Fitch Ratings has raised its estimate of India’s expected growth rate in 2018-9 to 7.8%. For anyone who has the least knowledge of business conditions in India today, this can only be a sick joke. For India’s economy is heading for a meltdown – 78 of the largest companies in the country are facing dissolution under the Indian Bankruptcy Code. Of them, 20 have already been declared insolvent and sent to the National Company Law Tribunal for dissolution.

Another 30 companies, all in the power sector, are also facing the guillotine because the Allahabad high court has denied them more time to sort out their woes. The debt of these companies alone amounts to Rs 140,000 crore. Among them are three giant power plants, the 4,000 MW Coastal Gujarat Power of Tatas, Adani power, Mundra and Essar Power. They are bankrupt because they had the temerity to base their plants and have been denied the right to set tariffs that will cover the higher cost of imported coal, by the Supreme Court of India.

Yet another 92 companies are on the chopping block because they are more than 180 days behind on their loan repayments. And as if that were not enough bad news, loan defaults by small companies have also doubled in the past year, signalling an imminent crisis in that sector as well.

The sickness has spread to the private financial sector. Infrastructure Leasing and Financial Services (IL&FS), a financial giant, has just defaulted on its interest payments and sent the stock market into a tailspin. Foreign investors have been leaving the Indian money market in droves: the rupee plunged to 71.7 to the dollar on September 20, against 65 on March 31, less than six months earlier. The RBI has halted the slide by raising the repo rate by a full half percent.

But how long will its finger keep the dyke from bursting?

Who, or what, is responsible?

In a note he submitted to the Estimates Committee of parliament earlier this month, former RBI governor Raghuram Rajan has identified two causes: an “irrational exuberance from 1994 till 1996” generated in promoters (of new projects) by the prolonged spell of rapid economic growth that began in 2003, and the government’s failure to live up to its commitments to the investors.

“A large number of bad loans,” he points out, “were originated in the period 2006-2008 when economic growth was strong, and previous infrastructure projects such as power plants had been completed on time and within budget. It is at such times that banks (and, needless to say, promoters) make mistakes”.

Their chief mistake was to “extrapolate past growth and performance to the future” and accept projects with very little equity capital, that relied almost entirely upon loans. When the upswing ended with the onset of global recession in 2008 and demand slackened, many projects became unviable.

Fraud, in the shape of inflated capital costs, over-invoiced import bills and unacceptably low promoters’ capital has played a part, he wrote, but it is only a small one. Rajan placed the remainder of the blame upon “governance problems” – a euphemism for the Central and state governments’ failure to provide promised inputs, such as land free of encumbrances, coal, power, water, and transport connections. Unable to generate revenues, the investors ate into their equity capital to meet the mounting burden of interest payments, till there was none left. Then they walked away from them. This is the reason why India is saddled with up to 1,160,000 crores of stalled, “zombie “ projects and Rs 950,000 crore of largely irrecoverable debt.

Rajan’s analysis is cogent, but incomplete. India has never been free of “governance problems”. There was a spell of “irrational exuberance from 1994 till 1996, followed by a steep slump in 1997 that lasted till 2002. But there was no pile-up of abandoned projects and irrecoverable debt then.

His ascription of the current decline to the impact of global recession is also suspect. For the recession began at the end of 2008, but India’s slide into industrial stagnation and insolvency began three years later in 2011. In between, it recorded two years of the highest industrial and GDP growth that the country has known. Why this delay? The answer is the crippling interest rates that the Reserve Bank imposed on the economy in 2010-11 and is persisting with, in the face of catastrophe, today.

A simple calculation is all that is needed to show what high interest rates do to infrastructure investment: If the promoters of power and highway projects, for instance, borrow money at 5% a year their capital cost, if not repaid, will doubled in 14 years. At 10% it will double in seven years. At 12% — the rate that even blue-chip companies were paying until 2015 – doubling takes place in 5.5 years.

Since the same high rates will simultaneously kill the demand for housing and make car and refrigerator loans unaffordable, investors will be hit from both sides. In addition to this the government reneges on its promises to provide the infrastructure needed for production, such as coal, power, water and transport, the only option left open to them will be to cut their losses and walk away. Rajan does not have a single word to say about this, because he is one of the high priests of the high interest rate regime that has bankrupted the country.

The evidence that this is indeed the cause of both the crisis in industry and in banking, comes from the pattern of bankruptcies. All but a few of the companies that are on the chopping block had dared to invest in infrastructure projects. The reason they had done so was that the public sector, which used to invest in infrastructure in the past, was no longer doing it. Public sector investment had been even more prone to delays because of the government’s failure to meet its commitments, but there were no stalled projects because it had the dual advantage of being loaned money by the banks at paltry rates of interest, and never having to fear bankruptcy.

To justify their suicidal commitment to price stability, three RBI governors in succession – Y.V. Reddy, D. Subbarao and Raghuram Rajan – have argued that price stability will automatically lead to growth. They have been buttressed by a much touted finding of IMF and other neo-classical economists that, contrary to the previously unquestioned belief, high rates of inflation do not automatically raise the rate of economic growth, but actually lower it.

“Inflation targeting” was born out of his flaky belief. The RBI made this its Bible despite the fact that none of these studies had been able to establish a causal link from high inflation to low growth. And it did so in the face of compelling theoretical and empirical evidence that the causal chain runs in the opposite direction, i.e from economic growth to inflation.

Some inflation has to accompany industrialisation because it requires the diversion of a part of current investment from producing consumer goods to capital goods. Every government of a rapidly industrialising country has had to face this problem and has resorted to price and distribution controls, such as rationing, fair price shops and food coupons. South Korea had an average inflation rate of 21% during the three decades in which it became an industrial powerhouse, and China has become one only with the help of stringent price controls on essentials, and negative real rates of interest on bank loans. In India, by allowing the RBI to make price stability the sole goal of policy the elected government sacrificed growth at the altar of stability.

What has made the RBI impose this suicidal policy on the country, and why have two governments capitulated? The first reason, the suicidal adoption of “inflation targeting” by the RBI without realising that the rich nations have entirely different goals for adopting it than the poor, has been described at length in these columns on an earlier occasion.

But the second, more pressing, reason is the imperative need to keep not prices, but the exchange rate stable. This has gained in importance with every year of high interest rates, because these have forced investors to borrow abroad, where loans have been available at rates as low as one to three percent, to keep their interest burden down.

Between 2008 and March 2015 around 300 of India’s largest companies borrowed Rs 4.5 lakh crores ($680 billion) abroad, mostly with maturity periods ranging from 3 to 20 years. Between March 2014 and March 2015, after Modi’s victory became certain, borrowings increased by $ 181.9 billion. This raised India’s outstanding external debt by 38% to $580 billion.

In India, by allowing the RBI to make price stability the sole goal of policy the elected government sacrificed growth at the altar of stability.

The euphoria was so intense that a very large part of the new debt was not hedged against the risk of a fall in the value of the rupee. As a result, in 2015, 59% of the $580 billion was vulnerable to devaluation.

For the borrowers, maintaining the exchange rate regardless of side effects therefore became a matter of life and death. The real, unspoken, goal of ‘Inflation targeting’ is to maintain not price but exchange rate stability at any cost. This quest has not only killed the real economy but created an imbalance between India’s foreign exchange debt and its reserves that has brought international hedge funds into the Indian money market, circling like wolves scenting a killing. What India is experiencing, therefore, is a mild version of the “Asian Financial ‘flu” that began in Thailand and spread to the whole of Southeast Asia in 1997 and 1998.

Unlike the Bank of Thailand in 1997, the RBI has had the sense to allow the rupee to depreciate in response the demand for dollars in recent weeks. But every few points drop in its value is increasing the risk of insolvency for the companies that have borrowed abroad.

How to stem the collapse

The only way to stem a further collapse is to lower the interest rate on long and medium term loans drastically to 4% or less. This will allow the embattled infrastructure and heavy industries to refinance their loans and drastically reduce their debt burden. Since the lower rates will also revive the housing, real estate and consumer durables industries, these companies will have a far better chance of repaying their re-structured loans than they have had in the past seven years.

Why 4%? The short answer is that in no country in the 19th century did companies building infrastructure face real interest rates of more than one or two per cent. The US government provided much of the capital that American companies sank into 300,000 kms of railroads between 1870 and 1891 free of cost in the form of land and timber felling rights that they could sell in the market. In the 20th century, South Korea and China achieved their breakthroughs by raising capital at negative real rates of interest, in effect taxation of peoples’ savings.

There is some risk that a sharp reduction of interest rates will cause an outflow of short term foreign investment . But this will get reversed when foreign portfolio investors see a sustained rise in share prices. More importantly, the availability of cheap capital that is free of exchange rate risk will end the long-term borrowing spree abroad by Indian investors that has precipitated the present crisis. The resulting reduction of demand for dollars will ease the pressure on the rupee.

But time is of the essence, for every day that the rupee continues to depreciate increases the repayment obligations of companies loaded with foreign debt and weakens their capacity to respond positively to measures designed to revive economic growth. One more attempt to avoid domestic collapse by propping up interest rates will bring on the foreign exchange crisis that the government is mistakenly trying to avert through monetary policy alone.

Prem Shankar Jha is a senior journalist and author of several books.