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Doomsday Deadline

Canara Robeco’s Ritesh Jain explains why he is not all that optimistic about the economy

The RBI might have given an upward bias to the government's forecast of 6 per cent growth. But Ritesh Jain is not all that optimistic. He feels that the central bank has a tough job on its hands balancing interest rates, currency movements and inflation. He shares his views on monetisation and why he feels it could eventually backfire.

We have a large fiscal deficit that will crowd out private borrowing and raise interest rates if not monetised by the government. Would you say that monetisation is the only way out?
I agree with the initial statement. A large fiscal deficit will crowd out private borrowing and raise interest rates if not monetised by the government. But monetisation will benefit the economy only in the initial stages. It sounds easy to implement — money is needed, so print it and the rates will not rise.

If monetisation is the only panacea, then why does the government not wipe out the entire fiscal deficit by printing more money? It has been done — the 1940’s in Germany is one such example. And the result was soaring inflation. There is no free lunch. Monetisation may sound convenient and easy, but all it does is prolong the pain.

There will be an increase in the price level. Everyone will suffer, but the lower income groups are hit the hardest. Interest rates go up for the government and the corporate sector, but corporates will end up paying the price for government inefficiency. In the initial stages of inflation, there is only gain, no pain. In the later stages, there is only pain, no gain. Every government loves printing money because it comes at no cost to them. But this will result in higher taxes for the next generation. Like I just said, there is no free lunch.

And ultimately, the money which has been printed has to go to someplace. And this monetised money will find its way to the most unwanted sectors.

And where would that be?
It would go where the return on capital is very high. This monetised money would find its way to the stock market and the liquidity would fuel a rally. Or we would have a bubble in the real estate market. So the government can decide to print more money, but cannot decide on the flow of that money. Money has a life of its own and creates one too.

The finance minister said that the government is not monetising the deficit, as in the RBI lending directly to the government. But the RBI will support the government’s borrowing programme through Open Market Operations. Do you agree with that statement?
The RBI has been involved in OMOs every second week. So the first question is, from where are they getting the money to make the purchases?

Secondly, the RBI built up ammunition when foreign inflows into the country were huge in 2007. They sucked in the liquidity by resorting to the MSS. Now they are indulging in MSS de-sequestering by putting the money back into the system. What money is this?

They have been monetising all along. I am sure the total monetised amount would be heading towards Rs 1 lakh crore in the near future. 

Looking at how the broad money supply growth target is determined each year, can you explain how we are way off the mark?
The M3 growth target is derived by the RBI assuming a certain GDP growth and expected inflation for that fiscal year. Also factored in is the income elasticity of demand for M3 growth, which according to RBI is put at 1.4.

So if it had to be put in some sort of formula, this is how it would appear:

1.4x GDP + inflation = M3.

So to support a 6 per cent GDP growth, then the working out would be:

8.4 (1.4 x6) + 5 (desired inflation) = 13.4 %

But is that what is taking place? At 9 per cent GDP growth, a desirable money supply figure would be 17-18 per cent. Now at 6 per cent GDP growth, the money supply is 20 per cent! So can you imagine the impact on inflation? If we take a GDP growth of 6 per cent and money supply growing at 20 per cent, you can see for yourself where inflation is headed:
8.4 (1.4x6) + Inflation = 20%

So you see inflation shooting up.

Look at the general price level around you. Inflation is on the rise. The prices of soft and hard commodities are going up. Copper is up 70 per cent year-to-date, nickel has gone up. Agreed, some of this rise could be attributed to speculative activity. But when you put too much money out into the economy, you will have to deal with inflation.

There will be deflation in what you own. But there will be inflation in the things you would like to own.

When WPI comes down, the CPI should also come down with a lag effect. But instead the CPI has not dropped, it has remained stagnant. Take the example of sugar, which has a 4 per cent weightage in the WPI. Sugar will go up by 50 per cent by the end of the year. And we are only talking of one commodity in the WPI basket.

I see inflation — in terms of WPI — touching 8-10 per cent by March 2010. Way above the RBI’s target of 4 per cent.

There’s a common view going around that we are in a “growth recession” — meaning that real GDP expands very slowly and with job contraction? In a “growth recession”, the additional money supply raises output rather than prices. So monetisation will not result in inflation. Your view?
Growth recession, I believe, is just an economic term. An increase in money supply will lead to inflation. I do not believe that the additional money supply will raise output rather than prices. It will only raise prices. If more and more power goes into the hands of the public sector and the money supply is increased, I do not see an increase in productivity and output. But if it went to the private sector, I would see that. 

When Pranab Mukherjee said that the RBI will support half the government’s borrowing programme, there was fear that this would put pressure on interest rates. Do you see them rising?
Definitely. This year, the banking system will have Rs 7,00,000 crore of fixed deposits. Now the government is going to corner Rs 5 lakh crore. That leaves barely any amount for the private sector. Sure, the latter can borrow from abroad, but the rates abroad are much higher, they have not fallen. This private demand for capital is going to result in interest rates rising. Let’s say there are some power companies borrowing 10-year money. We have a fixed amount of money available — remember this country is short of capital. And from what is available the government is taking a chunk. If they take much more, interest rates will shoot through the roof. That is why they are printing money.

Former RBI governor Rangarajan stated mid-July that the borrowing programme would put pressure on interest rates in the remaining part of this fiscal. But a low appetite for credit from the private sector would facilitate borrowing in the first half of the year and would minimise the impact of borrowing on interest rates. Your view?
True. The pressure will be seen in the latter half of the year.

There is always low appetite for credit in the first half of the year. There is huge amount of buying in the second half of the year. All the festivals and the wedding season are in the second half of the year so demand for goods and services increases at that time. Take a Bajaj showroom. He would keep more stock in the second half of the year rather than the first half. So he would require more working capital at that point of time. Now with the crisis lifting, people are getting more optimistic so there will be more demand for capital in the second half of the year.

I see the CRR rate rising in the next six months.

After months of hardly any real growth in credit, banks are now starting to see fresh pick-up in credit. Do you see this as an indicator of real revival in the economy?
Yes, there is demand for money. Those who held back on capital expenditure are seeing some stabilisation. The government formation in the Centre has done much to alleviate the uncertainty. Corporates are much more clear going ahead. Demand for money is already showing signs of revival and will pick up.

The U.S. is monetising their deficit. Do you see any difference with the U.S. economy and India on that front?
It’s true that the general public in the U.S. is indebted. The debt level as a percentage of their income is very high, as compared to India. But it’s perfectly alright to monetise the deficit in the U.S. The reason being that it is the foreigners who own their debt. They do not own their debt, so they will act in whatever way suits them best. So the U.S. is not too worried about the dollar falling. If the dollar falls hugely, housing prices will not fall but the debt levels will have fallen. Who will be left holding the bag? The foreigners who are holding the dollars. But is it in India’s best interest to take that dollar and increase the money supply in the system?

So what is the solution?
At this point, all I can say is that we have painted ourselves into a corner. Now, if we do not resort to this sort of deficit financing there would be a social revolution in this country.

The government will print more money, but where will it go? If there is a drought, money will have to be spent towards that. Money will have to be given towards the higher salaries recommended by the Sixth Pay Commission. Money will be spent on the NREGS. If the government stops providing NREGS money, it will force the unemployed to migrate to the cities. At least you are providing them with work for 100 days. When people are meaningfully employed, there will not be a social revolution. It’s when people lose their jobs or are unemployed that unrest sets in. And to top it all, population is also rising. When you have a situation of rising unemployment and rising population, it could well lead to social discontent.

But at the end of the day, is this country creating capital? I don’t see capital expenditure being done. Create infrastructure. Link the faraway village which is producing to the city. These farmers deal with perishable commodities so create an infrastructure for them.

So the government is now paying the price for the lack of fiscal prudence?
Exactly! When the times are good, the government should have built up ample ammunition to combat situations like the one we are facing today. Over the last four years, we have not had fiscal prudence. The government gave more importance to building revenue expenditure instead of focussing on capital expenditure. So, we were not building capital in this country, it was being left to the private sector.

Do you see disinvestment as an option? For instance, if Air India had to go public, would there be any takers?
Disinvestment is definitely a very good option. And, there are plenty of profit-making companies in the public sector which would interest investors. 

So printing money is not the right answer but the government has no choice.

That’s right. The government has no choice.

What effect will monetisation have on the currency?
Either interest rates will rise or the currency will take a beating. One of these scenarios will definitely take place. If you increase your money supply but other countries do not, your purchasing power has to go down.

The government will have to do a fine balancing act between keeping the currency stable and the interest rate low. You get foreign money coming in because they believe that your currency is stable or will appreciate. But when currency begins to depreciate, this money will run for the doors. Then what would be the incentive? Why would they come to India and buy debt if the currency is going to depreciate?

Due to a delayed monsoon, CMIE in its monthly review for July said that it expects the economy to expand by 5.8 per cent in 2009-10, slower than an earlier forecast of 6.6 per cent and below the government’s forecast. How bad is the effect of the monsoon?
Agriculture’s share in GDP has dropped but this community also has spending power. Look at Hero Honda where more sales take place in rural areas than in urban areas. Mercedes Benz sells the highest number of cars in India in the Punjab-Haryana belt. So on one hand you have the direct impact of the monsoon on crops. For instance, there has been a decline in production of the sugarcane crop so the price of sugar has shot up. On the other hand, the purchasing power of this community will drop. What about power generation? It requires water. A power cut affects business and industry and output.
Overall, I expect GDP growth to drop to around 5-5.55 per cent. 

This interview appeared in the August 2009 issue of Wealth Insight.