Industrial downturn

C. P. CHANDRASEKHAR

Indian industry is in the midst of a serious downturn. The Index of Industrial Production, the lead indicator of industrial production trends in the registered factory sector, contracted 2.2 per cent in June 2012, after a 2.8 per cent decline in May. What is worrying is that this recessionary trend is affecting key manufacturing sectors, including the once rapidly growing passenger car industry. According to the Society of Indian Automobile Manufacturers (SIAM), July was the ninth consecutive month when sales of passenger cars reportedly fell relative to the corresponding month of the previous year. Over the last financial year (2012-13) as a whole, car sales fell (by 6.69 per cent) for the first time in a decade. The reliability of these sales estimates is questionable, but they are indicative of a trend. Production figures point to a positive 8.7 per cent growth in the passenger car industry in July. But that seems to be merely the adjustment after months of production declines, of which some were sharp (Chart). This deceleration in growth seems part of a medium term trend. Between 2005-06 and 2010-11, which covers most of Indias high growth era, passenger car sales grew at a scorching 15.2 per cent per annum. That had fallen to 4.7 per cent in 2011-12, before collapsing last financial year. Not surprisingly, manufacturers are responding to the recession. Maruti Suzuki has reportedly asked some of its temporary workers at a Manesar plant to go on indefinite leave while Toyota Kirloskar is not renewing contracts of temporary employees. Some time back Maruti Suzuki India suspended production for a day at its Gurgaon plant, which is capable of delivering upwards of 3000 units everyday.

There are many reasons why this trend in the passenger car industry must be disconcerting for the government. The industry was in a sense the poster child of reform, delivering not just high growth performance, but also significant foreign investment, new products, better technology, some exports and competition that kept prices down. So the setback in this industry is far more significant than a sector-specific downturn. Rather that downturn has something to say about the sustainability of Indias high growth story. This is especially true because of the stimulus that drove manufacturing production and construction during Indias high growth years. Retail credit that went to finance housing investment, automobile purchases and durable consumption boomed during those years with the ratio of bank credit to GDP rising from around 20 to more than 50 per cent. It was this private debt financed expansion in demand that was an important explanation of the boom. In the case of the passenger car industry too, the principal factor factor driving demand and sales was access to credit. Being a commodity that has resale value and can therefore serve as collateral for the loan financing its purchase, the automobile is a prime candidate for debt finance. With banks keen to lend, middle class consumers who might have had to wait to accumulate adequate purchasing power, were now free to obtain credit and acquire the commodity immediately. Thus, after housing, the area in which personal loans have increased substantially is for purchases of automobiles, resulting in a rapid increase in vehicle ownership. This factor was principally responsible for the explosion in demand, sales and production. A corollary of this is that the decline in demand must partly be because the credit-driven growth in sales is proving difficult to sustain. The problem with a credit boom is that it feeds on itself. Periods when the economy is booming boosts confidence, leading to excess credit provision by lenders convinced that default is unlikely. This leads to an expansion of the universe of borrowers to an extent where the proportion of potential defaulters or subprime borrowers exceeds some critical level. When either evidence of overexposure or signs of rising default emerge, the retreat of overexposed lenders can be sudden. That is possibly happening in India, where a host of other indicators like inflation, a rising current account deficit and a weakening rupee are sapping confidence. This tendency can be cumulative, since slowing growth is accompanied by rising default. In sum, what the experience in the automobile sector could be pointing to is that the confidence required to keep growth going is waning. It is widely accepted after the 2008 crisis that growth and accumulation under a neoliberal regime ride on bubbles, facilitated by excess liquidity and credit in the system. In India, as in many other emerging market economies, the liquidity needed to drive incremental bank lending was ensured by large inflows of foreign capital into the economy. Though this process of liquidity infusion has not dried up, the confidence to ride on that liquidity to pump credit in the system seems to be on the decline. Moreover, in its effort to address the rupees decline the Reserve Bank of India is seeking to mop up rupee liquidity. This together with the increase in automobile prices that the rupee depreciation entails is likely to worsen the recession in the passenger car market in the days to come. That could intensify the industrial downturn.

RBIs heady cocktail

C. P. CHANDRASEKHAR
SHARE COMMENT (1) PRINT T+

In his Second Quarter Review of Monetary Policy, Reserve Bank of India governor Raghuram Rajan was candid enough to admit that GDP growth in the country this year may be lower (at 5 per cent) than earlier expected, and that inflation remains a problem. The inflation rate as reflected by the Wholesale Price Index has risen and as measured by the Consumer Price Index remains uncomfortably high. India is experiencing stagflation, requiring the RBI to think of reining in inflation without damaging growth further and possibly reviving it a bit. That is a difficult call. The centrepiece of the central banks policy response seems to be and was presented as a hike in the key interest rate, the repo rate, by 25 basis points from 7.5 to 7.75 per cent, to address inflation. However, that hike has been combined with a reduction in the marginal standing facility rate (from 9.0 to 8.75 per cent) and a measure to infuse additional liquidity into the banking system. The latter consists of increasing the liquidity provided through term repos of 7day and 14-day tenor from 0.25 per cent of net demand and time liabilities (NDTL) of the banking system to 0.5 per cent with immediate effect. Compare this with what the RBI governor did when he undertook the mid-quarter review of monetary policy this September. Then too he chose to hike the repo rate from 7.25 to 7.5 per cent arguing that the battle against inflation had not been won. On the other hand, he chose to lower the interest rate on the Reserve Bank of Indias marginal standing facility (MSF). Soon thereafter, in early October, the RBI strengthened its liquidity enhancement measures aimed at increasing

bank access to lower cost funds by: (i) further reducing the MSF rate by 50 bps to 9 per cent; (ii) conducting open market operations (OMOs) involving the purchase of government securities to the tune of Rs. 9,974 crore to inject liquidity into the system; and (iii) providing additional liquidity through term repos of 7- and 14-day tenors for a notified amount equivalent to 0.25 per cent of net demand and time liabilities (NDTL) of the banking system. There are clearly signs of addiction to an unusual cocktail of policies involving an anti-inflationary hike in the key interest rate combined with increased access to cheaper liquidity. What explains this choice of a combination of apparently conflicting measures? The repo rate is the rate at which banks borrow from the central bank against collateral that consists of excess holdings of securities that can serve to meet statutory liquidity ratio (SLR) targets. If banks are pushing credit, however, leading to a significant rise in the credit deposit ratio, then they are likely on occasion to need more liquidity than they can get by pledging/temporarily selling their excess SLR-type securities. To increase bank access to emergency liquidity so that they can keep pushing credit even if at slightly higher interest rates, the RBI had in 2011 established the marginal standing facility (MSF), under which banks can borrow against securities they hold as part of (and not just in excess of) their SLR requirements, subject to payment of a higher penal interest rate and with a ceiling to the amount of such borrowing they can resort to. The ceiling on resort to funds under this facility by banks was set at one per cent of their respective Net Demand and Time Liabilities outstanding at the end of second preceding fortnight. Originally the MSF rate at which banks borrow had been set at 100 basis point or 1 percentage point higher than the repo rate. This differential was hiked to 2 percentage points in July 2013 in a move that seemed motivated by the need to curb speculation on the rupee. The September 2013 Mid-Quarter Review of Monetary Policy partially reversed that hike by reducing the differential between the MSF rate and repo rate to 1.5 percentage points. With the latest policy announcement, which increases the repo rate while reducing the MSF rate, the differential has come down to 1 percentage point. In addition, besides access to overnight funds under these facilities, the increase in the ceiling on term repos provides an additional and longer-term source of liquidity to the banks. In sum, an important plank of monetary policy in recent times seems to be that of enhancing the ability of banks to push loans by increasing their access to emergency liquidity, the requirement for which may increase as a consequence of increased lending out of a given deposit base. The penalty imposed for resorting to excess borrowing from the central bank has also been reduced. So long as banks can find borrowers who are willing to pay the higher interest that lending backed by costlier (but cheapening) funding entails, they can lend more. This is possibly expected to support growth, by permitting lending to the retail sector for financing purchases of automobiles, two-wheelers, durables and much else. The government on its part has agreed to facilitate this by infusing capital into the banking system, which would also enhance their lending power. In this way, the RBI expects to address inflation as well as back growth. While growth may be supported by credit-financed personal expenditures, it is unclear why the demand this generates would not add to inflationary pressures just because the repo rate is being hiked. Reading between the lines the argument seems to be that this would result in the higher repo rate anchoring inflation expectations, whatever that nebulous phrase may imply.

Is there a flight of capital from India?

C. P. CHANDRASEKHAR

Sporadic news on the recent behaviour of foreign institutional investors (FIIs) has strengthened the impression that there has been a flight of capital out of India. Many, including government spokespersons, attribute the rupees decline and subsequent weakness to the withdrawal of capital from the country. India could have managed its balance of payments deficit, it is argued, if international developments such as a possible tapering of the Federal Reserves policy of quantitative easing had not resulted in a retreat of foreign investors. With the release of data on changes in Indias Net International Investment Position for the April to June 2013 period it is possible to assess the weight of this argument. The April to June quarter was the period when the rupee depreciated from its level of close to Rs.54-to-the-dollar to Rs. 60to-the-dollar, with almost the entire decline occurring over May and June. The evidence suggests (Chart 1) that Indias net investment position, or the net claims of non-residents on India, measured as the excess of non-resident capital that had accumulated in the country over total assets held by Indian residents abroad, had declined during these months by $12.5 billion, with the countrys assets abroad having fallen by $13.2 relative to the previous quarter while foreign assets in India fell by a larger $25.7 billion. These aggregate numbers reflect three tendencies. First that the situation during April-June 2013 was completely different from that in the immediately preceding quarters, when both asset accumulation abroad by residents and asset accumulation within the country by non-residents were rising. Second, that more capital had exited from India during this quarter than had been repatriated back to the country, requiring an examination of the categories of capital flow that were responsible for these inter-temporal changes in the inflows and outflows of capital. And, finally, that investors were indeed fleeing from India in this period when the rupee was in decline. A noteworthy feature of the recently released numbers (Chart 2) is that foreign investments categorised in the official statistics both as direct investment and as portfolio investment declined the former by $13.8 billion (5.9 per cent) and the latter by $13.7 billion (7.4 per cent).

In principle, direct investment is treated as being that by investors with a long term interest in dividend returns from the country and portfolio investment as that by investors with short term horizons and interest in capital gains. This is expected to make the former more stable and latter more volatile. The evidence suggests that this is not a distinction the categorisation actually makes. Even investment categorised as direct includes a component that displays volatility. Were the uncertain economic conditions resulting in the exit of capital from India also responsible for the decline in investment abroad by residents? This does not seem to be case (Chart 3) since the decline in assets held abroad by resident agents was not the result of a fall in foreign direct investment by them but because of a decline in the foreign reserves held by the central bank. On the other hand, resident investment abroad remained stable. That is Indias asset holding abroad fell because the Reserve Bank of India was using a part of its reserves to stabilise a weakening rupee, even if unsuccessfully. Reserve assets fell by $9.6 billion during April-June 2013 compared with the immediately preceding quarter. This has implications for the factors responsible for changes in Indias international investment position. It could be argued that foreign investors were pulling investment out of India because of external developments, such as the possibility that the Federal Reserves policy of quantitative easing would be tapered down, with a reduction in the access of investors to cheap money. But, even to the extent that this was true, the impact of that on the Indian rupee would depend on how important such investments were for financing India balance of payments. Given Indias large current account deficit, or excess of foreign exchange expenditures over foreign exchange earnings, those flows were indeed important. As net flows turned negative, the current account deficit emerged an important and more fundamental explanation of the rupees weakness. And it is that weakness that partly triggers the fall in the reserve assets held by the central bank. A large current account deficit and a weakening rupee also adversely affect investor sentiment, which (besides external factors) contributes in turn to a decline in foreign investment in the country. So while capital flight from India does matter when explaining the rupees position and the uncertain economic environment, the countrys balance of payments position is the more fundamental weakness that can and needs to be addressed.