‘The problem is in the financing of CAD’

Excerpts:

The current crisis is largely foreign-made — the unusual strength of the US dollar, and the unexpected increase in the price of oil. But, we have made the problem worse. For example, by advocating a rise in import taxes as a “remedy” to the CAD. This is neither necessary to address the problem, and is certainly not sufficient. The CAD was 1.9 per cent of GDP last year and 2.4 per cent in second quarter of this fiscal. It is likely to end up at 2.7-2.8 per cent this fiscal. Now, in a historical sense the CAD for a fast growing developing economies with a lot of catching up to do (as is the case with India) is 2-3 per cent of GDP; so, the CAD is near normal.

The problem is in the financing of this deficit. How did the financing problem come about, with a relatively normal CAD? Last year we received about $25 billion foreign portfolio inflows in the debt market and about $9 billion have flowed out this year. What we should be asking is why we got $25 billion last year, and why the large exit this year? Emerging economies are still receiving debt inflows, although not as large as last year. But why the large outflows?

A large part of the reduced inflow is due to the US Fed raising rates. The large inflow into India last year may in part be due to the RBI/MPC policy of keeping real policy rates extraordinarily high.

Recall that the MPC had stated that real policy rates should be around 1.25 per cent. In fiscal 2018, our real policy rates averaged 2.5 per cent (double of the MPC guideline), the highest since the 3.2 per cent level observed in 2003 (the repo rate regime started in 2002-03). Not only were Indian policy rates absolutely high, they were also comparatively high — the third highest in the world and just behind the two troubled economies of Brazil and Russia.

Did the economy require such high rates last year? Let us look at the fundamentals — inflation at 3.6 per cent, consolidated fiscal deficit at around 6.5 per cent of GDP, and CAD less than 2 per cent of GDP. Foreigners came in thinking that with the inflation rate so low and real interest rates so high, that the real interest rates were set to decline; but the MPC made sure they did not, and so they exited. Also, the 10-year bond yields galloped 150 basis points to above 8 per cent.

Note that in 2014 we had an inflation rate of 10 per cent, and bond yields at 8 per cent; we ended fiscal 2018 with inflation less than 4 per cent and bond yields above 8 per cent. So investors (foreign, domestic) exited, and have continued to do so.

The fundamental problem in our macro economy is that the central bank cannot seem to forecast inflation. And if it cannot reasonably forecast inflation, it will make policy errors. We have a MPC which is meant to control inflation.

The number one concern (as an analyst) I have is that the RBI with all its resources cannot even forecast three-month inflation. Everybody else has got the same information and their forecasts are better.

The (RBI) inflation expectations survey also needs to be looked into. I call it a junk survey/model. They keep using it. This time they didn’t want to raise rates for whatever reasons. Going by the past, they should have raised rates, but they said that short-term inflation expectations have gone up but long-term inflation expectations have declined; when they raised rates, they cited the opposite evidence.

This is now an open secret. Look at the power sector issue. Why cannot the RBI and the government (Power Ministry) solve this problem across the table? Why go to the court? So, there is a disconnect it seems.

The fiscal deficit is well in control. Everybody, including the RBI, had forecast that our fiscal deficit will expand in fiscal 2018 because of loan waivers, but it didn’t really expand. The GST revenues for March 2018 were not part of the fiscal deficit estimate for financial year 2018 — including it would have brought in the fiscal deficit to below the initial target of 3.3 per cent.

But, having emphasised the positives, I don’t want to give the impression that all is well. All is not well. And that is why I said this crisis is made outside of India, not made in India. Therefore, we cannot dismiss it, as we are part of the global economy.

I am looking at the questions exactly as you are. Take, for example, the exchange rate and compare it with those in other emerging markets. The refrain is that we are the worst performing Asian economy. But, you know the Asian economy is the best performing.

Singapore hasn’t had any inflation for a long time, Hong Kong doesn’t have inflation, and China’s is down to two per cent. The idea that we are the worst performing currency when you have Hong Kong and Singapore whose currencies have hardly changed.

Let us see how much of the problem from oil. We benefit from oil taxes. In terms of how we have reacted, I think we reacted badly — one is raising import taxes and second is asking oil companies to absorb a rupee decline in the price to the consumer. I have no explanation for this policy. It is not the right approach.

Rupee is a problem because of CAD financing. Now, what if I were to tell you that when you have realistic interest rates — , the RBI, by some magic, reduces the real repo rate — the currency will strengthen, there will be more capital inflows, end of story.

To reiterate, my plea is that we need to identify the problem. What is the problem? As far as pricing of oil I do not agree with the government decision. But, in terms of negotiating to buy the Iranian oil I am in complete agreement with the government. And even if it means some sanctions or whatever we will have to see, we don’t know as yet. My forecast is that we will be able to do something.

Globally, none of us can forecast what American President Donald Trump is up to. This is the uncertainty we need to face and think out of the box. And my recommendation is that capital flows go to countries that have realistic interest rate policies. High real interest rates show that you are not confident.

I am sorry to sound like a broken record. But it is useful here to compare what happened when NPAs were high in 1998-99. Real interest rate fell by about 450 basis points between 1999 and 2003, and given that we have the SLR, the banks have to keep an above normal amount of government security. And when your interest rate falls by 450 points your bank assets rise, and the share of NPAs falls.

Between 1998 and 2003, the GDP growth rate was 5 per cent or so except for 2003-04 when it was 8.5 per cent. But at the time of 5 per cent growth, NPAs were falling, inflation was staying at 4 per cent and interest rates were falling. Now let us take the record from when this government and the RBI first started recognising the problem of NPAs, and Raghuram Rajan correctly stated that we needed to correctly account for NPAs.

First we did correctly declare NPAs — so the numbers went up. It was a drain on the economy. And what did we do? Real interest rates between 2013-14 and 2017-18 went up by 430 basis points and NPAs have gone up by 500 basis points. There is no policy here that I am looking at, but basic numbers. I am not saying that if we would have followed a proper real interest rate policy that this would have solved the NPA problem. But it would have helped.

So we have a Insolvency and Bankruptcy Code, though not fully perfect, that is helping in solving the NPA problem. But when you have a credit meltdown, largely a result of the IL&FS crisis, we should have had the central bank coming out and soothing the nerves, but nothing like that has happened. We made a bad problem worse and we continue to make a bad problem worse.

I think as far as banks are concerned we have to go on a path of reducing government ownership in state banks. Absolutely a must, but we haven’t done that. I think we should be much more aggressive in cutting government ownership of banks, completely privatise Air India, and we should move to other aspects of modernising our economy.

Let us look at the politics and economics of it. The last loan waiver we have had was before the 2009 elections, and the agriculture production and weather prior to the waiver was very good. Yet, we brought in loan waiver when inflation was 9-10 per cent. This time, we had a drought in 2014-15, 2015-16, and this is only the fourth time in the Indian history that you have two successive droughts.

Whether one thinks demonetisation was good or bad we were hit by it in 2016. So three years of man-made and god-made challenges happened. Agriculture sector was hit badly by the weather and, at the same time, we have the problem of NPAs and real interest rates increasing, and slowing GDP growth

I am against loan waiver and the way MSP is being handled. But I acknowledge that these are very unusual times and farm incomes are low, and inflation has been kept low. What we have is the problem of income transfer to the bottom half of the population.

We have improved transfers with DBT and the Telangana model offers a realistic policy solution to the compensation of farmers. So I would not do loan waiver or radically increase MSPs, but rather do cash transfers a la Telengana.