The Reserve Bank of India (RBI) has refused to adopt a soft money policy once again, though the Indian GDP growth rate has decelerated to 4.5 percent, and despite cries for affordable money to fuel growth. Raghuram Rajan, the dapper Governor of RBI has stated that inflation is a greater concern than anything else. As students of economy know, inflation erodes the purchasing power and leads to a spiral of wages chasing prices. Inflation affects the export competitiveness of Indian products, and erodes India’s claim to global cost competitiveness. A major component of the Indian inflation scenario has been the high food inflation. This has hit the vulnerable sections of the Indian society, especially the daily wage earners, who are affected by only a partial inflation-indexing of annual salaries and lack of inflation-indexing of the daily wages.
The squeeze on real living conditions is contrasted sharply by the huge increase that has happened in the prices of real estate. Recent papers, for example, have been flooded with advertisements for apartments and villas that claim price tags of Rs 10 crore plus for downtown apartments and Rs 3 crore plus for apartments and villas in outlying suburbs, even in a conservative city like Chennai. The saga of galloping real estate prices against a backdrop of unsold housing stock is frustrating and enigmatic. There is no doubt that there is a huge element of speculation in the rapid increases of certain asset classes such as real estate and gold in India. Speculation, however, appears to be a larger cultural phenomenon, given the rapid fluctuations that occur in the Indian stock market and the fanciful nature of fancied stocks, euphemistically referred to as momentum stocks.
Banking on banks
Indian governments have conventionally treated inflation through fiscal policies, more specifically banking policies. Increase of interest and deposit rates on one hand, and mopping up of or release of liquidity into and from the banking system have been the specific tools. Deployment of these tools has led to alternate cycles of high growth and low growth, accompanied by low inflation and high inflation in the better times. The current situation, however, seems to be a more disparate combination of high growth and low inflation, set in a cultural background of speculative trends. Classic banking solutions are unlikely to provide the required solution. The other way of looking at this is in terms of demand-supply equation; the more goods and services are generated, the greater will be the price competitiveness leading to greater demand fulfillment with lower prices. As discussed earlier, the conundrum in India is one of more products and services at higher prices.
In India, the banking sector has played an enormous role, incomparable in any other country, of supporting the industry across a broad spectrum, playing a variety of roles. The banks have been the angel investors of sorts to set up, and support, micro and small enterprises. They have been lenders of first resort for medium scale enterprises unable to or unwilling to obtain private equity investments. They have been bank-rolling large enterprises in their expansion, diversification and globalization plans. And most importantly, they have been hugely risk-friendly in supporting gigantic infrastructure projects. Without the banking system, especially the national and nationalized banking system, industrial growth in India would not have been what it has been. Yet, the banking system has got in return been a specter of bad debts, non-performing assets and delinquent or defaulting accounts. It is a moot point if this high level of bad returns is due to the gross insufficiency of risk capital for the industry on one hand and the expedient dependence of the industry on the interest bearing loans on the other or due to a combination of poor industrial management, loose loan monitoring or high interest rate regime.
Expectation and speculation
It is perfectly natural and logical for the industry and bankers to have mutual expectations. However, if expectations are not based on solid forecasts, and if results are not reviewed against expectations, any transactional relationship moves into a zone of speculation. Speculation, as can be appreciated, is the act of forming opinions about what has happened or what might happen without knowing all the facts. Speculation is nothing but guesswork without a basis of facts; speculation is also engaging in a physical or financial transaction in the hope of a profit; the more usurious the hope of profit is the more speculative the transaction becomes. Expectation, on the other hand, is a belief that an outcome will happen because it is likely. Expectation is based on refined human capabilities of logic and rationality while speculation is based on primal human characteristics of greed or fear. It is important that economic and industrial management of India is based on sound expectations and not on shaky speculations.
It is perfectly logical for the experts and laymen to expect that the RBI will raise or lower interest rates, or tighten or liberalize liquidity each time the monetary policy is announced. It is, however, pure speculation (pardon the oxymoron!) if the stock market investors and operators indulge in massive selloffs or buyouts in anticipation of, or within minutes of, any particular movement in policy. It is important that all stakeholders base their judgments and actions on expectations, and eschew any preemptive or presumptive judgments and actions that are built on speculations. It is, therefore, commendable that Raghuram Rajan has been forthright in setting expectations on inflation and growth, and not fueling speculative trends. He discourages the widely held notion that low interest rates magically lead to high growth rates and advocates that the best way to promote growth is keeping inflation low. He is very clear, rightly so, that there is no tradeoff between inflation and growth. That said, India faces a threat from two hues of inflation, which hopefully will be addressed by authorities with similar objectivity and candor.
Real and unreal inflation
In any society, there cannot be a perfect match of demand and supply or of factors of consumption and factors of production. It is this mismatch that primes the drive for growth (potential demand outstripping physical supply) or leads the quest for competitiveness (physical demand lagging potential supply). The virtuous economic management seeks to develop and utilize factors of consumption and production to balance demand and supply at continuously increasing levels. The not so virtuous economic management seeks to tolerate inflation and curb consumption in times of short-supply of products and services. While this is a natural economic characteristic, proactive economic management and industrial management require that growth and competitiveness are always pursued as twin sides of the same coin. Clarity in fiscal and monetary policies set the stage for this. An integral part of this approach is the accessibility for continuously improving factors of production such as technology, talent and investments.
The economic mismatch generates real inflation as discussed above, but can be managed with emphasis on factors of production and other instruments of economic policy. However, it is the unreal inflation that tends to be a more dangerous scourge for the economy. Unreal inflation occurs when prices rule high, in some cases usuriously high, even when products and services remain unsold. The state of real estate mentioned in the beginning of this blog post (threefold increases in real estate prices when more than two-thirds of housing stock is remaining unsold, as an example) is an example of unreal inflation. There could be several other examples such as luxury hotel rooms being pricey despite low occupancy, luxury brands commanding unearthly prices or leading smart phones costing more than computers despite increased competition and lower per manufacturer sales. The unreal inflation is a fight between firms with erstwhile monopolies and deep pockets and the new generation resource constrained firms with follow-on products. In the unequal tussle, more often than not, the economy and society tend to be squeezed in and lose out.
The discussion on inflation and speculation as well as on real and unreal inflation brings forth several philosophical issues and guideposts. Firstly, it is clear that there should be a healthy balance between risk capital and borrowed capital in an industry so that each firm optimizes its cost of capital (disregarding for a moment the invisible and long term cost of equity capital). Secondly, the industrial comity, investor community and the banking sector must anchor their transactions around expectations rather than on speculations. Thirdly, the balance between demand and supply on one hand and the factors of consumption and those of supply must be dynamically optimized, with focus on continuous growth and competitiveness. Fourthly, economists and industrialists must learn to differentiate between real inflation (which is inescapable but can be managed cyclically) and unreal inflation (which is irretrievably erosive and needs to be rooted out). Fifthly, and most importantly, economic and industrial policies require a culture of trust, transparency, forthrightness, logic and rationality amongst all the stakeholders that consider growth and competitiveness as two sides of an integrated economic and industrial strategy.
Posted by Dr CB Rao on February 2, 2014