NPAs: The New Wedge in Centre-State Relations

NPAs are expected to acquire a two-tier, federal character with enormous implications for Centre-state relations

There was jubilation in stock markets recently after finance minister Arun Jaitley hinted at a scheme to sort out the messy tangle of bad loans in the banking sector. The equity market’s optimism beggars belief because NPAs—or non-performing assets, as bad loans are called technically—have remained impervious to an alphabet soup of previously attempted schemes. And now, NPAs are expected to acquire a two-tier, federal character with enormous implications for Centre-state relations.

In the post-1991 era, multiple schemes have been conceived and launched to tackle the menace of NPAs: DRTs (debt recovery tribunals, as suggested by Narasimham Committee-I and then subsequently amended in 2012), CDR (corporate debt restructuring), SARFAESI Act (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest), CRILC and JLF (Central Repository of Information on Large Credits and Joint Lenders’ Forum), 5/25 scheme, ARC restructuring (asset reconstruction companies, formed as a consequence of DRTs), SDR (strategic debt restructuring), AQR (asset quality review), S4A (scheme for sustainable structuring of stressed assets) and finally the IBC (Insolvency and Bankruptcy Code).

There are multiple reasons for many of these schemes failing, which includes an inadequate legal framework for pursuing resolution; however, the one reason that remains unchanged from pre-reforms period is final policy design always providing corporate borrowers enough protection so that they can reprise the same act all over again. And while public attention has focused on Vijay Mallya—deservedly of course—there are other larger industrial groups which are habitual offenders but manage the system adroitly. Former Reserve Bank of India (RBI) governor Raghuram Rajan was compelled to state: “…it is extremely important that banks do not use the new flexible schemes for promoters who habitually misuse the system (everyone knows who these are) or for fraudsters.”

This raises issues of “moral hazard”; in the Indian context, moral hazard has taken the form of corporates or public sector banks undertaking increasingly riskier behaviour because they know the government is underwriting that risk or bearing the cost of that risk. Post the 2008 financial crisis, moral hazard has acquired some flexibility globally: it has become acceptable to bail out institutions if government feels such failure can lead to widespread systemic risk.

This may have inspired finance ministry’s chief economic advisor Arvind Subramanian to blithely suggest that government should perhaps bail out large corporate borrowers because that is how “capitalism works”. He feels only write-offs can sort out the “mountain of debt” sitting on bank books, or settle the twin-balance sheet problem (over-leveraged companies and NPA burdened banks). 

Interestingly, Subramanian has also contributed to the NPA soup cauldron: the annual economic survey recommends the creation of PARA, or Public Sector Asset Rehabilitation Agency. Not to be left behind, even RBI’s recently appointed deputy governor Viral Acharya has gamely added his two-bit: PAMC (Private Asset Management Company) and NAMC (National Asset Management Company).

So, while attempts are being made to untangle the knotted skein of corporate bad loans, albeit through an ever-growing thicket of acronyms, Jaitley has at the same time flatly turned down requests for farm loan waivers. He has received wide support. State Bank of India chairman Arundhati Bhattacharya has warned that fulfilling such pre-election promises might lead to dilution of credit discipline: borrowers might tend to defer repayment till the next elections in the hope of loan waivers. This newspaper also recently pointed out that the Indian agricultural sector needs long-term structural investments, not short-term exchequer-funded loan waivers. There is merit in each of these arguments.

But, here’s a catch: the ruling Bharatiya Janata Party also promised farm loan waivers in its Uttar Pradesh assembly election manifesto. Having won the elections and faced with the prospect of fulfilling that promise now, Jaitley has used an escape hatch to wriggle out of the commitments. Answering the debate on Finance Bill in Rajya Sabha, he has asked individual states to foot the bill for farm loan waivers. He has effectively created a two-tier, federal, moral hazard framework: Centre’s responsibility to bail out large corporates and states get to write off farm loans.

This further complicates attempts at creating a long-term, sustainable set of solutions for controlling and resolving the financial system’s NPAs. It also adds new headaches to the already vexed Centre-state relations. Competitive waiver promises have already weakened the fragile balance sheets of Andhra Pradesh and Telangana. 

It also raises issues of discrimination. If the Centre wants to bail out some 30-40 large corporate borrowers on the pretext that their debt misery was the outcome of external shocks, does not the same logic or argument apply to farm loans, especially since many states have been victims of droughts, inadequate monsoons and crop failures? There is no doubt the NPA mess needs to be resolved urgently to kick-start investments and the growth process. But then, that solutions framework cannot be built on the foundation of discrimination and selective relief.

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

Arun Jaitley’s Shades-of-Green Budget

All said, a fog currently surrounds finance minister Arun Jaitley’s tax play on carbon credits

The West’s climate-change politics vilifies India for its pointed refusal to abandon coal as an energy source. This criticism continues unabated despite praise from multiple quarters for India’s Intended Nationally Determined Contributions (INDCs), submitted before the Paris climate summit in 2015. The INDCs commit to reduce the emissions intensity of India’s gross domestic product (GDP) by 33-35% from 2005 levels by 2030. Interestingly, the INDCs are voluntary, unlike past top-down climate governance mechanisms, such as the Kyoto Protocol.

India’s INDC moves are coming to life in myriad forms. Union finance minister Arun Jaitley has used the 2017-18 annual budget to incorporate some basic elements of a “Green Budget” as well as initiate India’s economic response to the West’s climate change politics. These policy initiatives include lighting up 7,000 railway stations across the country with solar power and halving basic customs duty (BCD) on liquefied natural gas—a relatively cleaner fuel compared to coal or oil—from 5% to 2.5%.
Green budgets deploy fiscal carrots and sticks to influence economic behaviour and improve the environment. Jaitley made a tentative start with his 2016-17 budget but without taking any of the long strides necessary to strengthen India’s commitment to sustainable development or place India firmly on the path to lower emissions. The measures in this year’s budget perhaps quicken the pace, but two decisions stand out for their curious configuration.

The first is a direct tax measure: a new section (115BBG) in the Income Tax Act makes income from the transfer of carbon credits taxable at a concessional 10% rate (plus applicable surcharge and cess). This income was earlier taxed at the normal rate. The directive would have been welcome had the timing not been mystifying. Critics have called the decision a delayed reaction, especially because carbon-credit markets are all but dead. The European Union’s emissions trading system (ETS) shut its doors in 2012; in addition, carbon credit prices have plummeted sharply, rendering the whole process of creation of carbon credits and subsequent trade unviable. But such criticism could also be hasty.

India is trying to create two domestic trading initiatives: Perform Achieve and Trade (or PAT) under the Bureau of Energy Efficiency and a Renewable Energy Certificate (REC) trading system. A third initiative has been launched in three states—Maharashtra, Tamil Nadu and Gujarat—for developing a pilot ETS programme to reduce particulate matter (such as sulphur dioxide) emissions. Only the PAT design, currently in pilot phase, comes anywhere close to an ETS.

The PAT mechanism has identified 11 industrial sectors accounting for 25% of GDP and 40% of India’s energy consumption: thermal power plants, cement, chlor-alkali, pulp and paper, petroleum refinery, power discoms, fertilizers, iron and steel, textile, aluminium and railways. PAT seeks to lower energy intensity in each of these industries through trade in energy savings certificates on designated power exchanges.

In the first phase, 478 companies from eight sectors were included in the programme and achieved an energy savings of 8.67 million tonnes of emissions (mtoe) against a target of 6.886 mtoe. In the second phase, 621 companies from all 11 sectors are being included in the scheme. Is Jaitley’s tax measure designed to provide greater acceptance of, or impart greater depth to, PAT? Did he use the term “carbon credit” interchangeably? This is a distinct possibility: Over the past few years, the number of ETS programmes has been rising across the world, trebling from 5 in 2012 to 17 now.

Throw into this mix China’s planned ETS going live in 2017—slated to become the world’s largest, and bound to change the nature of the game. China, South Korea and Japan are already exploring regional cooperation in carbon markets. Interestingly, India and China signed a bilateral agreement on climate change (goo.gl/BF3hke) in 2015. Both developments point to the possibility of enhanced regional cooperation, especially on a larger, plurilateral platform. But China needs to iron out some wrinkles: harmonizing cross-border compliance and enforcement regimes, improving liquidity, expanding the number of eligible sectors, fungible trading units, among others.

All said, a fog currently surrounds Jaitley’s tax play on carbon credits.

The second curious decision is ending the 5% BCD on the import of solar-tempered glass for the manufacture of solar cells/panels/modules. Simultaneously, and inexplicably, a 6% excise duty has been introduced, where none existed earlier, on domestic production of the same product, solar-tempered glass; it’s like expressing a preference for imports over domestic manufacture and thumbing one’s nose at the Make In India campaign. What adds to the mystery is that 5% BCD was imposed only last year, and in just one year the ministry has decided to backtrack.

There are only two plausible explanations. One, a domestic manufacturer favoured by the current political dispensation probably needs to import for a local photovoltaic fab facility, having already tied up with large importers. Alternatively, two-three large global tempered glass manufacturers have been able to impress upon the government the need to keep imports cheaper than domestic products.

Whatever the reasons, Jaitley needs to provide more clarity on these measures and what they intend to achieve.

The above article appeared in Mint newspaper on March 8, 2017, and can also be read here

The Budget Sidesteps Geostrategic Risks

Arun Jaitley’s budget seems to contain very little—by way of either allocations or strategic intent—to mitigate risks that endanger the Indian economy

Both the budget document and the Economic Survey have painstakingly detailed risks that endanger the Indian economy and can disrupt growth and employment impulses. Yet, the budget seems to contain very little—by way of either allocations or strategic intent—to mitigate these risks. The focus seems to be on surmounting immediate electoral challenges and neutralizing near-term policy distortions like demonetization.

Both Union finance minister Arun Jaitley and his chief economic adviser Arvind Subramanian see major risks emanating from the external sector. Jaitley’s budget lists multiple Fed rate hikes likely in 2017, commodity price uncertainty (especially crude prices) and “…signs of increasing retreat from globalization of goods, services and people, as pressures for protectionism are building up”. The Economic Survey also underlines the last two risks.

Given these clear and visible risks, it would be fair to expect defensive action, especially in areas of India’s strengths. The budget small print belies that belief.

Start with this year’s Economic Survey, which identifies clothes and shoes as ideal candidates for low-skill, high-employment manufacturing potential and for occupying crucial trade space being vacated by China. The survey also finds India has competitive advantage in these two items despite myriad challenges—such as domestic labour laws and tax structure, or the duty preferences enjoyed by competing countries in key buyer markets.

Given the Survey’s clear strategic direction, check out allocations for the commerce and industry ministry under the expenditure budget. Jaitley and his team have allocated only Rs0.01 crore to the Footwear Design and Development Institute, compared with Rs109.99 crore in 2015-16 and Rs25 crore in 2016-17. The institute provides skilled human resources and technology development to the leather and footwear industry. The Indian leather development programme (ILDP) gets a higher allotment of Rs500 crore, compared with Rs235 crore in 2015-16 and Rs400 crore in 2016-17. But then the ILDP focuses on improving the raw material base for leather units and the Survey actually shows non-leather footwear has achieved higher exports than leather footwear.

This is not the only mismatched allocation in the commerce ministry. There’s a token entry of Rs0.50 crore against the project development fund, which the ministry created with the Exim Bank to promote Indian private sector investments in Cambodia, Laos, Myanmar and Vietnam (commonly referred as CLMV nations) as part of Prime Minister Narendra Modi’s “Act East” policy. The creation of the fund was announced by Jaitley in his second budget in February 2015. There are, of course, no follow-up remarks in subsequent budgets.

The budget documents are littered with such examples. The geo-economic strategy, drawing from Modi’s repurposed foreign policy, betrays an excessive strategic reliance on select developed countries which could be a risk. The readout from the White House after US President Donald Trump’s brief telephone conversation with Modi reiterates that the US “…considers India a true friend and partner in addressing challenges around the world.” While these “challenges” remain undefined, Trump’s recent trade policy announcements now renders this alliance vulnerable. While it might be too early to declare doomsday, India needs a hedging strategy which includes exploring alternative markets.

And, yet, the budget sidesteps this obvious alternative. Take the example of Chabahar port in Iran, to which India has attached great geostrategic significance. The port offers India a land bridge to Afghanistan and Central Asian markets that bypasses Pakistan, and can become an alternative route to north Europe via Russia. Unfortunately, India continues to drag its feet on Chabahar, even though India and Iran started discussing it in 1997 and signed the first agreement in 2003 as part of the Delhi Declaration. This was further consolidated through a Trilateral Transit and Transport Corridor agreement signed during Modi’s visit to Iran in 2016.

Chabahar port has been allotted only Rs150 crore under the ministry of external affairs, compared with Rs100 crore in 2016-17. One could argue that since the project is being executed by special purpose vehicle Indian Ports Global Pvt. Ltd, a joint venture between Jawaharlal Nehru Port Trust (JNPT) and Kandla Trust, it might make sense to identify capital allocation to these two ports. The two ports have been allotted Rs1,850.30 crore and Rs393.90 crore for 2017-18, against Rs562.38 crore and Rs130.18 crore, respectively, during 2016-17. But there’s a catch: Both amounts have been listed under the head “IEBR”, or internal and extra budgetary resources, which means the government will not contribute any money and the two ports will have to generate these amounts from profits, loans and equity. Importantly, both ports are also implementing significant expansion plans (the JNPT’s plans include two new container terminals, two dry ports in Wardha and Jalna, and a special economic zone, among other things) and it is moot how much funds they can spare for Chabahar.

Is India going deliberately slow on Chabahar, given the Trump administration’s recent statements and executive order against Iran? India’s on-now, off-now engagement with Iran may have pushed the country closer to China through a joint military cooperation agreement and possible One Belt, One Road connectivity. The budget lost an opportunity to make some critical course corrections.

The article originally appeared in Mint newspaper on February 8, 2017, and can also be read here

Optics All The Way: Budget 2017 has brought to fore the astute lawyer-politician in Arun Jaitley

India’s finance minister Arun Jaitley has lived up to his credentials as a lawyer-politician adroitly: he has presented a budget for 2017-18 that pleases everybody but satisfies very few.

The capital markets investor class, including the foreign portfolio investor (FPI), is certainly happy. The movement of the stock market index reflected joy at being left alone: at closing time, the 30-share benchmark sensitive index was up 485 points in a relief rally. Investors were pleased that a rumoured restructuring of long-term capital gains tax was avoided. FPIs, who bring liquidity to India’s shallow markets, were spared additional tax blushes under something called the “indirect transfer provision,” which required tax to be paid on transfer of shares overseas if the underlying assets are located in India.

In the end, budget 2017 seems to be more about being seen to be doing the right thing rather than doing it. Jaitley’s thrust can be summed up in his own words: “My overall approach…has been to spend more in rural areas, infrastructure and poverty alleviation and yet maintain the best standards of fiscal prudence. I have also kept in mind the need to continue with economic reforms, promote higher investments and accelerate growth.”

This requires walking a fine line and Jaitley has husbanded all the political smarts he could muster.

Delicately balanced

On one side, the impending state assembly elections (in Uttar Pradesh, Punjab, Goa, Manipur and Uttarakhand) which begin on Saturday (Feb. 04) was bound to cast a long shadow on his plans. On the other side, Jaitley had to present a political budget without breaching the election commission’s restrictions.

Jaitley also needed lots of political nous since the budget had to be drafted in the backdrop of some momentous changes: demonetisation (which has dealt a severe demand and supply shock to the economy), the planned move to goods and services tax (GST), political developments in leading developed countries which could lead to severe economic consequences for India and other emerging economies. In addition, the fiscal responsibility and budget management committee’s report tied his hands by advocating fiscal prudence, barring exceptional situations.

On sum, though, there are a lot of announcements and political grand-standing but little by way of on-the-ground impact. For example, total expenditure planned for 2017-18 is up only 6.57% over the Rs 20,14,407 crore actually spent during 2016-17. That barely covers the rate of inflation. What’s even more disappointing, capital expenditure is budgeted to go up by only 10.7%. The country needs public expenditure to kickstart economic growth, especially in the absence of any private sector investment. Strangely, even though Jaitley has acknowledged this in his budget speech, he has failed to walk the talk.

Revenue could be a legitimate constraint. Tax revenues are expected to grow by only 12.7%, while non-tax revenues are actually budgeted to drop. Total revenue, including capital receipts, is expected to rise only 9.7%. One reason for the conservative estimates could be the expected shift to GST from July. The demand compression arising out of demonetisation could be another reason.

Political imperatives

Despite these limitations, the electoral imperative seems to have forced Jaitley to make numerous announcements for farmers, rural areas and allied sectors. In this, Jaitley has chosen to follow the footsteps of his predecessors by announcing grand schemes and allocating large sums. For example, he announced a Rs10 lakh crore agricultural credit target, against Rs9 lakh crore in 2016-17.

It’s curious that successive finance ministers chose to make this proud proclamation in the budget document when the money will actually be lent by various agri-lending agencies, such as the National Bank for Agriculture and Rural Development. There’s another strange twist: while the government promises to bear the interest subsidy on these concessional loans, the money kept aside for meeting the interest subsidy bill remains unchanged from last year. If the loan volume is likely to go up by Rs1 lakh crore, surely the subsidy element should also rise correspondingly?

Jaitley’s made another strange claim: he maintained that the pace of construction of rural roads under the Pradhan Mantri Gram Sadak Yojana had reached 133 km per day during 2016-17. This fact sits uneasily with roads minister Nitin Gadkari’s admission a couple of months ago that his ministry was unable to meet the highway construction target of 40km every day.

The political framework also probably stayed the finance minister’s hand from slashing corporate tax rates further, as had been promised in last year’s budget. In a year when demonetisation has affected millions of livelihoods and the ruling Bharatiya Janata Party wants to win Uttar Pradesh elections, the optics of helping large corporates could be a recipe for electoral hara-kiri.

He has instead cut tax rates for micro, small, and medium-scale enterprises with annual turnover up to Rs50 crore. His contention: their effective tax rate is higher than large companies and it is these units which actually create employment at the grass-roots level.

Arun Jaitley’s budget for 2017-18 pushes the political messaging of demonetisation further. He has painted a multi-hued picture that appeals to the stock market investor, because a rising stock index is often mistaken for economic health. His brushstrokes also strive to attract voters in various states by not only promising employment and income opportunities but also by painting the government as pro-disenfranchised and anti-privileged.

The above article was published in www.qz.com on February 2, 2017, and can also be read here

Budget And Moral Imperatives

Increasing public investment and employment remains a moral imperative for finance minister Arun Jaitley

Union finance minister Arun Jaitley is probably caught in a cleft stick. With demonetisation throwing a spanner in the works, his fourth budget will understandably try to achieve a balance between reviving economic growth and maintaining fiscal stability. These are two seemingly conflicting goals, with economists sharply split on both sides of the divide. The fiscal responsibility and budget management committee is also believed to have drawn some red lines. But Jaitley may not have much of a choice.

There are two ways to revive growth: either through consumption or through investment. Export-led growth could have been another possibility but India’s persisting trade deficit and the world economy’s delayed recovery makes it a non-starter. With demonetisation squeezing out demand, there could be attempts to stimulate consumption through some restructuring in direct taxes and some realignment of indirect tax rates (especially excise) on goods, in line with the proposed goods and services tax slabs. The clamour for fiscal rectitude, especially the threat perception posed by credit rating agencies, might stay Jaitley’s hand from over-stretching.

The other alternative is government’s capital expenditure, because demand compression is also likely to suck out the private sector’s desire to invest. However, there are valid concerns over the government’s ability to execute projects efficiently and within budgeted costs. Road minister Nitin Gadkari’s recent admission of highway construction falling short of desired targets reflects both private sector lassitude in taking up infrastructure projects and the government’s less-than-stellar record in project execution.

File photo of finance minister Arun Jaitley; photo courtesy: Reuters

At a pre-budget seminar in Mumbai, former Reserve Bank of India governor C. Rangarajan said public investment amounts to roughly 7% of gross domestic product (GDP), with the Centre and the states (collectively) accounting for 1.6% of GDP each and public sector units contributing the balance 3.8%. If quality of execution is a concern, there’s a proposal to re-route part of the Centre’s public investment to public-sector units (PSUs) as equity which, leveraged with bank loans, can be used for greater impact. It’s not the best, or ideal, solution, but it sounds workable.

A section of economists and demonetisation supporters claim that penal taxes collected through the two-tranche income-disclosure scheme are likely to provide Jaitley with elbow room to stretch his capex budget without upsetting fiscal targets. And though that is serendipitous (Rs15,000 crore is expected from just the first tranche), the question arises whether Jaitley would allocate a higher capex outlay even in its absence.

Interestingly, increased capital expenditure meets three objectives simultaneously: reviving economic growth, visible progress towards meeting the UN’s Sustainable Development Goals (SDGs) and implementing some of the campaign promises made by Prime Minister Narendra Modi during the 2014 general election.

India is a signatory to the UN’s SDGs, which succeeded the Millennium Development Goals. The SDGs cover 17 broad goals (incorporating 169 related targets) to be achieved by 2030. The SDGs have been framed with the singular purpose of achieving three overarching objectives: ending poverty, protecting the planet, and ensuring prosperity for all. The Planning Commission’s successor, NITI Aayog, has been entrusted with mapping the targets with different ministries, coordinating with them and helping the government meet the targets.

Goal 9 of the SDGs says: “Build resilient infrastructure, promote sustainable industrialization and foster innovation.” More importantly, this is directly related to Goal 8: “Promote inclusive and sustainable economic growth, employment and decent work for all.” This goes directly to the heart of the debate between fiscal hawks and those wanting the government to expand public investment for kick-starting growth; it also provides a compelling reason for the government to increase outlays for public expenditure.

Employment growth remains stagnant across the world. A joint study (goo.gl/ZvLcsf) by the International Labour Organization, the World Bank, the International Monetary Fund and the Organisation for Economic Cooperation and Development found employment elasticity (the direct relationship between employment growth and economic growth) in most G20 countries is low, giving credence to claims of “jobless growth”. India’s employment elasticity is said to be close to zero. A 2014 working paper by RBI staffers (goo.gl/U09o8b) has also pointed out how employment elasticity has declined in the post-reforms era, especially in the manufacturing sector.

The Bharatiya Janata Party’s (BJP’s) 2014 campaign manifesto promised to create new employment opportunities: “A strong manufacturing sector will not only bridge the demand-supply gap leading to price stabilization, but also create millions of jobs and increase incomes for the working class.” There were also commitments to create jobs in the small-scale sector, agriculture and agri-related industries. Unfortunately, the narrative in many states with high unemployment rates has changed thereafter.

So far, official data and anecdotes both indicate demonetisation-induced livelihood stress in urban and rural areas. People have lost jobs across manufacturing, service and agricultural occupations. Whether BJP wins or loses the approaching state assembly elections, increasing public investment and employment remains a moral imperative.

The above article was published in Mint newspaper on January 25, 2017. It can also be read here

Demonetisation And Budgets: All In The Mind

Arun Jaitley will soon be presenting the 2017-18 budget and his well-laid plans may have to incorporate demonetisation-induced changes

It’s 690 seats this year; another 964 seats are up for grabs next year, with the general election to follow in 2019. This inescapable political imperative will weigh on finance minister Arun Jaitley’s mind when he drafts India’s economic policy. The battle for occupying popular mindspace over the past two months is now telescoping into a two-year battle. And if the vast majority of Indians feel confounded after Prime Minister Narendra Modi’s surgical excision of 86% of currency, they shouldn’t despair: They are in the distinguished company of Jaitley who, presumably, is equally disconcerted.

Jaitley will soon be presenting the 2017-18 budget and his well-laid plans may have to incorporate demonetisation-induced changes, over and above those included for introducing the goods and services tax (GST) system. What’s worse, with the GST start likely to be postponed, revenue projections may now have to be recast along traditional lines. Two huge changes in three months is more than just a rude disruption.

Two other elements add to the confusion. One, the railway budget will be merged with the Union budget this year in a meaningful break from a meaningless tradition. Also, the traditional expenditure reporting format under the broad heads of Plan and non-Plan expenditure will be jettisoned.

File photo of Finance Minister Arun Jaitley; Photo courtesy: Mint  

Standing for a moment in Jaitley’s shoes, what’s likely to be more worrying is how the economic slowdown affects revenue growth and how that shapes spending plans—especially committed social sector or infrastructure expenditure—that cannot be trimmed, leave alone eliminated. Jaitley has already promised higher government pump-priming to boost economic growth. Many new variables have cropped up in the meantime, further skewing the math. Modi contributed gamely during his 31 December speech with promises to increase social spending under both new and old schemes.

For example, new interest subventions on small housing loans and farm loans or increases in the number of rural houses built for the poor under the Pradhan Mantri Awas Yojana are some of the schemes which might expand both capital and revenue expenditure bills for 2017-18. It is clear that Jaitley has little option in slashing the outlay for social sector schemes, especially when demonetisation has eroded rural incomes and the ruling Bharatiya Janata Party is unable to dismount the election treadmill. Apart from state assembly elections for Uttar Pradesh, Punjab, Goa, Uttarakhand and Manipur in less than a month, next year will see elections in Tripura, Rajasthan, Madhya Pradesh, Karnataka, Chhattisgarh, Nagaland, Mizoram and Meghalaya.

With the political economy constraining deep spending cuts—at the most, outlays might be shuffled around under different schemes—revenue generation becomes imperative for meeting many of the grand spending plans. This is where rubber hits tarmac.

The demonetisation narrative focused on cornering tax evaders and, through legislative amendments, forcing assessees depositing unreported incomes to pay higher penal rates. This would require enhanced tax scrutiny and inevitably involve some element of persecution. But by stating that demonetisation was launched to punish currency hoarders, it subjected the majority to widespread suffering for the misdemeanours of a few. The messaging was subsequently imbued with nationalist overtones and repurposed to focus on moving India to a less cash economy.

Enter the good cop: News reports claimed that Jaitley had hinted at lower tax rates in a meeting with tax officers, citing how similar attempts earlier had met with success. News leaks from unidentified finance ministry sources also made similar claims.

Jaitley later seemed to deny his statement without actually denying it. There’s no text of Jaitley’s speech; only a summary is available, which has him stating there was an urgent need for a change of mindset: “India has to move towards a mindset of voluntary compliance…payment of legitimate taxes should be considered as part of the process and nobody should think that tax evasion is acceptable.”

This is where things get muddied up. By using the term “mindset”, Jaitley pivots seamlessly into the arcane world of behavioural economics. It is reassuring to note that Jaitley recognizes the importance of mindset in correcting tax compliance behaviour. But his public musings betray a contradiction. Initiating mindset change is a long-term project which involves altering social norms using a combination of psychological and social forces. The post-demonetisation regime instead uses a carrot-and-stick approach: simultaneously offering incentives (aka the Laffer curve) and disincentives (penalties).

The World Bank’s World Development Report 2015—titled “Mind, Society And Behavior”—states clearly that penalties or incentives have failed to improve tax compliance across the world. The UK government’s behavioural insights team, also known as the “nudge unit”, claims to have used behavioural sciences successfully to improve tax compliance in the UK and other countries. Jaitley will do well to remember that like liquor prohibition failed to stem alcoholism and related social problems, a one-time demonetization (or a subsequent penal regime) might not be enough to raise tax revenue on a sustainable basis. While the impact of behavioural sciences in influencing policy outcomes is still imprecise, one thing is clear: lasting changes in social norms require long-term investments.

The above article was first published in Mint newspaper on January 11 and can also be read here

What’s In The Bag?

For all intents and purposes, the Budget is in the right direction. Except, it could use a plan to achieve its ambitious goals

From the moment finance minister Arun Jaitley began reading his career’s third Budget speech, all the way till the very end, the stock market’s bellwether index, the BSE Sensitive Index, oscillated wildly. Social media comments too reflected the mood in the bourses — swinging between complimentary and scathing, to downright snarky and fulsome praise. 

One tweet even claimed (without furnishing any proof) that though the Budget speech was read out by Jaitley, its key architect was Prime Minister Narendra Modi. Another, snidely claimed the Budget seemed to have UPA-III’s imprint, given its emphasis on rural and farm sectors. There were other similar tweets. While you can’t really expect a proper analysis in 140 characters, it’s true that the tenor and content of Budget 2016 has left experts confounded and desperate to find the one thread that ties up the whole package of measures.

Indeed, there are multiple strands to Budget 2016, each striving to provide a specific solution. The question is: do all these cohere to form a meaningful tapestry? Does it make sense? It might be worthwhile to examine some of the overarching themes in Budget 2016.

Let’s consider the first charge: Budget 2016 is a political document. To be fair, Jaitley had little choice. Economic policy-making cannot be conducted in a political vacuum. With key states (Assam, West Bengal and Tamil Nadu) going to polls this year, followed by Uttar Pradesh and Punjab next year, it might be naive to expect that Budget 2016 will be bereft of any political grandstanding. 

That might also explain this Budget’s exaggerated emphasis on playing Robin Hood: imposing a slew of additional taxes on the wealthy, under the heading “Additional resource mobilisation for agriculture, rural economy and clean environment”, without bothering to specify whether these taxes will indeed be sequestered for the specified objective, or even caring to explain what happened to taxes collected under similar heads over the years. Ironically, Jaitley has himself provided the counter-point: pensioners withdrawing life savings from pension funds will now have to pay tax on 60 per cent of the accumulated corpus, if it is not invested in an annuity. As a wag observed drily, Thomas Piketty’s whistle-stop tour through India has left economic administrators with fleeting notions of inequality.

Two other broad themes dominate Budget 2016: a stimulus package to spur rural consumption and enhanced outlay to speed up investment in infrastructure. As argued in these pages a few weeks ago (http://goo.gl/GvFnbP), Jaitley was faced with a binary choice: either ramp up public investment to derive economic growth, or stick to the fiscal straight-and-narrow. A spirited public debate ensued with growth adherents advocating a temporary slippage in fiscal deficit. Fiscal hardliners argued it would be foolhardy to relax vigil during these trying times of global turmoil; a downgrade by credit rating agencies would scupper even incipient growth impulses.

In the end, the minister has chosen both options. How he achieves both ends will have to be seen. While his public investment outlay is up 15.5 per cent over previous year’s estimates, he has also set aside large amounts for the rural and farm sectors. Jaitley stated capital expenditure on railways and roads will alone account for Rs 2,18,000 crore this year. Additional outlays have been announced for investment in power generation, ports and waterways. It is interesting to note that even in infrastructure investment, the emphasis is on the rural sector: investing in expanding the coverage of irrigation (to reduce Indian farmers’ vulnerability to fickle monsoons) and investing in rural roads and rural electrification. Connecting unconnected villages will help farmers get their produce to markets. 

In the midst of this enhanced spending, the FM has also promised to adhere to the fiscal deficit target: 3.5 per cent of gross domestic product. A lot will depend on the revenues he manages to raise — Rs 19,610 crore of additional tax revenue (some of it from soaking the rich) and a 25 per cent increase in non-tax revenues. One large chunk of non-tax revenues (Rs 98,995 crore, compared with last year’s Rs 56,034 crore) is expected to come from telecom spectrum auctions. The other source of non-tax revenue is a leap of faith: the government expects Rs 56,500 crore from disinvestments. In this fiscal year, the government managed only Rs 25,312 crore against a target of Rs 69,500 crore.

Undoubtedly, the agricultural sector needs additional resources: it is not only hobbled by numerous structural deficiencies but poor monsoons over the past two years have caused deep distress in the sector. The Budget wants to double farmer incomes by 2022, by facilitating easier access to markets for inputs and finished products, higher credit allocation and better infrastructure. But, the text lacks details of how this will be achieved; there is no mention of a roadmap.

A massive allotment of Rs 2.87 lakh crore — in the form of grant-in-aid — has been made to village panchayats and municipal bodies. Again, there is lack of clarity about the end-objective of this fund flow. Will it be used for local infrastructure? How will the money be spent — in one year or five years?

The FM’s intentions seem honourable and generally aimed in the right direction. The economy needs higher public investment in the absence of private sector capital expenditure; there are deep structural flaws in the farm and rural sector that need urgent corrective action; fiscal discipline is non-negotiable. What’s lacking is clarity, or the nuts and bolts of how the FM intends to achieve these objectives. There are some other unanswered questions in the Budget:

Monetary Policy and Monetary Policy Committee have now acquired a statutory basis. Details on the committee’s composition are absent. While it has been clarified that there will be equal representation from both the government and the central bank (with RBI governor getting the casting vote), it is not known whether the original plan of appointing a senior bureaucrat on the committee as an ex-officio member still exists. The bureaucrat’s status as an observer is to report to the ministry on the voting pattern of the committee members. I am sure you get the picture.

There is an overall increase in the incidence of cesses and surcharges. One example is the Krishi Kalyan Cess, which will levy an additional 0.5 per cent on all taxable services. When combined with a consumption upsurge, due to Pay Commission arrears and a fillip to rural demand, the after-effects are most likely to be felt on the price line. What happens to inflation targeting then?

PM Narendra Modi’s ambitious Make In India programme suffers from domestic industry’s negative propensity to invest. Industry, in turn, complains that bank credit is not forthcoming. Banks, on the other hand, carp that their ability to lend is seriously impaired by mounting bad loans. In short, banks need fresh capital to start the lending process once again. Against this background, Jaitley’s allocation of only Rs 25,000 crore towards bank recapitalisation is underwhelming. FM Jaitley also mentioned consolidation; is he proposing public sector bank mergers as a way of reducing the drain on the Central exchequer?

The fiscal deficit target for 2016-17 — 3.5 per cent of GDP — is premised on GDP growing at 11 per cent. Given the global headwinds, and exports contracting for 14 months consecutively, slippage in the 11 per cent target will not be very surprising. Hopefully, the government’s resource transfers will keep the growth trajectory along expected lines.

A lot of Jaitley’s wishes are riding on revenue estimates delivering. He collected an additional Rs 54,334 crore of indirect taxes over the budgeted estimate during 2015-16 by increasing taxes on petro products, at a time when oil prices were crashing globally. Gross tax revenues are expected to grow by 11.73 per cent during 2016-17, at the same rate as India’s GDP. He is expecting tax on luxury consumption and a plethora of cesses and surcharges to fill the gap. It might be a bit of a tall ask.

There are too many imponderables in this well-intentioned Budget. Hopefully, some clarity will emerge in the coming weeks.

This article was published as cover story in Businessworld magazine (issue dated 'March 21, 2016) as part of the publication's special Budget package, titled 'Budget 2016 Split Verdict'.

The story can be found here.

Budget: It’s Now Or Never

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. 

Busting Myths Around Raghuram Rajan's RBI

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 

Is the ‘Modi Premium’ Wearing Off in the Stock Markets?

As Modi completes one year in office, a sense of despondency pervades the customary reviews that ritually accompany such an event. Rumblings of discontent have emerged from various stakeholders and stock markets have taken the lead in signalling disappointment with his performance.

As Prime Minister Narendra Modi completes one year in office, a sense of despondency pervades the customary reviews that ritually accompany such an event. Rumblings of discontent have emerged from various stakeholders, including Corporate India. But it is the stock markets that seem to have taken the lead in signalling disappointment with his performance.

The bellwether index S&P BSE Sensex, comprising 30 stocks, has witnessed a major erosion in values over the past few weeks. From its all-time peak of 29,681.77 points achieved on January 29, 2015, the Sensex hit a low of 26,599.11 on May 7: a sharp drop of 3082.66 points (or 10.38%) in slightly over three months.

The capital market’s rebuff is symbolic: it tries to aggregate what’s going on in different parts of the economy and transmits its sentiment through one single number. And going by its recent behaviour, there seems to be plenty that is wrong, or perceived to be wrong.

Foreign portfolio investors, an influential investor segment in the capital markets, are a visibly disgruntled lot and they have been letting off steam by selling en masse. In the first 10 trading days in May (till May 18), FPIs were net sellers to the extent of $2.306 billion. FPIs enjoy disproportionate influence over Indian capital markets, primarily because they bring larger volumes to bear than domestic institutions. Low retail participation in the capital markets — either directly or indirectly — also keeps Indian markets shallow.

Tax uncertainties

These FPIs decided to head for the exit because of continuing tax uncertainty. Finance minister Arun Jaitley’s 2015-16 Budget had unequivocally clarified that tax will not be levied on the capital gains of FPIs in the current year. But, unfortunately, there was no assurance that past cases won’t be re-assessed. And, true to form, tax authorities sent notices to various FPIs to pay up for past gains. That precipitated widespread resentment, with some FPIs even going to court and, of course, venting their spleen by selling Indian stocks.

The minister, presumably rattled by the exodus and the bad publicity all this was generating, has gone out of his way to placate FPIs. Apart from putting all reviews and fresh cases on hold, he resorted to the time-tested stalling tactic: he appointed a committee. In effect, he has kicked the can down the road and bought some time. This incident also illustrates how FPIs have emerged as a crucial constituency, with an uneven share-of-voice.

Unsatisfactory corporate results is the other reason why Sensex is volatile. Many companies — especially in the mid-cap segment — have reported disappointing results for 2014-15, signifying that demand for goods and services continues to remain weak. A report in Mint has highlighted how Q4FY15 sales of 142 companies included in BSE-500 (and for which results were available) has grown at the slowest pace in 16 quarters since Q1FY11.

This is evidence that the economy is still far from recovery. The Index for Industrial Production has grown by only 2.8% during 2014-15. Consumer durables manufacturing contracted by 12.5% during the year, compared with 2013-14, signifying the lack of purchasing power in the economy.

Matters have been made worse by the unseasonal rain in many parts of the country this year, destroying hectares of standing crop, which typically comes to the farm markets in April. This is likely to further dampen demand for consumer goods in the rural areas. The stock markets are also trying to capture this trend.

Oil prices fall opportunity lost

One can argue that this is sheer bad luck and the government cannot be held responsible for this catastrophe. While that is true, it is also a fact that the government didn’t rush to reap the dividends of fortuitously low oil prices when it came to power. Since then oil prices have climbed 50%, spooked by the continuing West Asian crisis and some shale oil wells in USA shutting down.

There could be another charitable explanation for the unusually turbulent Sensex: that expectations from PM Modi might have raced way ahead of reality, especially after the depressing paralysis that gripped the economy in UPA-II’s second term. The common beef (pun intended) is that even the current BJP-led government has plumped for incrementalism, rather than bold policy measures they had promised.

There are two sides to this debate and both can be deemed valid. But, what is undeniably true is that the stock market has already started discounting PM Modi’s premium, even before he completes a full year in office. And, though the Sensex is still up 14.78% from where it was a year ago — it closed at 27,687 on May 18, 2015, compared with 24,121.74 on May 16, 2014 — it seems that market participants have already watered down their expectations and moderated their hopes about a magical, almost fantastical, turn-around in the economy.

Courtesy:

Published first in The Wire (http://thewire.in/2015/05/19/is-the-modi-premium-wearing-off-in-the-stock-markets/) on May 19,

and then subsequently reprinted in 

Gateway House (http://www.gatewayhouse.in/is-the-modi-premium-wearing-off-in-the-stock-markets/) on same day.

A Sharing of Instruments

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/