Category: RBI

Unintended Consequences of Demonetisation

January 2, 2017

The demonetisation scheme was launched without the govt thinking through consequences, hardships or logistical complexities of such an undertaking

Indian businesses have spawned some unique management practices. In his book When The Penny Drops: Learning What’s Not Taught former Tata Sons executive director R. Gopalakrishnan credits former ICICI chairman N. Vaghul with coining the term “Mafa”. Among the many variants of the acronym, the one that works best for India is “Mistaking Action for Achievement”.
Mafa seems to be a unique Indian trait, found frequently in Indian organizations. Executives, keen to show initiative, are often found launching ill-conceived projects with little or negligible homework. Managements, it seems, are content to see senior executives bustling around launching one abortive project after another, rather than thinking through strategy, returns and risks. Introspection is considered a luxury, a sign of indolence; shoot first, ask questions later.
The demonetisation scheme is an appropriate example. The government launched the exercise without thinking through the consequences, the hardships or the logistical complexities of such a mammoth undertaking.
The daily, arbitrary changes in rules puts demonetisation squarely within the theatre of the absurd. 
But, more importantly, the project also has numerous unintended consequences. In 1936 American sociologist Robert K. Merton wrote a popular paper titled “The Unanticipated Consequences of Purposive Social Action“. The central idea of the theory is that policy action by government can often lead to undesirable outcomes, or unintended consequences, that were not part of the original plan.
The policy landscape is littered with numerous examples. Many commentators link the US government’s determined push to make affordable housing universally available with the 2008 mortgage-fuelled, trans-Atlantic financial crisis. Research shows tightening anti-money laundering rules could end up increasing costs for official remittance channels, forcing remitters to lapse back to unofficial channels. Government incentives in Brazil’s auto sector are said to have caused over-investment, lowered capacity utilization and eventually affected productivity, employment and incomes.
The Indian government’s “surgical strike” on currency notes also has unintended consequences. Here’s how.
Unintended consequence-I: One of the avowed motives behind the 8 November edict was to flush out bank notes hoarded by tax evaders. And while this might succeed somewhat, faulty implementation has given birth to another unintended consequence: re-incentivizing hoarding. A delay in re-monetizing the system, after having sucked out 86% of currency by value, has created an unplanned scarcity. Banks do not have adequate supply—in branches or in alternative channels—of either old Rs 50/100 notes or the new Rs 500. It has forced many economic agents to squirrel away notes. The shortage has acted like a massive shock to the economy. Consequently, instead of draining the swamp, the demonetisation process now threatens to turn it into a crocodile pit.
In a statement read out during the fifth bi-monthly monetary policy press conference on 7 December, Reserve Bank of India deputy governor R. Gandhi said: “The Reserve Bank and the Central Government note presses are working to their full capacities and all efforts are being made to reach the notes to every part of the country… We reiterate that there is adequate supply of notes and hoarding of notes helps nobody’s cause.” The statement clearly shows that the central bank is cognizant of hoarding, and daily news breaks of various raids and recovered currency notes also prove that demonetisation has actually re-ignited the basic hoarding instinct.
Unintended consequence-II: It is now patently clear that the government did not adequately plan for the aftershocks. The exercise has deprived people from retrieving their own money from what were considered fail-safe bank deposits. 
This has a severe unintended consequence: It can erode people’s trust in banks, which has taken years of hard work and perseverance to build. A democratically elected government’s unilateral diktat, increasing the distance between a depositor and her legitimate deposits, can act as a perverse incentive: people may henceforth shove a few banknotes under the mattress before surrendering the rest to banks. This behavioural pattern is hardwired in the Indian psyche, having survived decades of a command-and-control regime which were marked by severe scarcities. 
It is also natural risk mitigation to build buffers against future autarchic government decrees that might once again restrict access to legitimate savings. Nobody likes queueing up for hours to reclaim their own money. While there won’t be a stampede to exit the banking system (and in fact there may be more Jan-Dhan bank accounts opened over the next few years), the demonetisation move has definitely corroded, if only marginally, confidence in the banking network.
There is an apocryphal story about a government rule boomeranging during the Raj. Seeking to clean up snake-infested Delhi, the British rulers announced a bounty for every dead cobra. While genuine snake-catchers got busy, some ingenious Indian entrepreneurs got even busier: they started breeding cobras, killing them and collecting prize money. When the government got wind of this, they shut down the programme abruptly, forcing snake breeders to release their wards back into various parts of Delhi. Hopefully, demonetisation won’t leave behind too many creepy-crawlies.

The above article was first published in Mint newspaper on December 14, 2016. It can also be read here.

Book Review: Repo And Its Masters

August 22, 2016

A RBI governor remembers his doughty fights, but cuts down on the math

WHO MOVED MY INTEREST RATE?
BY DUVVURI SUBBARAO
VIKING | PAGES: 323 | RS. 699

Central banks have been labelled exotic beasts: rarely seen in public, much less understood. Realisation of what central bankers do has been seeping in slowly. Over the past few decades, as bond and currency trading acquired gargantuan propor­ti­­ons, the arcane world of dealers kept a close watch on every statement coming out of central banks, parsing each phrase and analysing each nuance. Any action, or the faintest hint of a future one, had the potential to affect currency prices, bond rates and indi­vidual fortunes. This need for analysis and interpretation also produced a large tribe of writers called ‘central bank watchers’.
Over time, as societies overwhelmingly bec­a­me dependent on debt— for housing, education or buying their next television—larger sections of the population got interested in the central bank’s actions. Any increase or dec­­rease in interest rates, or liquidity conditions, had a direct impact on household incomes and lifestyles. And yet, despite this growing interface, cen­­tral banking remains shrouded in a mysterious and inscrutable cloak.
Former Reserve Bank of India governor Duv­vuri Subbarao makes a valiant attempt to lift this veil and demystify a central bank’s workings. This is a first and we hope this will enthuse others to share their views. But there are two ways of viewing the book’s purpose. One, in trying to explain a central bank’s operations, Subbarao creates an opportunity to justify his actions dur­ing 2008-13, a period of stubbornly high inf­l­ation, extraordinary exchange rate volat­ility and an unprecedented (and unbroken) spree of interest rate increases. A converse view is also possible: its primary function is to rationalise his actions and he uses it to dec­ode the RBI’s actions and working styles. Which set of lenses have been used? The narrative str­u­cture and the tenor seems to suggest it’s the latter.
This becomes clear as one ploughs thr­ough an otherwise eminently readable account. The book’s pre-launch publicity focused on the governor’s well-publicised conflicts with former Union finance ministers P. Chidambaram and Pranab Mukherjee. Central bankers have traditionally shared antagonistic relationships with fiscal authorities. The book dwells at length on Subbarao’s differences of opinion with Chida­m­baram and Pranab, and how rising prices and a slowing economy widened the rift between Mumbai’s Mint Street and Delhi’s Raisina Hill.
But, with due apologies to Shakespeare, met­hinks the governor doth complain a bit. This is not to imply he was wrong in his stand on interest rates. Subbarao stood up against the collective might of the government, Parliament, a misinfor­med finance sector and uninformed commentariat by defending his right to raise interest 13 times in quick succession. He explains quite expansively why the situation warranted such drastic action. The fiscal and monetary expansion post the 2008 trans-Atlantic financial crisis, without adequate investment in production and supply capacities, embedded inflationary tendencies in the economy. Given political leaders’ reluctance to tighten fiscal reins, it was left to the monetary authority to attempt demand compression through interest rate increases.
Face-offs between monetary and fiscal auth­orities are built into the design; Subbarao mentions as much in the book. In times of crisis, both work in lockstep, as was evident after the 2008 meltdown. But, the impact of an expansionary fiscal policy on inflation and economic growth was ignored by the political class and India’s cossetted business interests. Much of the book describes this clash of ideals.
But there are gaps in Subbarao’s acc­ounts—both when describing clashes with North Block or when recounting challenges faced during vital post-crisis moments. Here are two examples.
First, there’s no mention of his immediate predecessor’s track record. Subba­rao mentions Y.V. Reddy only in passing while mentioning how crisis forced him to rev­erse his predecessor’s string of interest rate increases. We are not asking for public display of dirty laundry. Reddy too had to contend with a frequently (and publicly) remonstrating finance ministry. Reddy’s interest rate increases, to burst speculative asset market bubbles, earned him unstinted praise from economists and observers worldwide.
But, here’s the thing. Subbarao was fin­ance secretary when Reddy was busy inc­reasing interest rates to stave off risks. Interestingly, even Chidambaram was fin­ance minister during that period and he made public his displeasures with Reddy’s insistence on rate hikes. It would have been interesting, and more honest, if the book also disclosed Subbarao’s role as Chidambaram’s finance secretary in his engagements with Reddy, and the lessons learnt from those interactions before moving to RBI. Subbarao limits his interface with Reddy to discussions on RBI’s balance-sheet; I am sure there must be more. If the governor is going to reveal all about his skirmishes with political authorities, his interaction with RBI as finance secretary should also be fair game.
Two, there’s not enough explanation about how the RBI managed its balance-sheet in the aftermath of the crisis. Or, enough inside dope about the crisis days following the closure of Lehman Brothers. Subbarao describes how the monetary tap was kept open at full tilt to give the financial sector confidence that funds were always available. This was largely a signalling and confidence-building measure to avoid payment imbroglios or defaults which get amplified into panic during crisis times. As part of the strategy, RBI kept repo rates (the interest rate at which RBI lends to banks against government securities) low; but the reverse repo rate (interest rate at which RBI accepts money from banks against securities) was always kept 1.5 per cent higher. This was particularly true of December 2008.
Interestingly, this rate difference converted RBI—usually known as a lender of last resort—into a borrower of last resort. Banks would occasionally use the repo window to smoothen temporary mismatches, but would dump far excess cash with RBI’s reverse repo window. Clearly, credit aversion in the immediate aftermath of the crisis forced banks to seek safe havens for their surplus cash. Given money’s fungible character, we also do not know if banks borrowed from the repo window, turned around and tipped over the same money at the reverse repo window, thereby earning a neat 1.5 per cent without breaking into a sweat. The central bank’s annual report for 2008-09 (June 30 year-ending) highlights this anomaly: outstanding repos shrunk to Rs 895 crore (previous year Rs 22,805 crore) and rev­erse repos swelled to Rs 88,335 crore (previous year Rs 300 crore). This surely had some consequences and it would have been interesting to know Subbarao’s views.
But, beyond this, Subbarao has done a superb task of shedding some light on a central bank’s specialised role, especially by making it accessible to a wider spectrum of readers. He uses simple language and infuses some humour when necessary. It stops short of being a complete masterclass because encounters with the political class keep intruding. But somebody needed to talk about these incidents because the public rarely gets to know how both institutions interact. Yet, it also doesn’t do full justice to the political economy of Indian central banking. So, what is it, a book on central banking or an expose? I see it as setting the record straight.
This book review first appeared in Outlook magazine and can also be read here

Credit guarantees attract investments

July 14, 2016

Indian infrastructure financing has for long suffered from rating concerns, but recent changes to credit enhancement are helping to plug this gap, enabling investment by foreign insurance and pension companies, and stimulating project exports.

A small refinancing deal in October 2015, followed by a similar one in January 2016, has supplied a critical missing piece, without which Indian infrastructure financing had been stunted for years. If this elusive financial instrument is now consolidated, it will enable infrastructure projects to attract strategic overseas funding as well as make Indian project exports more competitive.
The first transaction, of October 2015, involves power generator ReNew Power Ventures on one side, and the government-owned India Infrastructure Finance Company Ltd (IIFCL) jointly with the Asian Development Bank (ADB) on the other side. In January 2016, another energy company, Hindustan Powerprojects, concluded a similar deal with the IIFCL-ADB combine. Both ReNew and Hindustan Powerprojects have substantial investments in renewable energy projects.[1][2]
Both companies were refinancing existing bank loans with fresh bond issues—ReNew with Rs 451 crores[3] and Hindustan Powerprojects with Rs 380 crores.[4] The bonds were initially rated lower but were able to improve to AA+ due to “credit enhancement” provided jointly by IIFCL-ADB.[5] This enabled the bond issuers to lower their interest costs and, importantly, attract infrastructure-friendly international investors who have stayed away from Indian infrastructure projects because of rating concerns. The IIFCL-ADB’s credit enhancement has made their participation possible.
Credit enhancements (or credit guarantees) resemble insurance policies: a credible financial institution guarantees (for a fee) a bond issuer’s repayments. Such an assurance helps bond issuers obtain a better credit rating. Participation by multilateral institutions—such as ADB’s involvement in IIFCL’s credit enhancement—provides an additional layer of comfort and improves the rating by multiple notches. IIFCL plans to engage with other multilateral institutions (such as the World Bank) for future credit enhancement deals.
This crucial instrument has strategic geo-economic consequences: it can attract long-term overseas financing into fund-starved infrastructure projects as well as sharpen the competitive edge of Indian project exports.
Credit enhancement makes bonds issued by infrastructure companies eligible for investment by overseas insurance companies and pension funds. Both are custodians of long-term funds and thus ideal investors for long-gestation infrastructure projects. This has another advantage: since they invest for the long term, they remain rooted during periods of volatility.
A geo-strategic tool
Most Indian infrastructure projects were unable to tap into the global pool of insurance and pension savings because of rating restrictions. Indian infrastructure projects—public-private partnerships or completely private-owned—are typically executed through a special purpose vehicle (SPV, a separate company set up only to execute the project), with no recourse to the private sector parent’s balance sheet. In short, in times of crisis or default, SPV investors cannot dip into the parent’s resources. With no previous revenue track record, no visible safety net, and an extended project gestation period, SPVs usually got the lowest rating in the investment grade scale.
This deterred insurance and pension funds from investing in such projects. These long-term investors have strict internal regulatory and risk-management parameters, which includes the lowest credit rating that can be allowed for fixed-income investment. In most cases, it is fixed at AA. Incidentally, even Indian pension funds can invest in infrastructure bonds with a minimum AA rating.[6]
There is another collateral benefit arising from the credit enhancement programme. Deprived of long-term financing, most Indian infrastructure projects became dependent on bank financing, which is short-term. This inherent maturity mismatch has affected bank balance sheets adversely and choked off funding for other projects. According to Reserve Bank of India (RBI) data for March 2016, 16.7% of infrastructure loans advanced by banks have turned non-performing.[7] Credit enhancement now allows projects to replace bank loans with cheaper bond proceeds before they turn sticky; this also frees up bank funds for other greenfield/brownfield projects.
The RBI has also allowed commercial banks to provide partial credit enhancement, subject to certain conditions[8] for infrastructure projects that want to refinance their existing bank loans through bonds with lower interest rates. The availability of this facility will again improve the credit rating of the bonds, allowing a wider segment of investors to invest.
Credit enhancements will have the greatest impact on the infrastructure sector where projects have stagnated for want of long-term financing. According to the erstwhile Planning Commission, India needs approximately $1 trillion during 2012-17 to fix its infrastructure deficit.[9] A large chunk of this will be in the form of debt. But given the banking sector’s concerns on maturity mismatches, this debt has to be sourced from long-term investors at home and abroad. Without the rating upgrade mechanism, this was not possible.
Separately, Crisil Risk and Infrastructure Solutions Ltd and ADB have jointly recommended, in a technical assistance report[10] for India’s finance ministry, the creation of a separate bond guarantee fund. This fund’s shareholding pattern and capital structure should be designed with a AAA rating in mind.
A follow-up to their suggestion looks likely: the government-owned Life Insurance Corporation of India (LIC), India’s largest insurer, is planning to create a separate finance company that will provide credit enhancement to infrastructure bonds;[11]
Other kinds of credit guarantees are also falling into place. Project exporters have been able to lower their borrowing costs and improve their competitive appeal with credit guarantees from agencies like ECGC Ltd. Project exports by Indian public sector engineering companies are often guided by India’s geo-strategic considerations. Over time, many private Indian engineering companies have also started focusing on project exports as a revenue source. But since many of these projects were located in risky jurisdictions (for example, in parts of Africa), bank credit for executing these long-term overseas projects became expensive. Such guarantees therefore go a long way in easing such exports.
Exim Bank too has announced12 that it will focus on financing Indian project exports over the next three years. According to Exim Bank, Indian companies have a competitive advantage in project exports over some of their global competitors, such as China. This comes from years of executing large projects in developing and poor countries, which have demanding working conditions, which include rough terrain and fickle political climates.
Clearly a single critical financial instrument—credit enhancement—has the capacity to attract overseas investments as well as propel India’s strategic exports.

This feature was exclusively written for Gateway House: Indian Council on Global Relations. You can also read it here.

Reference

[1] Homepage, ReNew Power, <http://renewpower.in/>

[2] Homepage, Hindustan Powerprojects, <http://www.hindustanpowerprojects.com/>

[3] Sen, Amiti, ‘IIFCL Launches Renew Wind Energy’s Rs 451-crore “credit-enhanced” infra bonds’, The Hindu Businessline, 23 September 2015, <http://bit.ly/29DSsPs>

[4] Hindustan Powerprojects, ‘Clean Energy Arm of Hindustan Power first to place credit enhanced infrastructure bond’, Hindustan Powerprojects Blog, 5 January 2016, <http://bit.ly/29Di3XH>

[5] Schemes/Products, India Infrastructure Finance Company Ltd, Regular Credit Enhancement Scheme of IIFCL, <http://www.iifcl.co.in/Content/ceps.aspx>

[6] Pension Fund Regulatory and Development Authority, ‘Investment Guidelines for NPS Schemes’, Circular No PFRDA/2015/16/PFM/7, 3 June 2015, <http://www.pfrda.org.in//MyAuth/Admin/showimg.cshtml?ID=705>

[7] Reserve Bank of India, ‘Chart 2.9: Stressed advances ratios of major sub-sectors within industry,’, Financial Stability Report, Issue No 13, June 2016, p 24, <https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/0FSR2316BB76DB39BF964542B9D1EBE2CBC273E7.PDF>

[8] Reserve Bank of India, ‘Partial Credit Enhancement to Corporate Bonds (Notification to all scheduled commercial banks)’, RBI/2015-16/183, DBR.BP.BC.No. 40 /21.04.142/2015-16, September 24, 2015, <https://rbidocs.rbi.org.in/rdocs/notification/PDFs/P183165FFAB186FE4825A0FAD0E95739436F.PDF>

[9] Planning Commission, ‘Twelfth Five Year Plan (2012-17): Faster, More Inclusive and Sustainable Growth’, Vol. I, Sage Publications India, (2013), p. 18. <http://planningcommission.gov.in/plans/planrel/12thplan/pdf/12fyp_vol1.pdf>

[10] CRISIL Risk and Infrastructure Solutions Ltd and Asian Development Bank, ‘India: Preparing the Bond Guarantee Fund for India; Technical Assistance Consultant’s Report; Project Number: 44447’, Asian Development Bank, August 2014, <http://www.adb.org/sites/default/files/project-document/152971/44447-012-tacr-02.pdf>

[11] Laskar, Anirudh, ‘LIC-led NBFC may offer up to Rs1 trillion credit guarantee’,Mint, July 1, 2016, http://bit.ly/29wm5mX

[12] S, Arun, ‘Exim Bank’s African credit to boost service exports’, The Hindu, 12 June, 2016, <http://www.thehindu.com/business/Economy/exim-banks-african-credit-to-boost-services-exports/article8721312.ece>

A new trajectory for India-Africa ties

June 30, 2016

India now sees Africa as a promising market for Indian goods, services, and investments. This is evident in the government’s recent concerted focus on the India-Africa relationship—high profile visits by top leaders to African countries, a recasting of India’s development diplomacy, and an attempt to match action to past promises

India’s relationship with Africa has been through an unprecedented intensification in June 2016. In the first week of the month, Vice President Hamid Ansari visited Tunisia and Morocco. In the second week, President Pranab Mukherjee embarked on a tour of western and southern Africa, covering Ghana, Cote d’Ivoire, and Namibia. And in July, Prime Minister Narendra Modi is scheduled to visit Kenya, Mozambique, Tanzania, and South Africa.
The present renewed outreach is also unabashedly about business, and a good example of geo-politics combining with geo-economics. India views Africa as a promising market for Indian goods, services, and investments. So far though, any follow-up on promises had remained anaemic. Now, Indian leaders are seeking out fresh investment opportunities for Indian public and private sector companies in different African countries.
The vice president’s visits to Morocco and Tunisia are crucial because India imports phosphate—a critical raw material for fertiliser production—from these countries. Ansari also inaugurated an India-Morocco Chamber of Commerce during his trip to Rabat.
The president’s three-country tour provided an opportunity to further India’s business interests. At the India-Ghana Business Forum, Mukherjee said: “…the Indian Government would be ready to work with you in key sectors and areas of common interest and encourage Indian private as well as public entrepreneurs to bring more investments into Ghana.”[1] India’s cumulative investments in Ghana are over $1 billion and two-way trade during 2015-16 amounted to $3 billion.[2]
In Cote d’Ivoire, Mukherjee said: “…your country is blessed with fertile soil and abundant agricultural and mineral resources. Our public and private sectors are keen to join you in exploring these resources efficiently and in setting up agro-based industries.”[3]
At the same time, India’s development diplomacy for the continent has been through a strategic shift. Exim Bank, for example, is now likely to focus more on service exports, rather than compete with China for infrastructure projects in Africa.
The bank is looking to disburse close to Rs. 10,000 crores in Africa over the next three years as both commercial and concessional credit.[4] Service exports aim to build on India’s traditional strengths in Africa and will include healthcare, education, and information technology services. Exim inaugurated an office in Cote d’Ivoire during Mukherjee’s visit. The office is expected to widen the bank’s footprint in West Africa.
Exim Bank is also looking to sharpen its focus on another area of India’s traditional exports to Africa: project exports. It has requested the Reserve Bank of India to ease regulatory and compliance guidelines regarding minimum equity capital, leverage (the multiples—3X, 4X or 8X—of share capital that a company can borrow) and the maximum that the bank can lend to a single borrower.[5] These will be necessary if the bank is to make project exports one of its thrust areas.
These actions are in line with promises made during the Third India-Africa Forum Summit (IAFS) in October 2015. The first two editions of the summit—in 2008 and 2011—made numerous pledges but fell short on follow-up and delivery. Both sides were responsible for the indifferent implementation.
The last IAFS, held in October 2015, saw a strategic shift in focus—apart from the usual rhetoric, there was a better alignment of India’s global ambitions (both political and geo-economic) and traditional strengths.[6] [7] Importantly, the third IAFS created a formal monitoring mechanism to regularly review the progress of various projects at different stages of completion.
The summit aimed high—it also sought to create a global alliance of solar-rich countries.[8] Such an alliance will help create goodwill for India among Africa countries, and generate solidarity through collective bargaining when accessing IPR-protected technology from rich countries.
It’s starting with this summit that Modi has been building bridges with different African countries and soliciting support for a host of multilateral initiatives. These include backing for India’s membership of the UN Security Council along with a united front of emerging and poor economies at the World Trade Organisation.
The high-octane official Africa engagements will also help assuage concerns regarding India after recent allegedly racist incidents involving African nationals living in the country. But it is now up to India to ensure that its belated recognition of the critical role Africa can play in our strategic calculus, as well as in India’s trade and investment expansion plans, is not just a temporary spurt.

This feature was exclusively written for Gateway House: Indian Council on Global Relations. You can also read it here.

References
[1] Mukherjee, Pranab, ‘Address at the India-Ghana Business Forum Event’; Speech delivered at Accra, 13 June 2016, <http://presidentofindia.nic.in/speeches-detail.htm?531>

[2] Press Release, Ministry of External Affairs, Government of India, Visit of President to Ghana (June 12-14, 2016), 6 June 2016, <http://www.mea.gov.in/press-releases.htm?dtl/26872/Visit_of_President_to_Ghana_June_1214_2016>

[3] Mukherjee, Pranab, ‘President of India; Speech in response to welcome speech by President of Cote d’Ivoire’ Speech delivered in Abidjan, Ivory Coast, 14 June 2016, <http://presidentofindia.nic.in/speeches-detail.htm?534>

[4] S, Arun, ‘Exim Bank’s African credit to boost service exports’, The Hindu, 12 June, 2016, <http://www.thehindu.com/business/Economy/exim-banks-african-credit-to-boost-services-exports/article8721312.ece>

[5] Lele, Abhijit, ‘Commerce ministry, RBI to review regulatory norms for Exim Bank’Business Standard, 24 May 2016, <http://www.business-standard.com/article/economy-policy/commerce-ministry-rbi-to-review-regulatory-norms-for-exim-bank-116052400042_1.html>

[6] Documents, Third India-Africa Forum Summit, India Africa Framework for Strategic Cooperation, 29 October 2015, <http://www.iafs.in/documents-detail.php?archive_id=323>

[7] Documents, Third India-Africa Forum Summit, Delhi Declaration 2015, 29 October 2015, <http://www.iafs.in/documents-detail.php?archive_id=322>

[8] Speeches, Third India-Africa Forum Summit, Speech by Prime Minister Shri Narendra Modi at the Inaugural Ceremony, 29 October 2015, <http://www.iafs.in/speeches-detail.php?speeches_id=276>

The Legacy: Raghuram Rajan is leaving the battlefield just when he was getting the better of his rivals

June 20, 2016
India’s debonair central banker, Raghuram Rajan, leaves behind many broken hearts and disappointed souls. Chronicles of his legacy will list many achievements, but will also note that he left the battlefield just when he was getting the better of his rivals; what’s surprising is that the commander-in-chief agreed to his pre-mature withdrawal even though the general’s strategies could be seen bearing fruit.
Equally perplexing will be the choice of his replacement.
Both the government and Rajan personally have been advocates of an alternative global financial architecture. He has also been proposing for a while that it was time for a new Bretton Woods mechanism. And Rajan had taken the battle to the enemy camp. At the April 2016 spring meetings of the International Monetary Fund and the World Bank, Rajan observed how deeply multilateral financial institutions were in thrall of western economic orthodoxies. He even wryly remarked how ideas from emerging economies were dismissed as “crankiness.”
He was prescient about the trans-Atlantic financial crisis. He took on former US Federal Reserve chairman Ben Bernanke when US domestic monetary policy spilled over into the global economy and led to severe volatility in emerging markets. He is unlikely to have fond memories of the period: he had to douse this particular fire soon after his appointment in Sept. 2013.
So, here is question number one: Will his successor have the same zeal about promoting an alternative global financial architecture that is sensitive to emerging economy needs and is not partisan about any particular economic ideology?
Rajan also quits before another crusade could be brought to its logical end. He’s been battening down the hatches that allowed a cosy nexus between large corporate borrowers, bankers, politicians, and bureaucrats, to bleed public sector banks through questionable debt write-offs. Rajan had taken a large broom to bank balance sheets and forced them to take drastic action against defaulters.
Many large—and over-stretched—corporate borrowers have been carping about Rajan’s reluctance to reduce interest rates, which, when lowered, would have certainly helped moderate their interest burden. These same corporates also turned into quack economists on the matter of interest rates: in their collective view, only lower interest rates could bring back high rates of economic growth. This view is oblivious to the fact that the low interest rates in the US, or negative rates in Europe and Japan, have failed to promote any economic growth.
Time for question number two: Will Rajan’s successor have the stomach (or benign sanction from the government) to continue with the clean-up act? Or to hold rates steady when required?
So, what does Rajan’s legacy look like? Apart from the well-documented success in fending off volatility from the US Fed’s tapering in 2013, his tenure will be remembered for three systemic changes he fostered.
One will be the differentiated banking landscape that he designed and left behind. As RBI governor, he grandfathered the emergence of a new breed of universal, small, and payments banks. He was in the process of adding two more categories—custodian banks and wholesale (or long-term) financing banks—to the mix. We will now have to wait and see if his successor has the same enthusiasm for a differentiated banking model.
These new categories come in addition to existing myriad forms of cooperative banks, regional rural banks, local area banks, public sector scheduled commercial banks, State Bank of India group of scheduled commercial banks, old-generation private sector banks, new-generation private sector banks, and foreign banks.
Restive signs mark the payments banks space—three companies which received in-principle approval to launch payments banks (Cholamandalam, Tech Mahindra, and Dilip Shanghvi of Sun Pharma) returned their licences stating that the project was not economically feasible. Undeniably, and in true RBI style, the initial architecture is anti-profit and has flaws in it.
The second marquee item is his strict action against non-performing assets (NPAs) that continue to impair bank balance-sheets. This was viewed as his struggle to end Indian-style crony capitalism: large volumes of loans remain unpaid every year and yet defaulting borrowers manage to get fresh loans unfailingly with some help from politicians, bureaucrats, and complicit bankers.
The staggering amount of NPAs is a direct drain on taxpayers, since loss to state-owned bank balance sheets must be compensated with fresh equity infusion by the largest shareholder—government— every year.
Finally, the outgoing governor will be remembered for installing a new monetary policy framework, which uses inflation-targeting as its driving philosophy. It also includes a monetary policy committee comprising three government representatives and three central bankers, with the RBI governor getting the casting vote. This new structure overhauls the old belief that the economy’s fiscal (the government) and monetary policy (central bank) sides should remain out of each other’s hair.
While the government has been uncomfortable with Rajan’s public comments about governance and broader political economy trends—saying that central bankers should not interfere with the fiscal side—it has not shown the same restraint when trying to influence monetary policy.
It will have to be seen how future central bankers and monetary historians view Rajan’s acquiescence to large government presence in monetary policy making.

The article first appeared in http://www.qz.com/india and can also be read here.

What does Brexit mean for India?

June 19, 2016

On June 23, the United Kingdom will vote on whether they wish to remain a part of the European Union through the Brexit vote. The debate surrounding the vote has spurred many a heated and emotional debate. While the Indian government has not declared anything publicly – remaining in the EU would be beneficial to Indian businesses.

The Brexit referendum on June 23 — whether the United Kingdom (U.K.) chooses to stay on in European Union (EU) or to quit the mega regional agreement — has spawned its fair share of heated and emotional debates. Equities, commodities and currency markets have tossed and turned at either prospect. Indian markets have also been agitated at the likely outcomes. An impassive view, though, shows that Indian trade and business interests might benefit from UK staying in.
While the Indian government has not taken a public position on the issue, since it doesn’t want to be seen interfering in another country’s sovereign exercises, newspaper reports says Indian ministers have conveyed to their UK counterparts against exiting.[1]
This stand may have been informed by Indian business’s unambiguous and public support for UK staying on in EU. A statement issued by the Federation of Indian Chambers of Commerce and Industry (FICCI) says unequivocally: “…we firmly believe that leaving the EU, would create considerable uncertainty for Indian businesses engaged with UK and would possibly have an adverse impact on investment and movement of professionals to the UK.”[2] While the other leading industry association, Confederation of Indian Industry, has refrained from issuing any official statements, its representatives have expressed their reservations in different interviews.
There are valid reasons for Indian business concerns.
One, Brexit supporters say the UK will be able to sign new and better trade agreements — free of EU’s restrictive rules — with its strategic partners, such as India and China. They also cite the stalled India-EU trade and investment talks to buttress their argument. However, experience shows negotiating trade and investment pacts takes a long time. For example, the India-Korea Comprehensive Economic Partnership Agreement took five years to finalise[3]. There are concerns over the interim uncertainty for trade and investment flows.
There is another associated hassle. Assuming that Indian business tides over the interim uncertainties, it will still have to adhere to two different standards and rules when trading in the same geography. This entails additional costs.
Two, most Indian businesses use the U.K. as a springboard for their European operations, given India’s historical and cultural affinity with the country. If those favouring exit win, Indian businesses will have to install a parallel set-up on mainland Europe for conducting their operations. For instance, a portion of the Indian foreign direct investment (FDI) into the UK is to access the European markets. Now, Indian companies will have to separate their investments for the two distinct markets. This means additional costs, regulatory wrangles and legal complications. In addition, the complexity of negotiating new tax laws is likely to prove a nightmare.
Three, there are apprehensions that a Brexit success would inspire other EU members to explore a similar option. This would lead to fragmentation and the Indian government would then have to negotiate separate agreements with each country. This will add to the general confusion and add to regulatory and compliance costs for Indian business.
Finally, Brexit might raise myriad central banking problems. First, Reserve Bank of India (RBI) will have to re-calibrate its monetary policies to cope with the currency markets volatility. Additional liquidity measures might have to be implemented to stave off rupee volatility; this might temporarily derail the central’s banks monetary policy objectives for 2016-17.
But more importantly, if Brexit goes through, expect prolonged volatility in the currency markets and a sharp drop in both pound and euro values. This will not only mean a downward revision in valuation of RBI’s currency reserves, it will also require the central bank to re-adjust the composition of its ForEx reserves. Though not substantial, RBI’s volume of euro and sterling pound holdings are also not exactly negligible.
This feature was exclusively written for Gateway House: Indian Council on Global Relations. It can also be read here.

References
[1] Watch on Brexit, oil prices; The Telegraph; June 17, 2016;http://www.telegraphindia.com/1160617/jsp/business/story_91646.jsp#.V2TnN-Z96uU

[2] Singh, Dr Didar A; Ficci Secretary General; Ficci Comments on UK Referendum on Brexit; February 24, 2016; http://ficci.in/PressRelease/2293/ficci-press-feb24-uk.pdf

[3] Ahmed, Shahid; India-Korea CEPA: An Assessment; pages 45-98; Korea and the World Economy, Vol. 12, No. 1 (April 2011);http://www.akes.or.kr/akes/downfile/12.1.3_ahmed.pdf

Budget: It’s Now Or Never

January 19, 2016

The 2016 Budget could be the last chance for the government to redeem itself and find a way back into the common man’s heart.

It is that time of the year again. Newspapers, business channels, Internet sites are all full of ideas, suggestions and even advice for Finance Minister Arun Jaitley. The minister’s appointment diary is brimming with meetings scheduled with representatives from industry, trade unions and agriculturalists. They all come armed with wish-lists, hoping to influence the final design of this year’s Budget exercise. 
Jaitley is on track to present his third budget (for 2016-17) and, while patiently sticking to the routine of meeting various lobbies and representatives, he is aware of the criticism he faced for his first two Budgets and the challenges that lie ahead. It’s now or never; this might be his last opportunity to introduce bold reforms and sow the seeds of future growth. Next year might be too late; assembly elections for Uttar Pradesh and Punjab among other states are scheduled for 2017 and expedient politics traditionally triumphs sensible, hard-nosed economic measures in poll-bound years; the year also marks the beginning of the countdown to 2019 general elections.
To be fair, the FM does seem trapped in a cleft stick. Look at the hand he has been dealt: the global economy is struggling to emerge from a prolonged slowdown, leading to lower demand for Indian goods and services, and shrinking exports; China’s economic recalibration is spooking global capital flows and skewing the pitch for foreign direct investment (FDI) into India; indiscriminate past lending by banks (largely public sector banks) has impaired their ability to finance new projects, especially infrastructure projects; power generation and supply — essential for manufacturing activity — is stuck in a tangle of issues relating to fuel supplies, pricing, past regulatory infractions; agricultural output remains depressed due to sub-par monsoons, in addition to legacy issues of low productivity, inadequate credit and input supplies; this has dampened rural demand, thereby impacting a wide range of industries. 
In addition, the pre-election promises of fortifying the country’s manufacturing base, resulting in additional employment, fanned unrealistic expectations; when these did not materialise (as they were not expected to in such a short period), they spawned widespread disappointment with the regime’s economic managers.
It might be instructive to review the FM’s first two Budgets to decipher the tenor and direction of this government’s economic policy-making. In his debut (Budget 2014-15) innings, presented 45 days after taking office, the focus seemed to be on long-term, structural reforms: FDI up to 49 per cent in defence and insurance, guarantees of a stable and predictable tax regime, real estate and infrastructure investment trusts, incentives for foreign institutional investors (FIIs) and fillip to debt markets. The second outing continued policy thrust in the same direction: greater decentralisation and balanced regional growth through higher devolution to states, commitment to increased public expenditure to kick-start investment in the economy and a host of institutional reforms to attract fresh domestic and foreign investment.
But, expectations built up in the pre-poll season cannot be wished away easily and stakeholders have started voicing their disappointment. In short, Jaitley has to find ways to prod the economy into a higher growth trajectory immediately, without over-playing his hand or pushing the economy down a fiscal slope. On the other hand, the government is committed to certain expenditure — social sector allocations (especially in a year of agricultural distress and depressed rural incomes), a higher outgo because of Seventh Pay Commission recommendations and One Rank One Pension settlement (both are expected to result in combined outflows of about Rs 100,000 crore), interest burden on past government loans, capital infusion for state-owned banks and other PSU companies, plus a host of other obligations.
The Good News
Fortunately, revenue growth has been good. Data from the Controller General of Accounts shows net tax revenue for the first eight months (April-November) at Rs 4,64,864 crore, a growth of 12.5 per cent over the corresponding period last year. Non-tax revenues rose 35 per cent, helped primarily by spectrum auction proceeds and transfer of profits from public sector companies. There are three reasons behind tax revenue growth — higher duties on petroleum goods, the new service tax rates and the enhanced cess.
There are other encouraging signs as well. Bursts of public expenditure during June, July and September have taken the government’s total planned capital expenditure to Rs 97,788 crore during the first eight months of 2015-16, a 57 per cent jump over what was spent during the corresponding period last year. For example, funds allocated during 2015-16 to states and Union Territories for development of national highways, according to a PIB press release, is significantly higher than previous year: Rs 81,006.99 crore against Rs 31,495.20 crore in 2014-15, a jump of over 157 per cent. It remains to be seen how much of that allocation is actually spent. The National Highways Authority of India has so far awarded 43 projects in the current financial year for a total length of 2,624 kms.
The individual ministry-wise data provides greater insight. The ministries of road transport and highways, and rural development are among heavy-hitting ministries, with both having exhausted 74 per cent and 80 per cent of their budgeted plan expenditure for 2015-16 in eight months. Even the ministries of agriculture, health and family welfare and human resource development have spent a higher proportion of their budgeted plan expenditure than last year. More pointedly, among the large spenders seem to be ministries charged with key social sectors — such as, rural development and health. 
Clearly, the government is betting on higher public expenditure to shake the economy out of its torpor. This is classic text-book stuff. It is also in keeping with the FM’s undertaking in last year’s Budget speech to increase public investment outlay: “The total additional public investment over and above the RE (revised estimate) is planned to be Rs 1.25 lakh crore, of which Rs 70,000 crore would be capital expenditure from budgetary outlays.”
Clear & Present Dilemmas
The proverbial monkey-wrench is lack of revenue to finance public projects. While revenue generation has so far held up, largely on back of indirect taxes, there are multiple pressure points building up.
One, industrial activity as represented by the Index of Industrial Production shows 3.9 per cent growth during April-November 2015 over the same period last year, helped in large measure by festival shopping during October. Three among the top five items which contributed to October growth corroborates this — gems and jewellery, telephone instruments (including mobile phones) and passenger cars. On the flip side, what is worrying is stagnation in consumer non-durable items, which shrank by 0.5 per cent during April-November. In fact, consumer non-durable items stayed in negative zone in five of the eight months. In addition, the Nikkei Purchasing Managers’ Index also indicates manufacturing shrinking in December, affected partly by the Chennai floods. 
Two, the continuing fall in exports — close to 20 per cent by November — and its impact on overall manufacturing activity, is likely to dampen revenue generation in the coming fiscal. Worryingly, commerce secretary Rita Teotia was widely reported informing chambers of commerce that 2015-16 will end with $270-billion exports, markedly lower than $311 billion in 2014-15. The government and Reserve Bank of India (RBI) have allowed the rupee to depreciate, probably to keep exports competitive. This becomes especially critical when viewed against the Chinese central bank’s repeated devaluation of the yuan — in August 2015 and again on January 7, 2016.
This then, in short, is the FM’s dilemma. How does he meet the various expenditure demands — commitment to social sector schemes; need to keep investing in public investment to rekindle economic growth; allocations to agricultural sector to forestall distress; increase in salaries, wages and pension of government employees (including the armed forces); and, finally (but most importantly), increased allocation to states from the divisible central tax pool under the Fourteenth Finance Commission award. Worse, Jaitley has to fork out increased sums of money while staring down a diminishing exchequer.
The government seems to have reached the crossroads and needs to select a path that will help it emerge from this impasse. A few ineluctable options present themselves.
Feeling Fiscy
First, will the government be willing to take the fight to fiscal conservatives? In short, will it be willing to let the fiscal deficit slip just that wee bit to fire up animal spirits in the economy? 
This question goes to the heart of the Bharatiya Janata Party’s (BJP’s) economic philosophy, which has been morphing from its avowed “swarajya” policy in the 1970s and 1980s to pro-globalisation and support for foreign investment in the 1990s. Among the many consanguineous economic ideologies that exist within mainstream BJP, its affiliates and allies (such as Shiv Sena, Vishwa Hindu Parishad) and its mother organisation Rashtriya Swayamsevak Sangh, the umbrella right wing also includes economists of variegated hues — right-wing economists trained in Western universities (who find enlarged fiscal deficits and higher government debts anathema to the conservative notion of smaller government, low tax rates, and laissez faire economics) sitting cheek-by-jowl with free-market votaries who do not mind tweaking rules to protect domestic interests from competition (the lopsided FDI policy on foreign retail is a good example) or to suit local conditions. A lot will depend on who gets to monopolise airwaves in coming weeks.
There are other external pressures: credit rating agencies (especially the Big Two) are also wedded to fiscal orthodoxy and any deviation invites a rap on the knuckles or a downgrade, depending on the severity of the slippage. Interestingly, when the US allowed its fiscal deficit to expand to $1-trillion-plus between 2009 and 2012 — as it accelerated spending to stave off after-effects of the 2008 global financial crisis and the consequent economic slowdown — it did elicit censure from a section of Republicans in Congress, but that was pretty much it. It’s only in 2015, as the US economy continues to recover, that the deficit narrowed to $439 billion, the lowest since 2008.
Interestingly, while fiscal conservatism is considered an essential ingredient of the Republican ideological toolkit, even the Bill Clinton presidency adhered to large parts of this credo, attracting the new moniker “Liberal Democrats”. In a recent, cogent essay in The Atlantic Why America Is Moving Left, political scientist Peter Beinart, argues that President Barack Obama has pushed US economic policy dramatically to the left and it is likely to stay that way for some time to come. But, in India, conservative orthodoxy has slowly and insidiously sunk roots across ideological divides, thereby making fiscal deficits a dirty and contemptible term, even when sought to be used as a one-off, emergency measure. 
There are reasons to be wary of rising fiscal deficits; the reckless borrowing and spending of the 1980s brought India close to bankruptcy in 1990. Higher fiscal deficits and swollen debt levels could jeopardise the long battle that’s been waged to achieve fiscal stability, especially when the government’s inability to control wasteful spending or to execute expenditure rationalisation is well known. Relaxing vigil on the fiscal front is like a slippery slope: reining it back requires enormous political courage. 
If Jaitley, therefore, chooses to expand the fiscal gap a bit to finance all manners of expenditure (which increasingly look unavoidable now), he should expect commentators to look askance. To that extent, the FM seems to have already laid the foundation in his FY2016 Budget speech: “…insisting on, a pre-set time-table for fiscal consolidation pro-cyclically would, in my opinion, not be pro-growth…I will complete the journey to a fiscal deficit of 3 per cent in 3 years, rather than the two years envisaged previously…The additional fiscal space will go towards funding infrastructure investment.” But, between a paragraph in the budget speech and facing up to the risk lies a a wide chasm — and lots of criticism to boot.
Show Me The Money
The second tough call is raising revenue. As described above, higher tax revenues in the current economic environment increasingly seems difficult. There is no likelihood of an immediate increase in the number of tax payers which can compensate for the dip in revenues from existing tax payers. It will also be suicidal to increase tax or duty rates.
Part of the solution might lie in focusing on non-tax revenues, specifically non-debt capital receipts. The target for government disinvestment was Rs 69,500 crore and the achievement has been a paltry 18.5 per cent — Rs 12,852.90 crore. Evidently, the government’s policy of second-guessing the market has not paid off. It is also true that selling government assets in a falling market could invite Parliamentary condemnation, and the government may not wish to add this to its current list of woes. But, desperate times call for desperate measures. Jaitley might have to force the issue on this one. He does have some political capital in Delhi and he might have to expend chunks of it to push for disinvestment, regardless of how the Sensex behaves. 
Another partial solution exists in the balance sheet of numerous public sector units. The government is believed to have advised profitable PSUs to pay out higher dividend this year — 30 per cent of post-tax profits or of the government’s equity, whichever is higher. There must be some number-crunching behind this. Budget FY16 estimates Rs 36,174.14 crore inflows from PSU dividends. It is to be seen if the 30 per cent dividend diktat precipitates revenue inflows higher than budgeted. There is also a likelihood that the 30 per cent decree has been necessitated by a shortfall expected in dividends budgeted from RBI, nationalised banks and financial institutions — Rs 64,477 crore. Whatever might be the reason, the government’s revenue projections for the year-end, and the anticipated resource crunch in the next year, might have necessitated the 30 per cent order.
An alternative to leveraging PSU balance sheets also exists. At last count, PSUs were sitting on a cash chest of over Rs 2,00,000 crore. Some of this has already been committed to their expansion projects. But a large part is lying idle, invested in low-yielding assets, like bank fixed deposits. The FM has to marshal these funds for a part of his public investment exercise. 
A distinction might be necessary here. The PSU investible corpus should be used exclusively for creating productive assets closely aligned with the specific company’s business opportunities. Therefore, an engineering company’s cash reserves should be utilised for not only expanding existing manufacturing capacity but also creating new production capacity in the engineering industry. For example, this might be a good time to revisit India’s installed capacity for manufacturing turbines, boilers and generators. This is important because it is linked to another facet of Jaitley’s to-do list: energising Make In India. His boss, Prime Minister Narendra Modi, has been busy collecting air-miles over the past 20 months, soliciting foreign investment from various governments and corporations. The trips seem to have paid off with only a slight uptick in FDI — $16.631 billion during the first half of 2015-16, a 14 per cent increase over $14.691 billion in the same period of 2014-15 — and not the deluge expected.
One reason could be the continuing stress in the developing economies, thereby inhibiting capital flows. But, importantly, the trickle of FDI could also be related to India Inc’s lackadaisical investment propensity. Many large Indian corporations have not been entirely successful in shedding investment inertia acquired during the calamitous 2009-14 UPA-II regime. Domestic industry’s unconcealed lack of confidence invariably has a demonstration effect on potential foreign investors. This needs to be corrected and a beginning could be made by asking PSUs to invest in expansion and fresh capacity, which can crowd-in fresh private sector investment.
When In Doubt, Fly
With FDI continuing to remain important for India, PM Modi is expected to retain, if not increase, his itinerant routine. Apart from crafting a fresh foreign policy doctrine for India, which seeks to project the country as a new power (or, as foreign secretary S. Jaishankar calls it, “a leading power”), PM Modi is also actively trying to drum up investments for India. He sees economic diplomacy as the centre-piece of India’s foreign policy. 
But investments are only a part of economic diplomacy. Truth be told, economic diplomacy, which has a vital role in India’s desire to emerge as a “Leading” power, has twin responsibilities — opening up markets for Indian goods, services and capital (human and financial), as well as attracting foreign inward investments. In this task, he will need the unstinted support of the external affairs ministry. 
The Budget, shorn of inner party rivalry, can provide the necessary strategic impetus. One of the ways in which this can be achieved is through higher allocations to successful tools of development diplomacy (such as, the highly successful Indian Technical and Economic Cooperation Programme, under which 10,000 participants from 161 partner countries visit India to attend various capacity building courses). But, more can be achieved. With economic growth showing green shoots in the US but staying tentative in Japan and Europe, India needs to find new markets for its goods and services. After the 2008 global financial crisis, India was compelled to seek out the Latin American and African markets for increasing exports. But, performance has been desultory at best. The Budget should try to correct that.
At the end of the day, the Budget is a economic policy document and not just a statement of accounts. Or, a list of tax changes. It is expected to spell out a roadmap that indicates the direction of economic policy-making and galvanises the pace of economic growth. Too many opportunities have been lost in the past with policy architects focusing on minutiae; FM Arun Jaitley has the opportunity to make enduring course corrections. 
This article was published as cover story in Businessworld magazine, issue dated January 25, 2016, as part of a pre-Budget cover package titled ‘A Make Or Break Budget’.

It can also be read here. 

Don’t Bank On It

September 24, 2015

Decoding Raghuram Rajan’s antipathy towards industrial conglomerates.

Finally, India is on its way to hosting a differentiated set of banks, each of which will perform a set of pre-determined functions. Central bank Reserve Bank of India (RBI) granted in-principle approval on September 16 to 10 entities for launching a “small bank”. In August, it approved 11 institutions for activating “payments banks”. In 2014, RBI had granted approval to two private sector organisations for launching “universal banks”.

These “in-principle” approvals will be converted into licences after 18 months from grant of approval once the regulator is satisfied that the institution has met all conditions.

So far, so good. But a few issues need clarity.

One, different bank categories already exist in the system — cooperative banks (there are five kinds under this head), local area banks and regional rural banks. Add to that the universal banks which can broadly be slotted under four heads, according to ownership — State Bank of India and its associate banks, public sector banks, old generation private banks, new generation private banks and, finally, foreign banks. So, while competition is good, is it still unclear how the new banks will make any dent.

Let me explain.

Let’s start with the payments banks. According to RBI’s guidelines, these banks can only accept deposits, provide remittance services, issue ATM/debit cards (not credit cards), act as a business correspondent of another universal bank, distribute third-party investment products (another company’s mutual fund, insurance or pension fund products), among other things. But there’s one big difference: payments banks cannot lend. On top of which, they have to invest 75 per cent of their deposits in government securities or treasury bills with a maximum maturity of one year, and the balance 25 per cent in fixed deposits or current account of another scheduled commercial bank.

This brings us to the second point: The pathway to a respectable rate of return for payments banks seems ridden with multiple potholes. As per the guidelines, payments banks have four key areas of business opportunity, all of which yield fee-based incomes: fee from remittances, fee from transaction services (such as debit cards), fees from sale of third party investment products, fees for providing business correspondent services.

But given the capital cost, the network roll-out expenses and the cost of managing operational risks, this revenue source might not be enough to provide adequate returns. Or, the volumes that will be required to generate adequate returns might be difficult to achieve. Plus, given the demographic profile of a payments bank’s core constituency, ticket sizes are likely to be small and perhaps misaligned with acquisition costs. This is despite use of technology solutions to lower costs.

On top of this, the payments bank will have some genuine dilemmas. One, how does it price deposits? If it’s lower than universal banks, it could raise issues of discrimination. Also, if it has to make a spread from investing in gilts, then deposit rates have to be lower than the sovereign yield rates. Will anybody bite at these rates? It will, therefore, have to rely on high-yield fees, such as those paid on sale of insurance or pension products. Some kind of regulatory framework might be necessary here, given the scope for mis-selling.

The telecom operators, though, may have a slight edge. They might be in a position to leverage their network and customer base for remittances and other related services. This not only lowers their acquisition costs immediately but also obviates the need for brick-and-mortar network substantially.

That might explain why Aditya Birla Nuvo (Idea Telecom), Reliance Industries Ltd (Jio), Airtel M Commerce Services Ltd and Vodafone m-pesa Ltd have got an approval for launching payments banks. The other interesting candidate is individual Vijay Shekhar Sharma, who started popular mobile wallet company Paytm. Aditya Birla Nuvo is the holding company for the AV Birla Group’s financial and telecom services. Reliance, on the other hand, has tied up with India’s largest bank State Bank of India, apart from launching its nation-wide 4G telecom network Jio.

Many large corporates had earlier expressed a desire to obtain universal banking licences, but were quietly discouraged by RBI. Many large business houses owned banks pre-nationalisation and, for some of them, obtaining a banking licence is like re-acquiring a business that was snatched away. But, the payments bank guidelines do not spell out a clear migration path to universal banking.

On the other hand, the guidelines for small banks do have a clear transition route, which includes a five-year track record as a small bank. But, here’s the rub: the guidelines also say, “…proposals from large public sector entities and industrial and business houses, including from NBFCs promoted by them, will not be entertained.”

So, this is the third leg of RBI’s bank licensing process: keeping corporates out of banking, specifically the lending business, through an elaborate route.

RBI allows small banks to migrate to universal banks, but precludes industry houses from applying for small banks. It lets corporates apply for payments banks, but locks the door leading to universal banking. Even among payment bank applicants, companies or industrial groups which did not have a clear advantage in payments banking — such as Kalpataru Corporation or Videocon d2h Ltd — were not considered.

In its press release announcing names of successful applicants for small banks, RBI stated: “…the Reserve Bank intends to use the learning from this licensing round to appropriately revise the Guidelines and move to giving licences more regularly, that is, virtually ‘on tap’.” It’s still unclear whether on-tap licensing is only for small banks or will be extended to universal banks also, and whether there will be some thawing in RBI’s antipathy towards industrial conglomerates.

We might have to first wait for the NPA tide to ebb before RBI warms up to the idea of banks launched by industrial houses.

Originally published in Outlook magazine (http://www.outlookindia.com/article/dont-bank-on-it/295433#comments) under column “Man About Mumbai”  

Busting Myths Around Raghuram Rajan’s RBI

August 1, 2015
There is no definitive proof that lower interest rates will lead unquestionably to higher economic growth.

The revised Indian Financial Code, put in the public domain by Finance Ministry, has divided economists, observers and experts into two distinct, sharply-delineated camps. On one side are those who are desperate to clip the Reserve Bank governor’s wings, and on the other are those who want his unspoken, uncovenanted autonomy to remain untouched, uncompromised. 
In the midst of this brouhaha, discussions about reforming the central bank’s governance framework has fallen through the cracks. While the debate about reducing the Governor’s powers rages endlessly, there is little attention being paid to what happens even after the change is effected. The Governor will still be answerable only to Finance Minister, and not to Parliament or a select committee of Parliament, as is the practice in many countries and as it should be in India too. It is surprising that this aspect of central bank reforms has failed to merit any discussion.
The revised code, among other things, has suggested that monetary policy, the exclusive preserve of central banks all over the world, should be decided by a monetary policy committee. Today, the final decision vests with the governor who, after consulting multiple bodies and committees, then has the sole discretionary power to take any monetary action. It is the composition of this recommended committee that has got people worked up. According to the revised code, the committee should have the RBI governor in the chair, two more RBI employees and four “persons appointed by the Central Governor”. Moreover, each member will have one vote and decisions will be taken on the basis of majority vote. 
With four votes, the government’s nominees immediately constitute a majority. Even more sinister is Article 257 in the code, which enjoins the Central government to nominate one representative to the meeting. This representative will not have a vote but will participate in the committee’s deliberations and will read out a statement from the government at the meeting. The import of this is not lost: with a representative watching the proceedings and delivering the central government’s message at the meeting, will any government nominee dare go against New Delhi’s wishes?
Arguments have been made that, in a democracy, the executive should have some say over a critical economic function like monetary policy. There is a basic flaw with this argument; separation of powers is a fundamental tenet of democracy, especially where the government’s actions can have an abiding impact on people’s lives. The inflationary stickiness arising from the 2008-09 stimulus programme is still haunting the Indian economy. Unlike the thick, Constitutional boundary separating the legislature from the judiciary, the line segregating the executive and the central bank is thin and rooted more in convention and common economic sense. 
It has become fashionable for economists of a certain orientation to demand reduced powers for the central bank governor. There are a couple of problems with that. First, under the new contract signed between RBI and the government, RBI is responsible for ensuring that consumer inflation remains within a pre-determined band. If the Governor ’s powers to use monetary tools to achieve that objective are taken away, then it somehow nullifies the inflation contract.
Second, the Indian economy has always been marked by fiscal dominance, which has been cogently explained by Niranjan Rajadhyaksha (http://goo.gl/3uwpz4) in his column for newspaper Mint. In simple words, monetary policy in India has always followed fiscal policy. The government’s fiscal policy, resulting in fiscal deficits, has forced the central bank to fashion monetary policy with the objective of tackling the after-effects of fiscal excesses. The RBI has worked hard over the past 25 years to minimise the deleterious impact of government’s profligacy on monetary policy. The government, in seeking to control both fiscal and monetary policies now, will negate all that has been achieved in stabilising the economy.
At the heart of the demand to shift the reins of monetary policy is a popular myth: reducing interest rates will automatically stimulate economic growth. Like all myths, especially those relating to flying machines of antiquity, there is no definitive scientific — or statistical — proof that lower interest rates will lead unquestionably to higher economic growth. Interestingly, another prevalent myth about the Indian economy being “decoupled” from the global economy evaporated quite rapidly after 2009. 
Many economists and industry lobbies have been incensed by RBI’s refusal to lower interest rates. Former RBI governor D Subbarao raised interest rates 13 times in quick succession. It was hoped his successor, Raghuram Rajan, would be divorced from such “anti-growth” orthodoxies. And, even though he has lowered interest rates, the pace has not been found too satisfactory. 
Beyond myths, a softer interest rate regime definitely has some side benefits: lower interest rates will automatically reduce the debt servicing burden of many large corporates which have borrowed way beyond their digestive capacities. While the RBI has been critical about the mounting levels of sticky loans in bank books and the behavioural patterns displayed by corporate borrowers, the government believes the investment cycle — especially “Make In India” — will not revive unless this staggering debt mass is sorted out.
Finally, the revised code employs some rather curious appellations: for example, it keeps referring to the RBI governor as “chairperson”. For example, Article 256(2)(a) says the monetary policy committee will comprise “the Reserve Bank Chairperson as its chairperson”. Last time I checked, RBI had no chairperson. He doesn’t exist even in the RBI Act.
Courtesy Outlook magazine: http://goo.gl/V1IALu 

A Sharing of Instruments

March 9, 2015

RBI’s new brief to curb inflation comes with a cut in its independence

Like many other things, the Reserve Bank of India has come late to the party. And it has celebrated with a rate cut. Announced on Wednesday morning, outside its usual, scheduled policy review cycle, the RBI cut the benchmark rate by 25 basis points. This is questionable.

What’s curious is the timing: it seems to indicate that the RBI is returning a favour to the government for having signed the monetary policy framework agreement. Signed between the RBI and the Union finance ministry on February 20, it enjoins the RBI to bring inflation—as measured by consumer price index (CPI)—below 6 per cent by January 2016, and thereafter strive to keep it at 4 per cent (with an error margin of plus/minus 2 per cent). Any deviation will be considered a failing, requiring an explana­tion.

The monetary policy framework with a single nominal anchor was recommended by an RBI-constituted expert committee and chaired by RBI deputy governor Urjit Patel. The choice of CPI (combined) as nominal anchor is also in keeping with similar recommendations made by earlier committees, such as the Raghuram Rajan committee and the Percy Mistry committee. It would thus seem that a chorus of orchestrated voices, seemingly with an aligned ideological perspective, has managed to refashion the RBI’s role and purpose.

What is disquieting is the way it tilts at independent monetary policy. The decision also comes at a time when there is an attempt to steadily erode the RBI’s independence (however limited), either through curtailing its powers or through unilateral transfer to the executive, as evident in this budget.

The first is a move to amend Section 6 of Foreign Exchange Management Act (FEMA), which empowers the RBI to control foreign exchange flows. Arun Jaitley stated in his budget speech: “Capital account controls is a policy, rather than a regulatory, matter. I, therefore, propose to amend, through the Finance Bill, Section-6 of FEMA to clearly provide that control on capital flows as equity will be exercised by the government, in consultation with the RBI.” The immediate provocation for this is believed to be an embittered separation process between a leading Indian conglomerate and a foreign telco; to make matters worse, RBI rules on put options in share agreements delayed a settlement. Eventually, though, the RBI is believed to have made exceptions to its rules for this deal.
The second is the setting up of a public debt management agency “which will bring both India’s external borrowings and domestic debt under one roof”, which are all under the RBI’s watch currently. There is also no clarity on the nature of the agency—will it be independent, will it be under the finance ministry or quasi-autonomous? This clarification is necessary because a debt management agency should be in a position to either influence interest rates or take the punch-bowl away in times of excessive fiscal expansion.

In the aftermath of the RBI’s war-mode attack on inflation and inflationary expectations, influential voices have been demanding that its powers be curtailed or stripped. Many blamed the RBI, wrongly of course, for the current economic slowdown. This is not peculiar to India. With a prolonged global slowdown prompting countries to elect conservative candidates, central banks have felt the heat in Israel, Japan and Hungary.

The decision to forge a new monetary policy agreement, especially when aca­d­emics are questioning inflation targeting, has some unexplained areas. First, the RBI has no control over half the constituents in the rebased CPI index (food or fuel items), so this raises questions about influence monetary policy action can have on price behaviour. Second, the RBI has complained in the past about the quality of data collection and analysis, but is willing to submit itself to be judged by the same touchstone. Three, there is an undeniable, but com­­plicated relationship between employment and inflation. The latest economic survey highlights the dis­tortions in une­mployment data; this compact is then bui­lding a framework using the bedrock of two publicly ackn­owledged noisy databases. Four, the transmission route and the time-lag bet­ween monetary policy action and its impact on the price line is unclear; the RBI’s brave promise the­refore to hold down the price line to a specific number using monetary policy is surprising.

The final picture will emerge when monetary policy committee members are selected. One hopes they will be independent professionals, selected not for their political beliefs but their understanding of monetary economics. Finally, one also hopes that the RBI governor will get to have the last word on that committee.

Reprinted with permission from Outlook Magazine: 

http://www.outlookindia.com/article/A-Sharing-Of-Instruments/293613

and, 
Gateway House: http://www.gatewayhouse.in/a-sharing-of-instruments-2/