The role of the central monetary authority, globally, has been growing for some decades
Subramanian Swamy, an Indian lawmaker, alleges Reserve Bank of India (RBI) governor Raghuram Rajan has not reduced rates enough.
Wolfgang Schaeuble, German finance minister, alleges European Central Bank president Mario Draghi has reduced rates too much.
Central bank governors, it seems, just cannot get it right. Or may be they just do not have the power to deliver what their political masters want of them.
This dilemma has important ramifications for India, a country that needs to attract savings to accelerate investments.
The role of the central monetary authority, globally, has been growing for some decades. The logic of manipulating interest rates to control economic growth and inflation seems irrefutable. That is, until we turn to the case of Japan where economic growth stopped responding to a drop in interest rates. As is common in such cases, most believers of this theory simply ignored the Japan experience despite being faced with contradictory evidence. Japan, these proponents argued, was an “outlier". They hung on to the primacy of interest rates as an effective tool despite clear evidence of its impotence in Japan.
The power of manipulating interest rates was visible after the recent financial crisis. The huge monetary stimulus provided by major central banks helped stabilise the financial system. This was meant to be a temporary measure till the private sector re-leveraged. After all, at such low interest rates, who would not want to invest? However, the majority did not take the bait. And central banks kept lowering rates, both by setting the benchmark rate and then by buying securities from the market. Yet the private sector refused to invest. Japan it seems, after all, was not an outlier.
Yet, the tool of manipulating interest rates has not been discarded. As Charlie Munger, vice-chairman of Berkshire Hathaway, loves to say, “To a man with a hammer, everything pretty much looks like a nail". As economic policy cycles have become longer than election cycles, governments across the world have, in effect, passed on the responsibility of economic welfare to the central banks. The banks, in turn, are using the only significant tool that they have in their armoury—interest rate manipulation—to the hilt, effective or not.
There are two broad conclusions India can draw from this global experiment of manipulating interest rates to boost economic growth. Firstly, interest rates are an important, but incomplete tool. The other tools need to be identified and used effectively to accelerate investment. Secondly, since we want our economy to grow sustainably, we need to create an investment environment where we can attract global savings which are presently available at a low cost.
It is important to then look at how we can accelerate investments. Some, of course, say that lower interest rates are the answer without realising that the quantum of savings will drop. For example, nothing stops banks from paying lower rates on savings deposits. They do not do it for they fear people will look for other places to keep their savings, which would thereby lower the amount available to lend.
Recently, the RBI made a point about banks not reducing rates to the same extent as it had. To understand why not, requires a deeper understanding of the banking system. The monetary theory said, reduce rates and lending will occur. This is true if one ignores the fact that banks need equity capital to lend. Without sufficient capital, any amount of reduction in interest rates, will not goad a bank—local or global—to lend. And after the financial crisis of 2008, global capital requirements for banks are on the rise. In India, most banks are struggling to meet minimum capital adequacy norms; they have limited capacity to take on fresh risks by lending.
Another school of thought is that the government should invest. But why would we want to destroy the fiscal consolidation process when we can easily attract private capital into investments? Keeping the government balance sheet in good health will ensure that it has sufficient capacity to protect the country in case of any future crises.
What tools do we then have to promote investment, and thereby accelerate economic growth? The three Es—entrepreneurship, equity capital, and ease of doing business—are required.
Entrepreneurship needs to be nurtured. This requires individuals being willing to work hard and take risks. Unfortunately, recent developments have scared entrepreneurs. The concept of unlimited liability and personal risk would pour cold water on the best of business plans. It would seem mishandling private money carries more personal consequences than mishandling public money.
Second, in monetary economics, role of equity capital is largely ignored, even though it is the foundation on which debt capital rests. The government, through its tax policies, subsidises debt capital and penalises equity. This results in highly leveraged balance sheets which are unable to take on risks needed for investment.
Finally, the government should create a business environment which is easy, transparent and predictable in order to give investors the confidence and comfort to warrant risking their capital.
Merely lowering interest rates, therefore, will not achieve much; in fact, it may drive out the very capital India needs to grow. Andreas Dombret of Germany’s Bundesbank goes even further and argues that perhaps the role of finance in the economy should be less, and not more. He says: “More finance is not a panacea: beyond sustainable levels, more credit and financial activity may lead to more frequent and more severe financial crises."
Governors of central banks have been accorded superhero statuses because of the successful defence they mounted during the financial crisis. They may be great at stabilising a patient who comes into an emergency room, but are ill equipped to deal with organ transplants or removing malignant carcinomas. That squarely falls in the realm of political economy.
To conclude, India is uniquely placed to benefit from a global slowdown, as it can attract foreign risk capital at attractive rates. To do that, it needs to undertake significant structural reforms.
Huzaifa Husain, head equities, PineBridge Investments India.