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Side effects of Dr. Reddy's medicine

THOUSANDS of middle class families find their dreams of owning a house or a vehicle turning into a nightmare thanks to the Reserve Bank of India's battle against inflation. Many economists suspect that its resolute Governor Dr Yaga Venugopal Reddy is fighting a wrong battle.

On July 29, in his quarterly monetary policy review, Dr Reddy raised both Cash Reserves Ratio (CRR) and the repo rate to a more than seven-year high of nine per cent. Both stock and bond markets reacted promptly: the BSE Sensex fell 589 points, while the 10-year bond yield shot up to 9.4 per cent, seeing the bank's distinctly hawkish stance on inflation as a dampener for growth. This was further buttressed by the RBI's lower growth projection of eight per cent, down from 8.0-8.5 per cent earlier. Also, the inflation rate was projected 'close to seven per cent' by end-March 2009, up from five per cent earlier. The Reserve Bank's disheartening diagnosis coupled with the tough medicine was enough to spook markets.

Among the people directly hit are hundreds of thousands of borrowers of home loans and personal loans. Home loan rates had already increased on average from seven per cent in 2004 to over 13 per cent. As a result, the equated monthly installment (EMI) on a Rs2-million loan taken in November 2004 to be repaid over 20 years has gone up from Rs15,505 to Rs21,482 i.e. almost 40 per cent. They are rising further post-RBI's big rate hikes.

The alternative, of increasing the tenure of the loan, is hardly more attractive. If the interest rate rises from 10.5 per cent to 11.25 per cent, the tenure of a 20-year loan taken in January 2008 rises to 24 years and a month. If it rises to 12 per cent, as is very likely to happen soon, the tenure will rise to almost 44 years. If the rate goes up any further, the bank will be forced to increase the EMI because the interest component on the loan will exceed the original EMI. This is too crushing a burden even for families with decent incomes. Home loan defaults are on the rise and banks have been forced to possess and sell the flats mortgaged to them.

For real estate developers and builders also, the rate hike is bad news. They are currently grappling with dwindling sales, correction in land prices, tepid demand and rising input costs, even as they face a liquidity squeeze. In such a scenario, if banks hike the interest rates on home loans further, the residential demand is likely to get hit.

The cost of borrowing goes up not only for builders but for all ancillary and input industries as well, leading to a higher price tag for the real estate product. There have been instances of developers borrowing at interest rates ranging between 24 per cent and 36 per cent against 500 per cent collateral. The lack of liquidity is likely to impact deliveries, leading to project delays. This could also lead to distress sales and defaults by builders.

The plight of the automobile industry, another interest-rate sensitive sector, was summed up pithily by a spokesman who said "This is perhaps the first time we confront a situation where the cost of producing a vehicle, the cost of acquiring it and the cost of operating it are all going up simultaneously." Leading producers like Tata Motors and Mahindra & Mahindra are considering trimming production to match lower demand.

The IT industry is watching the impact on the currency, while the pharmaceuticals and FMCG sector are studying the implications for their margins. These are only a few examples. The fact is that Dr Reddy's shock treatment has produced convulsions of agony throughout the economy. As one bank after another is putting up its lending rates, companies are bracing themselves for tough days ahead. Corporate margins are already under pressure, with interest cost playing a significant part. In the quarter ended June 2008, a sample of 151 companies posted a rise of 36 per cent in sales but only 13 per cent in profits, with their interest costs going up by 36 per cent over the corresponding quarter last year.

Large companies have no choice but to follow through their plans, though fresh capacity-expansion plans may be put on hold. Taking the worst hit, however, will be small and medium sized companies, who cannot raise funds either abroad or through equity issues.

"But why complain about higher interest rates on home loans, business and consumer durables if these are necessary to bring down prices of bread and butter?" That is Dr Reddy's fascinating thesis on political economy of his prescription. The short answer is that it has not worked. The RBI has been consistently tightening liquidity since June 2006 to curb demand and, therefore, inflation. Inflation has, however, moved on relentlessly (accelerating to a 13-year high of 12.01 per cent for the week ended July 26), even as growth has begun to falter.

Like a losing gambler doubling his stakes in a desperate bid to recover his losses, Dr Reddy has been squeezing liquidity steadily to rein in prices, but with no success in sight. The reasons for the failure of his anti-inflationary policy are not new or remote.

As has been pointed out time and again, since the present inflation is mainly due to supply side constraints in primary articles (food and fuel), hardening interest rates will not help. Input prices have remain high and, as the RBI itself admits, higher interest payments contribute to higher costs which are passed on as has been the case with steel and cement.

There is also a contradiction between RBI's exchange rate policy of keeping the rupee down and its anti-inflationary stance. Even the excessive money supply in the system can be blamed on high interest rates persuading domestic companies to borrow cheaper abroad and bring in the dollars-over $22 billion in 2007-08 - that release domestic rupees and swell liquidity.

Interestingly, consumer price inflation has moderated to 7-8 per cent, while the wholesale price (i.e. producers' price) inflation is raging high. Most other central banks in the world focus on the former, but RBI seems to be focusing on the latter. But producer prices are made up of crude oil, food, steel and other globally traded commodities on whose prices India has little influence. Is Dr Reddy, then, fighting the wrong battle?

To be fair to the RBI, it has to reckon with government's profligacy- high subsidies, the farm loan waiver, and of course, the impending payout on account of the Sixth Pay Commission recommendations. These will stimulate the demand and aggravate inflation. As a result, the Reserve Bank has to apply the brakes all the more strongly since the government has its foot on the accelerator.

The RBI expects eight per cent GDP for 2008-09; but it cannot be taken for granted. At some point, the economy will yield to its blows. High interest payments will affect interest-sensitive sectors such as infrastructure as much as real estate and automobiles, with far more damaging consequences to the real economy.

Success or otherwise in monetary policy management is always known by hindsight. In the late 1990s also a sharp tightening of monetary policy led to a prolonged growth slowdown. Optimists may argue the structure of the Indian economy has changed; it is now more resilient and so on. But the reality is that the ratio of bank credit to GDP is now much higher than before. Hence the impact of any monetary tightening is also bound to be greater. Whether the short-term pain will be worth the long-term gain will be known only some years from now.