(This appeared in a recent issue of Moneylife. )
THE DEBASEMENT OF THE RUPEE
Inflation is perhaps the biggest destroyer of wealth. Imagine if I had put aside a sum of Rs.100 ten years ago and earned around 7% p.a. as a return. Today, I would be having around Rs.200/-. Ten years ago, I could buy dal at under Rs.30/- a kg/- or buy a litre of petrol at under Rs.25/-. Today, the Dal is close to 100/- a kg and petrol is over 60/- a litre and climbing. Of course, vegetable and food prices have more than tripled in this time. In essence, what I saved ten years ago, is today worth less than half. Half has been destroyed because I did not spend it. More important, my assumptions of ten years ago, that what I put aside would suffice for me today, have gone terribly wrong. If I cannot earn additional income (Ten 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 stop. To me, the biggest damage has been done with the increase in the interest rate on the Savings bank deposit, by the RBI. It virtually amounts to the regulator giving up on inflation. I would, in their place, have reduced the savings deposit rate to zero! Till a few years ago, savings bank balances beyond one lakh rupees would not earn interest on the excess. Today, banks pay interest on everything. The result of this move by RBI is for people 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 Bank interest rate has become a kind of a low point of expectation. Naturally, to park money anywhere else, we need higher returns. If the savings interest rate was 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 ten year instruments being floated with yields of 12% p.a. and above! It is not as if the banks are flush with money and the RBI will reduce credit offtake due to this move. In fact, the 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 on, in most industries the competition is minimal. This gives the companies to pass on the increased interest rate 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 the high interest rates.
In this environment, the villain of the piece is retail lending. It continues to grow unabated. A couple of percentage increase in interest rates has not deterred spending. 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 ‘book’ has diverted focus 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 ten percent 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 the individual to default and not impact his lifestyle in any way. Smart borrowers are using this aspect to run up loans, negotiate them after deliberate default and continue. I do not think that the credit bureau scores 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 buyers are 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 have its conclusion either by supply catching up with demand or by prices going up to an extent that at some point buyers will vanish / reduce dramatically. Supply does not look like it is going to catch up in a hurry. The most likely thing seems to be that we will go through a phase of rising prices. To me, this is a scary situation. We will see apparent prosperity, without increase in number of jobs. We will see fixed income earners (pensioners/retired persons) struggle to make ends meet. Income disparities will rise to record levels not seen before. Rising interest rates cannot benefit all. Only to those with continuing inflow of money, will rising interest rates be of 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 rate, 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 eight to ten percent per annum given the fact that our combined state central fiscal deficit will remain in double digits and the base savings rate having been raised to four percent. I will preserve my assets in as much short term assets as possible. I will wait for a stock market correction to add to my equities portfolio. What extent? Maybe another twenty percent fall from here or the same levels two years down the road (assuming that profit growth would still be around 15% p.a). Postpone most of my durable purchases and push back the buying of my second home. Put some more money in to Gold ETF’s. Follow the Shakespearean dictum of ‘Neither a lender nor a borrower be”. I would look out for fixed deposits / bonds to park some of my money. Liquid funds are back in fashion, with decent returns. I will avoid Income funds for now; till I am sure that the RBI is done with jacking up the 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 that we will go all the way to hyperinflation or a severe bout of stagflation. I bank on the domestic entrepreneurs to fight their way out of this, rather than expect the government of India to do anything constructive. The politicians are busy fighting their survival battles and economics, unfortunately has no place in that.