Growing without bubbles

The key challenge for India is to continue to ensure moderate credit creation in the real sector of the economy

December 21, 2014 10:42 pm | Updated 10:42 pm IST

Illustration: Satwik Gade

Illustration: Satwik Gade

India needs an alternative model for economic growth. A model which is more inclusive, less dependent on credit and clearly not driven by wealth creation from manipulated asset prices alone.

The standard developed-market model of growth has significant problems since it’s centred on a framework of constant credit infusion. In this model, a credit-infused growth cycle creates short-term prosperity and above trend economic growth for some time before an ensuing bubble on account of this credit creation busts the economy forcing the central bank to begin a new round of monetary stimulus yet again. The global central banks need to take responsibility for these credit-related catastrophes and need a more prudent approach to money creation and credit. Printing money and lending it to consumers to get them to spend on items they cannot afford have been the drivers of growth in the developed world for quite some time. These economies exhibit low saving rates, high rates of subjective time preference and focus exclusively on current consumption. Consumers and corporations imprudently borrow because of the availability of ready-made credit only to realize this eventually becomes a huge noose around their neck.

Debt to GDP ratios in the U.S. and Europe are strong testimony to this morally hazardous behaviour. At these levels of debt, the citizens and the financial institutions that serve them become prisoners to the vagaries of financial markets and panic every time growth slows down or interest rates go up since their viability is threatened at the core.

Indian context is different For India to aspire to walk in these footsteps would be truly tragic. We have a young dynamic work force, a culture where the pitfalls of leverage are well understood and a low subjective rate of time preference. This enables us to save more and think about a smoothened consumption profile over time rather than the gluttonous model of high current consumption. We, as a society, also care a lot about the next generation and are able and willing to sacrifice current consumption in order to leave behind a greater future consumption possibility set for our children.

Consumer debt-to-GDP for India is at 12 per cent and is the lowest amongst large-sized economies. To want to tweak with this framework in any way, I think is dangerous.

By no means am I asking the average Indian to compromise on a lower standard of living. I’m appealing to them to consume what they can afford, use credit markets in a prudent way and work harder, longer and smarter to save and invest resources to be able to then smooth consumption over time. A model of taking a mortgage on a house that one cannot afford and hoping that real estate prices will continue to head higher and implicitly bail out the borrower, as we now know, is a failed approach from the U.S. housing and real estate crisis of 2008.

Indian corporations learned this hard lesson as well. Several infrastructure and real estate-focused companies were over-leveraged at the top of the cycle, only to be left on the verge of bankruptcy, without access to loans and credit when the financial crisis hit. Their stock prices have collapsed, leaving their lenders and banks with non-performing loans that have yet to be written down. As stock markets in India hover close to their highs, we should work hard on preventing the next round of potential bubbles.

The track record of the global central banks when it comes to spotting bubbles and pricking them on time is poor.

To be fair, they don’t have either the expertise or the resources to get the job done. It becomes difficult for them to spot the excesses of greed and fear that emanate from the traders, investors, CEOs and participants in the financial markets.

After credit shocks, money and credit multipliers tend to be volatile creating the role for a central bank to smooth out large declines in the velocity of money and credit through selective intervention and monetary stimulus.

For the better part of the last 50 years, the velocity of money in India has been trending downward. This decline in velocity can be attributed to the expansion of monetization, modernization of the financial architecture and initiatives that have been aimed at financial inclusion.

The RBI should not use the decline in velocity argument too much to tweak with monetary aggregates.

What we can do is hold the RBI fully accountable for pursuing a conservative money policy, targeting low inflation, regulating with great vigilance the financial institutions that provide the credit to the economy and working aggressively to eliminate shadow banking activities at its very source.

Good versus Bad Credit Economists often remind us that all forms of money are credit but not all credit is money. The key challenge for India is to continue to ensure moderate credit creation and for this credit growth to happen directly in the real sector of the economy which contributes to GDP. Indonesia and China followed this route in the 1980s and so did Vietnam in the 1990s. These countries showed good improvement in living standards, had acceptable inflation rates and made significant strides in productivity as well.

What the RBI should avoid is credit growth directed towards financial and property assets which end up creating asset bubbles. These bubbles invariably require more credit intervention to fix them. The smartest decision for the RBI at this stage is to invest in a macro-prudential tool kit that keeps bubbles at bay. Understanding how the elasticity of bubble-prone sectors like stocks, real estate and corporate debt markets react to changes in economy-wide credit is an important step towards that goal. The RBI, through smart regulation, can get banks to focus on credit and lending to areas that improve the true productive capacity of the real economy.

Most importantly, the RBI should deliver real growth rates in monetary aggregates (M3) that are consistent with expected growth rates in real GDP. Any deviations from this simple rule should be done only to adjust the monetary aggregates for unexpected shifts in the velocity of money or to reflect elements of seasonality.

This simple rule for monetary targeting will create adequate growth without inflation or the worry of bubbles and will give the RBI time to remain vigilant in regulating the various financial institutions that offer credit to the economy at large.

The writer is the CEO of Meru Capital and a former Managing Director of Morgan Stanley & Co.

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