Prem Shankar Jha

Jaitley’s effort included many significant policy plans but had little to offer on reviving economic growth. Unless interest rates are lowered sharply, there is no possibility of recovery.

Only a drastic cut in interest rates can get the economy moving again. Credit: Shome Basu

Only a drastic cut in interest rates can get the economy moving again. Credit: Shome Basu

The Budget presented by Finance Minister Arun Jaitley on Monday contains a number of new departures that merit unstinting praise. Chief of these are a national crop insurance scheme for farmers, a health insurance scheme to protect families from the impact of illnesses that incapacitate the breadwinner and a three-year programme to provide 50 million families in villages with cooking gas facilities.

But on the revival of economic growth, the central challenge facing the country today, the Budget has little to offer. Instead, Jaitley implicitly absolved the government of responsibility for it’s failure to revive growth, by laying the blame on the “serious crisis” in the global economy but said the Indian economy held its ground despite the global headwinds.

The bad debt problem

The self praise, however, is muted. Both the Budget and the Economic Survey have admitted that all is far from well in the economy. The 2014-15 Survey had estimated that 880,000 crore rupees of investment was locked up in stalled projects, concentrated mostly in the heavy industry, construction and infrastructure sectors, and this year’s Survey dealt at length on the mountain of bad debt that this has created in the banking system. On December 31, 2015 the non performing assets (NPAs) – debt on which banks are not able to recover their interest and amortisation – of 24 listed public sector banks, including the State Bank of India and its associates, stood at a whopping 3,93,035 crore rupees, or about 11% of their loans. Private banks had not done much better; although they accounted for less than 20% of outstanding loans, their NPAs added up to 45,000 crore rupees.

This mounting bad debt has reduced banks’ willingness and capacity to lend, slowed the growth of credit to less than half of what it was during its heyday a decade ago and locked the entire secondary economy in the jaws of stagnation. Not surprisingly, industrial growth has been stuck at just over 3% for the last five years. This is close to 2% lower than the growth it recorded in the 1960s and 1970s, during the worst period of the closed economy. Judging from the quarterly data collected by the labour ministry, the slowdown in the growth of employment has been equally sharp.

It is in suggesting a remedy for the crisis that North Block is strangely reticent. Both the Economic Survey and the Budget reflect the conviction that the remedy lies in drastically simplifying and speeding up the procedure for declaring firms bankrupt and liquidating their assets. The Survey has likened the Indian economy to the Chakravyuhain the Mahabharata – easy to get into but very hard to get out of. Enabling companies to exit easily will release what Joseph Schumpeter called “the gales of creative destruction,” for it will free land, buildings and other assets for sale, and bring the capital locked in them back into useful circulation. Citing academic studies, the Survey has claimed that this will improve the productivity of capital by 30-40% and trigger an economic revival.

Jaitley has taken his cue from the Economic Survey. In paras 90-94 of his Budget speech he unveiled a spate of measures that will make it easier to set up asset reconstruction companies, to speed up the working of debt recovery tribunals by digitising the collection of information and recapitalise  public sector banks in order to free up the flow of credit.

Persistence of widespread insolvency

It was these announcements that sent the Sensex up by 800 points, the biggest one-day increase in seven years. But as a panacea for economic stagnation they will not suffice, for implicit in them is the belief that investment is going bad mainly because of the greed of investors who borrow too much and therefore run up very high interest costs, and because of cronyism and unprofessionalism in the management of public sector banks.

These are not the only, or even the main, causes of the malaise in the economy. One key indicator is the large number of companies with restructured loans that have once again become insolvent. In 2014-15, 57,000 crore rupees of restructured loans had gone bad, double the amount from the previous year.

The persistence of widespread insolvency despite the restructuring of debt shows that its cause is not episodic but systemic. Every single one of the economy’s problems can be traced back to the very high interest rate regime that has existed, with one short interlude, since 2007. This has drastically reduced demand by discouraging purchases made on instalment plans, including the purchases of housing and office space, automobiles, electronic and digital equipment, and home and office furnishings. These make up almost half of industrial production. It has also caused a collapse of the share market in all but a few sectors and a virtual disappearance of initial public offerings of shares since 2007. Finally, it has forced promoters to rely almost exclusively on bank loans to finance investment just when the cost of borrowing has gone up. This has greatly increased the risk of investment and is responsible for the large scale abandonment of infrastructure and heavy industrial projects that were highlighted in the 2014-15 Economic Survey.

The interest rate quagmire

Jaitley has urged the Reserve Bank of India (RBI) to lower interest rates on several occasions, and in July his chief economic adviser, Arvind Subramaniam, wrote an article in The Indian Express arguing that the cost of living index is no longer a satisfactory measure of inflation and urged the use of the GDP deflator instead. It is thus surprising that Jaitley did not say anything in his Budget speech about lowering interest rates, a point left out in the Economic Survey too.

This may be out of respect for the RBI’s autonomy in determining monetary policy. But central bank chief Raghuram Rajan has shown no inclination to lower the interest rate so far as he believes, with the cost of living index still averaging 5%, the RBI’s current policy rates – ranging 7.75-5.75% – are already low enough in real terms not to merit much further reduction. Additionally, he firmly believes that most of the problems of industry can be traced back to the mistakes of the promoters, who “do not have a divine right to stay in charge regardless of how badly they mismanage an enterprise, nor … have the right to use the banking system to recapitalize their failed ventures”.

But the RBI’s policy rates do not reflect the actual cost of borrowing. Today the average borrowing rate, including various bank charges, is over 11%. With inflation, measured by the GDP deflator, close to zero the real rate of interest for borrowers is prohibitive. Till it is brought down, and that too very sharply, there is no possibility of a revival of investment and an economic recovery.

The real test for the government will therefore come when the RBI announces its next policy review at the end of this month. If Rajan does not bring down interest rates substantially, Jaitley and Prime Minister Narendra Modi will have to choose between foregoing economic recovery or foregoing the services of Rajan. The choice, either way, will not be easy.

Prem Shankar Jha is the Managing Editor of Financial World and a senior journalist.

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Last month the RBI  governor Raghuram Rajan  defended his decision not to cut interest rates by saying “ It is not the RBI’s business to deliver booster shots to the stock market so that stock markets can soar for a short while, only to collapse when reality hits….What is important for us is sustained low inflation…the RBI will have no hesitation in delivering once we are assured of the low inflation”.  At the time when he said this wholesale price inflation was minus 4.1 percent; primary product inflation was minus 3.7 percent, fuel and power was minus  12.8 percent and manufactures minus  1.5 percent.   So what inflation measure was Rajan talking about?  The answer is the cost of living index.

But  chief economic adviser Arvind Subramanian pointed out in an article in the Indian Express as long ago as  June 12, that  this is the only index he should avoid  using, because its stickiness, and the widening gap between it and all other measures of inflation,  makes it suspect.   Subramanian had written  that pegging policy interest rates  to the cost of living made sense in “normal times”, but not in ‘unusual times’. ‘From the context it was clear that by normal times he meant those that had  existed till 2007, when the CPI., although much more volatile than the WPI, had traced the same long term path.

Times became ‘unusual’ after  2007.  Except for a few months  at the bottom of the global recession in 2010-11, the gap between CPI and WPI has widened steadily from 3 percent in 2010 to an  unprecedented 8 percent in August.  What is more this has happened inspite of the RBI using every monetary instrument to squeeze demand  and force prices down. The only conclusion one can draw  is that whatever is keeping the CPI inflation up, it is not an excess of demand.

If not demand then what is it measuring? There is only one remaining candidate: shortages of supply. The association of inflation with excess demand is so hard-wired into our thinking that it is often hard to remember that inflation can also be caused by  shortages in  supply. The idea of politically inspired, artificially engineered, shortages that last for long periods, is alien to economists’ thinking because it comes from the dangerous realm of political economy.  But once we open ourselves to this possibility it does not take long to see that it is, indeed, the reason why the behaviour of the CPI has changed so radically.

Foodgrain and cash crop prices ( hich account for more than 40 percent of the CPI) have become progressively less sensitive to  demand because   state governments  are setting minimum support prices for  more and more commodities. Today there are procurement , or minimum support, prices for more than 20 groups of food and cash crops, and the central and state governments have been raising these by  five  to seven  percent every year for more than a decade.

The rise in price of urban housing, which  accounts for 9.77 percent of the index,  is  almost entirely accounted for by the  growing shortage of urban land.  Tariffs on  transport, fuel and lighting, which   account for  another  17.1 percent, rose sharply  because of a  revival  of international oil prices till mid-2014,  a 40 percent fall in the value of the rupee after 2011;  a simultaneous removal of subsidies on diesel, gasoline and LPG, and a growing reliance on coal, imported  at four times the domestic price, for power generation.  All these are cost push factors that get  translated into an increase in the cost of living  through  administered changes in price.

Health and education make up another  9.04 percent. The cost of the former has risen because of drug price decontrol – another administered price change  — and because of a growing reliance on private health  services. The rise in the latter reflects the final collapse of the public schooling system.

In sum , whatever the  cost of living index may signify  in  countries where more than half of the population lives on pensions,   in  India it is an index not of excess demand but of the  failures of past governments. To use these  as a yardstick of inflation and curb industry  is to destroy India’s future and administer the kiss of death to its poor.

The right policy is not to leave   interest rates solely to politicians but link them to a measure that has been purged of all pressures caused by administered prices and  shortages of supply. The only one in India  that fully does this is   CRISIL’s Core  rate of Inflation Index (the CCII) .

The CCII is derived from the RBI’s Non-Food Manufactures Index (NFME) but excludes oil and metals because their prices are heavily influenced by global price trends. But it also  includes manufactured foods and beverages, which the NFME excludes. This measure of inflation has stayed close to the wholesale prices index, but is far more stable. In September 2014 when the fall in oil prices had just begun to bring down all indices of inflation, the RBI’s NFME fell to 2.8 percent and the wholesale price index to 2.38 percent, CCII index will not have fallen as much as the WPI but is almost certainly also showing deflation. Today, India desperately needs investment in infrastructure, and therefore the lowest possible long term interest rates. With the CCII at a long term rate of at most two percent thus there is not an iota of economic logic for keeping bank lending rates at 12 percent.

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Prem Shankar Jha
Coming on the heels of July’s 0.5 percent, the 0.4 percent growth of industrial production in August shows that the Indian economy is not on the road to recovery. The reason is the sustained high interest rate regime of the past four years. Industry has been begging for cuts in the cost of borrowing since March 2011. When Modi came to power it thought that its troubles were about to end. But on August 5, RBI governor Raghuram Rajan surprised the country by announcing that he would not lower interest rates, because at 8 percent consumer price inflation was still too high. He also announced that he would not lower rates till inflation, measured by the cost of living, had come down to six percent. So his September 30 refusal to bring down interest rates came as no surprise.
But Rajan went a step further and unveiled an inflation forecasting model which estimated that under the very best of conditions CPI inflation would not fall to 6 percent till January 2016. To Indian industry, which ceased to grow three years ago, this was the kiss of death.
Today there is not a spark of demand anywhere in the entire economy. Inspite of every inducement the growth of credit in the festive season till the 3rd week of September was Rs 17,800 crores against 108,000 crores in the comparable period of last year. Two of the RBI’s own reports have shown that capacity utilization in industry has been falling since the early months of 2012. But Raghuram Rajan remains fixated only on bringing down inflation.
What is worse he is using only one of four measures of inflation—the consumer price index, and ignoring the other three. These are the wholesale price index (WPI), the Reserve Bank of India’s non-food manufacturing index, and the ‘core rate’ of inflation. The WPI is an approximate measure of the rise in production cost. It is therefore crucially important for manufacturers and builders. The RBI’s non-food manufacturing index is a rough measure of the pressure of excess demand on prices because it filters out the impact of weather and export policies on agriculture. But CRISIL’s core rate of inflation is the most precise measure as it includes manufactured food items but excludes globally traded fuels and metals to filter out the impact of world commodity price changes.
Today WPI inflation has fallen from 9.6 percent in 2010-11 to a record low of 2.38 percent. The RBI’s NFMI has also fallen from 8.4 percent in June 2009 to 2.8 percent, mainly on the back of declining world commodity prices. CRISIL’s core rate of inflation is therefore higher, but only by 0.2 percent.
So why has the Consumer price inflation rate remained so stubbornly high? The answer is that the new method of calculation introduced in January 2011 has, in an unforeseen way, become a measure of the effect on prices not of excess demand but of bottlenecks in supply and the failure of the State to provide the infrastructure for growth. .
Primary foods, whose prices are determined almost entirely by supply constraints such as rainfall, area sown, and in the case of vegetables , the amount exported, account for 42.2 percent of the index. Housing accounts for 9.77 percent, but the index includes only urban housing whose supply is severely constrained by the shortage of urban land and the severe curbs the government has imposed on loans to builders.
Health and education make up another 9.04 percent. The cost of both has risen because of drug price decontrol and a growing reliance on private doctors and schools that reflects the failure of the state The only manufactured products included in the CPI are clothing , bedding and footwear (4.6 percent) and manufactured foods ( 8.2 percent). If housing is taken as a proxy for basic industries the total weight of manufacturing in the index comes to just 21 percent. The rest of this index reflects constraints in supply that high interest rates cannot remedy.
This is why four years of ‘inflation targeting’ using the CPI as the yardstick, has failed to make any dent in the CPI inflation. Today people are expecting the RBI to lower rates , but only because CPI inflation has fallen to 6.38 percent and, with diesel prices falling, will go lower.. But the cause — a sharp fall in world commodity, and particularly oil, prices—has nothing to do with India. And we have no idea how long it fall will last. Should domestic interest rates go up again if ISIS captures Basra, or China goes on another investment spree?
The Government has belatedly realized that interest rates determine not only money supply but also economic growth. So it is setting up a joint finance ministry and RBI panel to decide what it should be. But even this is not a sufficient safeguard. The Congress learned to its cost that inflation indices misinterpreted, and interest rates misapplied, can not only sink the economy, but the government as well. If interest rates are to be indexed to inflation it must be to the core rate of inflation, and be subject to whether the government wants growth or price stability. That is a decision that only the cabinet and the prime minister are qualified to make.

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Four months ago Narendra Modi rode to power on a promise to revive the Indian economy and restore to the people of India the future they had lost. But tendrils of doubt had begun to surface well before he completed his first hundred days in office. In the last week these have hardened into certainty.

In normal circumstances four months would have been too soon start judging the performance of a new government. But the BJP came to power in a moment of crisis on a huge wave of anger against the UPA government. Economic growth had crashed, industrial production was contracting, and almost no new jobs had been created since 2008, leaving an estimated 40 million new job seekers stranded. None of those who voted for Modi had expected an instant miracle, but they had expected the new government to unveil a credible, well worked out plan to revive the economy.

They didn’t get one. There was no hint of any change in the macro-economic policies that the UPA had followed in Finance minister Jaitley’s budget speech and there was none in Mr. Modi’s Independence Day speech. Instead as the government’s 100th day approached it’s spokespersons plucked at straws to showcase its success – a 3.9 percent growth in Industry and, on its back, a one percent rise in GDP growth from 4.7 to 5.7 percent. July’s data for industrial production pricked this balloon. Not only had year-on-year industrial growth fallen to 0.5 percent and manufacturing contracted, but the 3.9 percent growth in the first quarter turned out to be a statistical illusion. To those on the ground for whom nothing had changed, this began to look like proof that nothing would change in the near future.

The policy change needed to restart growth is a simultaneous, very sharp lowering of interest rates and a firm containment of the fiscal deficit. The interest cut will revive consumer spending, especially on durables, start a rise in share prices, and bring down the cost of new investment. If synchronized with a reduction of the fiscal deficit it will bring about a non-inflationary transfer of resources from government consumption to corporate investment.

The time for making this shift of policy could not be more opportune. The balance of payments deficit has been brought down from an unsustainable 4.7 percent of GDP in 2012-13 to a healthy 0.8 percent in the last nine months of 2013-14. Exports are growing at 10.2 percent, and engineering goods exports at 22 percent. Foreign exchange reserves have crept up in the past 12 months from $ 279 billion to $ 320 billion. The threat that a sudden rise in investment and consumption will trigger a foreign exchange crisis has therefore receded. In his budget Mr. Jaitley made a determined bid to contain the fiscal deficit by increasing tax collections, and announcing plans to improve delivery and save money. But he made no mention of interest rates. His budget announcement therefore became a bird with a broken wing.
One has only to look as far as the Reserve Bank of India to see why. In his latest Policy Review the RBI governor, Raghuram Rajan, again did not lower interest rates, even by a fraction. Instead as one justification for keeping them high has dissolved, he has hurriedly replaced it with another. Today the wholesale price inflation is at a five year low of 3.7 percent, and consumer price inflation has fallen to 7.8 percent, but commercial bank lending rates (including bank charges) remain at 13 to 14 percent even for financially sound companies. This gives a real rate of interest for manufacturers of 10 percent — a figure unheard of in mature market economies even in good times and suicidal in times of recession. Even by the yardstick of CPI inflation the real rate is over five percent, a rate at which investment is not possible. Is it surprising then that bank lending has grown by less than ten percent this year against 23 percent five years ago; that there have been only six new share issues so far in 2014, against an average of 110 in the same nine months of 2006 and 2007, and that the sales of all consumer durables, from autos to TVs, computers and office equipment has fallen by eight to fourty percent in the last one year?

In his 14 months at the RBI, Rajan has not mentioned economic growth. This may be kosher in the West, which does not strictly need growth. It is not kosher in India, where people have to earn something before they can start worrying about how much their money will buy.

Prime Minister Modi has promised to give India world class roads and ports, high speed trains ‘smart’ cities, rural electrification and water supply. These are all infrastructure projects, and infrastructure devours capital. In the best planned and executed projects the ‘bare’ construction period, when the money has actually to be spent, stretches from five to 12 years. Where will Mr. Modi find Indian entrepreneurs willing to take up such projects when interest charges alone can add 25 to 100 percent to his costs?

The answer, of course, is nowhere. So Raghuram Rajan must give up his obsession with inflation, and his attempt to fight it single-handed by choking India’s economic growth, or he must leave. If the Modi government cannot persuade him, and has not the courage to fire him, then the people will fire it at the next elections.

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Till as recently as two years ago India was enjoying a dream rate of growth, of close to 9 percent a year. Then the bottom fell out, and it happened so suddenly the few people even now fully understand why. In my WIKI I have posted an article that appeared in “The Hindu” ( all editions) on why this happened and why the situation is far from hopeless. If you are interested, I would greatly appreciate a feedback.

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For more than five years, the Indian economy has been growing progressively more slowly. The chief victim has been industry – which should be the muscle and sine of economic growth. The Indian government and its Central Bank have spared no effort to put the blame for this on the global recession. But the truth is that it is its own policies that have all but killed the economy. Today overall growth has collapsed from 9.4 percent three years ago to 4.8 percent. Industrial growth has almost disappeared, from 12.8 percent in 2009-10 to less than 2 percent.
No one in government even wants to talk about the fall in employment. The single cause of this catastrophe is that in the face of recession the Indian Reserve Bank has steadily raised interest rates instead of lowering them.

To justify this suicidal action it has put forward different justifications at different times. The most consistent is that India is suffering from a high rate of consumer inflation. This cannot be brought down without raising interest rates. What the Central Bank refuses to do is distinguish between demand pull and cost push inflation. This is suicide.

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