Where are we and what comes next?
Dr Ajay Shah
Good quality data about Indian business cycle conditions can be scoured from data related to non-finance, non-oil (n-f, n-o from here on) listed companies. In other countries too, people exasperated with official data have fallen back on the database of such companies.
Business cycle conditions can be effectively gauged from margins. Difficulties in profit margins are a hallmark of a difficult business cycle because the production cycle is maintained by sacrificing margins. Profit before depreciation, interest and tax divided by net sales (PBDIT/ net sales), shows that in 2002-08, the operating profit of n-f, n-o companies went up from 19 per cent to 23-25 per cent. This fell to around 19 per cent in 2011-12, reflecting the downturn. There was a slight surge in the demonetisation quarter and the following quarter, which is slightly baffling.
Contrary to the current state of n-f, n-o firms, finance professionals working in the stock market are using a method called “Nifty-implied earnings”, which is wrong, as it artificially over-inflates the apparent earnings of the Indian corporate sector.
Investments & Exports
In the context of Indian GDP, the action is taking place in investments and, to an extent, in exports. Net exports are small compared to investments (which are 30-35 per cent of GDP). So, investments are indispensable for the analysis of the economy. Here, instead of the CSO-compiled data on GCF, we must use the CMI Capex data, which is the master database of every project in the country, be it related to industry, infrastructure or housing. We take this microdata and construct three aggregates. First, we consider projects that CMI classifies as “under implementation”: this tells us the extent to which the infrastructure investment logjam has been cleared. Second, we consider the total value of the projects under implementation: this tells us about the demand side of the economy. Finally, we look at private sector projects announcements: these, in a way, reflect business confidence and are a telling sign of the state of the economy.
The data shows that around 2011, private infrastructure investment decreased in comparison to public infrastructure investment: as a corollary, the quality of investment also fell because private projects are bound to be better than public projects. By 2011, total worth of all the projects in the country stood at `100 trillion and after that we were stuck in nominal terms. Private infrastructure investment reached about `45 trillion in 2011 and started declining in nominal terms; the situation looks worse if you take in inflation. Latest data shows that total private infrastructure investment is around `24 trillion.
As far as exports go, total goods and services exports have languished at around 0-10 per cent from the highs of around 30 per cent.
Inflation & Monetary Policy
There are 3 components of the Indian CPI: 50 per cent of it is food, 25 per cent tradables and the rest non-tradables. We get very good proxies for the food and tradables components. The y-o-y WPI inflation data shows that food inflation has been low. Demonetisation also had a significant impact on the agriculture sector and, perhaps, this is one of the reasons for the low food inflation. Tradables inflation, measured either by taking WPI non-food, non-fuel inflation, or by multiplying the United States PPI with the rupee-dollar exchange rate, is modest.
The government’s intent of printing less notes is just an opinion about what the world will be because it can’t control the public’s demand for cash. Post withdrawals, banks are obliged to refill ATMs. If banks seek cash from RBI, it is obliged to supply the banks. The government has no say in the amount of cash that the people of India want. It remains to be seen where the supply curve of money will be, but after a disruption like demonetisation people might hold more cash in hand. After 2009, RBI sharpened its focus on inflation and raised rates from 4-5 per cent to 8-9 per cent. Since then, inflation has been under control and policy rates have decreased. But one should be more skeptical about this data. RBI has seven different monetary policy instruments, of which only repo and reverse repo rates are publicly announced. There are six other monetary policy instruments that RBI manipulates daily and these are not open to public scrutiny. These instruments have a more significant impact on monetary policy and, hence, we should be more cautious in separating rhetoric from reality.
Currency trading by RBI is robust. When RBI buys a dollar in the currency market, it injects a rupee into the Indian economy, and vice-versa. Currency trading is a monetary policy instrument and, yet, it is conducted in complete secrecy. No monetary policy committee is involved, and there’s no statement of objectives about currency trading.
In RBI Governor Subbarao’s tenure, currency trading was stopped, but it was resumed under Raghuram Rajan. We are back to a situation where RBI has become active in the currency-trading market. This has big implications on the short-term money market. In the last few months, RBI has built up around $25 billion in forward currency trading. So, a lot is going on in monetary policy beyond what is made available to the public; we don’t have a transparent monetary policy system yet.
In 2013, RBI hiked rates dramatically by 440 bps to defend the rupee, and after that there has been a big easing. Certain advisers to the then FM P Chidambaram claimed that in 2013, they told the FM that the rupee could be defended without hiking the interest rates. The deal was that the repo and reverse-repo rates wouldn’t be hiked; in fact, they were lowered slightly. But all other instruments were used to tighten the short-term money market, which led to a huge spike in the de facto policy rates.
There’s a looming threat over Indian monetary policy in the form of resumption of currency management. We are now in a much more managed exchange-rate environment and this is a source of distress. The law, which now clearly sets a CPI inflation target of 4 per cent for the RBI, may cause problems, as there is no room left for manouevring.
Our banking system is in a mess. Bank credit growth collapsed by 2011-12, reaching a low of 6 per cent real growth rate and it has stuck there. Firms need to find out non-bank sources of financing now, including deleveraging, as banks are in trouble. We are in this mess due to ineffective regulation and as banks haven’t declared their total NPAs. Banking regulation should say that once an IBC proceeding has begun, banks should mark down the liable assets to zero and the losses should be recognised promptly. IFRS asks for a forward-looking judgement of the market value of an asset; that’s what banking regulation is all about, and that’s what banks should mark to.
If there’s a shortfall of about `10 trillion in the Indian banking system, we don’t know where that capital will come from. For about 5-8 years, we are going to be an economy where bank credit to GDP will decline substantially. In such a scenario, the economy will have to rely on non-bank capital.
Finally, the main strategy for the macro and financial reforms in India is version 1.1 of the Indian Financial Code. Inflation targeting has been achieved, the MPC has been created, SEBI-FMC merger has been completed, Cabinet has approved the law on Resolution Corporation, and the DEA is expected to act soon on Public Debt Management Agency reforms soon. For bankruptcy reforms, IBC has been passed. Another major ongoing fiscal reform is the GST. Three big reform measures yet to be initiated are the direct tax code, reforms of tax administration and sound teams to handle these. At the end of this, we might have a great churning like the 90s, which saw the exit of many inefficient firms and reforms reinvigorated the economy. We might also see the demise of zombie firms and banks in the wake of banking crisis and the implementation of the IBC.
About the author:
Dr. Ajay Shah, Professor at the National Institute for Public Finance and Policy, studied at IIT, Bombay and USC, Los Angeles. He has held positions at the Centre for Monitoring Indian Economy (Mumbai), Indira Gandhi Institute for Development Research (Mumbai) and the Ministry of Finance.