Source :Money life :R Balakrishnan:
Inflation is eroding investments and the central bank’s monetary policy regime is preventing money from flowing into avenues of growth
Inflation is the biggest destroyer of wealth.
If I had put aside a sum of Rs100, 10 years ago, I would have earned around 7%pa as returns. Today, I would have had around Rs200 in hand. Ten years ago, I could buy dal at under Rs20 a kg or buy a litre of petrol at under Rs25.
Today, dal is close to Rs100 a kg and petrol is over Rs60 a litre—and climbing. Of course, vegetable and food prices have more than tripled over this time. In essence, what I saved 10 years ago is today worth less than half my original investment.
Half of my ‘savings’ has been destroyed because I did not spend it. More important, my assumptions of 10 years ago, that what I put aside would suffice for me today, have gone terribly wrong. If I cannot earn additional income (10 years ago, my plan was to stop having to go to work at this stage in my life, presuming that my savings were enough), I have to scale down my expectations or sell off some other assets.
Inflation is not going to come down anytime soon. To me, the biggest damage has been done because of the increase in interest rates on savings account deposits, by the RBI (Reserve Bank of India). It virtually amounts to the regulator giving up on inflation. I would, in its place, have reduced the savings account deposit rate to zero!
Until a few years ago, savings account balances beyond Rs1 lakh would not earn interest on any excess amount invested beyond this cut-off level. Today, banks pay interest on the entire balance. The result of this move by the RBI is that people tend to create a higher benchmark in terms of expectation of returns. If the savings rate had been brought down to zero, not many (barring some vested interest groups) would have protested.
At the same time, it would have had the magical effect of lowering people’s expectations. Today, the savings account interest rate has become a kind of base point of expectation. Naturally, to park money anywhere else, we need higher returns. If the savings interest rate were zero, our expectation of return from other instruments or avenues would have been lower.
Similarly, the RBI has hiked interest rates across the board. Now, we are seeing 10-year instruments being floated with yields of 12%pa, and higher! It is not as if banks are flush with money and that RBI will reduce credit offtake due to this move.
In fact, banks do not have enough money to lend. And a company will not stop borrowing for its regular needs simply because the interest rate has gone up by a couple of percentage points. In fact, due to lack of additional supplies coming in, competition is minimal in most industries.
This gives companies the leeway to pass on the increased burden of higher interest rates to the buyer. Inflation gets worse due to this vicious cycle.
What will get impacted is capital expenditure. Large projects will get postponed due to high interest rates.
In this environment, the villain of the piece is retail lending. It continues to grow unabated. Increase of a couple of percentage points in interest rates has not deterred spending. The consumer durables and automobile industries are growing at record rates.
Most of this growth is on account of credit purchases. Of course, it does help these industries, but these goods are virtually immune to price hikes in today’s environment of unfettered ambition and consumerism. Banks are continuing to grow this portfolio, unmindful of credit quality. The race for market share and the gambler-like urge to keep growing the retail ‘book’ has diverted the focus of banks to size rather than quality.
Many banks and lenders have outsourced even the critical function of origination of loans to third parties. Obviously, this will result in mounting bad debts. I am seeing consumer portfolios that have gone bad, being sold at 10% (or lower) of the outstanding value to other banks or asset-reconstruction companies.
Consumer activism and a benign regulatory attitude to defaulters have made it very easy for an individual to default—and not change his lifestyle in any way. Smart borrowers are using this aspect to run up loans, negotiate them after deliberate default and go on with their normal lives. I do not think that the scores from a credit bureau will have much impact in the near term, so long as it is used only as a pricing tool, rather than a denial of credit mechanism.
Credit is a useful mechanism to bring buyers and sellers together. However, when the number of buyers is more than the sellers, credit will only serve as a tool to push prices up. As the old saying goes, when credit has to be ‘sold’, it will end up as a bad debt.
This cycle will end either by supply catching up with demand or by prices going up to such an extent that, at some point, buyers will vanish, or their numbers will shrink dramatically. Supply does not look like it is going to catch up in a hurry. What is most likely is that we will go through a phase of rising prices.
To me, this is scary. We will see apparent prosperity, without increase in the number of jobs. We will see fixed-income earners (like pensioners or retired persons) struggle to make ends meet. Income disparities will rise to levels not seen before. Rising interest rates cannot benefit all. Only to those with continuing inflow of money will rising interest rates be of some gain. If I have already locked in my money, I cannot take advantage of rising interest rates. Even if I go through the mutual fund route, I will not gain. As interest rates rise, we will see the prices of assets fall.
So what do we do? One assumption I would like to make is that the RBI will stop its misguided driving-up of interest rates sooner rather than later. I will accept that inflation in India is going to have a run rate of 8% to 10% annually, given the fact that our combined state and central fiscal deficits will remain in double digits and the base savings rate interest has been raised to 4%.
I will put in as much of my savings in short-term assets as possible. I will wait for a stock market correction to add to my equities portfolio. But to what extent? Maybe another 20% fall in market indices from this point—or the market remaining at the same levels two years down the road (assuming that average profit growth of listed companies would still be around 15%pa).
I’ll postpone most of my purchases of consumer durables and push back the buying of my second home. In fact, I will follow the Shakespearean dictum of ‘neither a lender nor a borrower be’. I would look out for fixed deposits or bonds to park some of my money. Liquid funds are back in fashion, with decent returns. I will avoid income funds until I am sure that the RBI is done with jacking up interest rates.
What I have outlined is perhaps a pessimistic outlook. However, if I can be prepared for this, I can only have positive surprises. I am still not so pessimistic as to believe that we will go all the way to hyperinflation or a severe bout of stagflation. I bank on domestic entrepreneurs to fight their way out of this, rather than expect the Indian government to do anything constructive to correct the situation. Politicians are busy fighting their survival battles... and, unfortunately, economics has no place in that.
The author can be reached at balakrishnanr@gmail.com
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