King Canute, The Interest Rate Saga, And Missing Pixels

BloombergQuintOpinion 

Shankkar Aiyar @ShankkarAiyar

In the often quoted parable King Canute and the Waves, the King is urged by the people of the kingdom, particularly the courtiers, to use his mythical powers to make the waves obey his command. Of course, the waves didn’t pay heed.

The parable is important, in modern-day economics. The embedded belief is that — and central bankers across the globe have been valiantly wrestling to quell it — monetary policy has the fix for the why what and how of getting many moving parts of the economy chug and hopefully pick up pace.

The faith has subscribers in India too. Over five years, successive regimes have generated much lather on the need for lower interest rates and laid the onus on the Reserve Bank of India.

The thesis being lower interest rates will fuel consumption, drive demand, spur investment and therefore deliver higher growth.

The saga is well illustrated by former RBI Governor D Subbarao in his book, appropriately titled “Who Moved My Interest Rate”. Subbarao points out that both finance ministers, P Chidambaram and Pranab Mukherjee, were “piqued by the Reserve Bank’s tight interest rate policy on the ground that high interest rates were inhibiting investment and hurting growth.”

The quest for lower interest rates continued after Subbarao and the UPA regime. In December 2014, in the wake of fall in crude oil prices, in an oblique but persuasive way, Finance Minister Arun Jaitley pointed out that “Inflation has been helped by both moderation of food prices in India and also the global oil prices. And I do hope RBI bears this in mind.”

The advice was chorused and a tirade ensued. The RBI, then led by Raghuram Rajan, did not oblige immediately — preferring to wait till mid-January as it analysed global and local data. Urijit Patel who replaced Rajan has not been spared either from lectures on the correlation between the cost of money and growth.

The persuasive voice of Jaitley has frequently been followed by arguments of the dirigiste kind. Arvind Panagariya, then the deputy chairman of the NITI Aayog, who in September 2015 felt the RBI needed to cut rates by at least 1 percent. Chief Economic Adviser Arvind Subramanian has often chided the RBI for not getting it. Almost in sync, the advice and arguments were accompanied by solicitous expert opinion — many a time, hypotheticals as a certainty.

Be that as it may, the RBI has, in 32 months between January 2015 and August 2017, cut interest rates seven times — four times in quick succession in January, March, June, and September 2015 — bringing down the signal rate at which RBI lends to banks from 8 percent to 6 percent. For sure, interest rates have come down for borrowers of housing, education, personal loans — even if not as much as they should have. Also, banks are flush with funds post demonetisation.

The question that begs to be asked is have the 200 basis points delivered all that was argued as inevitable — did the waves obey the King?

Every indicator that should have progressed has in fact regressed. The theory of lower rates leads to higher credit offtake has not quite panned out. Worse, credit growth year on year in July 2017 is at 4.8 percent, lower than 7.9 percent in 2016 which again was lower than 8.4 percent in 2015. Pertinently RBI data shows “credit to industry contracted by 1.1 percent in June 2017” on the back of bare-bones rise of 0.6 percent in June 2016. Credit growth came from retail/personal loans and disbursements to housing.

Lower interest rates should have resulted in spurring investment but gross fixed capital formation, the Economic Survey data shows, has slid since 2013 from 33-plus percent, and is at a low 27.5 percent as per GDP data for 2016–17 released in May by the Central Statistics Office. The Index of Industrial Production has been flat and even negative in some months, capacity utilisation of core industries is stuck in a rut and gross domestic savings has dropped to sub 32 percent.

Indeed, one could paraphrase pop icon Tina Turner’s hit single and ask ‘What’s lower interest rates got to do with it; what’s low interest rate but a second-hand sentiment’. Lower rates are but a second-hand sentiment because the syntax of economic theory is inevitably ambidextrous — nothing happens on one hand without a qualifying the other hand.

Playbook Of Expectations

The quest for lower interest rates is legitimate. The crux is about expectations. C Rangarajan, former RBI Governor, puts it eloquently when he says “monetary policy is very efficient as a brake but its impact on acceleration is uncertain”.

In essence, while hiking of interest rates can rein in inflation and curb heating, lowering of interest rates does not necessarily deliver the opposite reaction.

Indeed, last week, the U.S. Federal Reserve has expressed doubts about the efficacy of monetary policy to push up inflation.

The enduring principle in economics is about necessary and sufficient conditions. A lower interest rate is necessary but is not sufficient on its own. The flaw in the expectation stems from the playbook.

There is a belief in some quarters within the government that India in 2017 is somewhat like what was in 2003–04.

A landscape of improved macro fundamentals which rendered India a low-cost high growth potential economy — that fuelled 9 plus percent growth for three years.

It is true that there are some similarities — coincidence does not necessarily translate into assumed consequence. The fact is, the GDP growth in the 2004–2008 period was accompanied by roaring credit offtake, nine-plus percent rise in industrial output, double digit growth in services, high savings, higher investments, rising exports — and above all high global growth which the Indian economy piggy-backed on.

The current 7 plus percent growth is a bit of anomaly. It comes amidst flailing export volumes, poor credit off-take, and weak investments.

It is riding productivity gains, higher government spend and private consumption. The list of mercies — small and otherwise — include continued low crude prices, Seventh Pay Commission boost to spending, a good monsoon, wealth effect of the rise in stock prices. Imagine otherwise!

If economic growth was a three-legged race — consumption, investment, and exports — India’s economy needs a solid prop. The missing pixels are investment and job creation. Add to it RBI’s fear of “weakening growth impulses” and “retrenchment of investment demand” — that delectable phraseology deployed by RBI Governor Urijit Patel.

Twin Troubles

The causalities are known. They have found repeated mention in the Economic Survey and in the RBI’s bi-monthly view on the economy. Top of the list is the issue dubbed the twin balance sheet problem — the cause is the burden of debt on corporate balance sheets and the pileup of bad loans on bank books. The hope that lower interest rates would alleviate the situation has not quite played out. Vulnerabilities in telecom and power could, it is feared, exacerbate the spectre of bad loans.

Worse, there are now doubts about consumption and weakening sentiments as revealed in the Monetary Policy Committee minutes. At an operational level, the disruption of demonetisation and GST is yet to pan out. And finally, the big if is global growth — this is most visible in the nervousness of information technology and services, in pharma and somewhat in commodities.

Also Read: Growth Concerns, Fear Of Financial Froth Split Monetary Policy Committee

The ‘iffiness’ is echoed across the globe. Questions persist about deceleration in the global economy, the return of stagflation, the sustainability of the global rally given Greenspan’s “bubble warning” on bonds, monetary tightening in the U.S. and its postponement in Europe, credit growth world over, growth in China and more.

The obvious focus will have to be on crafting policy for domestic growth. This calls for a review of the playbook and objectives.

Is the quest for growth just about the number/ratio or is it about outcomes?

For a political economy which sees an intake of over 10 million into the job market, the focus has to be investment-led growth which would enable job creation.

Upfront and hanging low is the opportunity in managing urbanisation. There has been much talk about the potential of affordable housing — it’s a chant heard from Raisina Hill to Mint Street. For this, the aperture of policy needs to be widened. The answer is in the Bharatiya Janata Party’s 2014 manifesto — 100 new smart cities. Mind you the BJP is in power in 18 states! The idea has the potential to impact over 100 segments, boost investment, generate employment and deliver growth.

The challenge before the government is to not to succumb to generalised “let’s do something” thinking and focus on specifics on the ‘things to do’. Frequently solutions are embedded in the problems — the way forward for investment-led employment-generating growth is to resolve the many questions that haunt the political economy.

This may be a good time to revisit the manifesto to re-calibrate the bearings.

Shankkar Aiyar is the author of

Aadhaar: A Biometric History of India’s 12 Digit Revolution 

and

Accidental India:

You can email him at [email protected] and follow him on Twitter.

His previous columns can be found here. This column was first published here.