Pointers To A Future-Ready Payments Policy

Regulation, almost always, lags technology development. But an opportunity to create a future-ready policy framework now seems close at hand

Events over the past few weeks have thrown up numerous pointers to what should be included in a future payments-system policy framework.

The Reserve Bank of India’s (RBI’s) 2017-18 annual report provided the first clue, proving a well-known policy paradigm: competition and freedom of choice are essential tools to avoid distorting markets and the broad economy. An overnight ban on Rs500 and Rs1,000 bank notes—accounting for about 85% of outstanding currency—dealt a body-blow to the economy in terms of jobs, incomes, livelihoods, investment appetite and overall economic growth. The ruinous effects manifested themselves last week: gross domestic product for April-June quarter grew by only 5.7%, the lowest in many quarters.

Demonetisation amounted to suppression of free choice—or freedom to decide how much cash to use, for which transactions—though different reasons were adduced to justify the decision. One of the reasons cited, which has persisted into the post-demonetisation period, is a desire to foster digital payments and to migrate the economy to a less-cash system.

This is a desirable economic objective. However, the policy vectors put in place reveal multiple gaps: lack of a robust competition and innovation policy; uncertainty over the payment regulator’s quasi-legislative powers; an unclear road map for achieving financial inclusion; and, an asymmetric preference hierarchy between different payment systems imposed on the consumer. The last one violates democratic principles by coercing the public to move away from a relatively low-cost payment system (such as cash) to a higher cost platform (such as, mobile wallets which involve connectivity costs).

The Supreme Court’s (SC’s) recent ruling on right to privacy as a fundamental right is likely to complicate the regulatory debate further and might necessitate a systems rethink. The judgement reads: “The balance between data regulation and individual privacy raises complex issues requiring delicate balances to be drawn between the legitimate concerns of the State on one hand and individual interest in the protection of privacy on the other.” The nine-judge bench, while acknowledging that the Centre has already appointed a committee under former SC judge B.N. Srikrishna to study the state of India’s data privacy and to submit a draft bill, hopes that the Union government will take “all necessary and proper steps”.

Still, the right to privacy ruling in itself does set out a future regulatory perimeter for digital financial services. The bench found some pointers in a 2012 report from an expert group on privacy, appointed by the erstwhile Planning Commission. Specifically, the report mentions a five-pillar conceptual scaffolding for drafting legislation to protect privacy: technological neutrality and inter-operability with international standards, which is still lacking; multi-dimensional privacy; horizontal applicability to state and non-state entities to ensure a level-playing field; conformity with privacy principles in line with global best practices; and a co-regulatory enforcement regime which envisages co-existence of independent regulators and self-regulating organizations. Ironically, some of these issues are still being debated in the policy space.

There are multiple views on what to make of SC’s judgement; for example, Chennai’s IFMR Trust, soon after the SC ruling, published a blog advocating stakeholder consultation to determine what kinds of data can and should be collected, the desirable regulatory regime for data mining and algorithmic techniques and a legislative terrain to “ensure that use of personal data is tied to legitimate proportional objectives and interests”.

There is another critical, and slightly obvious, ingredient necessary in the future regulatory mix: trust. This was evident when digital payments spiked during November-December 2016 and then tapered off subsequently; people abhor repression and any attempts to increase the value and volume of digital payments must be achieved through trust, not duress. Regulation must have a consumer bias and should not be designed to favour some service providers.

Lack of trust in paper money issued by sovereigns, and controlled by central banks, is growing as is wider acceptance of crypto-currencies. Already six large global banks—Barclays, Credit Suisse, HSBC, Canadian Imperial Bank of Commerce, State Street and the Mitsubishi UFJ Financial Group—have jointly launched a project to use block-chain for clearing and settling financial transactions, reducing time taken for conventional money transfers.

While bitcoins and other crypto-assets are still in an embryonic state in India, the pace of acceptance is slowly picking up. Many community-based initiatives have been advocating block-chain as an alternative to organized finance, viewed as exploitative. The finance ministry appointed a nine-member inter-disciplinary committee to suggest the way forward with crypto-currencies; the committee has submitted its report, which has not been made public yet. Eventually, though, RBI will have to decide whether it will allow money to also exist as crypto-currency, in addition to its role as a commodity (with or without intrinsic value), a financial claim and/or as an accounting entry.

Regulation, almost always, lags technology development. But an opportunity to create a future-ready policy framework now seems close at hand.

The article originally appeared in Mint newspaper on September 6, 2017, and can also be read here

The Republic of Statistical Scramble

Straightening out data inconsistencies should be a government priority

Many a caustic word has been exchanged in the acrimonious debate over the Indian economy’s employment data. One set of numbers claims the current phase of economic growth as jobless. Alternative data sets have accompanied vigorous assertions of rising employment. And then there are many in the middle, trying to make sense of the scant (and outdated) data and wondering how anybody reached any conclusion at all.

Welcome to the republic of statistical scramble in the age of Big Data. The Bharatiya Janata Party’s (BJP’s) 2014 election victory was predicated partly on the promise of enhanced economic well-being; straightening out data inconsistencies should be a priority on the path to fulfilling that promise.

Take a look at labour data. Currently, employment data is collated from different surveys, each one measuring different things using varied methodologies. NITI Aayog’s task force on improving employment data recently released the first draft of its report, which lists how several arms of the government get involved in collecting and mashing up data. The report is unequivocal about the current state of data collection: “The available estimates are either out-dated or based on surveys with design flaws that render them unsuitable for inferring nationwide employment level.”

On the demand side, the National Sample Survey Organization (NSSO), in the ministry of statistics and programme implementation (Mospi), conducts a comprehensive household survey once every five years, with the last one occurring in 2011-12. The labour bureau in the ministry of labour and employment also conducts two household surveys—a quarterly quick employment survey and another on an annual basis. These are in addition to the decadal population census surveys, which measure two variables: a headcount of all types of workers at 10-year intervals and all non-agricultural enterprises, regardless of size.

On the jobs supply side, Mospi conducts a statutory annual industries survey for units registered under the Factories Act, 1948. NSSO also conducts an unorganized units survey; this is in addition to the micro, small and medium enterprises (MSME) census conducted by the MSME ministry. Finally, various government administrative bodies, such as the Employees Provident Fund Organization (EPFO) or Employees’ State Insurance Corporation (ESIC), provide some indication of organized sector employment trends (though this is being increasingly undermined by growing preference for contract labour). In addition, there are some private sector surveys also—for example, by the Centre for Monitoring Indian Economy.

All these measures suffer from some infirmity, whether it’s methodological, unviable sample size, inability to distinguish between different types of employment, long gaps or irregular frequencies. But one thing is common: the findings only provide a partial picture and are therefore useless as a tool for policy design. Part two of the Economic Survey says: “The lack of reliable estimates on employment in recent years has impeded its measurement and thereby the Government faces challenges in adopting appropriate policy interventions.”

The NSSO has, in the meantime, begun a fresh, ambitious annual exercise to map all nature of employment data; a quarterly survey will generate similar estimates for urban areas. In its report, NITI Aayog has recommended, among other things, vast improvements to existing surveys, institutional and legislative changes, overhauling physical and digital infrastructure and more aggressive use of technology to crunch the time-gap. 

But the study might need to extend beyond employment data because statistical distortions also exist in other areas. NITI Aayog provides an example about the state of statistical confusion: each enterprise, while filing returns or statutory information, is assigned a different identification number under Good and Services Tax Network, EPFO, ESIC, Factories Act and Shops and Establishment Act.

This problem is not restricted to enterprise data and exists in other government departments as well. Take the example of estimating the cotton crop. Two separate ministries release two separate estimates every year.

The agriculture ministry’s cotton crop estimate for 2015-16 was 30.15 million bales of 170kg each, while the textile ministry’s estimate for the same year was 33.8 million bales—that’s a difference of 620 million kg! In the previous year, 2014-15, the estimates put out by the two ministries were 34.8 million bales and 38 million bales, respectively. This divergence seems bewildering, especially when acreage estimates from both the ministries broadly tally.

Forget discrepancies between ministries: this paper had reported (goo.gl/vsYGzc) how cotton yield figures differ widely within the agriculture ministry. There have also been reports (goo.gl/fd9adW) about vastly varying data on the number of taxpayers added since demonetization emerging from different parts of the government. Mismatch between data sets from within the government also breeds scepticism regarding the statistical robustness of national accounting, especially when anecdotal evidence seems contra to buoyant gross domestic product data.

India’s magnificent statistical heritage distinguishes the nation from its neighbours, whose growth record is often viewed with scepticism globally. This infrastructure needs an urgent overhaul to maintain credibility, perceive economic trends and deliver appropriate policy prescriptions.

The article originally appeared in Mint newspaper on August 23, 2017, and can also be read here

Road To Growth Is Paved With Low ICOR

India’s slowing investment rate and rising incremental capital output ratio, or ICOR, have led to low economic growth.

Two recent, and epochal, events deserve our unstinted attention because they mark the end of an era and the beginning of another one. These are critical because of a common thread linking both: the investment rate of the economy.

The 12th Five-year Plan has just ended, bringing down the curtain on decades of India’s planned economic growth and development. This was the last Five-year Plan; as an alternative, the Planning Commission’s successor NITI Aayog has announced the release of a three-year “action plan”, a seven-year “strategy paper” and a 15-year “vision document”. There is one key difference between these documents and Five-year Plans: The government is free to disregard the Aayog’s recommendations.

The end of a centrally planned economic system also coincides with the formal interring of the Planning Commission, an organization central to not only India’s economic strategy but also to its federal temper through the added responsibility of allocating grants, Plan and non-Plan funds to states. The commission’s federal remit was not granted through constitutional mandate and this generated sufficient heartburn, especially among non-Congress states. However, the commission’s shuttering is also due to questions raised about the relevance of centralized planning in a globalized, market-led economy. And then there is politics. The commission was created through a government resolution which makes it easy for the Narendra Modi government to bury it.

But before the institution is shut down, it might be worthwhile to examine the 12th Plan performance, especially some of its macroeconomic targets. The 12th Plan ran between April 2012 and March 2017, with a Congress-led administration in charge till April 2014 and the Bharatiya Janata Party-led government steering the Plan thereafter. Prime Minister Modi announced his intentions of abolishing the commission and ending Five-year Plans during his first Independence Day speech in 2014 but allowed the 12th Plan to formally run till its original expiry date.

The plan had set an average gross domestic product (GDP) growth target of 8% for the 2012-17 period. This growth target was not achieved in any single year by either of the two political dispensations, despite a step jump resulting from a new series introduced by the Modi government. The closest India came was in 2015-16, with 7.9% annual growth. Otherwise, the average growth for the period works out to below 7%, way lower than the average annual growth rate of 8% achieved during the 11th Plan.

A low investment rate is among the many reasons for the under-average performance. The 12th Plan envisaged an average investment rate of 34%. However, the investment rate has been declining every year, starting with 33.4% during the first year of the Plan; the Central Statistical Office’s second advance estimates for 2016-17 show gross fixed capital formation at 26.9% of GDP, the lowest in more than a decade. What’s worse, investments have not been forthcoming from either the private sector (which has historically contributed the bulk of investment as a percentage of GDP) or the government sector which should ideally be investing when private investment dries up.

In a recent newspaper article, former Reserve Bank of India governor C. Rangarajan has also pointed to low productivity of capital, captured through incremental capital output ratio, or Icor, which measures how many additional units of capital are necessary to produce one additional unit of output. India’s slowing investment rate and rising Icor have led to low economic growth.

Discussing Icor might sound anachronistic, especially since the service sector accounts for 55% of India’s GDP where the relation between capital invested and output is still unclear. In addition, supply-side thrusts (such as increased government consumption expenditure) can lead to higher GDP growth despite a depressed investment climate, which can then send garbled messages about improved capital productivity. Ordinarily, a falling ICOR should be accompanied by palpable technological improvements and skill enhancements, leading to an all-round increase in productivity and efficiency.

Discussions on capital productivity seem to be back in fashion because high ICOR in recent times (higher than six during 2013-16) have been complemented by sluggish economic growth, over-leveraged corporate balance sheets and burgeoning bad debts in the financial sector. These factors have dragged down the economy’s growth impulses. In all discussions on efficiency and factor productivity, it is usually Indian labour that has to bear the cross. But this time the focus is squarely on capital productivity.

Obsessing with high ICOR becomes necessary when resolution of non-performing assets (NPAs) tops the public policy agenda. Most of the reasons behind high Icor in India are similar to those found elsewhere in the world, but one unique Indian feature stands out: gold-plating, or padded-up project costs. This not only suppresses capital productivity but also distorts the viability of many projects. With institutions and regulators orchestrating Operation NPA Clean-Up in mission mode—for example, the newly-instituted Insolvency and Bankruptcy Board of India is already grappling with 35 transactions—it is imperative that all resolution mechanisms incorporate enough measures to deter future projects from gold-plating costs and getting away with it.

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

Silver Lining to India’s Trade Blues

India’s merchandise exports have now contracted for 13 months in a row, reflecting the global slowdown and impact of China’s economic recalibration. But, therein lay new opportunities and challenges for India’s economic diplomacy

India’s exports of goods have now shrunk for 13 months in a row. Even as this presents a threat to the government’s “Make in India” programme, it also provides some clues to future focus areas for India’s economic diplomacy.

Data for December 2015[i] shows merchandise exports at $22.29 billion, 14.75% lower than exports booked in December 2014. Cumulative exports for the first nine months of 2015-16 (April-December 2015) amounted to $196.6 billion, down 18% over the comparable period of 2014-15. There is one silver lining though: the trade deficit for the first nine months of 2015-16 ($99.2 billion) is lower than the deficit in 2014-15 ($111.68 billion). This is primarily due to lower oil prices.

There are two ways of slicing this data to understand incipient trends; locating the geographical source of this demand compression and looking at performance of specific commodities.

According to Commerce Ministry’s database on exports by region[ii], in dollar terms, the three destinations showing maximum contraction in Indian exports (or areas that are buying much less from India than in the previous year) are Latin America (down by 36.73%), Commonwealth of Independent States (CIS) & Baltic region (down 32.4%) and Africa (25.59%). Clearly, India’s foreign policy practice and economic diplomacy needs to expend greater energy on these areas.

Granulated regional data provides better insights. In Asia, for instance, the sharpest fall in absolute terms has been in exports to the West Asian countries that are members of the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates). The second largest drop in absolute terms has been exports to the ASEAN countries, followed by North East Asia (which includes China). While the GCC phenomenon can be ascribed to shrinking oil revenues, leading to diminution of demand for Indian goods, it is the slowing of the Chinese economy that explains the North East Asian drop and a second round impact leading to dwindling of ASEAN demand.

Examining trade data through the lens of performance of specific commodities highlights stasis in India’s manufacturing industry and the need for providing stimulus. This can be either through “Make In India” initiative or through additional investments. The data clearly shows slowing demand overseas for agricultural (rice, other cereals, oil cakes and oil seeds) and oil-related commodities. However, more importantly, import data shows a huge spike in purchases of pulses, gold and silver–indicating higher consumption–but demand for fuel, mineral ores and metals, machinery and equipment remained in negative zone, reflecting static industrial and manufacturing demand.

Yet, there are some oases of optimism— India’s trade in services for the first eight months of 2015-16 (April-November) showed a positive balance of $48.047 billion. In fact, this is one area in which India not only fares better than China (which has traditionally suffered a negative trade balance in services) but has also been able to stave off the China slowdown factor more effectively that merchandise trade.

This, then, points to another focus area for India’s future economic diplomacy, including its bilateral engagements with China or European Union (EU) and regional arrangements like Association of Southeast Asian Nations (ASEAN) or Regional Comprehensive Economic Partnership (RCEP).

The India and China example are instructive. India and China have multiple grounds for disagreement which occasionally drives a wedge between the two countries in multilateral negotiating forums. China’s overwhelming trade surplus with India and the festering border dispute are some of the legacy issues. Thesehave been joined by new contentions, such as India’s lack of response to China’s generous offer of building critical infrastructure.

But a common grouse should be uniting both countries’ interests at global negotiating platforms: services exports. This is because multilateral trade negotiations — such as those under World Trade Organisation (WTO) — or regional trade arrangements (examples being RCEP) and even bilateral agreements focus overly on goods trade. This is disadvantageous for India, which has competitive advantage in services but is denied level playing field in trade negotiations. China is likely to be in a similar situation when contracting exports of manufactured products forces its hand to provide a greater thrust to service exports.

India’s service sector has been a saviour for both domestic economic growth and for overall balance of payments. China’s trade in services is in negative zone because it’s a net spender on tourism and education: its trade balance was a negative $159.9 billion in 2014. This is ripe for change — a Chinese government policy document released in February 2015 set a target of $1 trillion of services trade by 2020, including accelerating services exports[iii] [iv].

With China expected to refocus economic efforts on strengthening its services sector and increasing its share in exports, both India and China need to coordinate their strategies and act in concert during multilateral trade and investment negotiations.

In fact, the UNCTAD Handbook of Statistics 2015, released recently[v] by the United Nations Conference on Trade and Development (UNCTAD), shows that services bailed out global trade during 2014. Data also shows the criticality of services exports for India, and its negative impact on China’s balance of payments. Given this strategic importance of services for both countries trade, and the continuing slowdown in demand for goods, overall global trade patterns are pointing towards the need for greater India-China cooperation in services trade.

References
[i] Department of Commerce, Ministry of Commerce and Industry, Government of India, India’s Foreign Trade (Merchandise): December, 2015;; <http://commerce.nic.in/tradestats/PressRelease.pdf>

[ii] Department of Commerce, Ministry of Commerce and Industry, Government of India, December, 2015;<http://commerce.nic.in/ftpa/rgn.asp>

[iii] The State Council; The People’s Republic of China, New guideline on boosting trade in services, ; 15 February, 2015; <http://english.gov.cn/policies/latest_releases/2015/02/15/content_281475056101818.htm>

[iv] Gerry Shih; China’s economic planners aim to boost service exports; Reuters, 14 February, 2015<http://www.reuters.com/article/china-exports-idUSL1N0VO09W20150214>

[v] UNCTAD;,International trade in services was main driver of growth in global trade in 2014 ; <http://unctad.org/en/pages/newsdetails.aspx?OriginalVersionID=1149&Sitemap_x0020_Taxonomy=UNCTAD%20Home>

Courtesy: Gateway House (http://goo.gl/cXKJYO)

IMF And RBI — Lost In Transmission

The IMF’s 2014 review has some good GDP news but its reservations on interest rates bears closer attention. It can take 32 months for the effects of a an interest rate cut to be felt. What does this mean for the Indian economy?

Christine Lagarde International Monetary Fund (IMF) Managing Director was in India on 16 March for a two-day trip following the 11 March release of the IMF’s 2014 annual review of the Indian economy. The review has some good GDP news for India. Predictably, everybody focused mostly on the growth forecast for 2014-15 and for 2015-16 and (expectedly) missed out IMF’s reservations on a key ingredient that facilitates growth in any economy — interest rates.

There’s a bit of a story behind the IMF’s salubrious growth forecast. The original set of two IMF documents (in which Indian GDP was initially estimated to grow by 6.3% in 2014-15 and by 6.5% in 2015-16) had to be supplemented by two additional reports — one a transcript of the discussion between IMF officials and media, and, two, a copy of the IMF Survey which updated India’s growth forecast, in line with the government’s new methodology. Consequently, IMF now expects India’s GDP to grow by 7.2% during fiscal 2014-15 and by 7.5% during 2015-16.

Growth junkies celebrated this international endorsement for India’s growth prospects. They have been hankering for a rate cut, arguing that the only thing standing between them and double-digit annual growth rates were intractably high interest rates. The Reserve Bank (RBI) has rewarded them with two rate cuts — one in January and another in early March, soon after announcement of Budget. There are now demands for more, and deeper, rate cuts.

But, if they had read the IMF report a bit more closely, they might have been disappointed. The source of frustration is an accompanying document released with the India country report — called Selected Issues (as background documentation) — which includes a chapter on monetary transmission. On the basis of an internal model, this document reckons that the two-stage transmission between a repo rate cut to bank lending rate cut, via the weighted average call money rate, takes a total of 32 months. The impact on deposit rates is faster at 23 months.

Translated, that means RBI’s repo rate cut in January 2015 is likely to result in lower bank lending rates only by September 2017. The final impact on economic output and price levels, and hence growth impetus, will take even longer to feed through the relevant economic linkages. While that does seem a bit extreme, there is no denying that there is a large, looming problem in the room that nobody wants to acknowledge: transmission problems, or crimps in the financial pipeline.

RBI’s rate actions tend to take ages to travel through the economic system before they translate into lower borrowing rates for firms and households at the other end. In short, the transmission time between RBI’s rate action and banks cutting their lending rates is inordinately long, fraught with uncertainties and resistant to any mapping or measurement. Hence, nobody knows — with any modicum of certainty — how exactly this decision travels through the system, or how long this entire process will take.

The IMF report also refutes RBI’s estimates regarding transmission time, as well as dents the central bank’s confidence of improving lags and lead times under the new monetary arrangement it has signed with the Centre. The Urjit Patel Committee had mentioned that “…monetary policy in India impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters.”

RBI has on numerous occasions — through working papers, speeches, media interactions and committee reports — acknowledged the problem of transmission leads and lags in India’s monetary policy. Most reports agree that transmission in India works through a number of channels — interest rate, credit markets, foreign exchange rates, asset prices (such as equity or house prices), expectations (about future shocks and belief in central bank ability to counter adversity) — with the existing fiscal and monetary system acting as final arbiters of the speed of transmission.

In each of the channels mentioned above, there are speed-breakers that slow down the pace of transmission. In the interest rate channel, for example, the existence of a large informal sector with largely inelastic borrowing rates, or high interest rates charged in the microfinance sector, impede transmission of rate cuts to output and inflation. Take government borrowing. Not only does it artificially dampen interest rates, it also forcibly appropriates a fixed amount of the banking system’s lendable funds, providing banks with a disincentive to heed market signals. This is one of the things that make it difficult for an RBI repo cut to materialise as a bank lending rate cut.

The Indian financial sector is dominated by banks, with public sector bank providing the bulk of banking services. The unusually large presence of state-owned banks

Hence, in the face of the conflicting transmission time periods provided by IMF and RBI, as well as the existence of innumerable structural road bumps that hinder smooth diffusion of monetary policy, there are legitimate questions about the efficacy of the monetary policy arrangement between RBI and the government.

Kind courtesy Gateway House (here) and Hindu BusinessLine (here)

GDP Blues: April-June (2012-13) Data Sums Up Economy's Woes

The year has begun according to expectations. GDP growth figures for the April-June quarter of 2012-13 – at 5.5%, measured on a year-on-year basis -- reveals that the slow growth trend thrown up by the final quarter of 2011-12 (at 5.3%) continues.

This is not entirely unexpected. In fact, many analysts had predicted the growth number close to the final number. For instance, Bloomberg and Reuters had predicted the growth number at 5.2% and 5.3% respectively. Rating agency ICRA had estimated 5.1% while Moody’s assessment clocked in at 5.2%. Some analysts have tweeted that at 5.5% Q1 GDP growth is actually better than expected.

However, there are a couple of issues that must be noted immediately. One, at this growth rate, India is no longer the second-fastest growing economy in the region. It now lags behind Indonesia and The Philippines, with Malaysia nipping at its heels. Niranjan Rajadhyaksha has a nice short piece on it in Mint (read here).

There are is another source of anxiety. Manufacturing growth during the quarter, measured on a year-on-year basis, comes in at a dismal 0.2%, continuing the trend from the previous quarters. So what really saved the economy seems to be a 10.9% growth in construction and 10.8% growth in the segment titled as “financing, insurance, real estate and business services”. This seems to be a bit of an anomaly: if construction grew by over 10%, then it must have consumed cement and steel. Yet, this does not reflect in the manufacturing numbers -- unless, of course, the construction industry was running down its accumulated inventory of raw materials. Also, steel and cement combined have a decent weight in the index for industrial production.

The pathetic manufacturing data pretty much reflects the slowdown tightening its grip on the economy. Given that 0.2% growth also means people consumed almost exactly as much as they consumed during April-June 2011, does it also reflect slowing down demand? Could be true, given that private consumption expenditure grew by only 4.7%. This is lower than the growth registered by consumption expenditure in the past few quarters, particularly 6.% in the immediately preceding quarter. After all, wasn't it the boast of policy wonks that the consumption story had kept the India story vibrant during the global slowdown? That engine of growth seems to be sputtering now.

The other engine of growth -- investment -- also throws up a depressing picture. Investment growth during Q1FY13 came in at a measly 0.7%. The Indian economy at this point seems like an aircraft with both its engines seizing up.

So, where is this 5.5% impetus coming from? Consumption of services? Perhaps, especially because of money distributed by the government in the form of social sector hand-outs. The segment “community, social and personal services”, which captures these payouts (or considered an euphemism for all kinds of social sector hand-outs), grew by almost 8%. The government’s own expenditure – under the head “government final consumption expenditure” – has also grown 9%.

This pretty much sums up the problem facing the economy: largesse distributed by the government is distorting income levels, creating a spike in aggregate demand without an accompanying boost in investment activity (or creation of sustainable assets). This, in turn, is leading to a situation of low growth and high inflation.

Rating agency Crisil has come up with two interesting reports, one of which states that rural consumption now out-strips urban consumption. This outcome is primarily a consequence of money doled out in the rural areas by the government, described by some economists as money thrown from a helicopter.

But, that still leaves many unanswered questions in this puzzle -- for instance, if the rural consumption story is really so strong, and growing apace, why isn't manufacturing responding by increasing capacity? Is it being discouraged by the current policy paralysis? Or, are expectations playing a major role: that this rural story may not be a secular trend and might peter out soon? Or, expectations that interest rates might not soften in the near future? Methinks it's a combination of all the three expectations.

Sir, Your Talk Time's Over...

Prime Minister Manmohan Singh, on June 6, announced a long list of projects that, when completed, can be expected to rejuvenate the economy's mojo. The markets -- already enthused by Reserve Bank deputy governor Subir Gokarn’s statement on rate cuts -- took heart from PM’s statements. In an economy devoid of any feel-good news and wracked by a steady stream of depressing developments (low GDP growth, a resurgent inflation rate, depreciating rupee, corruption, policy inaction), these two events were welcomed quite like the delayed monsoon clouds.

But it is primarily the PM’s statement that provides some hope to many beleaguered market operators. In short, the PM has proposed investments of over Rs 100,000 crore in various infrastructure projects across various sectors – such as, roads, power generation, coal, ports, aviation and railways. Read the full press release here and here.

The plan sounds grand and has all the right ingredients to lift the economy out of its current slough.

But -- and sorry to sound like a wet blanket -- market operators seem to be in for a big disappointment. What’s wrong with what has been announced? Technically, nothing. The economy needs large doses of investment at this juncture to pull it out of the morass and the recent declaration seems to fit the bill. But, such announcements have been made even in the past. Like earlier occasions, this time too, the government has trotted out only a large string of impressive numbers, but has failed to mention a couple of crucial facts.

Point One: Who, in the name of blazing heavens, has this kind of money today to invest in infrastructure projects? The government is already highly leveraged and is liable to get tripped by the market if it tries to borrow over and above its budgeted expenditure. The only way it can free up some cash is by cutting down on some items of non-plan expenditure, such as wasteful subsidies. But, as everybody knows, that is still a long shot. Even the private sector is hamstrung, with profits falling for FY12 and the continuing slowdown spooking all investment plans.

The only option left is overseas funding. But, the government needs to use the broom vigorously to clean up multiple acts before a single cent rolls in. For instance, there needs to be a serious rethink on external debt ceilings if the private sector is expected to pitch in with funds and expertise. Second, the government might need to use innovative structures to fund such projects without impacting the overall deficit numbers. (One can read ICICI Bank chairman K V Kamath’s interview for some ideas).

Point Two: Time to repeat the point that was made earlier. Such announcements have been often made in the past but without any follow-up on the achievements. In this case too, there seems to be no clues on how the government proposes to achieve these targets.

There are numerous reasons for the proverbial slip. For one, ministers handling the infrastructure portfolios are not schoolchildren in thrall to the headmaster or employees beholden to an autocratic boss. So, it really doesn’t matter whether they perform or not. These ministers are where they are because of other reasons. They have been elected to power and are holding a particular economic portfolio at the behest of the party chief and not the PM. Or, they are in the cabinet because they are part of the ruling coalition and helped UPA-II to stay on in power. Look at the empirical stuff: barring the ones facing criminal proceedings, not a single minister has been penalised for poor performance. Some have been merely shuffled off from one “lucrative” ministry to another.

Also, as has been seen on numerous occasions in the past, large projects are usually dogged by several problems: clearances, approvals, financial closure, regulatory hurdles. Add to that another malaise affecting most projects in India: the pay-off syndrome. Most large projects in India need to make pay-offs at multiple levels – at the central level, at the state and at the local municipality level. This adds to costs and, in many cases, renders the projects unviable. Inability to pay at any one level can delay the project irretrievably.

Do we have any word from the PM on how he’s going to block these malpractices? Nope. Any clues on how he proposes to give that all-important push to the projects? An investment tracking system has been set up (read here). Will that be that enough? As the cliché goes, only time will tell.

So, finally, how do we approach such announcements? I’d say hold the celebrations.

Propagating An Interest Rate Cut (Yet Once Again...!!)

Wrote this piece (click here) for FirstPost on why the RBI should start cutting interest rates immediately instead of waiting for inflation and inflationary expectations to subside. Someone commented that it might be better to wait for inflation to disappear before taking the shears to interest rates. Most other economists have also been echoing the same sentiment: it's better to first squeeze out inflation from the system (albeit with the help of only monetary policy) before easing the tight monetary system.

My only take is: a large component of inflation in India arises due to supply side issues. These have been lingering for decades and no solution seems to be forthcoming. I don't expect the Government to sort these out in a hurry. Given the fact that these structural deficiences are likely to be with us for some more time, we are left with only two choices.

One of them was articulated by RBI Governor D Subbarao in an interview to Wall Street Journal (read here). According to him, the non-inflationary rate of growth for India is around 7% -- in other words, any rate of growth beyond the 7% might get the engine to overheat and cause inflationary smoke to billow from below your bonnet. Somewhat like what has happened in the past 24 months or so. If as an economy, we are content with a 7% GDP growth rate (which, by the way, if infinitely superior than most other countries), then the current economic prescription seems just right.

However, as many studies have repeatedly shown, India needs to grow by at least 8-9% every year, for some more years, to sort out one of its endemic problems -- poverty. And, to grow at that rate, the economy needs a much higher level of investment. There are many reasons why investment growth has slowed in the current context -- scams, bureaucrats getting ultra-cautious, approvals not forthcoming, governance lapses stemming from the country's top-most office, uncertainty over the policy environment, and, high interest rates. While the government is trying to re-set the investment climate by making the right noises about policy and project approvals, these will have to viewed by industry as sustainable in the long-term before they start committing their cash all over again.

In the meantime, interest rate hikes by the RBI have had a greater demonstration effect. Since interest rates are far more visible and tangible, they have earned a disproportionately larger share of the blame for the economic slowdown. Therefore, if the RBI cuts interest rates now -- even if it's by only 25 bps -- it has enormous demonstration effect and has the potential to kickstart the revival process.

This is not to say that the inflation problem is trifle. But there is a limit to which monetary policy can sort out inflationary pressures arising out of government profligacy and neglect.

Investment Allowance As A Partial Panacea

Wrote this piece for ET (read here), advocating a partial solution to the current economic slowdown and the somnolent investment climate. All views are welcome.

Managing Business Cycles

Indian companies bulk up their investment just before the slowdown starts, aggravating the pressure on their bottom lines, rather than being ready with new capacities just when an upswing is taking place 

INDIA became a reluctant devotee of open markets ever since its close brush with bankruptcy. As a result, the country and its policymakers had no choice but to enroll for continuing lessons on the advantages and perils of open markets as well as global linkages. Even Indian businesses had to learn some hard lessons. But, without prejudice to the nature of the economic agency — whether it is the government or the private sector business organisations — the process has been like baptism by fire.

However, the Indian corporate sector has been unable to come to terms with one intrinsic open market phenomena, which is largely episodic in nature but has a close bearing on the future growth prospects of almost all companies. It is called a “business cycle” and impacts bottom lines directly. It is an unavoidable consequence of open markets and free competition. Most developed markets around the world have gathered years of experience about it and have geared many parts of their business activities to forecasting it and then taking action to either minimise its deleterious impact or to capitalise on its salubrious influence. But, most companies in India seem to be getting acquainted with this unique change process only now.

Examples bear out India Inc’s inability to spot this big trend. The Indian corporate sector’s genetic architecture still seems to suffer from a passive disposition to floating along with the tide. Sure, there are some exceptions to this languid and helpless approach, but these are only a handful. Part of the reason for this lassitude lies in history and partly it is also due to structural deficiencies in the market, over which most companies do not have any control.

Here is one example of how companies miss the timing. If one goes by the chronology of business cycles drawn up by Pami Dua and Anirvan Banerji (Business Cycles in India, August 2006), then the period between September 1991 to May 1996 is shown as an expansion period, indicating increases in output, employment, income and sales. But, data shows private sector savings quite placid during the expansionary period (1991-92: 3.1% of GDP, 1992-93: 2.7%, 1993-94: 3.4%, 1994-95: 3.5%), but peaking to 5% only in March 1996, just when the business cycle is about to contract. The story’s the same for private sector gross domestic capital formation, averaging around 13.5% of GDP, but suddenly peaking to 18.4% by April 1996, just as the slowdown begins. Predictably, the savings and the investment rates fell the next year. This seems to indicate that Indian companies bulk up their investment just before the slowdown starts, aggravating the pressure on their bottom lines, rather than being ready with new capacities just when an upswing is taking place.

Research shows that most Indian companies rely largely on external financing to finance expansion (Financial Development & Growth in India: A Growing Tiger in a Cage, Hiroko Oura, IMF, March 2008). The trend is greatly emphasised in firms younger in age and smaller in size. The paper provides pointers to another systemic challenge — dependence on external financing (including equity) is inversely proportionate to a company’s growth prospects. However, Oura also concludes that despite all the shortcomings in the economy, India’s recent growth spurt was largely due to productivity growth. Typically, most firms have two sources of financing — external and internal. Again, external can be divided into domestic and “overseas” finance. If one leaves aside equity, then the sources of financing in the domestic market are characteristically bank funding, trade credit and capital markets (for issuing bonds and a host of other short-tenure instruments, such as commercial paper).

According to studies done over time, it is shown that most Indian companies historically did not generate enough savings. For example, in the ’80s, private sector savings hardly amounted to 2% of GDP — it touched 2% in 1988-89 and reached 2.4% in 1989-90. Given this low rate of savings, the corporate sector had to depend largely on external financing, including equity financing. Over the years, as markets opened up and tax rates came down (diminishing the incentives of high leveraging), the corporate sector’s propensity to invest was then directly related to its ability to generate enough surplus so that a judicious blend of own funds, borrowed funds (which largely meant bank financing) and equity could be used as the optimum, lowrisk combination. However, to generate the kind of internal surplus, most companies had to wait for their savings to touch a critical mass. Ordinarily, by the time most companies could make use of the good times and generate enough bulk on their books, the business cycle would turn. Companies then tended to save their surplus — instead of spending it on capital expenditure — for seeing them through the tight periods.

One alternative could be then to use bank credit for the planned investment expenditure. But, that’s a non-starter given the corporate sector’s inclination to spend only when the cycle starts heading downwards. The April edition of IMF’s World Economic Outlook (aptly titled Housing and Business Cycle) mentions: “Bank credit cycles arise naturally as a result of business cycles. Specifically, bank lending typically rises during an expansion and declines during a contraction. In a downturn, firms’ demand for credit normally declines, reflecting a curtailing of investment plans in response to weaker economic prospects and greater spare capacity...The price of bank credit also varies with the business cycle because it incorporates a risk premium. During a growth slowdown, the risk of insolvency increases in both the corporate and household sectors. Banks typically respond by charging higher risk premiums and tightening lending standards, particularly for riskier borrowers. Hence, expansion of bank credit is typically procyclical, whereas risk premiums and lending standards are countercyclical.”

The only alternative left then is either the equity markets or corporate bond markets. Undoubtedly, the Indian equity markets have reached some degree of global sophistication and efficiency. However, the same cannot be said of the corporate bond market. Also, the efficiencies of the equity market are not enough to compensate for the deficiencies in debt financing. In the end, if we give allowance for the fact that the corporate sector has been maturing over the years, then the only impediment to an efficient corporate sector is the absence of a well-functioning bond market.

Published as an Op-Ed in The Economic Times (June 11, 2008).