The attempts of the Reserve Bank of India (RBI) to control inflation have been a non-starter. “Growth, particularly in the last two or three years, has been worth its weight in gold. In a global economic boom, an economic growth of 8%, 7% or 9% doesn’t really matter. But when the world is slowing down, in fact growth in large parts of the world has turned negative, to kill that growth by raising the interest rate is inhuman. It is almost like a sin. And the RBI killed it under the very lofty ideal that we will tame inflation by killing growth,” said Shankar Sharma, vice-chairman & joint managing director, First Global, in an interview to DNA Money.
“If you have got a matriculation degree, you will understand that India’s inflation has got nothing to do with RBI’s policies. Your inflation is largely international commodity price driven. Your local interest rate policies have got nothing to do with that. We have seen that inflation has remained stubbornly high no matter what Mint Street has done. You should have understood this one commonsensical thing,” he added.
Given this, Sharma feels that there is no way out for the RBI but to cut the repo rate in the days to come. Repo rate is the rate at which RBI lends money to the banks. “I do not rule out a 150 basis points cut in the repo rate this year. Manmohan Singh might have just put in the ears of Subbarao that it’s about time that you woke up and smelt the coffee. You have no control over inflation. But you have control over growth, at least peripherally,” said Sharma.
Growth is the only antidote to inflation, feels Sharma. “If your nominal growth is 15%, you will get 10-20% salary and wage hikes. Then you have more purchasing power left in the hands of the consumer to deal with increased price of dal or milk or chicken. If the wage hikes don’t happen, you are leaving less purchasing power in the hands of people. And wage hikes won’t happen if you have killed economic growth,” explained Sharma.
And getting economic growth started again will be very difficult. As Sharma put it “The laws of physics say that you have to put in a lot of effort to get a stalled car going, yaar. But if it was going at a moderate pace, to accelerate is not a big issue. We have killed that whole momentum. And remember that 5-6%, economic growth, in my view, is a disastrous situation for a country like India. You can’t say we are still growing.”
By keeping interest rates high the RBI has managed to slowdown credit growth of banks and thus made borrowing easy for the government of India, which has been borrowing big time to finance its fiscal deficit. Fiscal deficit is the difference between what the government earns and it spends. “There are not many competing borrowers from the same pool of money that the government borrows from. So far, indications are that the government will be able to get what it wants without disturbing the overall borrowing environment substantially. In a strange sort of way the government’s ability to borrow has been enhanced by the RBI’s policy of killing growth. I always say that India has 33 crore Gods and Goddesses. They find a way to solve our problems,” said Sharma.
Sharma also sees the rupee appreciating against the dollar, a prediction he made at the beginning of the year and which hasn’t worked out till now. But his optimism still remains. “I still maintain that by the end of the year you are going to see a vastly stronger rupee. I believe it will be Rs 44-45 against the dollar. Or if you are going to say that is too optimistic may be Rs 47-48. But I don’t think it’s going to be Rs 60-65 or anything like that.”
A major reason for Sharma’s optimism is a fall in oil prices and Indians buying lesser gold.
“At the beginning of the year our view that oil prices will be sharply lower. That time we were trading at around $105-110 per barrel. Our view was that this year we would see oil prices of around $65-75. So we almost got to $77 per barrel (Nymex). We have bounced back a bit. But that’s okay. Our view still remains that you will see oil prices being vastly lower this year and next year as well, which is again great news for India,” said Sharma. Also with gold prices touching all time highs in rupee terms gold imports have taken a beating.
“You should be seeing a much stronger rupee by the end of the year. Imagine what that does to the equity market. That has a big, big effect because then foreign investors sitting in the sidelines start to play catch-up,” concluded Sharma.
(The article originally appeared in the Daily News and Analysis on July 31,2012. http://www.dnaindia.com/money/report_an-ssc-pass-understands-that-inflation-today-has-nothing-to-do-with-rbi_1721962)
(Vivek Kaul is a writer and can be reached at [email protected])
Have you ever heard someone call equity a short term investment class? Chances are no. “I have always had this notion for many years that people buy equities because they like to be excited. It’s not just about the returns they make out of it… You can build a case for equities on a three year basis. But long term investing is all rubbish, I have never believed in it,” says Shankar Sharma, vice-chairman & joint managing director, First Global. In this freewheeling
interview he speaks to Vivek Kaul.
Six months into the year, what’s your take on equities now?
Globally markets are looking terrible, particularly emerging markets. Just about every major country you can think of is stalling in terms of growth. And I don’t see how that can ever come back to the go-go years of 2003-2007. The excesses are going to take an incredible amount of time to work their way out. They are not even prepared to work off the excesses, so that’s the other problem.
Why do you say that?
If you look at the pattern in the European elections the incumbents lost because they were trying to push for austerity. And the more leftist parties have come to power. Now leftists are usually the more austere end of the political spectrum. But they have been voted to power, paradoxically, because they are promising less austerity. All the major nations in the world are democracies barring China. And that’s the whole problem. You can’t push through austerity that easily in a democracy, but that is what is really needed. Even China cannot push through austerity because of a powder-keg social situation. And I find it very strange when people criticise India for subsidies and all that. India is far less profligate than many nations including China.
Can you elaborate on that?
Every country has to subsidise, be it farm subsidies in the West or manufacturing subsidies in China, because ultimately whether you are a capitalist or a communist, people are people. They don’t necessarily change their views depending on which political ideology is at the centre. They ultimately want freebies and handouts. In a country like India, they don’t even want handouts they just want subsistence, given the level of poverty. The only thing that you can do with subsidies is to figure out how to control them. But a lot of it is really out of your control. If you have a global inflation in food prices or oil prices you are not increasing the quantum in volume terms of the subsidy. But because of price inflation, the number inflates. So why blame India? I find it absurd that the Financial Times or the Economist are perennially anti-India. They just isolate India and say that it has got wasteful expenditure programmes. A lot of countries hide things. India, unfortunately, is far more transparent in its reporting. It is easy to pick holes when you are transparent. China gives no transparency so people assume that whatever is inside the black box must be okay. That said, I firmly believe the UID program, when fully implemented, will make subsidies go lower by cutting out bogus recipients.
If increased austerity is not a solution, where does that leave us?
Increased austerity, while that is a solution, it is not achievable. If that is not possible what is the solution? You then have a continual stream of increasing debt in one form or the other, keep calling it a variety of names. But you just keep kicking the can down the road for somebody else to deal with it as long as the voter is happy. Given this, I don’t see how you can have any resurgence. Risk appetite is what drives equity markets. Otherwise you and I would be buying bonds all the time. In today’s environment and in the foreseeable future, we are overfed with risk. Where is the appetite to take more risk and go, buy equities?
So are you suggesting that people won’t be buying stocks?
Well you can get pretty good returns in fixed income. Instead of buying emerging-market stocks if you buy bonds of good companies, you can get 6-7% dollar yield, and if you leverage yourself two times or something, you are talking about annual returns of 14-15% dollar returns. You can’t beat that by buying equities, boss! Even if you did beat that by buying equities, let’s say you made 20%, it is not a predictable 20%, which has been my case for a long time against equities. Equities are a western fashion. I have always had this notion for many years that people buy equities because they like to be excited. It’s not just about the returns they make out of it: it is about the whole entertainment quotient attached to stock investing that drives investors. There is 24-hour television. Tickers. Cocktail discussions. Compared with that, bonds are so boring and uncool. Purely financially, shorn of all hype, equities have never been able to build a case for themselves on a ten-year return basis. You can build a case for equities on a three-year basis. But long-term investing is all rubbish, I have never believed in it.
So investing regularly in equities, doing SIPs, buying Ulips, doesn’t make sense?
I don’t buy the whole logic of long-term equity investing because equity investing comes with a huge volatility attached to it. People just say “equities have beaten bonds”. But even in India they have not. Also people never adjust for the volatility of equity returns. So if you make 15% in equity and let’s say, in a country like India, you make 10% in bonds – that’s about what you might have averaged over a 15-20 year period because in the 1990s we had far higher interest rates. Interest rates have now climbed back to that kind of level of 9-10%. Divide that by the standard deviation of the returns and you will never find a good case for equities over a long-term period. So equity is actually a short-term instrument. Anybody who tells you otherwise is really bluffing you. All the fancy graphs and charts are rubbish.
Yes. They are all massaged with sort of selective use of data to present a certain picture because it’s a huge industry which feeds off it globally. So you have brokers like us. You have investment bankers. You have distributors. We all feed off this. Ultimately we are a burden on the investor, and a greater burden on society — which is also why I believe that the best days of financial services is behind us: the market simply won’t pay such high costs for such little value added. Whatever little return that the little guy gets is taken away by guys like us. How is the investor ever going to make money, adjusted for volatility, adjusted for the huge cost imposed on him to access the equity markets? It just doesn’t add up. The customer never owns a yacht. And separately, I firmly believe making money in the markets is largely a game of luck. Even the best investors, including Buffet, have a strike rate of no more than 50-60% right calls. Would you entrust your life to a surgeon with that sort of success rate?! You’d be nuts to do that. So why should we revere gurus who do just about as well as a coin-flipper. Which is why I am always mystified why so many fund managers are so arrogant. We mistake luck for competence all the time. Making money requires plain luck. But hanging onto that money is where you require skill. So the way I look at it is that I was lucky that I got 25 good years in this equity investing game thanks to Alan Greenspan who came in the eighties and pumped up the whole global appetite for risk. Those days are gone. I doubt if you are going to see a broad bull market emerging in equities for a while to come.
And this is true for both the developing and the developed world?
If anything it is truer for the developing world because as it is, emerging market investors are more risk-averse than the developed-world investors. We see too much of risk in our day to day lives and so we want security when it comes to our financial investing. Investing in equity is a mindset. That when I am secure, I have got good visibility of my future, be it employment or business or taxes, when all those things are set, then I say okay, now I can take some risk in life. But look across emerging markets, look at Brazil’s history, look at Russia’s history, look at India’s history, look at China’s history, do you think citizens of any of these countries can say I have had a great time for years now? That life has been nice and peaceful? I have a good house with a good job with two kids playing in the lawn with a picket fence? Sorry, boss, that has never happened.
And the developed world is different?
It’s exactly the opposite in the west. Rightly or wrongly, they have been given a lifestyle which was not sustainable, as we now know. But for the period it sustained, it kind of bred a certain amount of risk-taking because life was very secure. The economy was doing well. You had two cars in the garage. You had two cute little kids playing in the lawn. Good community life. Lots of eating places. You were bred to believe that life is going to be good so hence hey, take some risk with your capital.
The government also encouraged risk taking?
The government and Wall Street are in bed in the US. People were forced to invest in equities under the pretext that equities will beat bonds. They did for a while. Nevertheless, if you go back thirty years to 1982, when the last bull market in stocks started in the United States and look at returns since then, bonds have beaten equities. But who does all this math? And Americans are naturally more gullible to hype. But now western investors and individuals are now going to think like us. Last ten years have been bad for them and the next ten years look even worse. Their appetite for risk has further diminished because their picket fences, their houses all got mortgaged. Now they know that it was not an American dream, it was an American nightmare.
At the beginning of the year you said that the stock market in India will do really well…
At the beginning of the year our view was that this would be a breakaway year for India versus the emerging market pack. In terms of nominal returns India is up 13%. Brazil is down 3%. China is down, Russia is also down. The 13% return would not be that notable if everything was up 15% and we were up 25%. But right now, we are in a bear market and in that context, a 13-15% outperformance cannot be scoffed off at.
What about the rupee? Your thesis was that it will appreciate…
Let me explain why I made that argument. We were very bearish on China at the beginning of the year. Obviously when you are bearish on China, you have to be bearish on commodities. When you are bearish on commodities then Russia and Brazil also suffer. In fact, it is my view that Russia, China, Brazil are secular shorts, and so are industrial commodities: we can put multi-year shorts on them. So that’s the easy part of the analysis. The other part is that those weaknesses help India because we are consumers of commodities at the margin. The only fly in the ointment was the rupee. I still maintain that by the end of the year you are going to see a vastly stronger rupee. I believe it will be Rs 44-45 against the dollar. Or if you are going to say that is too optimistic may be Rs 47-48. But I don’t think it’s going to be Rs 60-65 or anything like that. At the beginning of the year our view that oil prices will be sharply lower. That time we were trading at around $105-110 per barrel. Our view was that this year we would see oil prices of around $65-75. So we almost got to $77 per barrel (Nymex). We have bounced back a bit. But that’s okay. Our view still remains that you will see oil prices being vastly lower this year and next year as well, which is again great news for India. Gold imports, which form a large part of the current account deficit, shorn of it, we have a current account deficit of around 1.5% of the GDP or maybe 1%. We imported around $60 billion or so of gold last year. Our call was that people would not be buying as much gold this year as they did last year. And so far the data suggests that gold imports are down sharply.
So there is less appetite for gold?
Yes. In rupee terms the price of gold has actually gone up. So there is far less appetite for gold. I was in Dubai recently which is a big gold trading centre. It has been an absolute massacre there with Indians not buying as much gold as they did last year. Oil and gold being major constituents of the current account deficit our argument was that both of those numbers are going to be better this year than last year. Based on these facts, a 55/$ exchange rate against the dollar is not sustainable in my view. The underlyings have changed. I don’t think the current situation can sustain and the rupee has to strengthen. And strengthen to Rs 44, 45 or 46, somewhere in that continuum, during the course of the year. Imagine what that does to the equity market. That has a big, big effect because then foreign investors sitting in the sidelines start to play catch-up.
Does the fiscal deficit worry you?
It is not the deficit that matters, but the resultant debt that is taken on to finance the deficit. India’s debt to GDP ratio has been superb over the last 8-9 years. Yes, we have got persistent deficits throughout but our debt to GDP ratio was 90-95% in 2003, that’s down to maybe 65% now. So explain that to me? The point is that as long as the deficit fuels growth, that growth fuels tax collections, those tax collections go and give you better revenues, the virtuous cycle of a deficit should result in a better debt to GDP situation. India’s deficit has actually contributed to the lowering of the debt burden on the national exchequer. The interest payments were 50% of the budgetary receipts 7-8 years back. Now they are about 32-33%. So you have basically freed up 17% of the inflows and this the government has diverted to social schemes. And these social schemes end up producing good revenues for a lot of Indian companies. The growth for fast-moving consumer goods, mobile telephony, two wheelers and even Maruti cars, largely comes from semi-urban, semi-rural or even rural India.
What are you trying to suggest?
This growth is coming from social schemes being run by the government. These schemes have pushed more money in the hands of people. They go out and consume more. Because remember that they are marginal people and there is a lot of pent-up desire to consume. So when they get money they don’t actually save it, they consume it. That has driven the bottomlines of all FMCG and rural serving companies. And, interestingly, rural serving companies are high-tax paying companies. Bajaj Auto, Hindustan Lever or ITC pay near-full taxes, if not full taxes. This is a great thing because you are pushing money into the hands of the rural consumer. The rural consumer consumes from companies which are full taxpayers. That boosts government revenues. So if you boost consumption it boosts your overall fiscal situation. It’s a wonderful virtuous cycle — I cannot criticise it at all. What has happened in past two years is not representative. It is only because of the higher oil prices and food prices that the fiscal deficit has gone up.
What is your take on interest rates?
I have been very critical of the Reserve Bank of India’s (RBI) policies in the last two years or so. We were running at 8-8.5% economic growth last year. Growth, particularly in the last two or three years, has been worth its weight in gold. In a global economic boom, an economic growth of 8%, 7% or 9% doesn’t really matter. But when the world is slowing down, in fact growth in large parts of the world has turned negative, to kill that growth by raising the interest rate is inhuman. It is almost like a sin. And they killed it under the very lofty ideal that we will tame inflation by killing growth. But if you have got a matriculation degree, you will understand that India’s inflation has got nothing to do with RBI’s policies. Your inflation is largely international commodity price driven. Your local interest rate policies have got nothing to do with that. We have seen that inflation has remained stubbornly high no matter what Mint Street has done. You should have understood this one commonsensical thing. In fact, growth is the only antidote to inflation in a country like India. When you have economic growth, average salaries and wages, kind of lead that. So if your nominal growth is 15%, you will 10-20% salary and wage hikes – we have seen that in the growth years in India. Then you have more purchasing power left in the hands of the consumer to deal with increased price of dal or milk or chicken or whatever it is. If the wage hikes don’t happen, you are leaving less purchasing power in the hands of people. And wage hikes won’t happen if you have killed economic growth. I would look at it in a completely different way. The RBI has to be pro-growth because they no control of inflation.
So they basically need to cut the repo rate?
They have to.
But will that have an impact? Because ultimately the government is the major borrower in the market right now…
Look, again, this is something that I said last year — that it is very easy to kill growth but to bring it back again is a superhuman task because life is only about momentum. The laws of physics say that you have to put in a lot of effort to get a stalled car going, yaar. But if it was going at a moderate pace, to accelerate is not a big issue. We have killed that whole momentum. And remember that 5-6%, economic growth, in my view, is a disastrous situation for a country like India. You can’t say we are still growing. 8% was good. 9% was great. But 4-5% is almost stalling speed for an economy of our kind. So in my view the car is at a standstill. Now you need to be very aggressive on a variety of fronts be it government policy or monetary policy.
What about the government borrowings?
The government’s job has been made easy by the RBI by slowing down credit growth. There are not many competing borrowers from the same pool of money that the government borrows from. So far, indications are that the government will be able to get what it wants without disturbing the overall borrowing environment substantially. Overall bond yields in India will go sharply lower given the slowdown in credit growth. So in a strange sort of way the government’s ability to borrow has been enhanced by the RBI’s policy of killing growth. I always say that India is a land of Gods. We have 33 crore Gods and Goddesses. They find a way to solve our problems.
So how long is it likely to take for the interest rates to come down?
The interest rate cycle has peaked out. I don’t think we are going to see any hikes for a long time to come. And we should see aggressive cuts in the repo rate this year. Another 150 basis points, I would not rule out. Manmohan Singh might have just put in the ears of Subbarao that it’s about time that you woke up and smelt the coffee. You have no control over inflation. But you have control over growth, at least peripherally. At least do what you can do, instead of chasing after what you can’t do.
Manmohan Singh in his role as a finance minister is being advised by C Rangarajan, Montek Singh Ahulwalia and Kaushik Basu. How do you see that going?
I find that economists don’t do basic maths or basic financial analysis of macro data. Again, to give you the example of the fiscal deficit and I am no economist. All I kept hearing was fiscal deficit, fiscal deficit, fiscal deficit. I asked my economist: screw this number and show me how the debt situation in India has panned out. And when I saw that number, I said: what are people talking about? If your debt to GDP is down by a third, why are people focused on the intermediate number? But none of these economists I ever heard them say that India’s debt to GDP ratio is down. I wrote to all of them, please, for God’s sake, start talking about it. Then I heard Kaushik Basu talk about it. If a fool like me can figure this out, you are doing this macro stuff 24×7. You should have had this as a headline all the time. But did you ever hear of this? Hence I am not really impressed who come from abroad and try to advise us. But be that as it may it is better to have them than an IAS officer doing it. I will take this.
You talked about equity being a short-term investment class. So which stocks should an Indian investor be betting his money right now?
I am optimistic about India within the context of a very troubled global situation. And I do believe that it’s not just about equity markets but as a nation we are destined for greatness. You can shut down the equity markets and India would still be doing what it is supposed to do. But coming from you I find it a little strange…
I have always believed that equity markets are good for intermediaries like us. And I am not cribbing. It’s been good to me. But I have to be honest. I have made a lot of money in this business doesn’t mean all investors have made a lot of money. At least we can be honest about it. But that said, I am optimistic about Indian equities this year. We will do well in a very, very tough year. At the beginning of the year, I thought we will go to an all-time high. I still see the market going up 10-15% from the current levels.
So basically you see the Sensex at around 19,000?
At the beginning of the year, you would have taken it when the Sensex was at 15,000 levels. Again, we have to adjust our sights downwards. A drought angle has come up which I think is a very troublesome situation. And that’s very recent. In light of that I do think we will still do okay, it will definitely not be at the new high situation.
What stocks are you bullish on?
We had been bearish on infrastructure for a very long time, from the top of the market in 2007 till the bottom in December last year. We changed our view in December and January on stocks like L&T, Jaiprakash Industries and IVRCL. Even though the businesses are not, by and large, of good quality — I am not a big believer in buying quality businesses. I don’t believe that any business can remain a quality business for a very long period of time. Everything has a shelf life. Every business looks quality at a given point of time and then people come and arbitrage away the returns. So there are no permanent themes. And we continue to like these stocks. We have liked PSU banks a lot this year, because we see bond yields falling sharply this year.
Aren’t bad loans a huge concern with these banks?
There is a company in Delhi — I won’t name it. This company has been through 3-4 four corporate debt restructurings. It is going to return the loans in the next year or two. If this company can pay back, there is no problem of NPAs, boss. The loans are not bogus loans without any asset backing. There are a lot of assets. At the end of every large project there is something called real estate. All those projects were set up with Rs 5 lakh per acre kind of pricing for land. Prices are now Rs 50 lakh per acre or Rs 1 crore or Rs 1.5 crore per acre. If nothing else, dismantle the damn plant, you will get enough money from the real estate to repay the loans of the public sector banks. So I am not at all concerned on the debt part. If the promoter finds that is going to happen, he will find some money to pay the bank and keep the real estate.
On the same note, do you see Vijay Mallya surviving?
100% he will survive. And Kingfisher must survive, because you can’t only have crap airlines like Jet and British Airways. If God ever wanted to fly on earth, he would have flown Kingfisher.
So he will find the money?
Of course! At worst, if United Spirits gets sold, that’s a stock that can double or triple from here. I am very optimistic about United Spirits. Be it the business or just on the technical factor that if Mallya is unable to repay and his stake is put up for sale, you will find bidders from all over the world converging.
So you are talking about the stock and not Mallya?
Haan to Mallya will find a way to survive. Indian promoters are great survivors. We as a nation are great survivors.
How do you see gold?
I don’t have a strong view on gold. I don’t understand it well enough to make big call on gold, even though I am an Indian. One thing I do know is that our fascination with gold has very strong economic moorings. We should credit Indians for having figured out what is a multi century asset class. Indians have figured out that equities are a fashionable thing meant for the Nariman Points of the world, but for us what has worked for the last 2000 years is what is going to work for the next 2000 years.
What about the paper money system, how do you see that?
I don’t think anything very drastic where the paper money system goes out of the window and we find some other ways to do business with each. Or at least I don’t think it will happen in my life time. But it’s a nice cute notion to keep dreaming about.
At least all the gold bugs keep talking about the collapse of the paper money system…
I know. I don’t think it’s going to happen. But I don’t think that needs to happen for gold to remain fashionable. I don’t think the two things are necessarily correlated. I think just the notion of that happening is good enough to keep gold prices high.
(A slightly smaller version of the interview appeared in the Daily News and Analysis on July 31,2012. http://www.dnaindia.com/money/interview_you-can-shut-the-equity-market-india-would-still-be-doing-fine_1721939)
(Interviewer Kaul is a writer and can be reached at [email protected])
Decisions are of two kinds. The right one. And the one your boss wants you to make. The twain does not always meet.
Duvvuri Subbarao, the governor of the Reserve Bank of India(RBI), earlier this week, showed us what a right decision is. He decided to hold the repo rate at 8%. Repo rate is the interest rate at which RBI lends to banks. There was great pressure on the RBI governor to cut the repo rate, after the gross domestic product (GDP) growth for the period between January and March 2012 came in at a very low 5.3%.
The Finance Minister, Pranab Mukherjee, declared openly that he was “confident that they (the RBI) will adjust the monetary policy,” which basically meant that he was ordering the RBI to cut the repo rate. The idea was that once the RBI cut the repo rate, banks would also cut interest rates leading to consumers borrowing more to buy homes, cars and durables. Businesses would borrow more to expand and in turn push up economic growth.
But economic theory and practice are not always in line. Subbarao, probably understands this much better than others, though until very recently he had largely stuck to doing what his boss the Finance Minister, wanted him to do. For the first time he has shown signs of breaking free.
The credibility of a repo rate cut
By cutting the repo rate the Reserve Bank essentially tries to send out a signal to banks that it expects interest rates to come down in the days to come. If banks think the signal is credible enough then they cut the interest rates they pay on their deposits as well as the interest rates they charge on their long term loans like home loans, car loans and loans to businesses. But the trouble is that even if the RBI cut the repo rate, the credibility of the signal would be under doubt, and banks wouldn’t have been able to cut interest rates.
Between the six month period of December 2, 2011, and June 1, 2012, banks have given loans amounting to Rs 4,46,563 crore and have borrowed Rs 4,27,709 crore. Hence for every Rs 100 that the banks have borrowed they have lent out Rs 104, which means they have not been able to raise enough deposits during to match their loans. So their ability to cut interest rates is limited. The question is why is the money situation so tight?
High fiscal deficit
The government of India has been running a very high fiscal deficit. For the financial year 2007-2008, the fiscal deficit stood at Rs 1,26,912 crore. It shot up to Rs 5,21,980 crore for 2011-2012. In a time frame of five years the fiscal deficit is up nearly 312%. The income earned by the government has gone up by only 36% to Rs 7,96,740 crore, during the same period. The huge increase in fiscal deficit has primarily happened because of the subsidy on food, fertilizer and petroleum. For the current financial year, the fiscal deficit is projected to be at Rs 5,13,590 crore, which is likely to be missed as has been the case in the last few years. The oil subsidy targets have regularly been overshot. This year the government might even overshoot the food subsidy target of Rs 75,000 crore.
The government finances its fiscal deficit by borrowing. When a government borrows more, as has been the case for the last few years, it ‘crowds out’ the other big borrowers like banks and corporates. This means that the ‘pool of money’ from which banks and companies have to borrow comes down. Hence, they have to offer a higher rate of interest. This is the situation which prevails now. So banks will continue in the high interest rate mode.
What must have also influenced Subbarao’s decision is the high inflationary which prevails. The consumer price inflation for the month of May stood at 10.36%. This is likely to go up even further in the days to come given that the government recently increased the minimum support price(MSP) on khareef crops from anywhere between 15-53%. These are crops which are typically sown around this time of the year for harvesting after the rains. The MSP for paddy (rice) has been increased from Rs 1,080 per quintal to Rs 1,250 per quintal. Other major products like bajra, ragi, jowar, soybean etc, have seen similar increases. This will further fuel food inflation. Also, after dramatically increasing prices for khareef crops, the government will have to follow up the same for rabi crops like wheat. Rabi crops are planted in the autumn season and harvested in winter. Economists expect higher MSP on agriculture products to push up the food subsidy bill by Rs 40,000 crore from its current level of Rs 75,000 crore. This means a higher fiscal deficit and in turn higher interest rates.
In a scenario where the inflation is over 10%, cutting interest rates can fuel further inflation, which isn’t good for anyone. The RBI in a release said that the inflation is “driven mainly by food and fuel prices.” That’s something Subbarao cannot do anything about and is for the government to sort out.
“In the absence of pass-through from international crude oil prices to domestic prices, the consumption of petroleum products remains strong…preventing the much needed adjustment in aggregate demand,” the RBI release said. The Subbarao led RBI seems to be clearing telling the government here to cut down on oil subsidies by increasing fuel prices as and when necessary.
In fact in a rare admission Subbarao even said that the last cut in the repo rate in April may have been a mistake. “The Reserve Bank had frontloaded the policy rate reduction in April with a cut of 50 basis points. This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives,” the RBI release said.
What this means in simple English is that the RBI may have been led to believe by the finance ministry that if they went ahead and cut the repo rate in April, the government would follow up by taking emasures to cut the fiscal deficit. But that hasn’t happened. RBI kept its part of the deal. The government did not.
The article originally appeared in the Times of India Crest Edition on June 23,2012.
(Vivek Kaul is a writer and can be reached at [email protected])
Many years before he became a social ambassador trying to highlight all that is wrong with India, actor Aamir Khan did this film called Rangeela. The movie had many firsts to its credit. The actress Urmila Matondkar, who had had a string of flops till then, wore a swimsuit on screen for the first time. It was AR Rahman’s first Hindi film, with all his releases before Rangeela being dubbed versions of his Tamil scores. The movie also had a lead character (played by Khan) speaking Mumbaiya Hindi, one of the earliest in the history of Hindi cinema, throughout the movie.
One of the lines that Khan spoke in the movie, and which has since become a part of popular culture, was “apun ka to bad luck heech kharab hai” (We all know what it means, so let me not waste time translating it). But before you start wondering why am I talking about Aamir Khan in a piece which is clearly not about him, let me explain.
Subbarao is in a huge Catch-22 situation. Even if he manages to lower long term interest rates the borrowing may not pick up.AFP
An individual mouthing the same lines like Aamir Khan in Rangeela 17 years back, right now, must be Duvvuri Subbarao, the governor of the Reserve Bank of India (RBI). The government of India seems to be in the mood to make his job tougher by the day.
The Cabinet Committee for Economic Affairs on Thursday (14 June 2012) approved sharp increases of 15-53 percent in the minimum support prices (MSP) of kharif crops, which are typically sown around this time of the year for harvesting after the rains (ie, September-October). “The government has accepted the suggestion made by the Commission for Agriculture Costs and Prices (CACP), which recommends MSPs after taking into account the cost of production,” said Home Minister P Chidambaram , after a meeting of the Cabinet Committee on Economic Affairs.
The MSP for paddy (rice) has been increased from Rs 1,080 per quintal to Rs 1,250 per quintal. For the ‘A’ grade variety the prices have been increased from Rs 1,110 per quintal to Rs 1,270 per quintal. Other major products like bajra, ragi, jowar, soybean, urad, cotton, etc, have seen similar increases.
This means UPA-2 has already put itself in election mode, and any interest rate cuts will mean helping a profligate government seek re-election with other people’s money. Should Subbarao be helping politicians by obliging?
Every year the Food Corporation of India (FCI), or a state agency acting on its behalf, purchases rice and wheat at MSPs set by the government. The “supposed” idea behind setting the MSP much in advance is to give the farmer some idea of how much he should expect to earn when he sells his produce a few months later. This price support is expected to encourage higher production of rice and wheat.
FCI typically purchases around 15-20 percent of India’s wheat output and 12-15 percent of its rice output. But what this price support often leads to is farmers producing a lot more than the required demand. With the FCI obligated to purchase what the farmers produce, its godowns overflow and at times the wheat and rice are dumped in the open, leading to rodents feasting on the crop. So if you see more such news items and photographs later this year showing this, don’t be surprised.
The significantly higher prices that the government is offering for the rice crop also mean an increased fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
For the current financial year 2012-2013 (i.e. the period between 1 April 2012 and 31 March 2013) the food subsidy has been budgeted at Rs 75,000 crore. Experts are of the opinion that this amount is underprovisioned and with the MSP of rice paddy going up, the food subsidy bill will shoot up significantly. “The underprovisioning of food subsidy in the current year is at Rs 31,750 crore. Now with increased MSP on paddy, the total food subsidy deficit at the end of the current year will be about Rs 40,000 crore, putting immense pressure on the food subsidy burden of the government,” a food ministry official told The Economic Times.
Given that the government is offering a significantly higher MSP for paddy in the kharif crop, a similar move can be expected for wheat, which is substantially part of the rabi crop, planted in the autumn season and harvested in winter. This means that food subsidies will go up even further, in turn pushing up the fiscal deficit.
The MSP for urad has been increased by Rs 1,000 per quintal to Rs 4,300. The MSP of cotton has been raised from Rs 600 to Rs 800 per quintal. Jowar saw the biggest jump of 53 percent per quintal.
Other than rice and wheat, many of the crops with announced MSPs do not have a designated government agency that buys the crop at the prescribed price. Hence, when an increase in MSP is announced it doesn’t necessarily lead to an increase sowing of these crops. But what it does is push up prices. As Madan Sabnavis, chief economist, Care Ratings, told Business Standard: “I can’t understand the need to announce MSPs for crops other wheat and rice, given (that) there is no official procurement. It does nothing, except pushing up food inflation.”
Religare Commodities, in a research note, expressed a similar sentiment. It said though higher MSPs for agri-products were thought to increase the sown area for a crop, in the last few years that doesn’t seem to be happening for most crops, except paddy, cotton and soybean.
The difficulty of being Duvvuri Subbarao
This announcement makes life even more difficult for Duvvuri Subbarao. First and foremost, the government is most likely to overshoot its planned fiscal deficit of Rs 5,13,590 crore for the current financial year 2012-2013. The government will have to borrow more in order to finance the increased fiscal deficit. More borrowing means that the current higher interest rate scenario is likely to continue.
The RBI is meeting on 18 June 2012 to decide on what its interest rate policy is going to be. It is widely expected that the bank will cut the repo rate (the rate at which it lends to banks). This, after the GDP growth rate for the period of January to March 2012 fell to 5.3 percent. The idea is that once the RBI cuts interest rates, banks will cut interest rates as well. Then business will borrow and so will you and me.
But reality is always different from economic theory. The RBI might cut the repo rate, which is a short-term interest rate, but long term interest rates on home loans, car loans, loans to business, etc, may not fall. This is because the government of India will have to borrow more for the long term to finance its increased fiscal deficit. And since its borrowing needs will go up, it will have to offer a higher rate of interest to attract lenders.
When the government borrows more, it crowds out private borrowing, meaning, there is a lesser pool of “savings” for private borrowers to borrow from. Hence, banks and other financial institutions which needed to borrow in order to give out home loans have to offer an even higher rate of interest than the government to attract lenders.
Hence, even if the RBI cuts the repo rate, whether that will have an impact on long term interest rates in India is doubtful. Over and above that, an increase in the MSP of the kharif crop will most likely to lead to higher inflation. This inflation will be on two fronts. One, as explained above, will be in the form of food inflation. The second will be in the form of suddenly increased incomes in rural India. This will lead to a situation where more money will chase the same amount of goods, leading to higher prices and thus higher inflation.
In a scenario where inflation is expected to go up, should the RBI be cutting interest rates or should it be raising them? Subbarao is in a huge Catch-22 situation. Even if he manages to lower long term interest rates the borrowing may not pick up. 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.”
And the current economic scenario in India does not look good enough for the businesses to borrow.
What the huge raise in MSPs tells us is that the Congress-led United Progressive Alliance is also getting into an early election mode. And the easiest way to get votes is to bribe voters at the taxpayers’ cost. Before the last Lok Sabha elections, the UPA waived off Rs 71,000 crore of farm loans. This move of substantially increasing MSPs of crops is in line with that move, though it’s not as big as that. However, the UPA raised MSPs by huge amounts even in 2008 — a year before the elections.
It’s likely that this might be a first in a series of moves which might lead to the UPA bringing the elections forward from 2014. Having the elections before 2014 clearly makes sense for the Congress, given that the state of the economy is only going to get worse in the days to come. Hence we might be entering a scenario where the UPA will come up with more boondoggles to woo voters.
This will make things even more difficult for Duvvuri Subbarao, who might well be telling himself “apun ka to bad luck heech kharab hai” more often in the days to come.
(The article originally appeared on www.firstpost.com on June 15,2012. http://www.firstpost.com/politics/kharif-msps-subbarao-ka-bad-luck-heech-kuch-kharab-hai-344697.html/1)
Vivek Kaul is a writer and can be reached at [email protected]
Duvvuri Subbarao, the current governor of the Reserve Bank of India must be a troubled man these days, professionally that is. The gross domestic product (GDP) growth has fallen to 5.3% for the period of January to March 2012. And now he is expected to come to the rescue of the Indian economy by cutting interest rates, so that people and businesses can easily borrow more, and we all can live happily ever after.
Cows would fly, only if it was as simple as that!
The mid quarter review of the monetary policy is scheduled for June 18,2012. On that day the Subbarao led Reserve Bank of India(RBI) is expected to cut the repo rate by at least 50 basis points (one basis point is one hundredth of a percentage). The repo rate is the rate at which banks borrow from the RBI.
Repo rate is a short term interest rate and by cutting this interest rate the RBI tries to manage the other interest rates in the economy, including long term interest rates like the rate at which the bond market lends to the government, the interest offered by banks on their fixed deposits, and the interest charged by banks on long term loans like home loans, and loans to businesses.
But the fact of the matter is it really has no control on these interest rates in the current state of things. To understand why, let us deviate a little.
Greenspan and Clinton
Alan Greenspan and Bill Clinton came from the opposite ends of the political spectrum. Greenspan had been a lifelong Republican whereas Clinton was a Democrat. Unlike India where there are a large number of political parties, America has basically two parties, the Republican Party and the Democratic Party. Greenspan was the Chairman of the Federal Reserve of United States, the American central bank, from 1987 to 2006.
But despite coming from the opposite ends of the political spectrum they got along fabulously well. In fact, when Clinton became the President of America in early 1993, Greenspan approached him with what Americans call a “proposition”.
Greenspan told Clinton that since 1980 the rate of inflation had fallen from a high of around 15% to the current 4%. But during the same period the interest rate on home loans had fallen only by 400 basis points from 13% to 9%. Despite the fact that the Federal Funds Rate (the American equivalent of the Indian repo rate) stood at a low 3%.
Why was the difference between the Federal Funds rate which was a short term interest rate and the home loan interest rate, which was a long term interest rate, so huge?
High fiscal deficit
The difference in interest rates was primarily because of the high fiscal deficit that the government of United States was incurring. Fiscal deficit is the difference between what the government earns and what it spends in a particular year.
When Clinton took over as President on January 20, 1993, the American government had just run a record fiscal deficit amounting to $290.3billion or 4.7% of the GDP for 1992. And this had led to high long term interest rates even though the Federal Reserve had set the short term Federal Funds rate at 3%.
The government was borrowing long term to fund its fiscal deficit. And since its borrowing needs were high because of the large fiscal deficit it needed to offer a higher rate of interest to attract lenders. When the government borrowed more it crowded private borrowing, meaning, there was lesser pool of “savings” for the private borrowers to borrow from.
Hence, banks and other financial institutions which needed to borrow in order to give out home loans had to offer an even higher rate of interest than the government to attract lenders. Even otherwise, the private sector has to offer a higher rate of interest than the government, because lending to the government is deemed to be the safest form of lending. Due to these reasons the difference in short term interest rates and long term interest rates in the US was high. So the repo rate was at 3% and the home loan rate was at 9%.
Greenspan was rightly of the opinion that a high fiscal deficit was holding economic growth back. This was the argument he made to President Clinton when he first met him. As Greenspan writes in his autobiography The Age of Turbulence – Adventures in a New World “Long term interest rates were still stubbornly high. They were acting as a brake on economic activity by driving up costs of home mortgages (the American term for home loans) and bond issuance.”
Other than the government which issues bonds to finance its fiscal deficit, companies also issue bonds to raise debt to meet the needs of their business. If interest rates are high companies normally tend to put expansion plans on hold because high interest rates may not make the plan financially viable.
Greenspan’s proposition to Clinton was that if the Wall Street got enough of a hint that the government was serious about bringing down the fiscal deficit, long term interest rates would start to fall . This would be good for the overall economy because at lower interest rates people would borrow more to buy houses and as well as everything else that needs to be bought to make a house a “home”.
As Greenspan writes “Improve investors’ expectations, I told Clinton, and long-term rates could fall, galvanizing the demand for new homes and the appliances, furnishings, and the gamut of consumer items associated with home ownership. Stock values too, would rise, as bonds became less attractive and investors shifted into equities.”
The US Congressional and Budget Office(CBO), a US government agency which provides economic data to the US Congress (the American parliament) to help better decision making, upped its projection of the fiscal deficit at that point of time. It said that the fiscal deficit is likely to reach $360billion a year by 1997. This data point put out by the US CBO helped buttress Greenspan’s point further and Clinton decided to do something about the fiscal deficit.
The Clinton plan
Clinton put out a plan which would cut the deficit by $500billion over a period of four years through a combination of higher tax rates as well as lower spending by the government. The fiscal deficit of the United States of America which had been growing steadily for years, started to fall from 1993. In 1993, it was down by 12% to $255billion. By 1997, the fiscal deficit was down to $21billion. In Clinton’s second term as President, the deficit turned into a surplus, something that had not happened since 1971. Between 1998 and 2001, the US government earned a surplus of $559.4billiondollars.
A lower fiscal deficit led to lower long term interest rates and good economic growth. The United States of America grew at an average rate of 3.9% between 1993 and 2000. In the eight years prior to that the country had grown at an average rate of 2.9% per year. So the US grew at a much faster rate on a higher base because the fiscal deficit was turned into a fiscal surplus.
This was also the period of the dotcom bubble but the fiscal surplus was clearly not the reason for it.
The moral of the story
As we clearly see from the above example, at times there is not much that a central bank can do on the interest rate front, especially when the government is running a high fiscal deficit. As I have often said over the past one month the fiscal deficit of the government of India has increased by 312% between 2007 and 2012. During the same period its income has increased by only 36%. The fiscal deficit target for the current financial year is at Rs Rs 5,13,590 crore, a little lower from the last year’s target. But as we have seen in the past this government has a tendency to miss its fiscal deficit targets regularly. So the government will have to borrow to finance its fiscal deficit and that means an environment in which long term interest rates will remain high.
In fact, some banks have quietly raised the interest rates they charge to their existing home loan borrowers, after the Subbarao led RBI last cut the repo rate by 50 basis points on April 17, 2012.
The interest being charged to some of the existing home loan borrowers has even crossed 14.5%, a difference of more than 6% between a long term interest rate and the repo rate, as was the case in America.
India has another problem which America did not in the early 1990s, high inflation. The consumer price inflation was at 10.36% for the month of April 2012. Urban inflation was at 11.1% whereas rural inflation was just below 10% at 9.86%. If Subbarao goes about cutting the repo rate in a rapid manner, he runs the danger of inciting further inflation.
So the only way out of this mess is to cut subsidies. Cut fuel subsidies. Cut fertilizer subsidies. This of course would mean higher prices in the short term, particularly if diesel prices are raised. An increase in the price of diesel will immediately lead to higher inflation, given that diesel is the major transport fuel, and any increase in its price is passed onto the consumers. The government thus has to make a choice whether it wants high interest rates for the long term or high inflation for the short term. It need not be said it will be a politically difficult decision to make.
Over the longer term it also needs to figure out how to bring more Indians under the tax ambit and lower the portion of the “black” economy in the overall economy. (You can read this in detail here: It’s not Greece: Cong policies responsible for rupee crashhttp://www.firstpost.com/economy/dont-blame-greece-cong-policies-responsible-for-rupees-crash-318280.html)
And there is nothing that RBI can do on any of these fronts. The predicament of the RBI was best explained in a recent column titled Seeking Divine Intervention, written by Rajeev Malik, an economist at CLSA. He said: “There are three institutions that keep India running: the Supreme Court, the Election Commission and the Reserve Bank of India (RBI). To be sure, most of the economic mess in India has the government behind it. And often the RBI is called in as a vacuum cleaner. But even the world’s best vacuum cleaner cannot be successfully used to clean up a garbage dump.”
(The article originally appeared at www.firstpost.com on June 4,2012. http://www.firstpost.com/economy/no-subbarao-wont-be-able-to-clean-upas-garbage-dump-331114.html)
(Vivek Kaul is a writer and can be reached at [email protected])