What India Inc needs to understand about interest rates


Vivek Kaul

Big business has been after the Reserve Bank of India (RBI) to cut the repo rate or the rate at which the central bank lends money to the banks.
There seems to be a certain formula to the whole thing. Before any monetary policy the business lobbies make a series of statements asking the RBI to cut interest rates. And when the RBI does not cut the repo rate, they make another series of statements explaining why the RBI should have cut the repo rate.
The belief is that a cut in the repo rate will lead to banks cutting the interest rates at which they lend. The statements made by the business lobbies normally try to explain how a cut in interest rates will lead to people borrowing and consuming more and companies borrowing and investing more. The RBI hasn’t entertained them till now.
In the monetary policy statement released on December 2, 2014, the RBI said that it might start cutting the repo rate sometime early next year.
The business lobbies immediately issued statements expressing their disappointment on the RBI not cutting the repo rate. Confederation of Indian Industries (CII), one of the three big business lobbies,
said in a statement: “At this juncture, even a symbolic cut in policy rates would have sent a strong signal down the line that both the government and the RBI are acting in concert to harness demand and take the economy to the higher orbit of growth.”
The phrase to mark here is harness demand (which I have italicized). As explained earlier the logic is that when the RBI cuts the repo rate, banks will cut their lending rates as well and people will borrow and spend more. This will mean businesses will earn more and will lead to economic growth.
Only if it was as simple as that: .
As John Kenneth Galbraith writes in
The Affluent Society: “Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment.” And vice versa—a large cut in interest rate decreases the monthly payment by a very small amount.
Let’s understand this through an example. An individual decides to take a car loan of Rs 4.5 lakh at 10.5%, repayable over a period of five years. The monthly payment or the EMI on this loan amounts to Rs 9,672. Now let’s say the RBI decides to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage).
The bank works in perfect coordination with RBI (which is not always the case) and decides to cut the interest loan on the car loan by 50 basis points to 10%. The new EMI now stands at Rs 9,561 or around Rs 111 lower.
If the interest rate is cut by 100 basis points to 9.5%, the EMI falls by around Rs 221.5. Hence, a nearly one tenth cut in interest rate (from 10.5% to 9.5%) leads to the EMI falling by around 2.3% (Rs 221.5 expressed as a percentage of Rs 9,672, the original EMI).
Now will people go and buy cars just because the EMI is Rs 111 or Rs 221.5 lower? Obviously not. People spend money when they feel confident about their economic future. And that is not just about lowering interest rates.
For loans of smaller ticket sizes (consumer durables, two wheeler loans etc.) the difference between EMIs when interest rates are cut, is even more smaller. Hence, the logic that a cut in interest rates increases borrowing, isn’t really correct. As Galbraith puts it: “During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans.”
What about the corporates? The business lobby CII felt that if the RBI had cut interest rates it would have “improved the poor credit offtake by industry”. In simple English this means that corporates would have borrowed and invested more, only if, the RBI had cut the repo rate.
But is that really the case? 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.”
But that doesn’t really happen. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience.
Business firms borrow when they can make money and not because interest rates are low [the emphasis is mine], Galbraith points out.
The last sentence in the above paragraph summarizes the whole situation. And it is difficult to believe that corporates do not understand something as basic as this.
This was also pointed out in a recent research report titled
Will a rate cut spur investments?Not really, brought out by Crisil Research. (I had referred to this report in detail on an earlier occasion).
In this report it was pointed out that investment growth in fiscals 2013 and 2014 fell to 0.3%, despite negative real interest rates (repo rate minus retail inflation). The real interest rate during the period was at minus 2.1%, whereas the real lending rate was only at 2.8%.
In contrast for the period between 2004 and 2008, had a real interest rate of 7.4%, and the average investment growth stood at 16.4% per year, during the period. Why was that the case? “The rate of return on investments – as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database – have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years,” Crisil Research points out.
This is precisely the point Galbraith makes— Business firms borrow when they can make money and not because interest rates are low.
To conclude, Indian businesses seem to have great faith in monetary policy doing the trick, when there are too many other factors holding back growth (I haven’t gone into these factors partly because they are well known and partly because that’s a separate column in itself).
Indian businessmen are not the only ones who seem to have great faith in monetary policy. This is a trend that is prevalent throughout the world. The central bankers are expected to use monetary policy and come to the rescue of the beleaguered economies all over the world.
Where does this faith stem from? Galbraith explains this beautifully in
The Affluent Society: “There is no magic in the monetary policy…[It] is a blunt, unreliable, discriminatory and somewhat dangerous instrument of economic control. It survives in esteem partly because so few understand it…It survives, also because active monetary policy means that, at times, interest rates will be high – a circumstance that is far from disagreeable for those with money to lend.”

The article appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 8, 2014

It’s time big business stops blaming Rajan and RBI for everything


Vivek Kaul

When small children don’t get enough attention from their parents, they cry. And until they get attention, they keep crying.
Big business in India is a tad like that. For the last one year it has been crying itself hoarse in trying to tell the Reserve Bank of India(RBI) to cut interest rates. But the RBI led by Raghuram Rajan hasn’t obliged.
In the monetary policy statement released yesterday, the RBI decided to maintain the status quo and not cut the repo rate, as big business has been demanding for a while now. Repo rate is the interest rate at which RBI lends to banks.
The lobbies which represent the big businesses in India reacted in a now familiar way after the monetary policy.
The Confederation of Indian Industries said that the economic recovery was still fragile and a decision to cut interest rates would have helped the small and medium enterprises (SME) sector, which is credit starved currently. The lobby further added that if interest rates would have been cut businesses would have borrowed more.
On the face of it this sounds like a very genuine concern.
But Raghuram Rajan explained the real issue with SMEs not getting enough loans in a recent speech. The bad loans of Indian banks, in particular public sector banks, have gone up dramatically in the recent past.
As on March 31, 2013, the gross non performing assets (NPAs) or simply put the bad loans, of public sector banks, had stood at 3.63% of the total advances. 
Latest data from the finance ministry show that the bad loans of public sector banks as on September 30, 2014, stood at 5.32% of the total advance.
Why have bad loans gone up by such a huge amount? “The most obvious reason,” as Rajan put it was “that the system protects the large borrower and his divine right to stay in control.” Who is the large borrower? Big business.
As Rajan explained: “The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken — the promoter threatens to run the enterprise into the ground unless the government, banks, and regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the upside, forgetting the help he got from the government or the banks – after all, banks should be happy they got some of their money back.”
Banks have tried to repossess assets offered as collateral against these loans in order to recover their loans, but haven’t been very successful at it. As Rajan put it in his speech: “The amount recovered from cases decided in 2013-14 under debt recovery tribunals was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake.”
Big businesses have been able to hire expensive lawyers and managed to stop banks from repossessing their assets. The small and medium enterprises haven’t been able to do that. Rajan said just that in his speech:“The SARFAESI [ Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest] Act of 2002 is, by the standards of most countries, very pro-creditor as it is written. This was probably an attempt by legislators to reduce the burden on debt recovery tribunals and force promoters to pay. But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”
Hence, small and medium enterprises have had to face problems because big businesses have decided to borrow and not to repay.
The CII further suggested that if RBI had cut interest rates businesses would have borrowed more. It needs to be clarified here that interest rates are not simply high because the repo rate is high at 8%. There are other reasons for it as well.
Big businesses have defaulted on such a huge quantum of loans that banks have had to charge the borrowers who are repaying a higher rate of interest. As Rajan put it in his speech “The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7% even while the policy rate is 8%. The difference, also known as the credit risk premium, of 5.7% is largely compensation banks demand for the risk of default and non-payment.”
This when the average home loan in the country is being given at 10.7%. Hence, a home loan to an individual is being given at a lower rate of interest than loans to power companies. And only big businesses defaulting on their loans are to be blamed for it.
Rana Kapoor who is the President of a business lobby called Associated Chambers of Commerce and Industry of India said: “RBI has obviously overlooked strong demand from the industry for a cut in the interest rates. The industry’s demand for lower interest rates was fully justified.”
Kapoor is the founder managing director and CEO of Yes Bank. It needs to be pointed out here that the bad loans of Yes Bank for the period of three months ending September 30, 2014, went up by 178.3% to Rs 54 crore in comparison to the same period last year.
What is surprising here is that a banker whose bad loan book has exploded is demanding a rate cut. I am sure Mr Kapoor understands how credit risk operates.
Also, business lobbies and businesses tend to totally ignore the fact that the RBI cannot do much about creating economic growth beyond a point.
As economist Tim Dudley puts it: “As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying (and under-appreciated) impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”
The phrase to mark here is “well-managed economy” and that is largely the government’s prerogative. Rajan acknowledged this
in the latest monetary policy statement. As he said towards the end of the monetary policy statement “A durable revival of investment demand continues to be held back by infrastructural constraints and lack of assured supply of key inputs, in particular coal, power, land and minerals. The success of ongoing government actions in these areas will be key to reviving growth.”
Criticising or trying to tell RBI what it should be doing, is not going to help big business much. If they have to criticise, it is the government they should be criticising. But that as we all know is not going to happen any time soon. Meanwhile, the RBI will continue to be the favourite whipping boy of big business.

The article originally appeared on www.FirstBiz.com on Dec 4, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Central banks wouldn’t have printed money if…

3D chrome Dollar symbolVivek Kaul

Cristina Fernandez de Kirchner, the president of Argentina, was visiting the United States in the autumn of 2012. A part of her itinerary included speeches at the Harvard and Georgetown universities.
Students at these universities asked her about the rate of inflation in Argentina. As Bill Bonner writes in his new book
Hormegeddon—How Too Much of a Good Thing Leads to Disaster, “Her bureaucrats put the consumer price index—at less than 10%. Independent analysts and housewives know it as a lie. Prices are rising at about 25% per year.”
Fernandez turned the tables at a press conference and asked her accusers: “Really, do you think consumer prices are only going up at a 2% rate in the US?”
This is a very important question to ask given that inflation is one of the most important numbers that are put out in the public domain. As Bonner writes “The ‘inflation’ number is probably the most important number the number crunchers crunch, because it crunches up against most of the other numbers too.”
What does Bonner mean by this? If your house price has doubled and if the price of everything else doubled as well during the same period, then you haven’t made any gains at all. The same stands true for your salary as well.
At a broader level, the economic growth (as measured by the growth in the gross domestic product (GDP)) is also adjusted for inflation. So, if the growth is 8% and inflation is also 8%, then there is no real growth. For real growth to happen the rate of growth has to be greater than the rate of inflation.
The point being that the rate of inflation is used to correct distortions that creep into other numbers. As Bonner writes “In pensions, taxes, insurance, and contracts, the CPI[consumer price inflation] number is used to correct distortions caused by inflation. But if the CPI number is itself distorted, then the whole [thing] gets twisted.”
Moral of the story: It is very important to measure the inflation number correctly. But is that really happening in the United States? As Nick Barisheff writes in
$10,000 Gold—Why Gold’s Inevitable Rise Is the Investor’s Safe Haven, “The need to distort actual values of inflation became even more important once governments began prodding social programs and indexed government pensions [i.e. government pension went up at the rate of inflation]. A single-point rise in the official rate of inflation would likely cost the U.S. government hundreds of billions of dollars in indexed government pension payments.”
The Boskin Commission was set up in 1995. It was formally called the Advisory Commission to Study the consumer price index. The commission came to the conclusion that the consumer price index overstated inflation. “These findings also concluded that since the CPI was used to measure indexed pensions, the projections for budget deficits were too large,” writes Barisheff.
The recommendations of the commission changed the way inflation was measured in the United States. As Barisheff writes “The changes implemented after the Boskin Commission’s report were significant, with the main distinction being that the CPI used to measure a “fixed standard of living” with a fixed basket of goods. Today, it measures the cost of living with a constantly changing basket of goods, measured with metrics that are themselves constantly changing.”
This change in methodology led to the inflation being understated due to various reasons. A World Gold Council report titled
Gold Investor: Risk Management and Capital Preservation released by the World Gold Council points out “The weights that different goods and services have in the aforementioned indices do not always correspond to what a household may experience. For example, tuition has been one of the fastest growing expenses for US households but represents only 3% of CPI (consumer price index). In practice, tuition costs correspond to more than 10% of the annual income even for upper-middle American households – and a higher percentage of their consumption.”
Then there is the issue referred to as “hedonic” adjustments. Let’s say you go to a buy a computer. The computer is being sold at the same price as last year. But its twice as powerful. “Now you are getting twice as much computer for the same price. You don’t really need twice as much power. But you can’t buy half a computer. So, you reach in your packet and pay as much as last year,” writes Bonner.
Those calculating inflation look at the scenario differently. They assume that since the new computer has more power, it has basically gone down in cost. “This reasoning does not seem altogether unreasonable. But a $1,000 computer is a substantial part of most household budgets. And this “hedonic” adjustment of prices exerts a large pull downward on the measurement of consumer prices, even though the typical household lays out almost exactly as much one year as it did last,” writes Bonner.
Further, hedonic adjustment does not take into account the rapid change in technology. As Barisheff points out “Hedonics overlooks hidden inflationary events, such as the rapid pace of technological development and lower production standards, which combined mean we need to replace appliances more often. In the 1960s, we bought one home telephone every decade, if that. We purchased a new television perhaps a little more frequently. Now we are changing our tech devices every couple of years. Hedonics, to be, fair, should account for this extra cost, but it does not.”
Other than hedonics, the substitution bias is at work as well. In this case, it is assumed that consumers substitute “cheaper goods for more expensive goods when relative prices change.” As Barisheff writes “The government is saying that when steak gets too expensive, people will forgo steak for hamburger. Somehow, this does not account for the fact that steak is getting more expensive, or that consumers do not automatically substitute.” Using, susbstitution, the government determined that food prices rose by 4.1% between 2007 and 2008. Nevertheless, the American Farm Bureau which tracks exactly the same basket of goods said prices rose by 11.3%.
Long story short, the inflation as it is being measured is being under-declared. Bonner points out that if they measured inflation now like they did in 1980, the rate of inflation in the United States would have been 9% and not 2%.
And if that were the case a lot of other things would change. If inflation would have been 9% and 2%, the Federal Reserve of the United States and other central banks around the developed world would not have printed the quantum of money that they have.
Economist John Mauldin in a recent column titled The End of Monetary Policy estimates that central banks have printed $7-8 trillion since the start of the financial crisis.
This was done primarily to ensure that with so much money floating around the interest rates would continue to remain low. At low interest rates people would borrow and spend. This would create some inflation. Looking that prices were going up, people would come out and shop, so that they don’t have to pay more later.
What has happened instead is that financial institutions have borrowed money at low interest rates and invested it in financial markets all over the world.
Nevertheless, if the inflation was 9% and not less than 2% as it stands now, central banks wouldn’t have printed all the money that they have in the first place.
This leads Bonner to ponder that “the problem with the “inflation” number runs deeper than just statistical legerdemain.” “It concerns the definition of inflation itself. Does the word refer only to rise in consumer prices? Or to the rise in the supply of money? The distinction has huge consequences. Because, in years following the 08′-09′ prices, it was the absence of the former that permitted central banks to add so much to the latter…As long as consumer price inflation didn’t manifest itself in a disagreeable way, central bankers felt they cold create as much agreeable monetary inflation as they wanted,” writes Bonner.
And that is something worth thinking about.

The article originally appeared on www.FirstBiz.com on Dec 2, 2014
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Oil at $65: Where oil prices go will depend on who blinks first, shale oil producers or OPEC


Vivek Kaul

The West Texas Intermediary (WTI) crude oil price has touched a five year low of $65 per barrel. As I write this, the WTI price stands at $64.5 per barrel. WTI is one of the grades of crude oil and is used as a benchmark to set oil prices.
This fall in oil prices has come about after the Organisation of the Petroleum Exporting Countries(OPEC) in a meeting on November 27, 2014, decided not to cut their production. In the past whenever oil prices fell, OPEC used to cut production in order to ensure that prices did not continue to fall. This has not happened this time around.
The primary reason for the same has been the rise of the shale oil producers in the United States. The United States was producing around 4 million barrels of oil per day in mid 2008. Since then the production has jumped to 8.97 million barrels per day (as of end of October 31, 2014). The entire incremental production has come from shale oil.
This has meant that the United States which is the biggest consumer of oil in the world is importing far lesser oil than it was in the past. Amrborse-Evans Pritchard
writing in The Telegraph points out that “America has cut its net oil imports by 8.7m barrels per day since 2006, equal to the combined oil exports of Saudi Arabia and Nigeria.” This is a reason to worry for OPEC and it has decided to not cut production significantly, and in the process it hopes to make shale oil producers unviable.
Prtichard also quotes C
hris Skrebowski, former editor of Petroleum Review, as saying that Saudi Arabia wants to cut down the annual increase in the production of US shale oil from the current one million barrels per day to 500,000 barrels per day. Saudi Arabia is the leader of the OPEC cartel and OPEC largely does what Saudi Arabia wants it to.
Given this it is not surprising that OPEC has continued to maintain a production of over 30 million barrels per day, despite falling oil prices.
As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “It is not surprising to see OPEC production – relative to its 30 million barrels a day quota – rising from virtual compliance to one where the cartel is producing above its agreed production allocation. Output rose to 30.974 million barrels per day in October, a 14-month high led by gains in Iraq, Saudi Arabia and Libya.”
The production of OPEC in the month of November 2014 stood at 30.56 million barrels per day. This was lower than the production in October, but still higher than the target of 30 million barrels per day.
OPEC is working with the assumption that shale oil is expensive to produce
Nevertheless as I pointed out in an earlier piece on shale oil there are as many estimates on the production cost of shale oil going around, as there are analysts.
In a September 2014 report Bank of America-Merrill Lynch had put the production costs of shale oil from $50-75 per barrel. Mian whose newsletter I have quoted earlier put the break-even price at $57 per barrel.
Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States.
Evans-Pritchard goes even lower. As he writes: “The International Energy Agency said most of North Dakota’s vast Bakken field “remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel.” He quotes Edward Morse, Citigroup’s commodities chief as saying that the  “full cycle” cost for shale production is $70 to $80, but this includes the original land grab and infrastructure. Nevertheless, the remaining capital expenditure “to bring on an additional well, could be as low as the high-$30s range.”
A Bloomberg report points out “Only about 4% of US shale output needs $80 a barrel or more to be profitable, according to the International Energy Agency. Most production in the Bakken formation, one of the main drivers of shale oil output, remains commercially viable at or below $42, the Paris-based agency estimates.”
What these data points tell us is that the Saudi led OPEC will have to drive down oil prices further, in order to ensure that production of shale oil becomes unviable. At least that is the observation one can make from all the data that is available.
The question is till when OPEC keep driving down prices. Mian estimates that “the current oil decline has potentially cost OPEC $250 billion of its recent earnings of $1 trillion”. Further, “lower the price of oil falls, the greater the need to compensate for lower revenues with higher production, which paradoxically pushes oil prices even lower,” Mian writes.
Most OPEC countries have built their budgets around high oil prices. “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment,” writes Mian.
Hence, the oil price at which the budgets of OPEC countries and other oil exporting countries breaks even, is very high. “The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup,”writes Evans-Pritchard.
Given this, while the OPEC is trying to make shale oil unviable it is bleeding as well.
Nevertheless, Saudi Arabia seems to have decided that it wants to drive down the price of oil and that is what is important. The Kingdom has the ability to withstand lower oil prices for a few years, feels Mian. As he writes “Saudi Arabia appears to be comfortable with much lower oil prices for an extended period of time. The House of Saud is equipped with sufficient government assets to easily withstand three years at the current oil price by dipping into their $750 billion of net foreign assets.”
The question is who will blink first, the Saudi Arabia led OPEC or the shale oil companies. And that will decide how far the oil price will fall.

The article originally appeared on www.FirstBiz.com on Dec 2, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

GDP growth at 5.3%: A lot needs to be done for the economy to see acche din again

deflationVivek Kaul

India has largely been a centrally planned economy since independence. The central planning increased dramatically in the second term of the previous United Progressive Alliance (UPA) government.
This led to a situation where India’s economy grew at greater than 8% in the aftermath of the financial crisis, when economic growth was collapsing all around the world. But this extra central planning has created many problems for the Indian economy since then.
As Bill Bonner writes in Hormegeddon—How Too Much Of a Good Thing Leads to Disaster, “Central planning can do a good job of imitating real progress at least in the short run.” And that is what precisely what happened in India, in the aftermath of the financial crisis.
The government expenditure exploded. In 2007-2008, the total government expenditure stood at Rs 7,12,671 crore. This doubled to Rs 14,10,372 crore by 2012-2013. This increased spending by the government landed up as income in the hands of the citizens, and they in turn spend the money. And this ensured that the Indian economy kept growing at a fast pace though economic growth was slowing down world over.
A substantial amount of this increased government spending was directly distributed to citizens through schemes like Mahatma Gandhi National Rural Employment Guarantee Scheme. The minimum support price offered on rice and wheat was also increased much more than was the case in the past.
This led to rural income growing at a faster rate than it had in the past. Initially, it did not matter. But as time passed this increased income translated into high inflation, particularly high food inflation.
Further, the trouble was that the government wasn’t earning all this money that it was spending. Between 2007-2008 and 2012-2013, the total income of the government did not go up at the same pace as its expenditure (it went up by around 57%), and the government borrowed more to make up for the difference.
The fiscal deficit in 2007-2008 was Rs 1,26,912 crore. This shot up by 286% to Rs 4,90,190 crore by 2012-2013. Fiscal deficit is the difference between what a government earns and what it spends. And the government makes up for the difference through increased borrowing.
This increased borrowing by the government crowded out other borrowers, that is, there wasn’t enough left on the table for other borrowers to borrow. This meant banks had to offer higher rates of interest to attract deposits. This pushed up interest rates at which they loaned out money as well.
Also, to control the high inflation, the Reserve Bank had to push up the repo rate, or the rate at which it lends to banks. Further, during the good years, the corporates loaded up on debt, borrowing much more than they could ever repay. A major portion these loans were taken by crony capitalists from public sector banks.
All these reasons led to what analysts call the “India growth story” coming to an end. High inflation forced people to cut down on spending as incomes did not keep pace with expenditure. Economic growth fell to around 5% from double digit levels and that is where it has stayed for a while now.
It was widely expected that with Narendra Modi taking over as the prime minister, the Indian economy will start seeing
acche din soon. But that hasn’t happened. For the three month period July to September 2014, the economic growth, as measured by the growth in the gross domestic product (GDP), was at 5.3%. During the period April to June 2014 the economy had grown at 5.7%.
The financing, insurance, real estate and business services sector which formed a little over 22% of the GDP during the period, grew by an impressive 9.5%. But other sectors did not do so well.
Agriculture which formed around 10.8% of the total GDP during the quarter grew by 3.2%. It had grown by 5% during the same period last year. Manufacturing which formed around 14.6% of the total GDP during the quarter was more or less flat at 0.1%. In fact, the size of manufacturing sector has fallen by 1.4% in comparison to the period between April and June 2014.
What this tells us clearly is that sustainable economic growth cannot be created by the government giving away money to citizens and then hoping that they spend it and create economic growth. For sustainable economic growth to happen a country needs to produce things. As the Say’s Law states “
A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” The law essentially states that the production of goods ensures that the workers and suppliers of these goods are paid enough for them to be able to buy all the other goods that are being produced. A pithier version of this law is, “Supply creates its own demand.”
In an Indian context this is even more important given
that nearly 60% of the population remains dependent on directly or indirectly dependent on agriculture, even though agriculture now forms a minor part of the overall economy. What this tells us is that the sector has many more people than it should. Hence, people need to be moved from agriculture to other sectors like manufacturing. And for that to happen jobs need to be created in these sectors.
The government recently launched the
Make in India programme to create jobs in the manufacturing sector. But just launching the programme is not good enough. For companies to make products in India a lot of other things need to be provided. They need access to electricity all the time and for that to happen we need to sort out the mess our coal sector is in. The physical infrastructure of roads, railways and ports needs to improve. The ease of doing business needs to go up considerably and so on.
As Daron Acemoglu and James A. Robinson write in
Why Nations Fail—The Origins of Power, Prosperity and Poverty regarding the industrial revolution that happened in Great Britain in the 19th century: “The English state aggressively…worked to promote domestic industry…by removing barriers to the expansion of industrial activity.” Similar barriers need to be removed in India as well. Also, entrepreneurs need to be confident that their contracts and property rights will be respected.
These things are easier said than done. What makes the scenario even more difficult in the Indian case is that Indian businessmen who operate in the infrastructure sector are not the most honest people going around. Raghuram Rajan, the governor of the Reserve Bank of India, more or less hinted at it in a recent speech.
As he said “The amount recovered from cases decided in 2013-14 under DRTs (debt recovery tribunals) was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake. Worse, even though the law indicates that cases before the DRT should be disposed off in 6 months, only about a fourth of the cases pending at the beginning of the year are disposed off during the year – suggesting a four year wait even if the tribunals focus only on old cases.”
If incumbent businessmen do not repay their loans and then banks cannot recover those loans, banks will not lend or charge a higher rate of interest when they lend. And this does not help the businessmen currently looking to expand their businesses by borrowing.
To conclude, there is a lot that the government needs to do to get economic growth up and running again. The only action that one has seen from the government until now is demanding that the RBI cuts the repo rate. Now only if creating economic growth was simply about cutting interest rates.

The article appeared originally on www.FirstBiz.com on Nov 29, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)