Regrouping for Growth - Interest Rates - III

This article by Shyam Ponappa was originally published in the Business Standard on September 4, 2013 and mirrored in Organizing India Blogspot on September 6, 2013.

What are possible ameliorative steps for India's economy? Taking stock, are we overreacting to our economic woes? Second, do our problems have global origins? To the extent they are home-grown, what were the missteps? How can they be corrected?

The answers to the first and third (overreaction, policy errors) depend on whether one takes a "static" or "dynamic" view. Static views compare measures at points in time to arrive at an assessment of better or worse. Dynamic views, by contrast, emphasise system-wide flows and consequences, as in financial simulation models, with the focus on outcomes. The real question is whether we can grow sufficiently so that foreign and domestic funds cover imports and build manufacturing, or shrink and risk a deluge.

Risk assessment

From a static perspective, the present situation is nowhere near the dangers of 1991. Flows, however, highlight the potential for danger of slow growth: a demographic bulge with high aspirations and low opportunities; and a large, low-skilled population. What's worse is that foreign investment-fuelled growth rode a wave of imports without sufficient development in direct manufacturing. This imbalance is heightened by the stoppage of iron ore exports and the slump in coal production because of mining scandals, aggravated by high coal and gold imports. The problems - in telecom, mining, aggressive environmentalism, retrograde tax impositions, inadequate manufacturing - are all self-generated except for oil prices and the Syrian crisis. They stem from abdication of governance, overreach, or greed, compounded by judicial and citizen backlash. Only the triggers are external - from capital flowing in to the signal of a cutback.

Policy missteps 1: Interest and profits

The left side of the chart below shows interest expenses and profits for several thousand listed companies over the last four quarters. In terms of flows, higher interest rates curtailed demand as intended, so lower revenues and higher costs reduced profits - all while supply-constrained inflation continued.

Above: chart depicting the rising interest and declining profit. Picture by Organizing India Blogspot

Some experts maintain that rate cuts won't affect growth, citing the lack of a clear correlation; or the insignificant share of interest in total costs (reportedly three per cent); or that rates drive savings or consumption, but not investment. Clear correlations are unavailable because credible research must cover all major variables and interrelationships; simplifying them can distort conclusions. The research must also include how the effects of changes vary for rising or falling, large or small economies at different stages of development. The other reasons appear to ignore aspects of flows like momentum and turbulence - or even the data. And aggregates and averages can be misleading, as detailed below.

Interest costs in 850 non-financial companies went up by 40 per cent as a share of earnings before interest, taxes, depreciation and amortisation over three years. While Ebitda roughly doubled, interest costs nearly tripled(http://articles.economictimes.indiatimes.com/2012-10-25/news/34729789_1_inflation-control-potential-growth-rate-capital-formation).

Interest costs in 2,242 companies reportedly doubled from 2.3 per cent to 4.2 per cent of revenues over two years. Costs two years earlier were 16 per cent of Ebitda, whereas in the quarter ending December 2012, costs were 34 per cent of Ebitda. Analysts attributed this to low demand, and expect worse in 2013-14 unless demand improves (http://articles.economictimes.indiatimes.com/2013-02-18/news/37160258_1_interest-outgo-rise-in-interest-expenses-interest-cost).

In July 2013, earnings of 85 out of 600 listed non-financial companies did not cover interest payments, up from 61 the year before; another 43 were at risk compared with 36 a year earlier, and non-performing loans were increasing (http://www.thehindubusinessline.com/companies/debt-traps-india-inc-as-profits-fail-to-cover-interest-outgo/article4889184.ece).

Aggregate costs and averages sometimes conceal problems. Credit Suisse reports that the aggregate interest cover for 10 large, overleveraged industrial groups has dropped from 1.6 last year (borderline) to 1.4 (inadequate). For four of these groups, interest costs exceed profits. Rejoicing in the woes of "profligates" is inadvisable, however, because a collapse affects everyone.

Policy missteps 2: Sustainable profits and stability

Profits are essential for savings, investment, stability and order. This is why sustained profitability is of paramount importance for India. Provided industrial relations are harmonious and demand is resilient, that is, momentum is positive, lower interest costs within reason can sustain positive sentiment, resulting in higher profits up to a point (see chart - right). This has been a matter of incomprehension or denial for government (central and states), the Reserve Bank of India, the judiciary, and many citizens.

Instead, we have populist handouts to capture treasuries, and irresponsibility in replenishing them. What started with cheap rice in the 1980s has degenerated into a free-for-all, promising a distribution from the treasury contingent on capturing it for aspirants, or recapturing it for incumbents: vote us in, and you'll get these spoils.

Plausible remedies

• Lower rates: A number of experts in India and abroad recommend a reversal of monetary tightening and reduced interest rates. Some aver that the biggest risk is stifling growth by raising rates, eg, Paul Krugman and Ryan Avent (http://krugman.blogs.nytimes.com/2013/08/22/generation-b-for-bubble/). Others, unfortunately, suggest confusing strategies, including raising rates to contain inflation, despite this not having worked and been shown to be detrimental.
  
• Fiscal responsibility: A second requirement is fiscal responsibility in trade-offs for resources, betrayed by all parties in the impractical Bills on food security and land acquisition. This is a crucial requirement from both the government and the Opposition. For example, an effective step would be to raise diesel prices by Rs 5 a month for three months (which the government could evaluate using simulations).
  
• Manufacturing: Another requirement is action supporting manufacturing. A National Manufacturing Plan has been mentioned for years, but only coherent action will change the perception of yet another plan on the shelf. For instance, the government has resiled on the preferential marketing access for telecom equipment, which will increase imports.
  
• Stalled projects: There have been future-oriented announcements, eg, on fuel supply for power projects, but no demonstrable actions and results.

In sum, a rate cut combined with consistent actions on fiscal responsibility, disentangling projects, manufacturing, and stop-gap measures like swap facilities for oil companies and "stretching" imported coal may provide a breather. These could have a stabilising effect on the rupee, improve sentiment, and re-establish India's growth potential.