the oil bill. Oil is sold internationally in dollars. Let us say the Indian basket of crude oil is selling at $108 per barrel (one barrel equals 159 litres). If one dollar is worth Rs 55.4 then India has to pay Rs 5983.2 for a barrel of oil. If one dollar is worth Rs 52.8, then India has to pay Rs 5702.4 per barrel. So as the rupee appreciates the oil bill comes down.
The oil marketing companies (OMCs) sell diesel, kerosene and cooking gas at a price which is lower than the cost price and thus incur huge losses. The government compensates the OMCs for these losses to prevent them from going bankrupt. This money is provided out of the annual budget of the government under the oil subsidy account. But as the rupee appreciates and the losses come down, the oil subsidy also comes down. This means that the expenditure of the government comes down as well, thus lowering the fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.
This is how a rising stock market may lead to a lower fiscal deficit. But that’s just one part of the argument. A rising stock market will also allow the government to sell some of the shares that it owns in public sector enterprises to the general public. The targeted disinvestment for the year is Rs 30,000 crore. While that can be easily met the government has to exceed this target given that the government is unlikely to meet the fiscal deficit target of 5.1% of GDP as its subsidy bill keeps going up. The Kelkar Committee recently estimated that the fiscal deficit level can even reach 6.1% of the GDP.
For the government to exceed this target the stock markets need to continue to do well. It is a well known fact people buy stocks only when the stock markets have rallied for a while. As Akash Prakash writes in the Business Standard “The finance minister will have to do a lot more than raise Rs 40,000 crore from spectrum and Rs 30,000 crore from divestment. We will need to see movement on selling the SUUTI (Specified Undertaking of UTI) stakes, strategic assets like Hindustan Zinc, land with companies like VSNL, coal block auctions, etc. To enable the government to raise resources of the required magnitude, the capital markets have to remain healthy, both to absorb equity issuance and to enable companies to raise enough debt resources to participate in these asset auctions.”
Given this the stock market has a very important role to play in the scheme of things. Controlling the burgeoning fiscal deficit remains the top priority for the government. But it is easier said than done. “Given the difficulty in getting the coalition to accept the diesel hike and LPG-targeting measures, there are limitations as to how much the current subsidies and revenue expenditure can be compressed. We can see some further measures on fuel price hikes and maybe some movement on a nutrient-based subsidy on urea; but with elections only 15-18 months away, there are serious political costs to any subsidy cuts,” points out Prakash.
Over and above this with elections around the corner the government is also likely to announce more freebies. Money to finance this also needs to come from somewhere. As Prakash writes “There is also intense pressure on the government to roll out more freebies through the right to food, free medicines and so on. If expenditure compression is intensely difficult in the run-up to an election cycle, higher revenue is the only way to control the fiscal deficit.”
For the government to raise a higher revenue it is very important that more and more money keeps coming into the stock market. For this to happen interest rates need to fall. And that is something that D Subbarao the governor of RBI controls and not Chidambaram.
The article originally appeared on www.firstpost.com on October 1, 2012. http://www.firstpost.com/economy/why-fm-is-tickling-the-markets-its-his-only-chance-474908.html
Vivek Kaul is a writer. He can be reached at [email protected]