How effective can the tool of Interest Rates be in guaranteeing future long term growth

[Providence]

I would like to discuss my thoughts on the matter here.

This is the thread which prompted me to think in this regard :

Old geographies, new orders -- China, India and the future of Asia


Thoughts are with respect to emerging economies only.


My stand : Interest Rate changes with a sole focus on inflation alone will be detrimental to long term growth prospects for the economy contrary to what the central banks in these countries might perceive to be the case.


Reasons :

(classical view - in literature)

Effect 1 : High interest rates will/are affecting negatively the cash flows of the huge infrastructure projects taken up during the global boom era of pre 2009.

(classical view - in literature)
Effect 2 : It has also been detrimental to present investment in economy which could have led to increased outputs in future.

Fact1 : Not only has the production capacity utilisation fallen from ~85% to around 75% in India but industrial investment has literally nosedived in both Brazil and India.

Fact2 : The NPA assets have also risen mostly in steel & infra sector more than agriculture.

( My Inputs )

Effect 3 :
Because of high cost of borrowing, the firms are tightening their working capitals in a big way. Like reducing inventory levels and reducing the no of shifts in factories etc thereby reducing the factory outputs.

Now, everyone will also agree that in most emerging countries, a significant portion of durable expense is debt funded. Eg Almost 100% of your car is on loan(credit), or say 70% of bikes are on loan, even AC/washing machines etc are on loan say 50% . The high rates therefore killing the consumption levels and people are now delaying their plans to purchase them more and more into future.

How most economists interpret the situation ? This is a momentary pause and everything will again function like a well oiled machine when interest rate drops ? -

This can't be any further from truth. What I will say is the economy in a manner of speaking would have effectively regressed or contracted. And reason is, the economy not only has to prop up the investment levels but demand which had vanished, also has to prop up. Basically your starting point after "the pause" is not where you had stopped before the turmoil but couple of steps behind where you were.

(My inputs)

Effect 4 :

Because of high interest rates, people borrowing are more interested in investing in high return projects or high speculative assets.

This may have a profound effect. These speculative assets may have large gestation periods and a risk element will be introduced and persist in the economy till the project ends. Also, as the world is seeing more of these cyclical shock and growth phases, more and more of the risks will be introduced in the economy
Also the fact that you will have to support your previous high risk projects during the next phase of recession, will make matter more worse.



@LeveragedBuyout Would you be so kind to share your thoughts in this regard ?

 

[asquare]

My two bits, posted in the other thread where you first raised these points-

While I agree with your analysis partially, I think you've misunderstood, somewhat, the motivations behind the high interest rate, at least in India.

While the RBI's (Indian central bank) inflation mandate is important, it has a financial stability mandate as well (of course, no central bank discusses financial stability concerns as explicitly as inflation concerns). Focussing narrowly on the inflation mandate, consumer price index (CPI) inflation was at double digits last year and is expected to be at around 6% in January. I think the 6% figure is reasonable for a developing country like India. If 6% sustains up to March, we should see some monetary easing.

Coming to the more relevant part for this discussion, the financial stability aspect, the current RBI governor is a strong believer in leverage cycles i.e. like GDP, aggregate leverage expands and contracts; peaks of leverage represent the most pressing challenges to financial stability. High interest rates force bad projects (and the companies that run them) that were executed only because credit was cheap to shut down. Highly leveraged firms either have to find a way to deleverage (if they are good enough to attract investment) or they have to shut down. This has been seen in the case of the Jaiprakash Group, a huge infrastructure conglomerate, that seems to be on the verge of shutting down because they can't service their debt at these interest rate's. Theres a similar story at the largest real estate developer, DLF.

The underlying belief is that purging bad loans, by making them unaffordable for the borrower, will help to make growth more sustainable in the long run. It is an extremely conservative approach to monetary policy, but not one entirely without merit. The current governor was a U of Chicago professor who was a loud voice predicting impending doom in the pre-crisis years. I think some of the conservatism comes from that experience. Wether he is being too conservative is up for debate, essentially a growth vs long term stability debate. The Chinese have not been as conservative when it comes to the financial sector, what impact that'll will have on their banks is yet to be seen. I wouldn't put it past the Chinese to keep things stable without a hitch, the have a knack for making things work. We haven't displayed that sort of competence, so far.

To your last point, it is one that economists are aware of- it's called 'hysteresis'- the effects of depressed economic activity persist well in to the future. There is someone at every central bank calculating the impact of hysteresis effects on the economy. They'll have an estimate and will have weighed it against other factors. So it's not that they aren't aware of it, they might have assigned too small a weight to the issue of hysteresis, depending on your perspective.

EDIT: To add a response to effect 4: This is called 'adverse selection' in the literature. The problem where you push all worthy creditors out of the market, because moderate risk projects can't finance loans when interest rates are high. Only very high risk/return projects get executed.

This is really the domain of proper regulation. It starts with simple things like better Know Your Customer regulations and extends to more complex micro-prudential issues. You're right, high interest rates need to be accompanied by very careful regulation.

A point that I missed earlier, the central banks are also concerned with currency stabilisation. While the RBI has indicated it's willingness to let the rupee slide to INR 70 to the dollar, it wants to do this in a gradual and controlled manner. We should see 65-66 levels once the rate cut is executed around March. Any more drastic rate cuts could accelerate the depreciation of the rupee.

What I'm trying to point out is that the central banks monetary policy stance is based on very complex considerations. As to wether the current monetary policy stance in India, Vietnam and other developing countries is optimal, I don't really know. To be honest, most economists will be on the fence and the finance guys talk through their asses in any case! If you want to read someone who has very strong opinions and thinks central banks are, in general, too conservative, check out Paul Krugman. Despite his Nobel, he's a somewhat discredited figure among economists, but he has a large following outside the profession.

 

[Providence]

Thank you for introducing me to some nice terms. I just have a 2 lecture experience in macro-economics so please indulge me even if I sound un-intelligent at any point.

While I agree with your analysis partially, I think you've misunderstood, somewhat, the motivations behind the high interest rate, at least in India.


Coming to the more relevant part for this discussion, the financial stability aspect, the current RBI governor is a strong believer in leverage cycles i.e. like GDP, aggregate leverage expands and contracts; peaks of leverage represent the most pressing challenges to financial stability. High interest rates force bad projects (and the companies that run them) that were executed only because credit was cheap to shut down. Highly leveraged firms either have to find a way to deleverage (if they are good enough to attract investment) or they have to shut down. This has been seen in the case of the Jaiprakash Group, a huge infrastructure conglomerate, that seems to be on the verge of shutting down because they can't service their debt at these interest rate's. Theres a similar story at the largest real estate developer, DLF.

The underlying belief is that purging bad loans, by making them unaffordable for the borrower, will help to make growth more sustainable in the long run. It is an extremely conservative approach to monetary policy, but not one entirely without merit. The current governor was a U of Chicago professor who was a loud voice predicting impending doom in the pre-crisis years. I think some of the conservatism comes from that experience. Wether he is being too conservative is up for debate, essentially a growth vs long term stability debate. The Chinese have not been as conservative when it comes to the financial sector, what impact that'll will have on their banks is yet to be seen. I wouldn't put it past the Chinese to keep things stable without a hitch, the have a knack for making things work. We haven't displayed that sort of competence, so far.

Couple of facts ( If you doubt the values please ask for reference - i don't have them now with me )

Fact 1: Check the level of NPA in those banks. It has actually increased. Check your central bank report.( not sure about the time line ) ( increase from 2.2% to 2.4% )

The idea of purging non performing assets only because it was highly leveraged and may have been only profitable above certain levels of GDP growth is extremely regressive. It inherently assumes that the recession years will be prolonged than what they publicly say and thus it's better to get rid of them NOW.

Also, who is actually supporting the failed debts now ? Your government only through the national banks !


Also by reinforcing such extreme views, what you guys are encouraging is, during the times of growth when a lot of projects will come, a lot of them will be rejected merely because there "might be" an economic shock 10 years down the line ? To me it sounds funny actually. Eventually, you guys will be the one losing out.

So effectively you guys are losing out now ( since projects are being purged now ) and will lose out in future ( decent enough projects won't take off hurting the economic activity levels )

How is that a pragmatic approach ?

To your last point, it is one that economists are aware of- it's called 'hysteresis'- the effects of depressed economic activity persist well in to the future. There is someone at every central bank calculating the impact of hysteresis effects on the economy. They'll have an estimate and will have weighed it against other factors. So it's not that they aren't aware of it, they might have assigned too small a weight to the issue of hysteresis, depending on your perspective.

It is called hysteresis effect thank you but how is this part answering my points ?

If I understood it correctly, effectively you are ok with starting couple of steps behind when each recession strikes just because you guys have to purge the projects which aren't viable no more ?

This is really the domain of proper regulation. It starts with simple things like better Know Your Customer regulations and extends to more complex micro-prudential issues. You're right, high interest rates need to be accompanied by very careful regulation.

Yes, actually because of high interest rates, only speculative and borderline non-speculative projects would be cleared for execution. How is that leading to long term sustainable growth

 

[asquare]

Thank you for introducing me to some nice terms. I just have a 2 lecture experience in macro-economics so please indulge me even if I sound un-intelligent at any point.





Couple of facts ( If you doubt the values please ask for reference - i don't have them now with me )

Fact 1: Check the level of NPA in those banks. It has actually increased. Check your central bank report.( not sure about the time line ) ( increase from 2.2% to 2.4% )

The idea of purging non performing assets only because it was highly leveraged and may have been only profitable above certain levels of GDP growth is extremely regressive. It inherently assumes that the recession years will be prolonged than what they publicly say and thus it's better to get rid of them NOW.

Also, who is actually supporting the failed debts now ? Your government only through the national banks !


Also by reinforcing such extreme views, what you guys are encouraging is, during the times of growth when a lot of projects will come, a lot of them will be rejected merely because there "might be" an economic shock 10 years down the line ? To me it sounds funny actually. Eventually, you guys will be the one losing out.

So effectively you guys are losing out now ( since projects are being purged now ) and will lose out in future ( decent enough projects won't take off hurting the economic activity levels )

How is that a pragmatic approach ?



It is called hysteresis effect thank you but how is this part answering my points ?

If I understood it correctly, effectively you are ok with starting couple of steps behind when each recession strikes just because you guys have to purge the projects which aren't viable no more ?

While NPAs have increased, I'm not sure how much of the increase is simply a result of better disclosure norms.

Your point about high interest rates, potentially, causing projects that would might otherwise be profitable to be avoided is valid. On the other hand, there's the argument that easy credit through low interest rates leads to financial instability. I would argue that it's better to have the true extent of bad projects known, to have them written off as NPAs and allow the NPAs to work their way through the system than to have the bad projects 'hidden' by low interest rates. Where the interest rate should be, to allow an 'optimal' quantum/quality of investments to take place is a tricky question. How central banks attempt to answer this is to run simulations (these days, these simulations are vey detailed and involve large scale macroeconomics models) with a number of scenarios which include various combinations of growth rates, productivity rates, interest rates, default rates etc (these models are called dynamic stochastic general equilibrium models). So what your argument comes down to is not wether the policy is inherently right or wrong but wether the scenarios being simulated are too pessimistic or not. I don't know the answer, I stopped being a macroeconomist almost 6 years ago now- all I'm trying to say is that your points are taken into account by every central bank.

The 'bare bones' model, which a lot of central banks build on, can be found here- http://www.nyu.edu/econ/user/gertlerm/science.pdf

My only point while raising hysteresis was to point out that the central banks, which are setting higher interest rates, are aware of this effect. Like all economists, they are trying to assess all the trade offs involved (in this case, financial stability and controlled inflation vs higher growth) and arrive at an optimum. I wish I had a better answer to the question 'Are they getting their assessment right?'. Unfortunately, I'm really not qualified to comment anymore. That's a question of what models they are using, are the models good, and how well they are interpreting the results. I can assure you that they take the growth vs. stability trade off very seriously though.

 

[Providence]

The 'bare bones' model, which a lot of central banks build on, can be found here- http://www.nyu.edu/econ/user/gertlerm/science.pdf

My only point while raising hysteresis was to point out that the central banks, which are setting higher interest rates, are aware of this effect. Like all economists, they are trying to assess all the trade offs involved (in this case, financial stability and controlled inflation vs higher growth) and arrive at an optimum. I wish I had a better answer to the question 'Are they getting their assessment right?'. Unfortunately, I'm really not qualified to comment anymore. That's a question of what models they are using, are the models good, and how well they are interpreting the results. I can assure you that they take the growth vs. stability trade off very seriously though.

Firstly, I have never claimed that I have discovered something new. Else I would have been writing papers.

Secondly, what better disclosures ? There has been no change in accounting standards and most NPAs are in infra and Iron & Steel sector. These NPAs are now owned by government owned banks which is an effective deduction from GDP in a manner of speaking.

Thirdly, my point is not wether the factors in my original post are taken in the model but the inflation focussed Interest rate changes as a policy per se.

I am looking for inputs in ways govt can stop the consumption levels from dipping and avoid starting from couple of steps behind so to say !

 

[asquare]

Secondly, what better disclosures ? There has been no change in accounting standards and most NPAs are in infra and Iron & Steel sector. These NPAs are now owned by government owned banks which is an effective deduction from GDP in a manner of speaking.

For instance, the NPA rules for Non Bank Financial Corporations (NBFCs), that are essentially quasi-banks which provide a lot of infrastructure loans among other things, have been made much stricter. I don't know if the RBI figure for NPAs included NBFCs or not. I would argue that identifying NPAs (and the bad projects that underlie those NPAs) is good thing, no matter who owns them. How do you see this as a reduction in GDP- GDP is only the value of goods and services produced domestically in a given year? It could have a positive or negative impact on future GDP depending on wether the interest rate set was optimal or not.

Thirdly, my point is not wether the factors in my original post are taken in the model but the inflation focussed Interest rate changes as a policy per se.

I am looking for inputs in ways govt can stop the consumption levels from dipping and avoid starting from couple of steps behind so to say !

This is a very important question. Encouraging domestic consumption takes a number of forms- from consumption tax credits, better availability of consumer credit (everything from consumer credit unions to allowing micro lending units), to reducing the current account deficit so that a lower percentage of domestic savings are used up in financing foreign liabilities.

A huge factor is providing better social safety nets (like social security) that give people the confidence to increase consumer spending throughout their lives. A stable social security system is the reason why savings rates are much lower in the developed world.

 

[LeveragedBuyout]

@Providence Thankfully, @asquare has already provided an excellent explanation, so there's little for me to add. I would only offer, from a manager's perspective, that low inflation leads to better long-term planning, and low inflation leads to a "harder" currency (which stabilizes the financial system, encourages rational consumption, and ameliorates current account deficits for certain types of import-dependent economies). That's is why the first mission of most central banks is to control inflation, because an inflation rate that exceeds certain thresholds inflicts widespread damage on the economy.

That said, the United States Federal Reserve does have a dual mandate that targets both low inflation and maximum employment. In recent years, the emphasis has been on employment, but that is because the inflation monster was conquered through credible (and employment-damaging) efforts 30 years ago.

It appears you are specifically referring to India in your OP, but I am not qualified to speak about India's particular needs, since I am not familiar enough with its economy. Generally speaking, though, I agree with @asquare that reducing leveraged speculative investment is a worthy goal, both focusing investment away from low-quality mal-investment (leading to higher productivity and greater returns) and also reducing the creation of NPLs in the future from that mal-investment.

 

[tranquilium]

Keep in mind that interest rate is only one of the many tools available for a country to adjust its economic policy, particular for a country like China which has a powerful control over its monetary and economic policy.

I can't speak for India, but here is my analysis for China:

Effect 1: Chinese major infrastructure projects are funded by government. This is completely independent of interest rate as demonstrated by the rapid rate of Chinese infrastructure development in the past decade. In fact, vast majority of Chinese stimulus during the 08 crisis is in form of infrastructure projects instead of loans.

Effect 2: This effect might have been the case, but you forgot the counterforce to investment imbalance----regulation and subsidiaries. For example, China handled overflow of capital into steel industry by setting environment regulations to curb small steel mills.

Effect 3: For China, this one is more related to culture. Chinese doesn't like borrowing or owing debt. For example, housing purchase "down payment" in China is typically in range of 80% to 90% of the whole price. Culturally, Chinese family tends to have large amount of saving and only make purchases when they can pay the whole thing up front.

Effect 4: Again, this only applies if there is no regulation and political interventions. For example, Chinese real estate market was overheating in 2011 to 2012 and the government responded with policy intervention, which diverted capital flow away from these risky and frankly, less productive sectors.

I always found it is strange why people would lump "developing coutnries" together. Each country is an unique animal. What is true in one place is not necessarily true in other places.