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Sunday, December 07, 2008

Policy responses to India's economic slowdown

What might come next in the Indian economy?

India is more integrated into the world economy than ever before. In 2000, goods and services exports were roughly 12% of GDP. Today, they are at roughly twice this number. Gross flows on the BOP (summing across the current account and capital account) were roughly 50% of GDP in 2000. Now they are at 125% of GDP. As these numerical values suggest, the pace of change on India's integration into the world economy has been quite dramatic. This increased integration into the world economy means that global shocks affect India more.

Turning to the global economy, the depth and international co-movement that we are seeing in this business cycle downturn is worse as compared with prior experience.

We are thus faced with an unprecedentedly large shock hitting an unprecedentedly integrated economy. The impact of this external shock will hence be unprecedented. We are in new terrain here. Our intuition has been shaped by the past 20 years. But this intuition is a poor guide to optimal decision making at the level of a firm or the country in the situation that we now face.

What are the channels through which the changed environment impinges on us? The first channel is reduced demand for Indian exports. The second channel is the impact on profitability of many Indian companies owing to lowered prices of their products on the world market. The third channel is the reduced investment owing to the change in animal spirits of CEOs.

Some people are emphasising financing constraints as the channel through which investment could drop. But even before you get to financing, the really important problem is about whether a CEO wants to invest or not. When the future looks difficult, CEOs undertake less investment.

Fluctuations in investment are now the big force shaping the Indian business cycle. Gross capital formation to GDP has jumped from 25% to 38% in a few years. A massive investment buildout is presently underway. Private corporate investment has fluctuated quite a bit with changes of as high as 10 percentage points of GDP in a few years. If expectations become very pessimistic, investment could drop by 5 to 10 percentage points of GDP. This would be a massive shock which would set off a business cycle downturn.

For more on the new forces shaping the Indian business cycle, see my article New issues in macroeconomic policy from last year. You will also find the first chapter `The Economy' of this book to be of interest, particularly Section 1.4.2 titled Perfect Storm?.

In short, the scenario to worry about for calendar 2009 is one where investment drops by a few percentage points of GDP because entrepreneurs are pessimistic about what the future holds.

What can monetary policy do?

The paper The current liquidity crunch in India: Diagnosis and policy response, that Jahangir Aziz, Ila Patnaik and I wrote in early October, frames the questions of monetary policy in the downturn. By and large, RBI has done all the right things on rupee liquidity. Dr. Subbarao did something new and important yesterday when, for the first time, he said that RBI will try to ensure that the call rate stays within the LAF. This will help stabilise the expectations of the bond market about the volatility of the short rate, and thus reduce the fears of banks who were otherwise hoarding liquidity.

With the latest RBI actions layered on top of what they have done in previous weeks, I think the short rate and rupee liquidity are broadly okay. The problem of rupee liquidity is broadly under control.

Monetary policy in India has the power to do damage. If the liquidity tightness of late September had continued, we could have had a run on many or all private banks. Many mutual funds could have experienced acute distress. A broad-based financial crisis could have erupted. These unhappy scenarios have been forestalled by the timely, unorthodox and effective RBI actions.

While bad monetary policy in India can do a lot of damage, there is little room for monetary policy to help counter a business cycle downturn by cutting rates (as is done in mature market economies). The reason for this is the lack of a monetary policy transmission. When the central bank of a mature market economy cuts rates, a complex and sophisticated financial sector takes the `raw material' from the money market and transforms it into enhanced asset prices across a wide range of assets all across the economy. In India, owing to the lack of the `Bond-Currency-Derivatives Nexus', this monetary policy transmission does not take place. The policy rate, expressed in real terms, has gone into negative territory but there is little likelihood of it having a serious impact on aggregate demand. The problem is not a liquidity trap; the problem is the broken monetary policy transmission.

What about the exchange rate, which can be a key element of monetary policy if it's not allowed to float? I think RBI is making some progress on getting away from pegging to the dollar. RBI doesn't release adequate data but my guess is that roughly half of the change in reserves is valuation changes. Many people have focused on the large drop in reserves (measured in USD) as a measure of RBI's attempts at currency trading. But when valuation changes are taken into account, what RBI has been doing there is smaller than it seems [link].

The bottom line is that when the Asian crisis struck, and a business cycle downturn in India was impending, India raised rates (200 bps on 16 January 1998). Exchange rate pegging led to the loss of monetary policy autonomy. This time around, the currency has been allowed to depreciate in exchange for domestic monetary policy autonomy: i.e. lowering interest rates when there is an impending downturn.

What can fiscal policy do?

Can fiscal policy help? I feel this is not the case for two reasons. First, there isn't the fiscal space. Second, the institutional mechanisms through which spending can happen do not exist. I am hence not surprised by the modest aspirations of the recently announced fiscal stimulus. Each percentage point of GDP is Rs.50,000 crore and we are discussing a drop in investment of a few percent of GDP. When it comes to movements of a few percent of GDP, fiscal policy in India is just a spectator.

In terms of automatic stabilisers, there is really only one: corporation tax. In a downturn, corporation tax will drop. At present, it is at roughly 3% of GDP. So perhaps there will be a swing of as much as 1 percent of GDP there. While this is nice in terms of getting countercyclical fiscal policy, it simultaneously makes India's fiscal position look precarious. As an example, this makes it harder for Indian firms to borrow abroad because the Indian sovereign credit rating may worsen in an environment of lower GDP growth and a bigger fiscal deficit. And in this global environment, lenders are much more careful about buying junk (which is where Indian issuers are now).

Summary: the macroeconomic policy response to an impending downturn

The textbook response to an impending downturn is to cut interest rates and enlarge the fiscal deficit.

In the past, the word `business cycle' didn't mean much in India, and macroeconomic policy never tried to do such things. It is an important milestone in India's economic history that we have a weekend in which both monetary and fiscal policy have attempted to respond to business cycle conditions. Stabilisation of the business cycle is one important task of the State in a well functioning mature market economy. We have atleast come to the point where such aspirations are starting to be heard. This is progress.

But in terms of the actual capability to stabilise, a lot is lacking. Long-standing policy blunders, particularly on prevention of a liquid bond market and a liquid currency market, have ensured that India does not have a well functioning Bond-Currency-Derivatives (BCD) Nexus. As a consequence, the monetary policy transmission is weak. As a consequence, the impact of cutting interest rates is small. Mistakes in monetary policy can do damage, and RBI has been doing the right things in helping ensure that it does not do damage. But monetary policy cannot stabilise to a substantial extent.

With fiscal policy also, we are paying for our sins of not reforming. The great business cycle expansion from 2002 onwards should have been a time to put our fiscal house in order. As Vijay Kelkar used to evangelise, the time to fix the roof is when the sun is shining. By today, we should have been holding a GST fully integrated into the Tax Information Network run by NSDL, and we should have had a central fiscal deficit of zero. That would have given us the ability to make large reductions of the GST as counter-cyclical fiscal policy. The right things were not done in the last five years. As a consequence, today, fiscal policy is largely ineffective.

Then what can be done?

A big negative shock is hitting the firms. Some of the firms are fundamentally sound but will require external finance to make it through the downturn. The most important question now is: Can external finance be delivered fast enough and to the right places?

Some of the firms are going to die. There, what would be nicest is if they free up resources gracefully and frictionlessly. By and large, the labour market (that's dominated by the informal sector) works well: firms will shed people, wages will go down, the labour will be absorbed in new places. India has a fairly classical labour market. One key thing we need to do different is to not draft speeches where Indian firms are urged to not sack people; speechwriters should instead be singing paeans to the great flexibility of the Indian economy, that even exceeds the flexibility of the US.

Turning to the assets of weak firms, what is required is good bankruptcy process, or even before that, the control transactions through which brands, factories or companies are sold. To the extent that these control transactions take place, it is best. But for these control transactions to take place, the strong firms require external financing to buy assets.

In calendar 2009 and 2010, economic efficiency will be about the extent to which a discriminating financial system is able to deliver a breath of life of external financing to the good firms (while denying finance to weak firms and encouraging and enabling control transactions for their assets). We should do everything we can to increase the ability of the financial system to play these roles.

The Indian banking system is singularly ill-equipped for this role. In 2009 and 2010, most borrowers will look bad in terms of standard accounting data. Banks in India have a bias in favour of putting investment opportunities in the hands of firms with strong cashflow in historical data. Processes of banks are oriented towards looking back in accounting data and not forward in projecting the outlook for firms. But what will matter the most in 2009 and 2010 is getting working capital and growth capital to good firms which are currently not doing well.

In the big picture, a good financial system is one that is able to deliver low correlations between the cashflow of a firm and the investment of the firm. This issue looms large in thinking about 2009 and 2010. Achieving low correlations between cashflow and investment requires forecasting the prospects of firms instead of looking back at their accounting performance; it requires loans based on future cash-flow rather than loans based on assets. It requires brainpower, organisation culture, and a regulatory environment that is not found in Indian banking. On a horizon like 2009 and 2010 I am pessimistic about achieving change on these things.

Hence, the opportunity for public policy to make a contribution in handling 2009 and 2010 lies in non-banking finance. The positive contribution that policy makers can make towards 2009 and 2010 lie on three directions.

I. Removing capital controls

Removing capital controls will directly augment external financing. By `external' here, I mean financing that is external to the firm. In addition, foreign capital tends to come through more intelligent channels of intermediation such as private equity funds or securities markets, which helps improve the quality of use of this capital.

As an aside, capital inflows will reduce the pressure on RBI to sell reserves if they succumb to currency pegging. But that's not an important issue. The really important issue is to get a financial system that will be able to deliver external financing to good firms in 2009 and 2010.

II. Financial sector reforms

The second direction is the implementation of the Patil, Mistry & Rajan reports, so as to achieve a better functioning financial system.

A few days ago, Tata Motors resorted to borrowing Rs.2000 crore using fixed deposits: i.e. direct deposit taking from households. As Piya Singh points out in The Telegraph, Tata Motors is not alone in doing this. I asked why such a 19th century structure was being used, why it wasn't just a bond issue that was being purchased by households, and the answer was: because regulations interfere with doing an unsecured bond issue.

The right way to organise this transaction is as a bond issue. As an example, in the US, unsecured debt is listed and traded on exchanges. These debentures are issued with face value of $10 or $25, with a 5-8% dividend yield. For Ford and GM, these are trading under $5. Almost all unsecured debt (e.g. AT&T, Sprint, Kraft, etc.) is now available at low prices i.e. high interest rates. Here is an example of bonds issued by GM: their share, the bond and the offer document for this bond. For more on this, go to and type "XGM" into the search box. A household that believes these firms will make it through the downturn can buy this paper. Instead of households doing company deposits, this interaction should be done through public securities markets.

These are the sort of things that can and should be rapidly fixed. We need to urgently get the corporate bond market going, and solve myriad other problems on financial sector regulation, so as to get Finance in shape for performing the roles that are required of it in 2009 and 2010. As an example, there has never been a time when Chapter 7 of Raghuram Rajan's report, on the infrastructure for the credit market, was more important.

The time horizon required to make a big difference on the Bond-Currency-Derivatives Nexus, by implementing the Patil, Mistry and Rajan reports on this subject, is roughly one month. There are no difficulties in these financial reforms in terms of how voters will feel.

III. Economic reforms : the only effective counter-cyclical lever

Given that we do not hold the capability to do counter-cyclical monetary or fiscal policy, what tools for stabilisation do we have? If the root cause of our problem is the animal spirits of CEOs, and the damage that we take on private corporate gross capital formation when they lose confidence, then the most important lever that India has by way of countercyclical policy is : economic reforms. To the extent that domestic and foreign investors think that India is on the right track and that India is doing the right things, the willingness to invest will be greater.

This is both about doing the right things and not doing the wrong things. E.g. we dodged some bullets recently on issues like short selling or shutting down markets after terrorist attacks in Bombay: while wrong policy paths were carefully evaluated, in the end these paths were not taken.

I feel we have to work particularly hard on doing the right things in economic policy reform, for this is the only real countercyclical lever that we control.

It is interesting to look at this in a global perspective. There are $100 trillion of resources worldwide that are trying to get invested, and assets in numerous countries do not look so attractive. Alternatively, look at the world from the viewpoint of an Indian multinational. The prospect of expanding in many other countries is now less appealing than it was last year. In India, in contrast, the deep drivers of growth remain intact. There are very few countries which have the positive long-term growth possibilities of India. The key question is whether the State will do the right things so as to create the enabling framework of public goods to enable and support the rise of a mature market economy. If foreign and domestic investors are persuaded that India is on the right track of market-oriented reforms, investment can come about on a scale enough to matter for business cycle stabilisation.

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