Budget 2018: A Trinity of Challenges Confronts Arun Jaitley

Budget 2018 is Arun Jaitley’s last full budget before next year’s general election and he may choose to do nothing but wait it out

There is something magical about the number three. In Shakespeare’s tragic play, it is three witches who provide Macbeth with a prophecy. The Chinese consider three as the perfect number, three represents the holy trinity, and so on. Finance minister Arun Jaitley’s last Union budget turned out to be quite prescient when he presaged three identifiable risks for the Indian economy: the Federal Reserve increasing interest rates, oil prices rising, and a retreat from globalization. Most of these risks are playing out with slight variations.

There are new fault lines developing now and it will be interesting to see whether the upcoming Union budget has a toolkit for these challenges.

One emerging danger is the capital market’s decoupling from the real economy. This was perceptively highlighted in recent interviews by Uday Kotak, executive vice-chairman and managing director of Kotak Mahindra Bank. In one interview he said: “Money is coming to a broad funnel and it’s going into a narrow pipe where massive amount of Indian savers’ money is now going into few hundred stocks…The amount of money that’s going into small and mid-cap stocks is something on which we have to ask tough questions. Is there a risk of a bubble?”

Kotak could be on to something. According to data from the Association of Mutual Funds in India, investment in mutual funds (net of redemptions) during April-December 2017 was up 28% over the previous year’s corresponding period. Much of this is flowing into stocks and influencing key indices: the 30-share S&P BSE Sensex has appreciated over 29% in the one-year period between 18 January 2017, and 18 January 2018. No other asset class can match these returns. State Bank of India’s fixed deposits for one year pay 6.25%, the government’s 364-day T-bills were recently auctioned at a cut-off rate of 6.52%, metals have ranged between 14-18%, gold yielded about 4%, crude oil is roughly 6% up and real estate continues to remain in the dog-house.

Two provisos merit mention: bitcoins are excluded because they are not available widely (like art or horses) and all the above returns are taxable while returns from investment in stocks for more than a year are tax free.

Curiously, and by serendipitous timing, discussions over a long-term capital gains (LTCG) tax on equity holdings are suddenly in play. LTCG—defined as gains realized from equity sales after holding for more than a year—are exempt from taxation. Short-term capital gains are taxed at 15%. The LTCG debate looks and feels like a test balloon floated to gauge the mood for new taxes. The guessing now is that tax-free LTCG may require a longer holding period of, say, two years. Even then, it is unlikely to yield great tax revenues.

Herein lies Jaitley’s dilemma: a larger section of Indians is now affected (directly or indirectly) by market movements and there’s no saying how additional taxes will have an impact on share values. Jaitley may want another Tobin-like tax to slow down runaway markets—investors already pay securities transaction tax, averaging around Rs 7,400 crore annually—but without rocking the boat. The market’s reception to government slashing its additional borrowing programme by Rs 30,000 crore (Rs 300 billion) was euphoric—the BSE Sensex rose over 300 points—ignoring that Rs 20,000 crore (Rs 200 billion) extra will still be borrowed. It is all down to managing the news cycle so that markets do not reverse course.

The LTCG speculation may have been prompted by need for new tax sources, given the slowdown in overall tax revenue accretion—till November 2017, 57% of the full year’s target had been collected while expenditure has raced ahead. Tax revenue growth is slack because the goods and services tax is taking time to settle down. Cheerleaders have made much of the spike in income-tax collections (15% higher than the corresponding period last year) but are silent about the slowdown in indirect taxes which not only provide a larger proportion of tax collections every year but also indicate continuing stagnation in the real economy with direct repercussions on unemployment.

There are red lights flashing elsewhere. Post demonetisation, money supply is in a frisky zone—in the 12 months to 22 December 2017, it has grown by 10.5% against 6.2% in the previous 12-month period. This has forced the Reserve Bank of India to suck out around Rs3.4 trillion liquidity between 26 December and 6 January. So, a rate cut looks remote at the moment.

Add to these the persistence of risks Jaitley mentioned last year—oil prices inching up and the Federal Reserve’s December interest rate increase with more likely to come in 2018. Then there’s the US’s new corporate-friendly tax bill which provides companies incentives to take back home roughly $3 trillion of global profits—Apple, for example, has announced it is repatriating close to $252 billion.

All this complicates Jaitley’s task. This is his last full budget before next year’s general election and he may choose to do nothing but wait it out. But he has to contend with three (that number again) challenges, which will directly have an impact on eight state elections this year and a general election next year—balancing a hysterical stock market with a slow real economy, providing enough policy measures to incentivise private sector investment and spur job creation, ensuring adequate allocations for the rural sector given the continuing farm distress.

Beyond that, it is most likely to be a holding operation which, in itself, is no mean task.

The above article was first published in Mint newspaper and can also be read here

Fintech Moves In The New Year

Government and regulatory agencies expected to provide some policy actions and regulatory direction to fintech

The lingering after-effects of demonetisation were felt through calendar 2017. These were further buffeted by the introduction of the goods and services tax. Both events hastened the adoption of fintech, particularly digital payments. The trend is likely to be consolidated during 2018, with government and regulatory agencies expected to provide some policy actions and regulatory direction.

The government’s resolve was perhaps reinforced by EY Fintech Adoption Index 2017, which surveyed 22,000 respondents across 20 countries. India’s adoption rate is seen as among the highest in the world, second only to China’s. So, what can finance minister Arun Jaitley do in his last full budget that can further improve the adoption rate?

Some pending issues from last year’s budget need his attention first.

One, the 25-billion digital transactions target, spanning multiple platforms (Unified Payments Interface, Unstructured Supplementary Service Data, Aadhaar Pay, Immediate Payment Service and debit card), is likely to be missed. This will require the government to conduct additional research on what needs to be done, especially how best to ground such annual targets in reality.

The other pending issue is completing the formation of a Payments Regulatory Board, which was set up through an amendment to the Payment and Settlement Systems Act. While the new board was a follow-up to the Watal Committee’s recommendations, the composition of the board disregards the committee report’s spirit and intent. The board currently has equal number of representatives only from the Reserve Bank of India (RBI) and the government.

There are a host of other targets and promises that were made in the previous budget that either remain unfulfilled or about which updates are not available in the public domain—such as, using Small Industries Development Bank of India’s refinancing role to allow small and micro units to access formal finance, or accelerating financial inclusion using digital payments platforms. In the forthcoming budget, Jaitley will need to iron out numerous regulatory and infrastructure issues.

The first move should be to re-imagine the role of National Payments Corporation of India (NPCI). The company introduces itself as “an umbrella organization for all retail payments in India.” The NPCI was set up with the “guidance and support” of RBI and the Indian Banks Association for creating a reliable and robust payments infrastructure in India. Its shareholders are commercial and cooperative banks and its products are limited to only the banking industry. This is where the distortions set in.

Currently, NPCI is like the owner and major user of a common infrastructure facility and allows only select customers to use this resource. NPCI’s products should be given the tag of utility infrastructure, to be used as an open application programming interface by the fintech industry. This is likely to foster new products and innovation. In other words, if the government plans to use fintech to achieve financial inclusion, it cannot afford to exclude non-bank payment service providers from common utility infrastructure.

Second, administered merchant discount rates (MDR)—the rate which banks charge merchants for providing payment infrastructure—have been quite contentious, especially since they are seen as an intrusion into a commercial relationship between the card issuer (mostly a bank) and the merchant. The RBI’s latest regulatory guidance caps MDR charges to drive up merchant acceptance of digital payments. Two anomalies emerge which need some course correction.

The guidelines spell out differentiated capped rates, based on the annual turnover of the merchant. This might become cumbersome and subject to various abuses. There is another problem. The RBI’s moves can be viewed as a market development strategy for fostering greater acceptance of digital payments. However, in all such endeavours, it is desirable to spell out the sunset period. For instance, the Union cabinet has decided to subsidize merchants for all digital transactions below Rs2,000 for the next two years. Even if one ignores the policy’s overt political ambitions, there is a visible end-point for the exercise.

Third, the government must take a call on blockchains and crypto-currencies soon. The government and RBI have been repeatedly cautioning investors about risks of investing in cryptocurrency, especially bitcoin. Simultaneously, a committee under the secretary, economic affairs, in the finance ministry is examining all issues related to cryptocurrencies. Policy and regulatory action should try to remain a step ahead of market practices, especially since some Indian banks have already developed blockchain technology to deal with overseas clients. Axis Bank, ICICI Bank and Yes Bank have all separately developed, or tied up with technology companies, to use blockchain technology for faster cross-border remittances. For example, the State Bank of India has joined hands with 29 other banks and finance companies (including ICICI Bank) to fund BankChain, a blockchain based cross-border payments platform.

Finally, RBI’s guidelines on peer-to-peer (P2P) lending need further refinement to bolster the nation’s growing fintech credentials. The rules have confusing eligibility criteria, are ultra-conservative in lender exposure limits and allocate too much discretionary power to the central bank without spelling out specific trigger points for regulatory action.

The above article originally appeared in the Mint newspaper and can also be read here