Growing without bubbles

The key challenge for India is to continue to ensure moderate credit

creation in the real sector of the economy
Guru Ramakrishnan

ndia 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 developedmarket model of growth has
signicant problems since
its 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 nancial institutions that serve them
become prisoners to the vagaries of nancial 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 prole over

ILLUSTRATION: SATWIK GADE

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 sacrice 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 largesized 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. Im 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 nancial 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 dont 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 nancial 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.

..........................................................................................
WHAT THE RBI SHOULD AVOID IS CREDIT GROWTH DIRECTED
TOWARDS FINANCIAL AND PROPERTY
ASSETS WHICH END UP CREATING ASSET BUBBLES.
.............................................................................................

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 nancial architecture and initiatives that have
been aimed at nancial 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
ination, regulating with
great vigilance the nancial
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
ination rates and made signicant strides in productivity as well.
What the RBI should avoid
is credit growth directed to-

wards nancial and property

assets which end up creating
asset bubbles. These bubbles
invariably require more
credit intervention to x
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 reect elements of seasonality.
This simple rule for monetary targeting will create adequate growth without
ination or the worry of bubbles and will give the RBI
time to remain vigilant in
regulating the various nancial 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.