Past four weeks were a roller coaster time for not just USDINR traders but also for us “experts”.
Past four weeks were a roller coaster time for not just USD-INR traders but also for us “experts”. Right after the Q2FY18 GDP numbers got released, around end August, there was sharp rise in 500/1000 word columns in all forms of media, proclaiming how Indian economy is spiraling downward and why GoI and RBI are not taking steps to arrest the economy from the tailspin. Social media was not to be left behind, even a 140 character was not enough to tame the spirits of “extrapolation”, buzzed with dire forecasts for Rupee, stock markets, economy and even for NaMo govt for 2019 elections. Many suggested ways to regain the lost paradise by urgently using the magic wand of:
1) Spend more and push the fiscal deficit higher
2) Lower repo rate further. Some even suggesting cut rates so deep that real rates turn negative
For many common folks it might be intriguing that how come for almost every problem the economy faces, suggestion are the above two remedies. It is refusal to learn from economic history and a kind of lazy economic thinking that leads one to suggest the above measures as solutions to most economic ills. However, it does not mean that there is no merit in the above two actions. There are times when Government has to stand against the cycle and pump prime the economy, because the economic engine has suffered a cardiac arrest. Those times are not so often as is made out to be. Like a patient if a person suffers cardiac arrest so often, then it’s not CPR which is the solution, it’s a change of heart that is needed.
The effective inter-bank borrowing rate in India has come down from 10.25% to 6.00%, reduction of 425 bps, over the past 4 years. Yet “experts” complain that it is higher cost of borrowing which is holding back investments. Cost of capital is a balancing act between needs of savers in financial assets and of borrowers. No central bank should fine tune the rates without considering the trade-off. The trade-off is also between impact on growth through credit off take and macro-economic stability, through FX rate and migration of gross savings from physical to financial assets.
I will delve a bit deeper into the sectorial credit growth in India. Credit off take by micro, small, medium and large enterprise comprise ~40% of non-food credit. Credit growth of micro and small enterprises peaked around 24% y/y rate around January 2014, around the time, when effective rates in money market were peaking. Since then they have decelerated systematically to below 0. Credit to medium size enterprise too peaked by mid-2013 and since then have been on a downhill. Credit to large enterprises peaked by mid-2011 and since then have been on a downswing. All the three time series show a sharp deceleration post demonetisation. However, since January 2017, there has been a notable improvement in momentum in all three times series. Credit growth of small/micro enterprise and large enterprise have witnessed sharp improvement and now at or above zero line.
Even if I accept the “lag” in credit growth and cost of funds, but even then there is little visible correlation between repo rate/call money rate and credit growth in the above sectors. Intuitively there has to be a relationship. Any corporate finance executive would tell you that cost of funds matter but cost of funds in itself is not a sufficient condition. Even within cost of funds, cost of borrowing of a corporate is function of credit spreads too- how much the lender is looking to charge for his credit worthiness. Anecdotally we know the investment/credit binge of corporate prior to 2012, for nearly a decade, lead to many bad capital allocations. Sour balance sheets have pushed up the credit spreads of the Indian corporates, especially the ones outside the services sector, where the binger primarily occurred. There is little RBI can do about the credit spreads, through repo rate or CRR. For example, if a stressed construction company is borrowing at 15%, it is paying 900 bps as credit spread (15%-6%).
Since 2011, global economic growth slowed down and even consumption growth in India slowed. The slowdown in both these engines, coupled with investment slowdown caused capacity utilization to fall. Low capacity utilization and high credit spreads may be more responsible for low credit off take by the industrial sector, who account over 40% of the aggregate credit growth in India.
Credit off take of the services sector accounts for nearly 25% of the gross non-food credit. Within services sector, the major sub sectors are: tourism & hospitality, professional services, wholesale & retail trade, commercial real estate and other services. All of these time series have witnessed the jolt after demonetisation. However, almost all of them show little correlation with RBI’s cost of funds. India’s real estate had become bubble long back and part of the growth in NBFC lending was to this sector, through various means. A slowdown in lending to the real estate was inevitable.
Now turn attention to consumer lending. Consumer credit’s share is little over 21%. It continues to log impressive growth of 15/16%. Pre-demonetisation this part of the economy was witnessing growth closer to 20%. There is a visible inverse correlation between cost of inter-bank lending and retail credit. Credit growth bottomed out in 2013, around 11/12%. As CoC tumbled in the inter-bank market, credit growth improved to nearly 20%. Common sense indicates there are more factors apart from cost of credit that positively drives retail credit growth. It can be factors viz,: employment growth, wage growth, credit penetration (in India, the shadow banking sector has done an excellent job of disbursing credit to many untouched and unbanked sectors. Even the Fintech sector is playing an active role), consumer expectation about future etc.
Finally, credit to agricultural sector, which is around 13% of gross banking credit being disbursed outside the priority sector. Credit growth used to be around 15% pre-demonetisation but after demonetisation it has decelerated on a month on month basis to 7%. Once again, intuitively one can understand that there factors apart from cost of money which affect the demand for credit from the sector. One of the factor which comes to mind, almost immediately, is seasonal rains or lack of inclement weather.
To sum it up, one can argue that RBI has done enough by lowering the cost of funds in the inter-bank segment to support growth. Factors which are still have hamstrung growth are outside the scope of cost of capital. Therefore, lowering repo rate further would have little economic benefit.
From benefit, let us focus on cost. Indian government is working on policies to channelize the savings of Indians from physical savings to financial savings. One of the three criticisms faced by policymakers for disproportionately high physical savings over financial savings are:
1) Real interest rates are negative: There is little or compensation for savers to park their money in financial assets. Inflation, on average has been much higher than post tax returns on financial assets. Then why should an Indian bother about financial assets. It is no surprise, that Indians love gold. Gold is one currency, which Indians are allowed to own legally, inspite of capital control, and which has been in a nearly 100 year bull run, thanks to failed economic and fiscal policies, which has caused Rupee to become so weak. For the first time, RBI has formally anchored the value of Rupee by targeting positive 200 bps of real rates. Decently positive real rates have helped savers to look at financial assets over hard assets to park their surplus
2) Large unbanked population: Over the past few years, banks and shadow banks, along with Fintech companies have spread their reach to previously unbanked or under banked parts of the population. Spread of JAM, Jandhan, Adhaar and Mobile and Digital India is helping accelerate the revolution.
3) Significant size of informal or black economy and corrupt economy: Government has taken numerous steps to formalize the Indian economy and make it cleaner. GST is a major catalyst. However, there is a substantial cost involved. Cost can be political, as vested interests who benefitted from the old regime, hit back and try to block the reforms. Cost can be economic, as consumption and investment is impacted. However, I welcome the resolve of our respected Supreme Leader Shri Narendra Modi and his team, in face of such significant opposition.
Adequate compensation for savers in financial assets for risk of inflation is not just important for higher financial savings but it is also important to ensure that we continue to receive the share of savings from foreign investors. A foreign investor is not exposed to domestic inflation through cost of living but he is exposed to inflation through its impact on the currency. Inflation is a loss of purchasing power of a currency. In order to restore that purchasing power, not only inflation have to be under control but also compensation for the inflation, real interest rates have to be kept positive. A currency which has consistently negative real rates is vulnerable to devaluation, like Rupee has faced so many times since Independence. A weak currency is a major deterrent to foreign investments. Therefore, a positive real rates and low inflation policies are important to not only churn more domestic savings towards growth of the nation but also pull foreign savings towards India. However, more savings we pull from the world, the more demand we leak into the global market, through current account deficit. But not current account deficits are bad. I will explain this in a separate article, as it requires me to dispel a lot of misconceptions surrounding capital inflows and trade.
From interest rates, let us turn our attention to fiscal policy. A quick calculation on the quarterly GDP data on nominal GDP shows that government expenditure has contributed 200 bps to growth in nominal GDP since the trough of 2013, almost fully compensating the loss that occurred from slowdown in private investments. Consumption growth was contributing between 800-900 bps to nominal GDP before demonetisation is now down to just over 500 bps. Government has already reached 96% of the budgeted deficit for FY18 as they front loaded the expenditure. GoI facing shortfall in capital receipts by way of lower receipts from telecom sector, dividends from PSUs and dividends from RBI. The total shortfall could be as high as 65,000-70,000 crore or 0.5%. I expect GoI to expedite asset sales and strategic divestments to compensate for the shortfall to keep the GFD around 3.2%. The consolidated fiscal deficit, center and state combined is expected to be around 6%, which is one of major reason why rating agencies have shied away from upgrading India’s sovereign rating.
Steps being taken to formalize the economy and lower corruption would lead to higher share of national income for the government, by way of taxes and other forms of revenues. As a result, over the medium to long term, GoI can sustain higher expenditure without having to compromise on the overall fiscal deficit. At the same time, GoI has paid keen attention on quality of fiscal expenditure, which was neglected under the UPA. As a result, fiscal deficit is no longer as inflation as it used to previously. All in all, GoI has little room for short term expansion of its fiscal borrowing, without triggering an adverse market response on Indian bond yields.
Over the month of September, it was not only the “experts” who panicked, even Rupee traders too panicked. USDINR which traded as low as 63.80 in early September, depreciated to nearly 66.00 levels. I believe it was significantly lopsided positioning which triggered an over-reaction. Long positions in Rupee was so bloated that the provocation from uptrend in USD in overseas market, coupled with fear of fiscal and monetary hara-kiri back home, triggered the sharp fall in Rupee against USD. However, the above chart shows how even during such a stress, Rupee performed better than its peers, a sign of a fundamentally strong currency.
I am delighted to see RBI not buckling under pressure from media and columnists and not even the government. RBI stuck to its guns in its last monetary policy and maintained a neutral stance in its policy. It cautioned the government against fiscal adventurism. Governor said that RBI perceives the economy’s loss of momentum as transitory. At the same time, the newly constituted PMO economic advisory council recommended government to stick with its fiscal deficit target. Two major policy levers, where India has bungled up many a times in the past, by trying to score some cheap short term gains, is not going to be case now under the new government. Rupee bulls should take comfort, which the macro story around Rupee: adequately positive real rates, low inflation, structural reforms, prudent fiscal policy and high political stability is not going away.
Hence, it is no surprise that USDINR, which had shot up from 64.00 to nearly 66.00, is now about to open Monday morning closer to 64.60 levels. Yes, we can expect RBI to step in and offer resistance to further Rupee appreciation. However, Rupee is expected to trade strong due to a combination of softening US bond yields, impasse over Trump’s tax plan and local Rupee buying by FPIs and exporters. We can see a test of 64.20/30 levels over the medium term.
NOTE: The views expressed are those of the author and not necessarily of Financial Express Online.