The Hindu Business Line : Let's keep the yield curve flat

India is among a few large economies with a flat yield curve. This is an extraordinary and positive achievement accomplished by policies aimed at lowering the incremental long-term interest rates over the short-term rates. By keeping import tariffs as low as possible and the FDI door wide open, India can keep the yield curve low and flat, say G. Ramachandran and S. Naresh.

"There have been three great inventions since the beginning of time: Fire, the wheel and central banking."

— The Economist, quoting Will Rogers, the American humorist, Survey of the world economy, September 23, 1999.

IT IS not a question of whether volition and effort have gone into flattening the yield curve in India. The question is if volition and effort should go into giving a positive slope to the yield curve.

If volitional effort can indeed make the yield curve acquire a preferred slope or remain flat, then such volitional effort should be expended towards keeping the yield curve flat in India.

By keeping the yield curve flat and low, the Reserve Bank of India — the central bank — would significantly improve the probability of the economy growing at a rate of over 6 per cent.

India is among a few large economies of the world with a flat yield curve (Business Line, August 22). The flattening of the yield curve may be regarded by some as happenstance. It is not.

It is an extraordinary and positive achievement. It has been accomplished by policies aimed at lowering the incremental long-term interest rates over the short-term rates. The policy aimed at encouraging long-term foreign direct investment (FDI) is an example.

Short-gestation assets

The key to improving the probability that the economy would grow at over 6 per cent lies in promoting the allocation of household incomes to consumption, and the allocation of a very large part of domestic savings to short-gestation assets.

Short-gestation assets include inventories of food and clothing, factories that assemble appliances from imported components, and infrastructure such as trucks that have low payback periods. In this context, assets such as housing are equivalents of short-gestation assets because they boost current period consumption.

By contrast, long-gestation assets have long payback periods. Long-gestation assets such as steel mills and dams take years to justify the initial investment and to deliver what they promise. They are typically concentrated in a few locales of the economy with the benefits moving laterally as well as down, but slowly.

Therefore, long-gestation assets tend to be risky and vulnerable to adverse price changes. Investments in steel mills in Bokaro, Rourkela, Durgapur and Bhilai show that the lateral movement and trickling down may take longer than expected.

Long-gestation assets are a must for an economy. But the obsessive focus on the creation of long-gestation assets has had its adverse effect on the total economy. What is disturbing is that they have delivered less than promised.

As a result, India faces a daunting revenue deficit. Moreover, it has become necessary for the government to use a very large part of tax revenues and borrowings merely to pay for the administrative overheads and interest on borrowings. There is little investment now by government now on long-gestation assets. It is difficult to escape the realities of checks and balances!

A turnaround in the fiscal health of the nation — from awful to awesome — can be accomplished by accepting the realities of the checks and balances that have emerged. The turnaround can be accomplished by promoting consumption and investments in short-gestation assets. It is not surprising that the flat yield curve has been signalling this shift and the reality that underpins the turnaround.

The `why' curve

Yield curves show what it costs to borrow money over a range of loan periods from the present to, say, ten years and beyond. Yield curves typically show the interest rates when the government is the borrower and where there is total certainty that it would honour all claims when due.

An economy's yield curve is considered flat when long-term interest rates are not considerably higher than short-term interest rates. The yield curve is flat and low — in relative terms — when long-term and short-term interest rates are not too high in comparison with the long-term growth expected in the economy.

By contrast, a yield curve would have a significant positive slope when the interest rate on a ten-year loan is, say, 5 per cent more than the interest rate on a one-year loan. The higher interest rate on the longer-term loan signals the higher demand for money to be invested in longer-term assets than in shorter-term assets.

The slope of the yield curve — 500 incremental basis points over the incremental nine-year period — may be justified by the higher expected return on assets with a gestation of ten years.

The yield curve can have a significant negative slope when the interest rate on a ten-year loan is, say, 5 per cent less than the interest rate on a one-year loan.

Negatively sloped yield curves occur infrequently but they are not improbable. The lower interest rate on the longer-term loan signals the higher demand for money to be invested in shorter-term assets than in longer-term assets. The negative slope of the yield curve may be justified by the higher expected return on shorter-term assets, say, inventories of consumer goods.

The general inference that economists make from yield curves is that the slope signals the equilibrium demand for money that can be profitably invested in assets of different gestation periods. The joint inference is that the slope signals the equilibrium supply of money through allocation of incomes by households to assets of different gestation periods.

When the slope is positive, producers are willing to pay higher interest rates to finance assets with longer gestation. Savers require a higher interest rate to invest in long-gestation assets. When the slope is negative, producers are willing to pay higher interest rates to finance assets with shorter gestation.

Flat is not bearish

Many economists and analysts hold the view that a flat yield curve signals a bearish long-term outlook. The lowering of long-term interest rates with respect to short-term rates has often been regarded as a signal of a drying up of attractive opportunities to create long-gestation assets.

From such a perspective, the flat yield curve may be seen as a signal of the drying up of the demand for creating long-gestation assets in India.

However, such an inference would be quite erroneous. The demand for creating long-gestation assets in India has not dried up. What have dried up are the government's penchant and its need for creating long-gestation assets. If the yield curve is seen as a chart of interest rates where government is the borrower, it becomes evident that the government has no particular need to borrow long term to merely pay interest on past borrowings and to pay for administrative costs.

Interest on past borrowings and administrative costs are short-term uses.

If they were unlikely to be met and paid off, there would be a rise in short-term rates and a fall in long-term rates. Such a two-step process too would lead to the flattening of the yield curve.

However, the flattening of the yield curve in India has not been the result of a rise in short-term rates and a fall in long-term rates. It has been the result of a pronounced fall in long-term rates and a slightly less pronounced fall in short-term rates.

This two-step process could be regarded to belong to a global fall in interest rates. But it may be more apt to regard it as a sign of bullish expectations of consumption and a pronounced rise in tax revenues to government on the back of consumption and an all-round rise in incomes driven by consumption.

Towards utilitarianism

Fire and the wheel predate central banking by many millennia. There is little that is utopian about fire and the wheel. For long they have been regarded as the most utilitarian of inventions around which humankind and human civilisation have progressed.

The combination of the wheel and fire in the form of the engine, the locomotive and the automobile has accelerated progress beyond ordinary expectations.

The effectiveness of the wheel, fire and the combination thereof is primarily the result of their utilitarianism.

Central banking is a 20th century invention in its current form. Its original task in the 19th century was to finance government spending. Its original aims were unrelated to the achievement of price stability. However, objectives related to price stability have overwhelmed all other utilitarian needs over the last three decades in some of the major economies of the world.

Central banking in India has shown that there is little need to allow utopian objectives to overwhelm utilitarian objectives.

The steady growth over the last three decades has been achieved amidst reasonable price stability. India's utilitarianism can be further reinforced by keeping the yield curve flat and by promoting consumption and the creation of short-gestation assets. Would the above fuel inflation? No. Short-gestation assets are most effective in promoting supply to satisfy unmet demand.

Moreover, India can keep its reputation for maintaining price stability intact by keeping import tariffs as low as possible and the FDI door wide open. Imports and FDI would together keep the yield curve low and flat. Consumption would then fuel a spurt in jobs. That is the recipe for all-round growth.

(The authors are financial analysts. Feedback may be sent to markets@prosyslab.com or indiagrow@sify.com)

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