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India can outperform China by '08

August 09, 2003

Ten, five, even three years ago I would have, and did, make the bet that China's growth rate would outperform India's. Today, I would have to be more circumspect. My bet is that India will begin to outperform China within the next five years.

What accounts for this change in perspective? Sustained improvement on many fronts including the development of physical infrastructure (especially roads, ports and telecommunications), trade and tax policy reform, and the coming of age of a new generation of Indian entrepreneurial talent all add up to impressive change.

But, by far the most significant development in the Indian macro story is the declining cost of capital. It is difficult to exaggerate the impact that falling interest rates have had on the functioning of the Indian economy.

Over the past three years, borrowing rates have declined by about 600 basis points for most medium to large sized enterprises in the country. Whereas such companies were paying 14 per cent on one-year loans three years ago, today they are paying only 8 per cent. Borrowing rates for some of the largest corporates are up to 200 basis points lower.

In part, the declining interest rates reflect a fall in the rate of inflation. But even in real terms, interest rates have fallen sharply. What is key is that this does not reflect merely a cyclical adjustment, although that is part of the story.

It is in fact largely the result of the progressive dismantling of a system of administered interest rates in the country. To be sure the system is still not fully disbanded. Rates on small savings deposits are still fixed by administrative fiat.

But now there is at least greater flexibility and pragmatism in how they are set. So what we have seen is a significant structural decline in interest rates that has the potential to trigger fundamental improvements elsewhere in the economy.

First, compared to China and the rest of East-Asia in its high growth phase, India's manufacturing sector is much smaller (16 per cent versus 35 per cent of GDP). The popular perception, until very recently, has been of an uncompetitive Indian manufacturing sector hobbled by poor physical infrastructure and rigid labour regulations.

It turns out that perhaps the most serious handicap faced by Indian manufacturing has been the relatively higher cost of capital. Between 1997 and 2000 real interest rates on the average five-year loan fell from 7.8 to 4.9 per cent, whereas in India they actually rose from 6.4 to 7.8 per cent (due to a decline in the domestic inflation rate).

Since 2000, however, the trend has reversed thanks to several cuts in the administered interest rates in India. For the first time that I can remember, real interest rates in India are lower than in China. And the effects of this are dramatic.

Consider the following: Every 10 per cent fall in interest rates leads on average to a 30 per cent increase in profits before tax for larger Indian corporations.

For firms in manufacturing that operate with higher levels of debt relative to the average for all companies (companies in the less asset intensive service industries can operate with lower debt-equity ratios), the impact on PBT of declining interest costs is likely to have been even larger.

Given that borrowing costs for larger corporates have fallen as much as 40 per cent in the past three years, profits before tax for these companies have more than doubled, raising returns on equity to well above the cost of capital. Suddenly, even manufacturing activity is looking like an attractive proposition in India.

Second, India's predominantly state-owned banking system has been capital constrained for many years, weighed down by non-performing assets created during the investment boom following the initial years of economic reform in 1993/95.

As a result banks have become risk averse tying up more than three-quarters of their balance sheets in government securities. The decline in interest rates has handed this passive banking system a salutary bonus in the form of enormous paper gains on their portfolio of government securities.

This bonus is about to turn into cash, thanks to a scheme that would have the government buy back its paper from the banks at some modest discount to the market rate.

The buy-back scheme would go a long way towards recapitalising the banks, allowing them to get back into the business of lending to the private sector. This would represent a big efficiency gain for the intermediation of the country's financial savings.

Third, declining interest rates have helped a relatively new industry take off. Consumer credit and mortgage financing was a very small industry in India even as recently as five years ago. The last three years especially have seen an explosion in this business.

Home mortgages have been growing at 25 per cent per annum as housing has become affordable for the first time to salaried Indian professionals.

Needless to say the housing and construction industries are benefiting by extension. Similarly, India's automobile and motorcycle industries have been on fire thanks in large to the affordable auto financing.

Fourth, declining interest rates have helped ignite a hitherto moribund equities market. For the past couple of years, the Indian stock market has been one of the most undervalued in the world. Falling interest rates have made it an irresistible value that both local and foreign investors are now beginning to see.

This in turn has helped jump- start the government's privatisation programme. In a cacophonous democracy that is India, privatisation has remained stalled in the face of pressure from state sector unions and populist sentiment against possible foreign strategic investors.

The IPO of Maruti Udyog Ltd, India's leading state-owned car manufacturer has demonstrated how widespread retail participation in the offering along with careful calibration of the offer price in buoyant markets can eliminate populist opposition to privatisation.

Suddenly privatisation is no longer a dirty word and it now looks as if we will see real progress on this front in the coming months leading up to the next elections.

Finally, one of the abiding concerns of most economists has been India's consolidated fiscal deficit which has been running at close to 10 per cent of GDP for the several years and its burgeoning domestic public debt which had crept up to over 75 per cent of GDP by the end of the fiscal year ending in March 2002.

The Central and state governments spent more than a quarter of their total budgetary expenditures, or the equivalent of 6.5 per cent of GDP, on servicing the stock of outstanding debt last year. Said another way, interest payments on domestic debt accounted for more than two thirds of the government's consolidated fiscal deficit -- the primary deficit of central and state governments accounted for only a third of the overall deficit.

Should interest rates remain at their current levels for another three years, the average cost of outstanding government debt could decline by a quarter relative to last year, and the consolidated fiscal deficit would, everything else being the same, decline by a good 1pe r cent of GDP.

Thus, interest rate deregulation by itself should contribute to a material improvement in the government's fiscal situation, although this should hardly give licence to the government to waste such savings on larger current expenditures.

It is amazing how powerful a simple thing as interest rate flexibility can be in terms of unleashing the potential of an economy. It is a reminder that the single most important price in the economy is the price of capital.

Now is the time for the government to move to complete deregulation of interest rates. The multiplier effect of such an initiative would make India outperforming China a sure thing.

The writer is managing director, Warburg Pincus. The views expressed are personal.

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