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Email to Friend|Posted on 31 July 2012

OPINION

Our BRIC mindset will ruin us

Karan Mehrishi says high inflation is rampant in these nations due to incompetent Govts THE GOLDMAN Sachs report that clubbed India with the three other emerging global giants brought much-needed pride to recognitionstarved Indian intelligentsia. The inclusion of India in the exclusive BRIC Club restored the belief that the Indian state could bring socioeconomic welfare to its people if not immediately then at least

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eventually. In recent years however, pride in being part of the group has somewhat subsided. W ith high interest rates becoming a norm in the BRIC club, India must break the shackles of a dangerous belief system. High interest rates are basically connected to notoriously high inflation in these countries and apparently there is very little the respective central banks can do about the situation. At 7.25 percent, India has the highest inflati on in BRIC. Brazil, China and Russia have inflation rates hovering close to 5 percent. Inflation is high because incompetent governments have not given the private sector enough room to evolve and develop. Unlike western Europe and the United States, several paralysing policies (including high interest rates) have resulted in a situation where the private sector in the BRIC countries could not build sustainable supply chains and sufficient economies of scale. Things started looking up towards the end of 199 7, when the Asian economic crises was at its peak and the present -day BRIC members replaced the fallen from grace ASEAN members as the worlds next high return havens for overseas investors. With average GDP growth rates averaging over 6 percent, investo rs found these markets a necessary supplement to their low roes from the stagnant west. However, with the 2008-09 economic crisis, overseas investments diluted and as mandated by stricter fund governing policies of the EU and the US, investors had to withdraw and invest a significant portion of their portfolios in safer AAA rated markets. None of the BRIC countries had AAA rated bonds and therefore capital flight could not be checked in a timely manner. As a result, FDI-and FII-fueled economic growth subsided and real incomes in the BRIC countries could not really match the rising prices of everyday commodities; inflation was a natural conclusion. In order to contain inflation, almost all Central Banks of BRIC countries increased interest rates and deliberately tried to restrict private investment and consumption. To compensate, deficit spending was promoted and sovereign governments took the onus on themselves to stimulate economic growth. Since government expenditure cannot solely depend upon individual hou sehold savings, the BRIC members even contemplated the BRICs Bank (along with

South Africa), which could be financed by their collective foreign reserves worth over $4 trillion. Cheap untied money from such an institution would have been then used by members to increase government spending. This fiscal side dependent policy however destroyed the confidence of private industry as high interest rates reduced investment and consumption functions, due to which IPOs underperformed; Stock markets eroded shareholder wealth and general demand declined. In contrast, interest rates in the US and EU are extremely low (hovering at about 1 percent) because the west does not want a repeat of the Great Depression of 1931. On comparing todays situation to that of the 1931 economic crises, we find that the situation was similar. There was a significant time of monetary easing through the 1920s and credit was cheaply available. This situation resulted in significant bad debt in bank balance sheets (as people invested in risky deals because credit was cheap). On hearsay, people lost faith in the financial strength of their commercial banks and this led to bank runs. A deflationary situation was caused in the US prior to the events that caused the Great Depression and the central bank (Federal Reserve) tried to contain this malady through a sudden increase in interest rates; this too was counter -productive since consumers who had borrowed money at lower interest rates suddenly found themselves under significantly more debt. WHILE FIXING high interest rates, the BRIC members do not seem to understand one simple fact of economics if interest rates are higher than the rate of GDP growth, there is bound to be inflation. Now that the GDP numbers are becoming smaller, like other BRIC countries, India cannot simply survive a situation like this. In order to understand the true face of the high interest rate-low growth relationship one must study the case of Brazil, the so-called underdog of the BRIC club. If the Latin American giants m onetary policy is analysed closely, it reveals that Brazil has had high interest rates for a long time primarily because of persistent high inflation. After averaging 16 percent through the last decade, the prevailing interest rates now stand at a little l ess than 9 percent. Even today, the Brazilian central bank is blocking out private

investment for the sake of aiding deficit spending and reducing inflation. The countrys policymakers believe that increased government expenditure will increase money supply for government-enabled projects, thereby creating jobs and raising living standards. At the same time, the high interest rates will deter excessive private investment and consumption, thereby controlling inflation. Even though Brazil is one of the few co untries in the world which has a relatively stable food price index (the number one contributor of inflation in India), the central bank has continued with its policy of monetary tightening. High interest rates have led to a situation in Brazil where growth is contained in the name of controlling inflation and the economy continues to grow at less than 4 percent per annum for the last four decades. If Brazil had followed a free market policy and allowed interest rates to be governed by market forces with periodic fiscal intervention, the state of the nation would have been different. In India in the near future, four decades of low growth will destroy the natural fabric of our country given its complex demographic. Remember, our economy depends largely on ou r own consumption and not on the vagaries of foreign consumers. No additional employment can be created in a situation where interest rates are high. The resulting no-growth scenario will thus add to dejection and make matters worse for India. The author is an emerging markets expert. The opinions expressed are his own. karan.mehrishi@gmail.com

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Email to Friend|Posted on 31 July 2012