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.
Philosophical
issues
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
