More on Why we should not bail-out AI

How GoI should deal with Air India, writes Gopinath, the founder of Air Deccan

Should the Government Bail-out Air-India?

 

So, finally Government of India (GoI) agreed to bail-out a loss making PSU monster AIR INDIA (AI). Well, they call it financial restructuring. In means a substantial cut in interest on AI loans and improving operational efficiency and implementing the turnaround plan.

And you know how well GoI executes its plans.

Should the GoI bail-out an inefficient national carrier?

Is this the same Government that refused to bail-out a private air company?

Why don’t the same logic is applied to a PSU? And plz don’t say that being a national carrier it is our pride  and all such emotional stuffs!!!!!

You know India is country that needs money in good projects, not to infuse money in a loss-making PSU which is in ICU.

Why should GoI not bail-out is that you know GoI can reduce its fiscal deficit through disinvestment proceeds. First, it can stop infusing public money to bleeding PSU company which majorly caters to  the needs of BABA-NETAs. Secondly, it can sale this company and get some money. Since GoI is putting money to the tune of Rs 30OOO Crores, the disinvestment proceeds will be at least equal to that. It means it can reduce fiscal deficit by Rs 60000 Crores. It is such good chance to correct its fiscal slippage.

And by agreeing to save AI, the GoI has not shown any serious commitment to reduce its fiscal deficit.

Now think of the macro-economic implications of this exercise: A reduced fiscal deficit means higher rating by rating agencies (which implies that country's  macroeconomic situations remain stable or good), second it will less crowd out private investment (remember, liquidity is some what tight, though it has been infused by the recent RBI rate cuts). And importantly, it would help reduce inflation.

After all, I don’t understand why we have to be bail-out AI? Is there any compelling reason?

PS: Chetan Bhagat has a piece on ToI.

PPS: When it comes to saving a loss-making PSU, GoI takes decision less time compared to starting the much needed reforms.

Misplaced Focus?

The recent announcement by the RBI has surprised the market participants. The RBI chooses to reduce the short-term repo and reverse repo by 50 basis points each. RBI has also duly acknowledged the upcoming upside risk to inflation. That the oil marketing companies demanding for higher prices of petro-products day after the annual monetary policy is announced is a pointer to it. It seems that RBI is more concerned about growth. In fact this is the ‘sacred mantra’ which every policy maker is chanting and mad for.

Recognising its failure to combat inflation and the single minded growth objective has led the RBI to increase the threshold inflation to 6.5% in the medium run. So the earlier tolerable inflation of 4.5% will be a history. While most of the developing countries like Brazil (it embraced inflation targeting in 1999) and South Africa (2000), and Ghana (2007) are chasing inflation, our central bank is ‘macho’ about growth. Note that 6.1% growth rate (third quarter of last fiscal) is not a bad figure at all. But expected inflation of 6.5% is surely a bad music to ears of ‘mango people’. To bail out United States from the protracted recession Harvard Economist Ken Rogoff proposed higher inflation that got supported by his Harvard colleague Greg Mankiw, even from the current Fed Chairman Ben Bernanke, Christina Romer, President Obama’s former Chair-woman and many market monetarists and Nobel laureate Paul Krugman. Despite the severity of recession yet the Fed has not pursued this policy. It clearly demonstrates how much significance they offer to inflation (Note that US inflation rate is even below The Fed’s unofficial target of 2%). 

RBI’s rate cut of this magnitude may be based on five reasons. First, an unexpected bigger cut would provide commercial banks enough incentive to lower its lending rates. Second, the transmission mechanism will be more effective and take less time. Third, the RBI tries to learn from its past mistake. One reason why the increase in policy rates could not help much in reducing inflation in a timely manner is that the ‘baby-step’ or the ‘piece-meal’ approach of the central bank. Hence, it thought that so as to have a bigger impact on the outcome it needs to cut drastically the policy rates. Fourth, by lowering rates, the RBI sent signal to the foreign investors that cost of doing business has lowered. And finally, the RBI wants to infuse more liquidity to the market.

But the very first reason may not be achieved. It is because while higher policy rate motivates the commercial bank to increase the interest rate, this may not be the case when the RBI lowers its key policy rates. The reason is that commercial banks are now vying to attract savers through increased deposit rates. Further, RBI has also increased the flow of the saving deposit rates. Another factor that might pour water in the hopes of the Governor Subbarao is the “uncertainty” factor. Banks are not sure whether there will be any further rate cuts. In that case banks are expected to maintain status quo, limiting the effectiveness in the transmission mechanism unless they are being pressed by the finance ministry.

Rationale

It is not difficult to nail down the motive behind the cut in policy rates. RBI cited in its monetary policy statement that the deceleration in the economic growth is the result of slower industrial growth. Further, RBI should not panic at the falling Index of Industrial Production (IIP) which is highly fluctuating and are far from credible and calls for scrutiny. Again, RBI thinks that liquidity was squeezed as credit demand both from industry and agriculture has not peaked up. This leads to contraction in gross fixed capital formation (GFCF) both in the second and third quarters of last year. In other words, the RBI thinks that money was tight for this period. Though private GFCF are below the trend since 2008-09, but they have rebounded following a drastic fall in 2008-09. Hence, quarterly fluctuations do not warrant such steep cut on the policy rates given that both WPI inflation and CPI inflation are hovering around 7% and 9% respectively. Since the onset of high interest rates, the growth rate of credit to industry remains stable. Agriculture recorded a steep fall in the credit growth from 22.9% in 2009-10 to 10.6% in 2010-11.Two factors contribute to this. First, the impact of high interest rates and second, the non-food credit growth rate has increased from 16.8% from 2009-10 to 20.6% in 2010-11. The behaviour of eight core industries shows that the growth rate is around its trend rate of 5.5%. Though these falling numbers call for a reduction in the policy rates we need to ask as to who contributes more to it: global slowdown, higher interest rates, or supply side problems? It seems that the current understanding of the RBI is that our growth has slowed down because of global slowdown which is not entirely right. Growth has been robust following the sharp decline in 2008-09. Rather, the major contributor to the economic slowdown is the almost zero growth rate of agriculture. Agriculture is still the major determinant of growth and inflation. Agricultural performance feeds through to the rest of the economy through supply and demand linkages. Reduced agricultural growth reduces supply to industry, thereby reducing industrial production. Further, a reduced income from agriculture and the fact that they spend more on the food stuffs also contribute to the contraction in demand for industrial production. Hence, the decline in industrial performance is not that investment is not picking up. Rather, the diagnosis and the solution remain elsewhere.

The best option could have been to let the policy rates remain intact and wait till the next mid-quarter review to see the evolution of both WPI and CPI inflation and how GDP and IIP behave. The RBI’s policy moves will not help much. Instead targeting inflation could help better achieve more economic growth. A 2011 article in the prestigious Journal of Policy Modeling, written by Salem Abo-Zaid and Didem Tuzemen  has shown that the effects of targeting inflation in developing countries are associated with lower and more stable inflation, as well as higher and more stable GDP growth. They also conclude that non-targeting countries would highly benefit from targeting inflation. In the least case will may have higher GDP growth (satisfying needs of the policy makers and of the government) and higher inflation (surely, welfare-reducing to ‘aam aadmi’.  If any central bank, facing a declining industrial production and hence, economic growth and high inflation, they must ask this question before advancing for monetary policy: how much of the benefit a poor man extracts if it increases the growth rate by one percentage point more compared to how much of the benefit a poor man loses if it increases the inflation rate by one percentage point more (or if there is a chance that inflation might increase) or it does not any take any step to reduce inflation from high rate.

 Solution lies elsewhere

While much of the solution lies in the government, it tries to save its image through the rise in GDP. Hence, the government thinks that high interest rate has stifled down the growth rate of GDP. So the pressure from the government cannot be ruled out in easing the key policy rates. By reducing the policy rates, the RBI has put the ball in the government’s court. First, to address its fiscal deficit, it needs to reduce subsidies. If it does, it will increase the petro prices and urea prices. It will be translated in to higher headline inflation. And if it does not, it may result in the crowding out of private investment (examining the crowding out hypothesis for India for the period 1970-71 to 2009-10, Jagadish Prasad Sahu and Sitakanta Panda in a 2012 article in the prestigious Economics Bulletin have empirically shown that government investment crowds out private investment in the long run). Only the 2G/4G auction and embracing the GST can help the government in correcting the fisc. Government must address the supply side issues promptly and boost the agriculture investment and reducing the subsidies which will help in the long run. It must cure policy paralysis, remove the infrastructure constraints; raise the ease of doing business, and lessen the time overruns. It must recognise the limits of the monetary policy which can’t control these factors.

In the pursuit of growth RBI should not heap misery on more than half of the country’s population. We can at best wish for the victory of RBI’s great gambling and optimism.