Unintended consequence

High interest rates could accelerate the flow of foreign funds from low-yielding developed nations

By Mohan Sule
The market expressed its disapproval of the Reserve Bank of India’s steadfast refusal late last month to lower interest rates. The annoyance was understandable. Besides keeping the bank rate steady, the central bank increased the capital for banks’ restructured standard assets and downward revised the GDP growth forecast for the current fiscal for the second time. Perhaps the apparent contradiction in these positions has escaped the central bank. Low interest rates fuel growth and so also restructuring of loss-making companies, whose numbers increase during a downturn. How can the economy grow if obstacles are raised in the path of these contributors? From the policy composition, it is apparent that Mint Road believes that the major trigger has to come from the Central government and it can at best play a supporting rather than a leading role in scripting the growth story. The finance minister has to share the blame for the RBI’s obsession with inflation, particularly so with polls looming around the corner. His intention to nearly halve the fiscal deficit from the current level in another four years is fine as along the details of the roadmap are spelt out. Not a single rupee was collected from PSU divestment in the last seven months. Yet the market is supposed to trust the government in meeting the Rs 30000-crore target in the remaining period. The other three options — of trimming subsidies further, hiking taxes, and cutting spending — do not look feasible at this juncture. The recent increase in prices of fuels resulted in the walkout of UPA-II ally TMC and renewed attacks from opposition and civil society on the issue of corruption. There is the danger of the economy slipping into recession if indirect taxes are bumped up amid a slowdown. Instead of going down, spending tends to increase on the eve of election.

The inescapable conclusion is that the government is hoping for a gush of foreign funds into retail and aviation and inflows from auction of the second-generation spectrum to balance its spending spree. Why would foreign direct investors want to invest in a country that risks being slapped with a junk credit rating if it does not speedily reform seems to be beyond the comprehension of the policy makers. Against this backdrop, the RBI’s caution looks prudent. The stubborn stand, however, could backfire and create more harm than good. If inflation is the central bank’s core concern, the higher cost of money compared with other major economies, which are holding down interest rates to spur growth, could act as a magnet for hot money searching for better yields and release more liquidity. The silver lining is that high interest rates could achieve what the government has not been able to so far: foreign funds could revitalize the stock markets, boost business confidence to take up stalled expansion, and breathe life into failing companies. This means the Indian economy will no longer act in tandem with the global economy. The decoupling that did not happen post 2008 credit crisis in spite of the domestic orientation of the economy could be in the making now as a consequence of India’s reluctance to fully integrate with the rest of the globe by softening its lending rates.

There are two reasons for this unintended series of developments. First, India imported inflation along with foreign capital during the 2003-07 bull-run, which raised the affluence level. The wholesale price index more than doubled in September 2008 from five years ago. The heating of the economy was largely contributed by the surging prices of commodities. However, inflation in India did not cool down even though the collapse of Lehman Brothers halved it for OECD countries by September 2012. As a result, the gap between the middle class and the poor in India widened, spurring the launch of many welfare programs and preventing policy makers from correcting the fiscal imbalance by reducing subsidies. Together, these developments contributed to more than doubling the fiscal deficit in the four years to FY 2012. The consequence of higher interest rates and increased dollar inflows will strengthen the rupee, making imports and the cost of borrowing for Indian companies cheaper but also boost asset prices, and, in the process, squeeze the government to act. Cutting subsidies is going to fuel inflation in the short term before the impact of narrowing fiscal deficit allows the central bank to reduce interest rates. How long this period will be will depend on to what extent the government goes in slashing expenditure. Chances of the US economic recovery gaining momentum are bright after the presidential elections, providing a fillip to exports and helping in easing the pain of transition to a cleaner balance sheet. So the market should look at the current developments as half glass full.

Double standards

Companies should have to adhere to the same rigorous criteria for borrowing as an education- or a home-loan consumer

By Mohan Sule
Why is that success of some companies trigger skepticism, cynicism and even derision but the failure of some others evoke a feeling of shock, sadness and even sympathy? The first category comprises companies whose dizzying rise is largely due to crony capitalism rather than due to display of gut and daring, which are more likely to be the hallmarks of the second. It almost seems a travesty that the lot that has political patronage seems to be thriving merely because of the fact that the promoters have been lucky enough to be born in well-connected families, who flourished during the licence-raj regime and were favored while granting entry into the emerging sectors. Most of them hold a controlling stake, using government financial institutions and the small investors as supporting actors, to fuel their wealth, ambition and image. On the other hand are the entrepreneurs who are venturing into an uncertain landscape not to burn their cash reserves but to translate a dream into reality by circumventing government regulations, surmounting bureaucratic obstacles, convincing hardnosed private and institutional equity participants, and inspiring the small investors and consumers. Of late, both types of companies are in the news due to the renewed focus on the nexus between politicians and the corporate sector and the torturous deterioration in the health of two companies that were among the showpieces of the post-reforms era.

The hurdles encountered in the rehabilitation of Kingfisher Airlines and Suzlon Energy could compete with any Hollywood thriller for the twists and turns. After each hopeless turn of event, there appears a glimmer of hope that the two companies will get a second shot at survival, only to be dashed by complications arising from global economic slowdown and the resultant volatility in foreign exchange. The problems of the airline and the wind turbine producer can be traced to their accumulation of too much debt to grow. In hindsight, they erred not for aiming too high but in doing so on a shaky base. Though not a first-generation entrepreneur, Vijay Mallya entered the Rajya Sabha to beat the system. His high-cost, all-frills airline indeed filled up a space that arose from the rapidly expanding middle class. Tulsi Tanti set to harvest wind energy as an alternative to the pricey crude oil. Their initial success spurred them to embark on bigger gambles. Mallya’s acquisition of Air Deccan in 2007 was essential as the aviation space was undergoing consolidation to increase market share so as to gain pricing power. By then the dynamics of the industry had changed. The liquidity crunch of 2008 brought renewed focus on the bottom line of the aviation industry that was recovering from the blow of the terrorist attacks on the US in September 2001. As luxury airlines closed or were acquired in the aftermath, low-cost airlines became fashionable. Flyers changed their priority from comfort to convenience. Compounding the problem was the surging prices of aviation turbine fuel, receiving a fillip from China’s growth juggernaut. Soon after Suzlon took on cumulative debt for over US$2 billion to buy two European companies, one in 2006 and another in 2007, to achieve scale, liquidity dried up on the seizure of global financial institutions, with the euro zone particularly hit hard. Acquisitions that seemed sensible became albatrosses.

Should the two companies be allowed to fail? The licence of Kingfisher has been suspended and foreign lenders early October rebuffed Suzlon’s request for extension to redeem their bonds. It would be a pity indeed if they are not extended some sort of life-support system till the global economy turns around. In the meantime, it is time to examine how companies’ ambition to become sizeable players in their market can be tempered with reality. At the outset it is important to impress on promoters that they cannot turn their companies into world-class entities while retaining more than 51% ownership. They have to turn minority shareholders to enable institutional investors to have a greater say in capital expenditure as well as cost trimming on adverse turn of events. Any plan to raise debt more than two times sales or net profit should be approved by at least 50% of the non-promoter shareholders. The Reserve Bank of India needs to set a up a separate cell to monitor the foreign debt of companies as well as domestic lending institutions’ exposure and alert them of worrisome trends that would impact repayment. Importantly, promoters issuing debt should have adequate backup of assets or have a consortium of lenders to throw a lifeline. If the home of an ordinary borrower has to be mortgaged with the housing finance company and an education loan comes only with a collateral of equivalent value, why not create a level-playing field for companies, too?