Indian industry is in meltdown. Seventy-eight of the largest companies in India are facing dissolution under the Indian Bankruptcy Code. Twenty have been declared insolvent and sent to the National Company Law Tribunal for dissolution. Thirty more, all in the power sector, will also be sent to the guillotine because the Allahabad High court has denied them more time to sort out their woes. Another 92 companies are on the chopping block because they are more than 180 days behind on their loan repayments. As if these woes are not enough, loan defaults by small companies have also doubled in the past year, signalling an imminent crisis in that sector as well.
Are all the owners and managers of these companies, and their bank managers corrupt, as the government would have us believe? The idea is absurd. Most of the companies on the chopping block had dared to invest in infrastructure projects. And that the reason they did so was that the public sector was no longer doing it. This concentration of failure in the most capital-intensive projects, and the sheer pervasiveness of the collapse shows that the cause is not confined to individual delinquents, but systemic.
A systemic collapse can only result from a systemic failure. In India, the RBI, has dealt it by imposing and then maintaining a regime of very high interest rates for industrial borrowers since 2010, regardless of the rate of inflation. It did this when inflation measured by the time-honoured wholesale price index was 8 per cent. It has persisted with this over the past four years when WPI inflation has been close to zero.
To justify this, three governors of the RBI in succession have argued that price stability will automatically lead to growth. They have buttressed this belief by citing a succession of IMF staff papers and other studies that have claimed to show that high rates of inflation do not raise the rate of economic growth, as was accepted for decades, but actually lower it. They did so despite the fact that not one of these studies has been able to define, let alone establish, the causal chain that leads from high inflation to low growth.
And they have done so despite the compelling theoretical and empirical evidence that some inflation has to accompany industrialisation because it requires the diversion of a part of the income of the economy from producing consumer goods to capital goods. The economic miracle in south east Asia and China bears this out: South Korea had an average inflation rate of 21 per cent during the three decades in which it became an industrial powerhouse, and China has done so only with the help of stringent price controls on essentials.
Making price stability the first goal of policy, therefore, sacrifices growth at the altar of stability. That is what the RBI has been doing since January 2007.
What has made it impose this suicidal policy on the country, and why have two governments capitulated? The first reason is that our RBI governors have tried to outdo their industrialised country peers in orthodoxy by adopting inflation targeting without realising that the rich nations have entirely different goals. But the second, more fundamental, reason is the imperative to keep the exchange rate stable. This has arisen because when the RBI raised the average domestic borrowing rate by 3 per cent in 2007-8, and did so a second time in 2010-11, it drove heavy industry and infrastructure companies to foreign capital markets, where unhedged loans were available for as little as 3 per cent.
Between 2008 and March 2015, around 300 of India’s largest companies borrowed Rs 4.5 lakh crore ($680 billion) abroad, mostly with maturity periods ranging from three to 20 years. Between March 2014 and March 2015, after Narendra Modi’s victory became certain, borrowings increased by $181.9 billion. This raised India’s outstanding external debt by 38 per cent to $580 billion.
The euphoria was so intense that a large part of the new debt was not hedged against the risk of a fall in the value of the rupee. As a result, in 2015, 59 per cent of the $580 billion was vulnerable to devaluation.
For the borrowers, maintaining the exchange rate regardless of side effects has therefore become a matter of life and death. The goal of “inflation targeting” is not, therefore, price, but exchange rate stability. This quest has not only killed the real economy but created an imbalance between India’s foreign exchange debt and its reserves that has brought international hedge funds into the Indian money market, circling like wolves. What India is experiencing is a mild version of Thailand’s economic collapse in 1997, which triggered the “Asian Financial flu”. The RBI has had the sense the rupee has depreciated by 10 percent in the last few months to 71.8 to the dollar, and is being hedged in forward markets at Rs 75.
The only way to stem the collapse is to lower the borrowing rate for loans with five or more years’ maturity to 4 per cent or less. This will allow embattled infrastructure and heavy industries to refinance their loans and revive the demand for consumer durables and office equipment. The revival of these sectors and of housing, will greatly improve the viability the massive restructuring of debt by the public sector banks in the past three years. This has been a dismal failure so far because restructured companies faced the same market conditions as before.
Why 4 per cent? The short answer is that no country in the 19th century built the colossal infrastructure needed by industry with real interest rates of more than one or two per cent. In the 20th century, South Korea and China achieved their breakthroughs by raising capital at negative real rates of interest — hidden tax.
The risk that a reduction of interest rates could increase the outflow of foreign capital is real but likely to be short-lived. First, industrialists burned by the plunging rupee will have no reason left to borrow abroad. Second, the cheaper rupee will increase exports and reduce imports. Third, lower returns on term deposits in banks will shift some of the money to the stock market causing them to rise. When investment and consumer spending revive, these will gain value and pull foreign direct and portfolio investment back to the country and stabilise the exchange rate in a sustainable manner without killing investment.
But time is of the essence. Every day that the rupee depreciates, increases the repayment obligations of companies loaded with foreign debt and weakens their capacity to respond positively to measures designed to revive economic growth. One more attempt to avoid domestic collapse by propping up interest rates will bring on the foreign exchange crisis that the government is mistakenly trying to avert through monetary policy alone.