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Dosa Economics, Avoiding Brazil Steroids, Dissing Tariffs and Letting Banks Revalue Assets: The Raghuram Rajan Speech

Rajan’s recent speech in Delhi offers great tidbits to consume and see how the RBI is thinking.

Learning from Brazil: Don’t Take the Stimulus Steroid

Perhaps Brazil offers a salutary lesson. Only a few years ago, the world was applauding the country’s thriving democracy, its robust economic growth, and the enormous strides it was making in reducing inequality. It grew at 7.6 percent in 2010, and had discovered huge oil reserves which the then President Lula likened to “winning a lottery ticket”. Yet the country shrank by 3.8% last year, and its debt got downgraded to junk. Growth will be no better this year. What went wrong?

Paradoxical as it may seem, Brazil tried to grow too fast. The 7.6 percent growth came on the back of substantial stimulus after the global financial crisis. In an attempt to keep growth high, the New York Times says the central bank was pressed to reduce interest rates, fueling a credit spree that overburdened customers are now struggling to repay. Further, Brazil’s government-funded development bank hugely increased subsidized loans to corporations. Certain industries were favored with tax breaks while price controls were imposed on gasoline and electricity, causing huge losses in public sector firms. Petrobras, the national oil company, which was supposed to make enormous investments in oil drilling, instead became embroiled in a corruption scandal. Even as government pensions burned an ever larger hole, budget deficits expanded, and the political consensus to narrow them has become elusive. Inflation touched double digits in the 4th quarter of 2015.

While the Brazilian authorities are working hard to rectify the situation, let us not ignore the lessons their experience suggests. It is possible to grow too fast with substantial stimulus, as we did in 2010 and 2011, only to pay the price in higher inflation, higher deficits, and lower growth in 2013 and 2014. Of course, India is not in the same situation today. Given the inhospitable world economy and two successive droughts, either of which would have thrown the economy into a tail spin in the past, it is to the immense credit of the government that we have over 7 percent growth, low inflation, and a low current account deficit. But it is at such times that we should not be overambitious.

Emphasis mine.

My take from this is that Rajan is wary of a government spending led recovery in the economy, and that’s what he meant by growing too fast. The fact is that the government can subsidize growth – for example, it can spend money (on roads, bridges, or like China did, on breaking bridges and building them back again) which will give money to people. Many times, the money spent results in no productive work or assets – like much of NREGA or the food subsidy in India when they buy rice and wheat and leave it to rot. That kind of spending will show growth when you spend money; since that spent money is added to GDP.

But over time, since no productive assets are being created, the more money just results in higher prices (meaning: inflation).

All government spending of the sort – including the favouring of some industry through tax breaks or through price controls, or even through unmanageable pensions, has an impact on creating inflation.

So, if the government’s going to have to spend and will widen the deficit, then we will see lower growth and higher inflation. Rajan warns that this measure will only slow future growth.

Don’t Ignore the Deficit While Pushing For Growth

There is a public discussion of whether India should postpone, yet again, the fiscal consolidation path it has embarked on. Clearly, the Government will balance various compulsions in taking its decision. But a number of facts are worth pointing out:

The consolidated fiscal deficit of the state and centre in India is by far the largest among countries we like to compare ourselves with; presently only Brazil, a country in difficulty, rivals us on this measure. According to IMF estimates (which is what the global investor sees), our consolidated fiscal deficit went up from 7 percent in 2014 to 7.2 percent in 2015. So we actually expanded the aggregate deficit in the last calendar year. With UDAY, the scheme to revive state power distribution companies, coming into operation in the next fiscal, it is unlikely that states will be shrinking their deficits, which puts pressure on the centre to adjust more.

Some say that fiscal expansion is necessary to generate the growth needed to put our debt to GDP ratio back on a sustainable path. This is a novel argument. Ordinarily one would think that a government should borrow less, that is, run lower fiscal deficits, in order to reduce its debt. But there is indeed a theoretical possibility that the growth generated by the fiscal expansion is so great as to outweigh the additional debt that is taken on. Unfortunately, the growth multipliers on government spending at this juncture are likely to be much smaller, so more spending will probably hurt debt dynamics. Put differently, it is worth asking if there really are very high return investments that we are foregoing by staying on the consolidation path?

First, this is a revelation. While the fisc is less than 4% at the central level, the state deficits push us over the edge at 7.2%!

Second, Rajan warns us that we won’t fix our debt-to-gdp ratio by fiscal stimulus. This is correct. But maybe the goal is NOT reducing debt-to-gdp – which according to me is an absurd measure. What we should care about is: What percentage of your income are you paying out as interest on your debt? For india the answer is more than 30% and that should simply not be acceptable.

In fact what Rajan should be saying is: there is no reason to think that that government can’t spend more without attempting to, at the same time, earn more. Why can’t they expand and build more roads, while at the same time, sell stakes in public sector companies (even if they are at a low rate, through a drip selling process)? Why can’t they recapitalize banks by only putting HALF the capital they need, asking them to use IPOs for the rest – this will be a great thing at these low stock prices.

On the Bond Markets: They Will Punish You For Overspending

Of course, the common man does not really care whether we stay on the consolidation path or not. But the bond markets, where we have to finance over ₹ 10 lakh crore of deficits plus UDAY state bonds, do care. Deviating from the fiscal consolidation path could push up government bond yields, both because of the greater volume of bonds to be financed and because of the potential loss of government credibility on future consolidation. It was James Carville who said “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” The Government understands the importance of bond market confidence, but I wonder if the economists debating in public put adequate weight on it.

Higher bond yields means higher interest payments as a % of revenues. And if there’s no corresponding rise in revenues, participants will sell government bonds and increase bond yields.

The Dosa Economics

In what is a brillant demonstration of inflation, Rajan explains why higher interest rates (coupled with higher inflation are bad). His speech might be complex to understand (it was said, not written) but here’s the story:

  • A common refrain is that falling rates hurt retirees who only depend on their savings returns. But Rajan calls that out.
  • Take two cases: 10% interest rates with 10% inflation,
    or 8% interest rates with 5.5% inflation.
  • You have 100,000 rupees, and a dosa is Rs. 50. So you can buy 2,000 dosas today.
  • What about a year later?

Case 1: You get 10% return after a year, or Rs. 10,000. Your principal meanwhile is also returned, so you get Rs. 110,000. Infaltion is 10% so the Dosa now costs Rs. 55. How many dosas can you buy? Answer: 110,000 / 55 = 2000 dosas. Nothing has changed for you. (Except in real life you have to pay tax etc. but let’s leave that aside)

Case 2: You get 8% return, or Rs. 8,000. Plus the principal back, so Rs. 108,000. And inflation at 5.5% means that dosa is now 52.75. How many dosas can you buy? Answer: 108,000 divided by 52.75 = 2047 dosas. That’s even higher than you were able to buy last year!

Dosa Economics


This is because the “real ” return is positive. Savers need to understand that real positive returns make them richer, even if the interest amount is lower. People should not be “living on interest” – indeed, they should be looking the cost of what they get to buy, and eat into principal when needed, because the lower interest rate and even lower inflation means a better system for them in the future.

Finally! A Sane Thought On Silly Raising of Tariffs

Let us turn to the industrialist. At a recent conference, I met a businessman who complained that his business was getting torn to shreds by imports. He was lobbying for safeguard duties. When asked for evidence of unfair competition, he said his revenues had not grown at all, with his volume growth barely offsetting the price decline for his product. While commiserating with him, I said lower input costs must be a boon, because commodity prices have fallen even more sharply than output prices. He grudgingly agreed they had helped. When asked about his profits, he eventually admitted they were at an all-time high. But nevertheless, he said, we need safeguard duties because foreigners are dumping below cost! Put differently, businesspeople complain about low output price inflation, but the inflation that matters to them is the inflation in their profits, which is higher. For instance, analyzing 2nd quarter results for non-financial non-government corporations, we find that while revenues have fallen by 8.8% year on year, input costs have fallen by an even higher 12.4%, so that gross value added has gone up by 10.8%.

Clearly, there are industries in trouble. We should, however, be particularly careful about raising tariffs at a time when costs are falling everywhere – aside from the inflationary impact, for every happy domestic businessman whose prices are raised by the imposition of tariffs on imports, we have an unhappy domestic businessman whose costs are raised by the very same tariffs, as well as unhappy consumers.

For a head of a central bank who has just shown us that steel – which is demanding the maximum tariffs – is the most indebted sector and likely to hurt the banks the most if there are defaults, this is a brave thing to say. And he’s right of course – the imposition of such duties and import taxes hurts us more than it helps us.

Banks Must Recognize NPAs,  Can Revalue Assets And It’ll Add To Capital

Banks are afraid of the NPA label because it hits their capital ratios – every NPA requires a provision that leaves them with lesser free capital and therefore the ratios look even worse. The answer to this, is to raise capital as a buffer to such recognition, and to recognize bad loans when they can be. Otherwise, we become a zombie banking economy.

If loans are written down, the promoter brings in more equity, and other stakeholders like the tariff authorities or the local government chip in, the project may have a strong chance of revival, and the promoter will be incentivized to try his utmost to put it back on track. But to do all this deep surgery, the bank has to classify the asset as a Non Performing Asset (NPA), a label banks are eager to avoid. Alternatively, instead of deep surgery, the banks could apply band aids, they could “extend and pretend”, lending the promoter the money he needs to make loan payments. The project’s debt obligations grow, the promoter loses further interest, and the project goes into further losses.

Also banks, largely the public sector ones, have a lot of assets they carry at “cost” value. Canara Bank, for instance, has apartments in Cuffe Parade in Mumbai – massive, 2,000 sq. ft. apartments at a place where you might find buyers at Rs. 100,000 per square foot (each apartment is Rs. 15-20 cr.). But since they carry it at cost, and the apartments were acquired for a few lakhs in the 1960s, the assets are held at nearly no value.

Of course, the banks could sell these assets and realize the cash, which adds to their balance sheet, but large sets of such assets can’t be sold in a hurry either.  So Rajan has a solution:

The Finance Minister has indicated he will support the public sector banks with capital infusions as needed. Our estimate is that the support that has been indicated will suffice, especially when coupled with other capital sources that are usually available to banks. Our various scenarios also show private sector banks will not want for regulatory capital as a result of this exercise. Finally, the RBI is also working on identifying currently non-recognizable capital that is already on bank balance sheets, such as undervalued assets. The RBI could allow some of these to count as capital as per Basel norms, provided a bank meets minimum common equity standards.

I have prescribed a solution which banks can do: Sell the assets to each other and “lease” them back. All they have to pay from their pockets is the government taxes on registration. I think the RBI allowing banks to reassess assets will be problematic – who will ensure transparency? But a sell and lease back transaction can be made more transparent via auctions. 

And He Ends With Nigeria 🙂

Many of you must have received an email from me saying that the RBI had concluded a pact with the IMF or the British Government to take over the gold found on pirate ships in the sixteenth century, sell it, and give the proceeds to deserving citizens like you. In return for a small transaction fee of ₹ 20,000, the email goes on, I would be happy to transfer the sum of 50 lakh rupees into your bank account. Without pausing to think why I need ₹ 20,000 when I supposedly have ₹ 50 lakhs of your money with me, some of you send ₹ 20,000 as requested into an untraceable account. My office then gets repeated phone calls from you asking what happened when the ₹ 50 lakhs does not show up. The truth is that we are all gullible – no amount of warnings that the Reserve Bank does not ask you for your money helps. The central theorem of financial literacy is “There is no such thing as a free lunch”. In the context of financial investments, it can be restated as “There is no return without risk”. We need to imprint these two statements in everyone’s head and we intend to roll out campaigns to do so.

I’ll add to this. Replace RBI by QNet, or any of these random MLM schemes, or ULIPs. Mr. Rajan may not agree with me, and he can’t really be seen dissing ULIPs. They have positives, one of which is to serve a solid social need of parting a sucker from his money. But the concept is all the same – if something looks too good to be true, it is.

What Happe
ns Tomorrow?

Tomorrow at 11 AM, Rajan has yet another monetary policy announcement:

While I’ve added a lot of my views, here’s what my thought process is:

  • I had a strong indicator that RBI would cut rates now. I don’t know why, but all the data said it was okay to do so – inflation isn’t too bad, banks have been slowly cutting rates, there is definite fiscal consolidation going on and finally, everyone knows that foreign capital will flow in if we cut rates not if we keep them high. (it’s a theoretical disaster to discuss this with economists, who argue that debt returns drive capital flows. A casual look at the data shows us that it’s indeed the opposite, but why ruin a good argument with real data?)
  • In my mind a 0.25% rate cut was, and still is, a good idea.
  • But could Rajan wait till the budget? My mind tells me that is silly; why would you say you’re basing your monetary policy strategy on inflation and growth, which both seem to find solace in lower interest rates now….but then decide to wait for the budget announcements to see if inflation will creep back in later?
  • Or does he buy the argument that lower rates would continue to drive away foreign capital?
  • Rajan seems okay with banks taking hits and raising capital, which he says is available. So if banks recognize NPAs they won’t be “evergreening” them through lower interest rates.
  • Given all of this I still think there’s a good chance of a 0.25% rate cut. The last cut was in September, and February is far enough for another one.

Note: I’m guessing. This is not a science. Mr. Rajan is a smart person but monetary policy involves more than just him. We don’t know what other inputs he has. I’ve been wrong before, and I could easily by wrong tomorrow. Don’t trade on this opinion, please.