Why I am against any rate cuts at this moment?

There has been a lot of chatter, pleading, begging, hectoring, bullying and also inane hoping in favour of a rate cut by our RBI governor. Each fortnight every man on the street confidently predicts that there will be a rate cut. I am reminded of my father who predicted each years school exam question papers by pointing out each question as likely and very important.

However, I being the dogmatic and the contrarian stand firmly against any rate cut at this moment. However fortunately I do have some reasons in support of my stand, other than the usual one being “copper the crowd”.
Before I go forward, let me explore the various reasons the cut-mongers are forwarding. One of the most vocal and loud voices is from the government itself. It argues that a rate cut will inject liquidity into the economy, fuel credit expansion and bolster growth. Another section, equally astute argue that a rate cut will have the added implication of “rationalising” the cost of capital. In turn it will make many, now distressed borrowers into prime assets, reducing NPA of the PSU banks and improving hold your breath, credit expansion.

Another class argues that this will again bring in the risk taking animal spirits back into the economy. For good measures it will also improve infrastructure spending for the private players. Needless to say, many of the infrastructure contractors are having a tough time maintaining their cash flow on one hand and juggling the bureaucratic maze, fogginess in regulations etc on the other. All in all, the argument is broadly in line with the benefits of credit expansion.

What are the biggest problems staring ahead of us, right now? The biggest problem is a lack of economic growth. But this is also a very limiting answer. What kind of growth do we really need? Does the growth of 2003-2008 sound extremely desirable, especially in the wake of the cockroaches that are coming out of the various closets?

Let me offer an answer. We need growth, no doubt. Let that be a two digit growth- I will be the first person to call for policies which drive them. But definitely a mindless credit expansion is not the way to go forward. Let us tease out the various ideas here. Growth and its nature needs to be determined going forward for our policymakers. What do we really desire. I cannot say I have all of its facets down pat, but I definitely have some ideas:

1. We need a high technology driven growth. A growth which is fuelled by genuine innovation improving the efficiency of Indians and others. Our incremental capital output ratio since 2003 to 2011 has hovered around 4. This implies that Rupees 4 of capital was required to drive the output of 1 Rupee. Not a great number, but it looks stellar when compared to the ICOR of 2014. It is at a dismal 7. This ratio has to be reduced and this is only possible when real innovation comes through. A higher or lower cost of capital is not going to prove any difference here purely because the real engines of innovation- our MSMEs are anyway not considered credit worthy by our banks. What is needed is to encourage more venture capitalists, angel investors etc.

2. Any country can post stellar growth numbers if reported in a currency which is depreciating fast. Let us report our numbers in Zimbabwean dollars, we can have a mind boggling growth rate. This growth rate however is not because we Indians suddenly stopped reproducing and started producing more. This growth rate will look enormous simply because the “unit” which we have chosen to express ourselves itself is falling at a high rate. To rationalise the perspective, would we want an inflation-driven growth?

When I term a growth as inflation driven, it effectively implies that the total economic value added in the country is consistently and far less than the reported gross domestic product of the country. This is because GDP of a country is expected to reflect the total economic value added at the first place. If it is consistently beating the real fundamental then definitely it’s the inflation which is bufferring up the ship .

What about the usual adage that a little bit of inflation is always a positive thing for the economy?, you may ask. Sure enough, but we have so much in our country right now that we can happily export some of it and yet have more than we need.

3. The most sanest of ideas in favour of a rate cut is that of infrastructure boost. The current cost of capital is definitely a death bugle for many of our fine(and often fine paying) infrastructure companies. They were squeezed by a lethargic government and high cost of capital. Project overruns and fast deteriorating balance sheets are the welcome boards which greet any infrastructure CEO each morning.

However the bigger question is, is this a band aid on the problem or a real excision of the cancer? I argue that the real problem is not high cost of capital but the lack of capital. Each infrastructure project has a horizon of 20-25 years in the books of the companies. Bridges etc can be included as 40 years assets. However a bank financing these projects invariably has to match the asset and liability duration for prudential loan servicing. However by the norms of RBI long duration loans are not allowed to be issued by the banks. The logic goes that the banks are not financing or venture capital institutions but rather short term financing businesses.

In these contexts of numerous paradoxes and the proverbial chicken and egg situation- lowering the cost of capital wont be as helpful as opening up the entire bond market will be.

Asset-Liability mismatch is a clear problem and its only solution is financing has to move away from banks to properly functioning bond markets.

4. One of the biggest issue which compelled me to write this article is the problem of inflation. As individual investors the greatest problem we have is not lack of growth. It is inflation. Every dollar you earn from your paycheque or your investments is subjected to the swords of taxation. However taxation like all matters of devil need not be always visible, tangible and directly observable. You can have invisible, intangible and indirectly observable taxation as well. We know it by the name of inflation. To understand the implication of the same, consider the usual discounted cash flow mechanism to calculate the net present value of any investment avenue. At 8% real growth rate and another 8% long term historical inflation rate. This makes our index return a 16% compounded growth rate over the long term. This in essence brings a benchmark on all other investments we make. 16% in index will be our opportunity cost. This renders anything less than 24-25% less than desirable. An owner-manager with such business dynamics will find doing business tantamount to running on a treadmill. Lots of huffing and puffing but zero displacement. And needless to say a vast majority of our equity markets and ergo a common investors portfolio will consist of the businesses with their return on capital ranging from 18-25%.

Is it any surprise that in spite of capital markets having a history of more than 100 years in India we Indians still buy gold and not businesses? We have the answer even if we don’t know it. Between government and inflation nothing is left for us.

As in biology, survival first- growth next: similarly purchasing power survival first, hence the predilection of Indians towards purchase of hard assets: gold, silver, real estate etc.

Coming back to our original point if owner manager finds running a treadmill at 24-25% return on capital then surely the minority shareholders will find his capital not sweating enough for him. He may feel rich but he definitely wont be rich.

RBI thankfully has for the first time inflation targetting its core concern(which should be). I salute and thank Urjit Patel and Raghuram Rajan for bringing this pragmatism. There has been quite a bit of chatter and I hope a chatter rooted in genuinity, that Finance Ministry too supports inflation targeting and intends to make it a statutory responsibility. If that is so then it will be necessary to stick to the goals of 6% inflation by Jan 2015 (which seems to be slightly challenging) and 4% inflation by Jan 2016 (which seems to be genuinely difficult to achieve) which Dr Rajan earlier in December 2013 announced. In that light, the cuts should be indefinitely postponed; reforms of bond markets, capital markets, infrastructure norms accelerated and FDI norms relaxed.

Rate cut is no solution. At least I fail to see it as one of any of the problems we Indians are facing.


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