Tuesday, February 13, 2007

Rate Hikes Counterproductive


The RBI (Reserve Bank of India) the central bank in India has yet again raised the Cash Reserve Ratio. What this means is that banks should lend less of their deposits and currently keep more than 6% of the deposits with the RBI instead of lending. This will lead to higher interest rates for loans, by the supply-demand economics.

Inflation in India is raising very high and currently over 6%, the highest in 2 years. It has mainly contributed by the increase in food prices, along with world oil prices, property boom in India along with expanding business cycles. Whenever inflation grows high, banks follow the textbook method of raising interest rates, so that people will borrow lesser to buy stuff and the the demand will reduce therefore and the price raise will be contained.
Why is it counterproductive?
First, the inflation is more due to the supply side economics rather than demand side economics.

1. Real Estate

While, it is true that people are betting high & high for good properties, the core problem here is the lack of availability of good properties. For example, my 2000 sq ft property in Madurai has hardly experience inflation, while properties in Chennai, B'lore & Mumbai have shot over the roof. This is because, people get very few choices to buys houses if they want a minimum level development. The solution will be to develop properties more and more so that anybody with a decent level of employment could get a decent housing. India is no short of land - currently having more than 30 trillion sq ft of which atleast 10% is fallow and underutilized. So, if we have 3 trillion sq ft, every Indian household could build a 12000 sq ft bungalow and dont even need high raises! That's ideal, but the point is with proper development every household could be assured of a good housing. Invest more in planned housing development and allow real estate developing corporations to expand more and even if the SEZs turn out to be just real estate development, still it will do good for the nation. And once, enough supply of good houses are made, the prices will fall in the super hot spots.
2. Agriculture
Why the food prices have gone up should not be a surprize for those who watch Indian agriculture. The sector is in a state of shit, and the last decade there has been no growth in the yield or productivity, while industrial production surged and technology zoomed. Our per-hectare productivity for most crops are among the lowest in the world, and we have the highest wastage in the world. Lands have to be consolidated, supply chains strengthened and flattened and technology/capital has to reach the field. Allow big private houses to repeate their magic with industry on the field, and with a good retail sector growth, Indian farmers have huge potential to grow. If we do right things, we could potential expand the end value of Indian agricultural produce by 3-4 times and wipe out shortage that is boosting the prices now.
3. Cement/Steel & basic commodities
These are not too different from agriculture. India has vast reserves of coal, iron ore and bauxite (aluminum ore) and they are hardly utilized due to red-tapism. This had forced the stellar players in this field like Tata Steel & Birla's Hindalco to look for overseas purchases. Allow greater reforms, liberalize laws and promote greater development. Given our enormous potential in this segment, most commodities excluding copper & oil, could head south with better technology.

The key in all these three things are - investments, reforms & consistent policies. Regarding the last two the government has the ball in its court and regarding investments the increase in interest rate will jeopardize all the growth. If the interest rates climb up so much, the infrastructure, power development and these three sectors will suffer and the projects might be derailed.
Instead of taking a myopic view, the RBI should curtail the temptation to increase rates and realize that textbook methods are not directly applicable to this complex nation. The need for the hour is greater investment and the RBI should direct them to the right sector and by increasing the rates the RBI is not only curtailing growth but also leading to future inflation by choking supply & infrastructure.

God shall bring lights to the darkness filling economists' brains.


Anonymous said...

Yo my man Balaji,

Thanks for the optimistic babble from Redmond. However you seem to have missed a key component of India, the pervasive stench of a corrupt feudal society. Sure your tips would work if we had a functional society ruled by a fair and just government, we DON'T!
Real estate in India is not ruled by economic theory's but by blasted politician's controlling land prices and city expansion plans. Education is restricted to those who have the means. Infrastructure will not be developed in interior areas as these are valuable vote banks for our fetid ruling class.
I live and work in Chennai in one of the most extraordinarily corrupt societies in the world, I find your postings whimsically naive. Get a grip dude! and spend some time working with the government in Chennai, Bangalore and Delhi rather than having some fictiously fond memories of your motherland.

Balaji said...

To the anonymous,

Thanks for your comment. I do understand Indian government & bueraucracy. I've lived in villages, interacted with the worst of what India could be while visiting the debtors of the bank my father was managing. I've interacted with politicians on both sides of India-US and have seen and observed three continents.

Though, my knowledge is by no means comprehensive, from what I have observed, Indian problems are not too unsurmountable and its issues are not much different from the processes that went in the rest of the world, over the course of time.

If you have a better solution to any of the problems, let me know.

Edward Hugh said...


I haven't time to offer a full comment, but you know more or less what I think. I think the most important is probably for central government to get the fiscal situation under control, although the rumourology has it that this is already improving, partly due to all the growth I guess.

The RBI is limited in what it can do anyway, as I have been suggesting, due to the presence of the carry trade, and this is also reflected, please note, in the inversion of the yield curve. So under these circumstances what central bankers can and cannot do is a really moot point. Accepting reality is sometimes helpful.

Whatever may be happening in some sectors India is definitely NOT overheating. I feel you have modified your opinion somewhat on the housing bubble aregument, and I am pleased to see it. You talk a lot of sense in what you say.

The Economist had a piece on Japan and the carry trade at the end of last week, so they definitely see the connection between this and what they are saying about India. Of course they take the opposite view, it is all going to unwind, bla, bla , bla... They even cite Professor Roubini, who I think until recently at least you were in some agreement with.

Mail me sometime so we can talk directly. I am a risktaker, and would be very happy to give you space to post on India on GEM, if that was OK with you new bosses that is.

I also agree that the SEZs are important, that is why I ahve posted on these on IEB, and I am working with Arjun on something on this for GEM,


and keep me posted when you have something interesting.