India
Monetary Policy: Is it Too Aggressive, Too Soon?
April 17, 2007

By Chetan Ahya | Mumbai

Steep rise in interest rates in the last four months

While the Reserve Bank of India (RBI) had been gradually tightening since the second half of 2004, the pace has picked sharply over the past four months. A representative measure for a broad trend in tightening would be the trend in mortgage lending rates. While they had moved up only 50 basis points from the bottom of 7.5% during the 17-month period between September 2004 and January 2006 (we call it phase I) and 150bp in the ten-month period between February 2006 and November 2006 (phase II), it has moved up sharply by 250bp in the four-month period between December 2006 and March 2007 (phase III).  A similar trend is reflected in consumer loan rates and borrowing costs for small and medium-sized companies.

Debating measures taken by the RBI

The RBI tightening move in the past four months has raised a debate among policymakers, the corporate sector and market constituents. The corporate sector is the most vocal group. Indeed, in a recent business barometer survey by Delhi-based The Associated Chamber of Commerce and Industry of India (Assocham), 86% of the 250 CEOs, CFOs and Managing Directors believed that “the RBI has started over-reacting to the inflationary expectations without realizing that increasing the cost of money beyond a certain point would slow down economic growth” and 90% of the respondents were “upset over the RBI catching them by surprise every now and then, without giving them time to even hedge their borrowing cost in the short term”.

There have been many such arguments criticizing the RBI’s measures. In the following paragraphs, we discuss some the criticisms against the RBI’s policy moves and possible explanations for these moves:

First, a large part of the inflation pressure is due to food prices rising and that monetary policy tightening will not help it. Analysis of price trends for various WPI components indicates that a major part of the recent acceleration in overall inflation is due to manufacturing products. Over the past 12 months, while the headline overall inflation rate has accelerated to an average of 6.5% in March 2007 from 3.9%, inflation in the manufacturing products basket has accelerated to 6.6% from 1.7% (manufacturing products have a weighting of 63.75% in the WPI). During the same period, inflation in food articles, which have a weighting of 15.4% in the WPI, has accelerated to 10.6% from 5.3%. Most importantly, inflation excluding food and global commodity-linked products (a proxy for core inflation) has accelerated to 6% as compared with 3.9% in the corresponding week last year.

The weekly inflation rate has become the most widely watched number in the financial market as it is perceived that the central bank is concerned by rising inflationary pressures. We believe that inflation is only one of the symptoms of the root problem of domestic imbalance of actual growth running above potential growth. Moreover, as the central bank has already highlighted in the recent policy statements, it is concerned not only about inflation (one of the symptoms) but also about the widening trade deficit, property prices, the stretched banking sector balance sheet and credit quality.

The real issue is the demand-supply imbalance. Strong growth in demand at a time when the effective supply creation (growth in productive capacity) response is weak explains this overheating. Over the last three years, while global risk appetite-driven liquidity supported strong demand growth, government policy response to accelerate the country’s production capacity has been slow. Hence, the problem of overheating is unlikely to be resolved with three months of aggressive tightening and/or two months of denominator effect-led deceleration in inflation.

Second, why was the RBI so slow in the first place? The key argument supporting this question is that the RBI is supposed to be forward-looking and take tightening measures in time and not shock the market. However, in this context we highlight the monetary policy statements dated July 25, 2006 and October 31, 2006, where the RBI clearly presented the complexities it is facing in estimating potential growth and therefore arriving at the conclusion on overheating. While there were traditional signs of overheating like sustained high consumer credit growth, a widening trade deficit and rising asset prices, we believe that the RBI had consciously been taking some risk pursuing tightening in a measured manner. By the second quarter of 2006, in our view, it was clear that demand was running higher than supply (productive capacity) and was showing up in traditional overheating indicators.

However, the RBI did not start tightening aggressively until December 2006, as it argued that its ability to conclude on the need to tighten at a faster pace was made difficult by the fact that the economy was going through structural transformation and its gradual integration with the global economy added to the uncertainties (see excerpts from July and October 2006 monetary policies at the end of this note). In other words, the RBI did not want to go aggressive before being sure that the supply-side response would not match the accelerating demand growth.  The aim was not to over-react to a potential transient overheating.

Third, the recent aggressive tightening will slow (demand) growth: The RBI statement released on March 30, 2007 has left no doubt that the central bank is opting for price stability at the cost of growth. It appears that since the last quarter of 2006, the RBI has started becoming concerned on overheating. We believe that the first clear signal towards a coming shift in monetary policy was indicated in the October 2006 statement, which raised concerns on the issue of overheating. As further strong evidence of overheating emerged, the RBI had little choice but to slow demand growth in order to reduce demand-supply imbalances. The key objective is to ensure that the inflationary trend does not become self-reinforcing and elevate inflationary expectations.

Fourth, aggressive tightening will choke off the very supply-side response that the RBI was hoping would come through. As we have been highlighting, clearly the ideal outcome would be to get a strong supply response. The key challenge for the RBI in determining the monetary policy response to the concerns on potential overheating is the extent of the lag in supply-side changes. Although later than warranted, clearly the investment cycle is picking up and therefore in the strictest sense a large part of the supply constraints will be transient in nature. However, the effective supply creation could take some time and in the intermittent period macro stability risks could exacerbate. This lag will be particularly high in areas where government participation is required.

In this context, in December 2006, when the RBI hiked the cash reserve ratio, it indicated “there are also reports that expansion of capacity is underway, but the realisation could be constrained over the next two years”. Considering this lag, the RBI is forced to tighten right at the time when capex is picking up. Moreover, as the RBI’s statement in January highlighted, “Investment demand is strong and is augmenting productive capacity. But it is also important to recognize that the addition to productive capacity occurs with a lag and the first sign of a step-up in investment is reflected in an expansion of aggregate demand”. In other words, the RBI is indicating that in the near term even investments would only push aggregate demand higher, exacerbating the overheating problem.

Fifth, inflation is a transient problem and the country should absorb the cost of high inflation in the intermittent period instead of tightening aggressively. One of the options for the RBI would be to wait for the supply response to emerge over the next two years, appreciating the point that supply response is always inelastic, particularly during the take-off stage of economic growth. Some inflation pressure is inevitable though transient in nature. However, there are two issues before the RBI in the Indian context. The democratic political structure does not permit politicians to accept higher inflation for 1-2 years. More important, to be sure that overheating is transient, there needs to be a firm policy response from the government to ensure it clears all the hurdles in the investment cycle, particularly in the infrastructure sector. Indeed, as we highlighted in our recent note on this subject (see Supply Response: New Hurdles Are Emerging, April 2, 2007), India’s supply -side response tends to be particularly slow in areas where government influence is high. The central bank has little control over this issue.

Bottom line

We believe that the RBI pursued a balanced approach until third quarter of 2006. However, with persistent signs of overheating on account of aggregate demand running higher than supply (growth in productive capacity), the RBI has clearly chosen to focus on macro stability even if it comes at the cost of slowing growth. We believe that the RBI is unlikely to pause until there are clear signs of growth slowing. Apart from cyclical sector data points like automobiles sales, we believe that the most important indicator would be bank credit growth.

We expect the RBI to maintain tight monetary policy at least in the next 3-4 months. In the coming monetary policy statement to be announced on April 24, we believe that there is a 50% chance of the RBI leaving the policy rate unchanged. However, in such a scenario, the RBI would indicate that it is still in the tightening mode. We believe that the RBI is likely to hike its policy at least once or twice more. The wildcard for policy moves, particularly the cash reserve ratio, will be the trend in capital inflows and global risk appetite for emerging markets assets.

Appendix: Excerpts from RBI’s Monetary Policy Statements

July 25, 2006

“………..Central bankers all over the world revel over the dream run of low inflation coupled with high growth in recent years. They are confronted with the confusing realities presented by financial markets, oil markets and inflation uncertainties. They face the uncertainties of the future more acutely than ever before, since an increasingly globalised world is making assessments as well as policy options in the domestic arena very constrained. India is no exception to this, but a greater complexity is imparted since structural transformation of the economy and its gradual integration with the global economy add to the uncertainties. Yet, the trade-offs and judgments have to be made, keeping in view the criticality of timeliness in actions and flexibility to respond appropriately.

For our economy, the domestic considerations continue to dominate and maintaining growth momentum is of the highest importance, but if, contextually, priority has to be accorded to demand management, price stability, inflation expectations and financial stability, there should be no hesitation to do so. The current situation calls for some stabilising influences while keeping all the options open for the future to maintain a successful and dynamic balance between growth and stability that has been the hallmark of our macroeconomic policies during the reform period……”

October 31, 2006

“……Against this background, it is critical to be watchful for early signs of overheating. An overheating economy is one which is growing rapidly and its productive capacity cannot keep up with resulting demand pressures. Emergence of inflationary pressures is usually seen as the first indication of overheating. In this context, policy makers keenly analyse the behaviour of the output gap, i.e., the excess of current output over potential or full capacity output. In the context of setting monetary policy, judging how close an economy is to operating at full capacity is crucial. If the monetary authority senses that there is unutilized capacity, the increase in demand generated by growth can be accommodated without inflationary pressures and, therefore, the need to act against overheating may not arise. On the other hand, if demand is running ahead of full capacity, there is a case for tightening of monetary policy with a view to slowing down the economy and heading off overheating.

Globally, there seems to be increasing difficulty in identifying the symptoms of overheating. There is some evidence of a blurring of the relationship between output gaps and inflation. Moreover, the size and direction of an economy’s potential output is becoming increasingly difficult to diagnose. In particular, globalisation has expanded the supply potential of various economies, especially emerging economies. In the recent period, it appears that the current positive supply shock has made the concept of potential output fuzzier than in the past.

For a developing economy like India, the concept of overheating is less of a guide for monetary policy than in advanced economies on account of the existence of large unemployment/ underemployment of resources and the absence of a clear assessment of potential output. Furthermore, it is difficult to obtain a clear judgment of potential output in an economy that is undergoing structural transformation. Nevertheless, recent developments, in particular, the combination of high growth and consumer inflation coupled with escalating asset prices and tightening infrastructural bottlenecks underscore the need to reckon with dangers of overheating and the implications for the timing and direction of monetary policy setting. While there is no conclusive evidence of overheating in the Indian economy at the current juncture, the criticality of monitoring all available indications that point to excess aggregate demand is perhaps more relevant now than ever before.…….”

“……….In the external sector, there are signs of abiding strength and the current account deficit has been well-managed so far. On the other hand, there are indications of growing demand pressures and potential risks from rapid credit growth and strains on credit quality. High levels of monetary expansion and the evolution of the liquidity situation will need to be continuously monitored for any signs of risks to inflation. The elevated levels of asset prices also represent a risk to the outlook for macroeconomic and financial stability. In brief, at the current juncture, for policy purposes, the two major issues that exert conflicting pulls are exploration of signs of overheating firming up to warrant a policy response, and, the impact of lagged effects of earlier policy action on the evolution of macroeconomic developments…..”

“….recent developments, in particular, the combination of high growth and consumer inflation coupled with escalating asset prices and tightening infrastructural bottlenecks underscore the need to reckon with dangers of overheating and the implications for the timing and direction of monetary policy setting. While there is no conclusive evidence of overheating in the Indian economy at the current juncture, the criticality of monitoring all available indications that point to excess aggregate demand is perhaps more relevant now than ever before.”

December 8, 2006

“……….As per the RBI’s Industrial Outlook survey, a majority of respondents from the private corporate sector expect higher increase in prices of both inputs and outputs. There are reports of growing strains on domestic capacity utilisation. There are also reports that expansion of capacity is underway but the realisation could be constrained over the next two years…”

January 31, 2007

  “........the demand for bank credit remains high, extending the high growth phase that began in 2004. Accordingly, concerns remain relating to credit quality and that some banks may be overextended in terms of the balance between sources and uses of funds, as reflected in high credit deposit ratios. The growth in banks’ investments in Government and other approved securities appears to be low relative to credit growth. Excluding LAF holdings, banks’ SLR investments are close to the statutory minimum which has implications for liquidity management. Credit growth is also being reflected in the sizeable and higher than anticipated expansion in money supply. <…….>on the external front, the trade deficit, which is a relevant indicator of domestic demand conditions had expanded to 6.5 per cent of GDP in 2005-06 and is set to rise even higher in the current financial year. Export growth has regained vigour, but there are shifts in the pattern of imports. There are reports that expansion of capacity may be constrained in terms of pending import orders. <…….> there is increasing evidence that the infrastructural bottlenecks are becoming tighter and more binding. <…….> some indications of wage cost pressures seem to be in evidence. Surveys of corporate activity show that the staff costs of the sampled firms increased sizeably in the first half of 2006-07, particularly for information technology (IT) and services companies. While staff costs in manufacturing firms have increased at a more moderate pace, they are likely to face incipient pressures on margins from rising input costs. <…….> elevated asset prices are generating wealth effects which are fuelling aggregate demand.”

 

March 30, 2007

“……….The stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability with immediate monetary measures and to take recourse to all possible measures promptly in response to evolving circumstances…..”

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Strategy & Economics
Me, My Wife and My Financial Advisor
April 17, 2007

By Gerald Minack | Sydney

I recently attended a meeting where my wife and my financial advisor discussed what to do with my money.    Neither reads my research, but they know my views so all I was allowed to bring to the meeting was the coffee.  What interested me, as an uninvolved observer, was the apparent irresistible attraction of leveraging up — an attraction that others have clearly succumbed to

The reason for the meeting was that I’ve lost what has been my favorite long-term investment — one that generated a guaranteed after-tax return of around 8% — repaying my mortgage.  Owning your own home outright was something that my parents’ generation strived to achieve; the final mortgage payment was a cause for celebration.  But times have changed.  My financial advisor now saw a mortgage-free home as on opportunity to — you guessed it — increase my debt.  It seems an unencumbered asset is a wasted asset. 

With that meeting in mind, this note looks at:  1) why borrowing to invest is so attractive; 2) the extent of household borrowing; and 3) the risks.  

Losing to make money: The attraction of debt

Let’s take an example:  buying a rental property with an after-cost yield of 2%, funded at around the current mortgage rate of 8%.   (Gross rental yields are now closer to 3.5%, but the yield net of direct costs is closer to 2%.)  The break-even capital gain on that combination of funding and yield is just over 3%. 

There are a few points to note about this:

The break-even capital gain for the example of 8% funding cost/2% asset yield is barely above the RBA’s inflation target.   In other words, negative gearing ‘works’ even if there is no appreciation in real asset prices.  

This doesn’t capture opportunity cost.   However, compare the alternative — say, an unleveraged purchase that yields the long-bond rate (now around 6%).  This adds 60bp to the break-even capital gain requirement.  So, for example, for an 80% debt-funded purchase of a residential property yielding 2% to beat the return on a 6% government bond, the required capital gain is 3.6%.  (I’ve assumed no capital gain on the bond.)   In other words, the hurdle is not a lot higher.

The attraction of negative gearing is not particularly sensitive to interest rates.  A 1% lift in funding costs lifts the break-even capital gain by 50bp (per year).  Put another way, a 25bp tightening by the RBA will have barely a decimal point impact.

The tax rate has a perverse impact.  The tax rate enters the calculation in two places: first, it drives the value of the negative gearing; second, it also affects the tax on the capital gain.  But remember that only half the capital gain on an asset is taxable, while all the financing loss is deductible.  As a result, a lower tax rate means that the reduced capital gains tax is more than offset by the reduced benefit of negative gearing.  For someone on a marginal tax rate of 25%, the break-even capital gain on the typical investment property rises to 3.8%.  In other words, tax cuts increase the capital gain hurdle rate.  Or, put another way, a higher tax rate makes borrowing more attractive. 

Borrowing-to-invest has been a hugely successful strategy for the past 20 years.  So not only do the numbers look attractive, but deeply embedded experience says it works. 

The bottom line is that leveraged investing has worked in the past, and seems likely to continue working even in a ‘normal’ environment for asset prices — that is, assets don’t need to continue to generate the super-normal returns seen through most of the past two decades to encourage leverage.  

Everyone’s doing it: The rise and rise of debt

Household leverage has exploded.  Households borrow not just to invest — the household sector is running a cash flow deficit (in the jargon, negative net lending).  The net lending concept is different to the traditional household saving rate.  Broadly speaking, it adds back to saving non-cash expenditure items (notably, depreciation), but then takes account of households’ investment spending (largely, but not solely, residential investment spending). 

In theory, net lending should equal the household sector’s borrowing less its purchase of financial assets.  In practice, there is a discrepancy between the two series due to errors and omissions.  This error can be reasonably large: in the year to the June 2006 quarter, for example, the reported cash flow deficit for the household sector was A$47.5 billion, while the net increase in debt was A$30.1 billion.  A A$17 billion error is not trivial.  However, I will ignore it because this error is dwarfed by the gross flows, which is what I will focus on. 

Net lending and gross financial flows provide a measure of the extent to which Australians are following their financial advisers’ advice and borrowing to invest.  In 2006 Australians purchased $99 billion of financial assets, and increased their debt by $124 billion — or 22% of household income.   These are flows; not captured here is the valuation change, particularly of the assets.  The rise in asset prices means that net wealth continued to increase, even though borrowing far exceeds the purchase of assets. 

Who is doing the borrowing?  Most people, it seems.  The best data on investment relates to property, because tax records show who owns a rental property.   While higher income earners are more likely to own an investment property, a sizeable percentage of average income earners (say around $55,000 per year) own properties.  Moreover, there is a less pronounced income skew for properties that are run at a loss.   Also remember that the number of income earners in the top groups is relatively small.    Taxpayers in the top bracket (over $200,000 per year) own only 2% of investment properties; taxpayers in the $50-80,000 bracket own 25% of loss-making investment properties. 

The ‘attraction’ of losing on an investment — that is, negative gearing — is clear from tax office records.  In 2003-04, the latest year for which tax data are available, 64% of property owners claimed that the property was loss-making, up from 54% in 1994-95.  Given the increase in the number of property investors, it means that 8.5% of tax payers now claim to own loss-making properties, up from 5.8% a decade earlier. 

The aggregate numbers provide more evidence of the ‘success’ of this approach.  Using national accounts data, it now seems that the household sector has turned its housing stock into a substantial cash-flow drain — reversing the long-standing trend.  The cash-flow drain also now offsets aggregate dividend income from equities. 

Bear in mind, however, that these figures only take into account the cash flow on these investments.  The simple point is that investors have made money due to capital gains.  And the seemingly low hurdle rates suggest that households will continue to borrow to invest in such cash-flow negative assets.

What could possibly go wrong?

The headlong rush into leveraged investment raises two risks. 

The first is that the investments don’t work out — that is, that past performance is no guarantee of future success.   As discussed above, interest rates do not appear to be the most likely problem — although the RBA may tighten further, it seems very unlikely that it will tighten by the hundreds of basis points required to undermine the apparent attraction of borrowing to invest. 

The big investment risk is that those capital gain hurdle rates are actually too high to jump.  I think that that is possible, even, say, on a 10-year horizon.  Looking at rolling 10-year returns on Australian equities, negative returns over that horizon can happen, but the past 20 years have seen exceptionally high returns. 

In fact, the single most important determinant of long-term investor returns is fairly simple: the price at which the asset was bought.  Buy a cheap asset and returns tend to be high, buy an expensive asset and returns tend to be low.  In the early 1980s, Australian equities were exceptionally cheap; now they look exceptionally expensive. 

The second risk — the unstated risk — is not connected with the investment side of the leverage transaction.  It’s the risk that the debt burden cannot be maintained.  In short, the second risk is not investment-related, but economic/income-related: that the investor can no longer sustain a cash-flow negative asset. 

To again focus on housing, it’s possible to calculate the income drag on loss-making investment properties for various income levels. The aggregate loss across all taxpayers is insignificant.  The aggregate loss for all property owners is more significant — at the low end, the reported loss on the property is equivalent to 22% of income.  Further narrowing the focus to just taxpayers who claim that their property is loss-making, the burden becomes significant at almost all income levels — the loss accounts for 10% or more of taxable income for all but the highest paid. 

This points to the heavy financial burden that borrowing-to-invest puts on participating households.  It also emphasizes the point that when looking at credit risk, averages are meaningless.  The average household will never go broke.  But the period of super-leverage has greatly increased the number of at-risk households.   In 2003-04, there were 938,015 taxpayers who claimed to own loss-making rental properties.

All this underscores my long-held view that the next downturn will produce a major credit shock. 

What’s not clear, of course, is when that may occur.  But the fact is that with the attraction of leverage seemingly irresistible, it’s very likely that the debt levels will continue to rise until the next downturn arrives.  Ironically, therefore, the later the downturn comes, the worse it will be.  The only basis for not being worried is if you believe that there will never be another downturn. 

Finally, for investors themselves — even those not exposed to the credit risks — the existence of huge amounts of leverage-backed assets means that there is the likelihood that even a vanilla economic downturn will turn into an asset market rout.   Let’s put it this way:  I’m not going to mortgage the house to invest in markets. 

 

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