Would inflation have been lower if interest rates were lower? & Market Outlook

Given the kind of stance that RBI has taken over the last two years where they have totally ignored growth concerns while chasing the elusive inflation it is pertinent to try to evaluate if inflation would actually have been lower if RBI had cut rates and eased the liquidity pressures in the economy.

The start of RBI’s interest rate hike cycle was with absolutely the right logic. Demand pressures in the economy were high and there were chances of bubbles developing across various segments of the economy. Also the unbridled lending binge by banks, especially PSU banks combined with huge dole outs by the government risked inflation going out of hand.

However this logic worked very well till around 9 months to a year back at which point of time we saw Industrial Growth virtually come to a standstill and corporate balance sheets started getting extremely stressed. At this stage the problems that the government at the Centre was facing combined with collapsing growth saw a run on the INR start. This further complicated the inflation problem as the INR fell nearly 20% in a period of a few months. This was also the time when global growth concerns also led to commodity prices coming under pressure globally. As such we have seen a 20-40% correction across commodities over the last one year or so. However the impact of this has been totally missed by the Indian economy due to an extremely depressed INR. The rupee has fallen drastically over the last two months too. This has happened at a time when several emerging markets like South Korea, Philippines etc have been grappling with huge currency appreciation fears. As such it is not a case where there has been a fall in EM currencies in general. The performance has been divergent and has followed the direction of economic stability as it seems in the mind of the markets.

As I have argued several times in the past, RBI will not be able to control the ghost of inflation by traditional monetary policy measures. This is because monetary policy has become non traditional and experimental all over the globe. The US FED, ECB, BOJ all have been following different forms of non traditional methods in order to try to stimulate the economy.

RBI’s tight policies started becoming counterproductive as soon as the economic growth figures started showing that it is no longer higher demand that is driving inflation. Infact it became the opposite. Supply pressures have continued to increase and will become worse as the investment cycle has come to a complete standstill. Those demanding a higher interest rate environment as it favors depositors have to reexamine their logics.

Let’s see the case of China. Here the government has given a huge fiscal stimulus over the last 3 years, interest rates continue to be low and demand pressures high. Fixed asset investment has continued to grow at 20% plus, Industrial growth at 9% or higher. So why is the inflation so low? The main reason in my view is that the focus is on improving productivity and increasing supplies. If supplies remain adequate then inflation can remain low even in an environment of high demand.

Monetary authorities say that high interest rates are not the factor behind a lower investment cycle but there are other factors behind it. This is very true, the government has tried its best to lower economic growth and affect the confidence of people in the Indian economy by either taking no decisions or wrong decisions over a long period of time. It is only over the last 3-4 months that we have seen a positive move from the side of the government. However the fact of the matter also is that any industrialist that we talk to normally tells us that a vast majority of projects are unviable at current interest rates. The viability increases as rates come down. The logic is very simple i.e. the ROCE and RONW clearly depend on the cost of funds in setting up a capacity. How can we ever say that interest rates do not influence the viability of projects?

Given the extreme stress in the balance sheets of corporates, delays in project approvals, low demand and high interest rates most companies are not investing. This is in turn making most banks turn to consumer finance, which in a sense can be called non productive lending. As such the money that the banks are collecting from depositors is increasingly been given out for consumption. This is exactly what the RBI is trying to control. Not only banks, a huge number of retail NBFC’s have substantially grown their books over the last couple of years. As such stressed corporates and the fear of higher NPA’s by lending to corporates are driving most financial intermediaries towards consumer lending.

Moreover a deeper analysis of the reported inflation figures becomes necessary at this stage. For example excise duties were increased by 2% in the current year’s budget. Given that this move was across the board this move by itself has lead to a spike in inflation by an average of 1-1.25%. Now this is not demand driven inflation, it was a fiscally positive move which has led to this spike. The decontrol of fertilizer prices along with the much delayed increase in electricity tariffs by various electricity boards has also led to a spike in inflation by nearly 0.6-0.7%. Now these are structural moves which were supposed to happen over the last 3-4 years but have happened in one shot over the last one year. As such out of the reported inflation of 7.5%, nearly 2% is due to moves that have nothing to do with demand pressures.

As I mentioned earlier most global commodities have corrected significantly. However the lack of faith in the Indian economy combined with the high Current Account Deficit has led to a fall in the Indian currency. Now in terms of terms of trade the fall in the INR should have been very positive for Indian exports given the fact that most competing currencies have seen huge appreciation in the same time frame. However this has not happened mainly because of the high cost of export credit, reduction in export subsidies when overseas demand as such was under pressure and lack of cheap export credit which most countries have been providing to their exporters. Export credit and equipment finance for importers is freely available for buyers of products out of China. A recent report suggested that the US Exim bank is offering extremely cheap credit for buyers of American products. As such easing liquidity and lowering interest rates can push exports significantly and start a virtuous cycle that will increase exports, reduce the CAD, boost the value of the INR and get inflation down.

However taking such moves requires out of the box thinking. If traditional monetary policy had been followed in the US, UK or Europethese countries might be in a depression. The consumer inflation in the UK last month was 2.7% and the overnight rate in that country is 0.5% and there have been several binges of money printing. If traditional monetary policy had to be followed the overnight rate should ideally have been higher than inflation i.e. over 3%. Such a rate would kill the economy of the UK. Similarly inflation in Euro zone continues to be above 2% and overnight rate stands at 0.75%. So why are central bankers looking at the picture differently and not increasing rates to bring inflation down? The reason is clearly that given the fiscal & deleveraging issues facing nearly 50% of the global economy the general expectation is that demand pressures will remain low for a prolonged period of time and as such inflation will stabilize a
t lower levels eventually. If this is to happen globally, why will such a thing not happen in India too?

Another reason given by keeping rates up is the high Fiscal Deficit of the government. That logic also does not hold today given the global context where the biggest fiscal issues today are being faced by the USA; however the FED has continued to keep monetary policy more than accommodative. Similarly most European countries and Japan have huge fiscal issues. This does not mean that growth needs to be killed. Infact the lack of faith in the economy due to the slowdown has led to low valuation for government PSU companies and the inability of the government to raise disinvestment money required to cut the Fiscal Deficit. The 2G auction was an abject failure due to inability of corporates to pay higher as a result of a slow economy and general negativity. The slowdown in economic growth has put pressure on government revenues which will further increase the Fiscal Deficit. If we properly evaluate the cycle of reducing Fiscal Deficit in India in the first decade of the 2000’s it was not due to any huge expenditure control but due to higher revenues as the economy grew strongly. As we have seen unfortunately in some of the EU economies, huge fiscal contraction attempts at a time when the economy is growing slowly leads to a further slowdown which in a vicious cycle leads to an even higher fiscal deficit.

Unfortunately in India we seem to be going the same way where the focus is not on reviving growth, which by itself will reduce the Fiscal Deficit but on growth contraction which is putting further pressure on the Fiscal Deficit. Focus on growth will increase government tax and non tax collections, bring the Fisc in control and lead to lower rates in the economy.

Markets look well positioned for an up move among all negativity. The government in all probability will now last the course given the failure of the no confidence move of Mamata. As such political uncertainty should be low going forward. Growth has bottomed irrespective of whether the government and RBI take steps for a revival towards 7-8%. Clarifications on GAAR are expected shortly, which could be a positive trigger. The same is true of the National Investment Board. The cash transfer scheme might help the government politically; however the bigger point for all of us is that it is extremely positive for the economy as it will lead to a reduction in subsidy payouts and lead to a drastic reduction in the huge distortions in the economy as all products move towards market rates. Internationally the resolution of the Gazaconflict combined will the imminent Greek bailout deal should be positive. The partisan bickering in the USalso seems to have reduced post Obama’s reelection and there seems to be more seriousness in addressing the Fiscal Cliff. December is normally a positive month and especially this time things are falling into place for it to be positive. Let’s see if we end the year with a flourish.