The Hindu Business Line : `We will see stabilisation only in 2010'

One of the biggest problems we face now is finance for infrastructure, as access to foreign capital is drying up. To get that kind of long-term finance we need to start developing a bond market, for which institutional investors such as pension funds and insurance companies should be willing to invest more..

DR RAGHURAM RAJAN, HONORARY ECONOMIC ADVISOR TO THE PRIME MINISTER

Dr Raghuram Rajan, honorary economic advisor to the Prime Minister, was easily the star speaker at the recent Pan IIT global conference of IIT alumni held recently at IIT Madras. The cavernous students activity centre deep inside the verdant campus, which can seat almost 3,000, was nearly full. Alumni and students came in droves to hear Dr Rajan expound on the world financial crisis and its impact on India. An IIT Delhi and IIM-A alumnus, who later went on to be the Chief Economist at the IMF, he gave a simple exposition of the problems besieging the world of high finance the world over. Business Line caught up with Dr Rajan, who is also a professor of finance at the University of Chicago, before his talk and sought his views on a wide range of issues.

Excerpts from the interaction:

What is your analysis of the global financial crisis and how did things come to such a pass?

Globally, of course, it is a very deep crisis emanating from the US. The US has been providing residual global demand, especially US households, which have been consuming perhaps obsessively and what we are seeing in the last two quarters is an abrupt retrenchment of consumption in the US. It is happening for a variety of reasons. Households have lost a lot of wealth, the economy is turning down, prospects of significant job losses and credit has become very tight because of the financial sector crisis so in the last quarter consumption has fallen dramatically and is likely to fall also in successive quarters and as a result a huge chunk of demand has disappeared.

It's reflected in oil prices, in export demand, which has collapsed in a number of countries - in India we had 12 per cent negative growth. The epicentre of the crisis is the US households. But it is propagating everywhere. People thought that Japan and Europe would be able to withstand this but they are also, it turns out, also heavily dependent on the US, their financial sectors are also linked and problems are going through. In general, we are experiencing a very deep downturn which will probably extend to the end of next year and it is likely that only in 2010 that we are going to see significant stabilisation at the earliest

What is the impact that you are seeing on the Indian economy?

As far as India goes there are three different forces at work. One, the same financial sector turmoil in the US has caused investors there to pull back on lending, banks are stopping to lend to riskier credit and as in other emerging markets India has experienced a virtual sudden stop in foreign inflows. Now what that does it forces the Indian banking system to ramp up to meet those flows which has disappeared. Even if the banking system looks like giving credit as before that is not enough because a whole lot of financing has disappeared from the system.

Second, even within India the money market funds used to be a source of funds for NBFCs; they have experienced significant withdrawals, in some cases 30-40 per cent deposits have fled and they moved to banks. Banks in turn have to put aside a certain percentage of their funds in government securities while they also have to lend to the private sector. In net the amount of credit available for retail, for housing, has come down because of this movement from money markets to banks. So, the financial sector has worked this way in curtailing credit. We have the effects of the monetary policy tightening in the past, which are still making their way through the system in higher interest rates, which has precipitously killed demand in the auto sector.

I think the lag effect of interest rate hikes are being felt now, even though the interest rates have been cut banks are still in the process of first absorbing the previous interest rate hike. Eventually they will pass through the cuts but it will take time. In the meantime the interest rate sensitive sectors are experiencing some trouble. The third effect is on the export sector, textiles, metals and mining, these are sectors which are also experiencing severe stress because the world economy has slowed down. So, these three forces, credit, interest rates and external demand are impacting the Indian economy severely.

The Left parties have been saying that India has not gone through reforms so is not suffering as much as West. If we had gone for full scale reforms India would have been suffering as much as the west. Is there validity in that argument?

When there is a huge worldwide event, it is possible that if you are exposed more to the world you would suffer more. If we had opened up more we would have suffered more now. But we may have grown faster before so net-net it is not clear.

That said, I think what this crisis is also telling us is the extreme danger of having an unreformed system. One of the biggest problems we are facing now is finance for infrastructure. Why are we facing this problem? Because earlier we got finance from foreign equity investors; Indian promoters got foreign investors' equity for their stake in the projects. Overnight that has dried up and we are seeing the consequences of not having access to foreign capital - very essential infrastructure investments are finding it hard to close.

Ultimately in India we haven't nurtured long term risk capital because banks want short term, they are not capable or interested in the long term. So, in order to get that kind of long term finance we need to start developing a bond market and to do that we need some of our institutional investors like pension funds, insurance companies willing to invest more. These are all areas we need reforms and unfortunately some of the political forces haven't been favourable and this is holding the country back?

Is this then the right time for more reforms?

Where do we get infrastructure from; somebody has to finance it. Either we get it from outside and nobody wants to invest in India now - they don't want to invest anywhere - they want to keep their money in their own country. We don't have long term financing in India; the banks are not willing to lend - would they lend 10-15 years to infrastructure? Unlikely. So you see the consequences of having an underdeveloped financial system as we don't have financing for some of the most essential things we need infrastructure financing being one of them.

There is a definite case then for the government to step in?

Because we cant get it from the market it may well be the government that has to take up some of the burden but in the long term is better that the pension funds, the insurance companies take up some of that long term financing and be more liberal with them and allow them to invest and not say that they must invest only in government bonds. Once you say that they can only invest in government bonds, the only source is then the government. And it is not clear that you want the government deciding where to invest between promoters.

A large section of industry feels that whatever package the government has announced is a tad too little and too late. The global economy is reacting very fast. Do you think the government and the RBI have done enough to stimulate the economy?

Let me put it this way: the pace of events across the world has been dramatic and governments have been reacting because people have not envisaged the size of the problem. In the middle of the year people were saying that India would be immune to the problem and then we have seen over the past few months exports fall through the floor, we have seen financing dry up. We had a problem of too much money coming in beginning of the year and now we have a problem of too little.

To some extent governments have to react to events. It is hard to anticipate everything. But government policy does not work instanteously, it takes time. Take the case of monetary policy. The effects of the interest rates hikes are still playing. Bank deposits - they are still willing to borrow from you at 10 per cent even though interest rates have fallen. They will adjust and cut deposit and lending rates and you will see it coming through. So monetary policy has lags and you have to allow time for it to play through.

Now, as more room is created, you will see inflation rates come down and it will give the RBI more room to cut interest rates but it doesn't mean that those interest cuts will result in lower lending rates immediately. What matters is not just rates but availability of bank credit. Lots of industries are complaining that they are not getting access to credit. So we have to work on a number of fronts. But you don't want to push the banks too hard. Industry would like banks to lend whatever they can but if this is going to turn into an NPA next year banks have to be careful because 70 per cent of banks are in government hands and the NPAs are taxes that you will pay.

So you want to be a little careful that banks are not forced into making loans they will regret down the line. I would say you got to do what you can to make sure interest rates come down or is reflected in the price of credit and make sure adequate sources of credit are coming in, adequate foreign currency liquidity is also available; those are things that the government has to work on but it doesn't have a magic wand. But even after the government announced rate cuts we haven't seen banks passing it on.

Absolutely, which is why there is a legitimate question: how do you make those banks push those through, it's going to take time, doesn't happen overnight, never happens, it will pass through slowly, they have to cut deposit rates, then as the cost of funds come down it will enable them to cut lending rates.

A lot of the increase in rates is not because of the increase in base rates but because of the spread as banks perceive that firms are very risky; they need to be confident that the risk is going to come down; these are all reasons why it's going to take some time. The government can say lend, but the banks are going to ignore it until they feel comfortable doing it. Pushing them too hard to make loans is not wise either because you are forcing them to override their caution about credit.

The government is trying to perk up consumption but doing nothing in the area of investments? Investment is where the problem is but is the policy response adequate?

I tend to agree that the problem is not as much consumption in India as investment. To the extent RBI has cut interest rates, that has been helpful as it has provided ample liquidity and is trying to alleviate credit conditions. That is one important aspect of enhancing investments because interest rate cuts will allow people to take a long term view of investments.

Of course, the RBI will judge whether interest rates levels are appropriate or not given the inflationary expectations - that's an ongoing process. Still we moved from tightening to fairly rapid and significant cuts in interest rates, including in the reverse repo. The other parts which are missing in infrastructure is that it is not financing but also execution.

We need to close on projects, need to ensure land acquisition takes place fast, input contracts are signed, for example in power, need to ensure feedstock is available at a decent and stable price, those are things that need to be done. So we need to enhance the speed of execution in order to offset the fall in investment plans in corporations but also there is a financing gap which we need to think about. Hopefully something should happen.

The RBI has done its bit but is the stimulus package enough?

Let me through it back at you, what would you stimulate if you say consumption is not the problem?

Through investments.at one point there were people willing to lend money to Indian industry.

At this point you need to find sources of capital to fill the missing gap in risk capital that is there. With the world financial markets in the state it is in you have to think cleverly; it is not growing on trees. Let me assure you that at this point of time there is no capital available.

Noises about willingness to invest does not always translate into investments. There is a process of wooing other parties so that you have decent projects. A lot of the sovereign funds have been burnt by going in too early. So you need to present them with complete projects; here's what we want to do and here is the financing piece where you come in. A lot of people are looking at such sovereign funds to fill the gap, so you have to look at other sources of funds.

So, where are these funds investing now, where are they going?

Even the West looks tremendously attractive, given where the stock prices are. If you look at the range of firms trading at extremely lows; Boeing, which has order books extending to 2015, is trading at new historic lows in terms of prices. There are a lot of assets looking very cheap now and we are competing with those assets. The fact that we have growth does not necessarily mean that they will invest. People want to put in India but it's not the only prospect.

The other side of the story is confidence - it's very fragile. Can't the government boost this sentiment with large infrastructure projects? Can't it use the forex reserves for such projects and back it with sovereign guarantee?

Let me be very clear about this because this thing keeps coming again and again in India. The forex reserves aren't free money. The RBI has issued liabilities against these reserves - market stabilisation bonds and currency. So, it's not that the forex reserves are unencumbered assets that it won't add to the deficit and we can just take them and use them as we want. If we use them we are essentially deficit financing because that hole in the RBI's reserves has to be backed up the government. So, do we go into more deficit financing? At this point of time when infrastructure is finding it very hard to raise adequate capital, there is a role for the government to step in otherwise you will find huge power shortages down the line.

What do you expect growth rates to be at in India? The government is projecting 7 per cent while some are saying it could even be 5 per cent?

I have said publicly that 5 to 7 per cent is a good bet.

That's a big band, isn't it?

I am saying that we have extreme degrees of uncertainty at this point so it's difficult to be precise. Some people have to do it because of the nature of their jobs. I don't have enough information to give a point estimate.

Would this be an appropriate time to push through reforms; what about capital account convertibility?

We are talking about external commercial borrowings - do we increase or decrease the amount? Right now no ECBs are coming in. At this point of time it would be useful to think of what reforms we need to attract more capital. We have a shortage of long-term risk capital so we need to create conditions for a more vibrant bond market.

That is an objective, but how do you do it?

Well, there are four commission reports telling what steps you need to take. There is plenty of advice we just need to start doing it.

With the bailout package for the auto giants in the US does it look like governments will get more involved in businesses?

Across the world there is a danger of these bail outs being asked for by those who have gotten into trouble and claiming that they are essential to the economy and need to be bailed out. I think one could make the case that certain financial firms are too big to fail and do need to bailed out but the form of bail out is important. You want to make shareholders and bond holders experience some pain for letting the firm go under and maybe CEOs may need to suffer a bit for getting into that situation.

Given that financial firms are being bailed out now everybody and his uncle want a bail out on the grounds they are critical for the economy. It is dangerous for a government to give into everybody who demands it especially for a government which is strapped for resources. You need to be careful where you put your money especially if the recession is going to be long because there will be further claims down the line and you don't want to blow your treasury when down the line key expenditure will be needed to be made. It is important for governments to be prudent - unlike the US where the debt to GDP ratio is still under 50 per cent and it can go some way.

What more do you think the government needs to do by way of measures to stimulate the economy?

I think it takes a little bit of time, you are all impatient, but it will happen, there is a strong pressure to pile up measure after measure .the concern about piling on too many measures is that it may work in perverse ways and you may run out of ammo - I am not saying conserve ammo for when things get worse, but if you put lots of measures in place, they may not be as effective, so let things push through than put another.

Are the corporate governance issues like in Satyam's case going to more risk premium that investors demand?

I would believe that the authorities would look closely at what happened and find out if there are loopholes because this kind of action certainly brings the entire corporate sector into undeserved disrepute. Independent directors are a problem the world over - there are lots of ways around it - but the question of what happens and investigating what happened and how related party transactions don't take place without vetting by the shareholders is very important because there are so many possibilities of misuse.

Isn't it contradictory that the American economy is weakening but the currency is strengthening?

The currency is weakening again. But that's the point. The financial markets, the government bond markets in the US are considered so deep that, despite all mayhem breaking loose outside, people are still willing to invest. That's the point about structural reforms. The Government of India should be so trusted so that even if the economy plunges, forbid that happens, people trust government securities and put their money in.