FROM BUSINESS WORLD OF 22 JANUARY 2006
An
interest-driven cycle
Whenever I write
about the economy, it upsets some people. Just now, when the economy is doing
well, if I say that there will be a downturn, people think I am spoiling the
party. If they read analysts’ reports, they will find the theme of caution is
now almost a year old. But then, analysts are read only by people who pay,
directly or indirectly, for their services; and analysts are congenitally
pessimistic. If they warn against catastrophes that do not come to pass, their
clients will forgive them; but if they fail to predict a bust, they are not
worth their salt.
If I predict a
downturn, am I also not being a pessimist? And is not pessimism a form of
wishful thinking, just like optimism? It cannot be ascertained whether I am
predicting a bust because I am mental or not. But what matters is not what I
predict, but why.
What I am saying
is the following. The widespread belief that the current boom is driven by
Indian companies that became efficient and globally competitive during the
downturn of 1997-2002 is mistaken. It was started by the increase in liquidity
and decline in interest rates that resulted from the rise in reserves. Reserves
rise because people who have foreign exchange – exporters, foreign investors, NRIs
abroad – sell it to Reserve Bank. In return they get Rupees. So a rise in
reserves inevitably increases money supply. If people get more money in their
bank accounts, they will repay old debts and borrow less. That reduces the
demand for loans, and leads banks to reduce interest rates. Both lower interest
rates and lower debt increase business profits. That cheers them up, and they
start investing. And more cash cheers people up and they begin to splurge on
consumer goods. That is the kind of boom we are having, not the kind in which
the higher profits come through a reduction in real inputs into production.
Although the latter also happened, it was not the cause – its timing was wrong
for it to have been the cause.
This sequence
would go into reverse if reserves begin to fall. Money supply would fall,
liquidity would decline, discretionary expenditures such as investment and
expenditure on consumer durables – of which houses are the most important –
would fall, and that would pull the economy into a downturn. The rise in
reserves has virtually come to a halt; we should ask ourselves whether this is
accidental and temporary or denotes a change in trend. To me, it is clearly a
trend – it is driven by the rapid deterioration of the balance of trade. It is worsening
at such a rate that the current account deficit must outrun capital inflows
before many months pass, let alone years.
People ask: if
Germany, Japan, Korea, Taiwan or China went on booming for decades, why cannot
India? That is because their booms were export-driven. Their balances of
payments too, like ours, were in surplus; their interest rates too were driven
down by liquidity being fed by a payments surplus. But their payments surpluses
continued for decades because their exports went on rising at least as fast as
imports. Our imports are rising faster than exports; that is why our boom
cannot last.
But what about
the world’s confidence in India? About India being the hero of the 21st
century? The world’s view is shaped by what is happening now, not what will
happen tomorrow. India is booming today, so the world is impressed. The day the
boom goes bust, the world will see India as a boring country and turn to the
countries that are booming then.
And might the
downturn, when it comes, be a soft landing? May we just slide from 7 per cent
to 5 or 6 per cent? We may; CSO may varnish GDP figures and soften the landing.
But our financial system generates too much debt and too little equity. When
liquidity dries up, loans become difficult to get and interest rates rise,
borrowers get into trouble. Some of them cannot service their loans; the assets
they bought with borrowed money are sold to repay their debts. The commonest
such assets are land, real estate, shares and equipment; their prices will fall
the hardest. Because our economy is debt-ridden, it has sharper downturns.
Remember, Japan’s downturn lasted a decade because it too is debt-ridden.
When the
downturn comes, not only will prices fall, but there will not be enough buyers;
these assets will turn illiquid. Just now people are panicking because flat
prices are skyrocketing and they feel that unless they buy now, they will never
be able to buy a flat. They are wrong: when the downturn comes, there will be
plenty of flats to buy. For those who have money and a job at that time. Just
wait; just as a sunny day has dark clouds on the horizon, dark clouds have a
silver lining.
