Book Review: Repo And Its Masters

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

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

Central banks have been labelled exotic beasts: rarely seen in public, much less understood. Realisation of what central bankers do has been seeping in slowly. Over the past few decades, as bond and currency trading acquired gargantuan propor­ti­­ons, the arcane world of dealers kept a close watch on every statement coming out of central banks, parsing each phrase and analysing each nuance. Any action, or the faintest hint of a future one, had the potential to affect currency prices, bond rates and indi­vidual fortunes. This need for analysis and interpretation also produced a large tribe of writers called ‘central bank watchers’.

Over time, as societies overwhelmingly bec­a­me dependent on debt— for housing, education or buying their next television—larger sections of the population got interested in the central bank’s actions. Any increase or dec­­rease in interest rates, or liquidity conditions, had a direct impact on household incomes and lifestyles. And yet, despite this growing interface, cen­­tral banking remains shrouded in a mysterious and inscrutable cloak.

Former Reserve Bank of India governor Duv­vuri Subbarao makes a valiant attempt to lift this veil and demystify a central bank’s workings. This is a first and we hope this will enthuse others to share their views. But there are two ways of viewing the book’s purpose. One, in trying to explain a central bank’s operations, Subbarao creates an opportunity to justify his actions dur­ing 2008-13, a period of stubbornly high inf­l­ation, extraordinary exchange rate volat­ility and an unprecedented (and unbroken) spree of interest rate increases. A converse view is also possible: its primary function is to rationalise his actions and he uses it to dec­ode the RBI’s actions and working styles. Which set of lenses have been used? The narrative str­u­cture and the tenor seems to suggest it’s the latter.

This becomes clear as one ploughs thr­ough an otherwise eminently readable account. The book’s pre-launch publicity focused on the governor’s well-publicised conflicts with former Union finance ministers P. Chidambaram and Pranab Mukherjee. Central bankers have traditionally shared antagonistic relationships with fiscal authorities. The book dwells at length on Subbarao’s differences of opinion with Chida­m­baram and Pranab, and how rising prices and a slowing economy widened the rift between Mumbai’s Mint Street and Delhi’s Raisina Hill.

But, with due apologies to Shakespeare, met­hinks the governor doth complain a bit. This is not to imply he was wrong in his stand on interest rates. Subbarao stood up against the collective might of the government, Parliament, a misinfor­med finance sector and uninformed commentariat by defending his right to raise interest 13 times in quick succession. He explains quite expansively why the situation warranted such drastic action. The fiscal and monetary expansion post the 2008 trans-Atlantic financial crisis, without adequate investment in production and supply capacities, embedded inflationary tendencies in the economy. Given political leaders’ reluctance to tighten fiscal reins, it was left to the monetary authority to attempt demand compression through interest rate increases.

Face-offs between monetary and fiscal auth­orities are built into the design; Subbarao mentions as much in the book. In times of crisis, both work in lockstep, as was evident after the 2008 meltdown. But, the impact of an expansionary fiscal policy on inflation and economic growth was ignored by the political class and India’s cossetted business interests. Much of the book describes this clash of ideals.

But there are gaps in Subbarao’s acc­ounts—both when describing clashes with North Block or when recounting challenges faced during vital post-crisis moments. Here are two examples.

First, there’s no mention of his immediate predecessor’s track record. Subba­rao mentions Y.V. Reddy only in passing while mentioning how crisis forced him to rev­erse his predecessor’s string of interest rate increases. We are not asking for public display of dirty laundry. Reddy too had to contend with a frequently (and publicly) remonstrating finance ministry. Reddy’s interest rate increases, to burst speculative asset market bubbles, earned him unstinted praise from economists and observers worldwide.

But, here’s the thing. Subbarao was fin­ance secretary when Reddy was busy inc­reasing interest rates to stave off risks. Interestingly, even Chidambaram was fin­ance minister during that period and he made public his displeasures with Reddy’s insistence on rate hikes. It would have been interesting, and more honest, if the book also disclosed Subbarao’s role as Chidambaram’s finance secretary in his engagements with Reddy, and the lessons learnt from those interactions before moving to RBI. Subbarao limits his interface with Reddy to discussions on RBI’s balance-sheet; I am sure there must be more. If the governor is going to reveal all about his skirmishes with political authorities, his interaction with RBI as finance secretary should also be fair game.

Two, there’s not enough explanation about how the RBI managed its balance-sheet in the aftermath of the crisis. Or, enough inside dope about the crisis days following the closure of Lehman Brothers. Subbarao describes how the monetary tap was kept open at full tilt to give the financial sector confidence that funds were always available. This was largely a signalling and confidence-building measure to avoid payment imbroglios or defaults which get amplified into panic during crisis times. As part of the strategy, RBI kept repo rates (the interest rate at which RBI lends to banks against government securities) low; but the reverse repo rate (interest rate at which RBI accepts money from banks against securities) was always kept 1.5 per cent higher. This was particularly true of December 2008.

Interestingly, this rate difference converted RBI—usually known as a lender of last resort—into a borrower of last resort. Banks would occasionally use the repo window to smoothen temporary mismatches, but would dump far excess cash with RBI’s reverse repo window. Clearly, credit aversion in the immediate aftermath of the crisis forced banks to seek safe havens for their surplus cash. Given money’s fungible character, we also do not know if banks borrowed from the repo window, turned around and tipped over the same money at the reverse repo window, thereby earning a neat 1.5 per cent without breaking into a sweat. The central bank’s annual report for 2008-09 (June 30 year-ending) highlights this anomaly: outstanding repos shrunk to Rs 895 crore (previous year Rs 22,805 crore) and rev­erse repos swelled to Rs 88,335 crore (previous year Rs 300 crore). This surely had some consequences and it would have been interesting to know Subbarao’s views.

But, beyond this, Subbarao has done a superb task of shedding some light on a central bank’s specialised role, especially by making it accessible to a wider spectrum of readers. He uses simple language and infuses some humour when necessary. It stops short of being a complete masterclass because encounters with the political class keep intruding. But somebody needed to talk about these incidents because the public rarely gets to know how both institutions interact. Yet, it also doesn’t do full justice to the political economy of Indian central banking. So, what is it, a book on central banking or an expose? I see it as setting the record straight.

This book review first appeared in Outlook magazine and can also be read here

When The Postman Knocks...

Finance minister P Chidambaram recently stated that Reserve Bank of India is likely to issue licences to seven new banks (read here). A total of 26 applicants had applied to be awarded banking licences. The FM's comments have immediately sparked off a guessing game about the identity of the lucky seven. 

We are loath to give up an opportunity to speculate; we will therefore definitely hypothesize about the lucky seven. But that is for a later posting. For the moment, let us focus on another important aspect. Mr Chidambaram also said that these new institutions should strive to create new banking templates and not follow the business model adopted by the existing, new-generation, private sector banks. One tends to agree with him, though the scope for innovation in the Indian financial sector does seem quite limited, what with the numerous regulatory and political obstacles erected for banking operations.

Whatever be the message, one only hopes that the FM's imprimatur of avoiding clones doesn't force the central bank to grant a banking licence to the postal department. The postal department is claiming that its massive network gives it access to almost all corners of the country, including large areas which go either unserved or under-served by formal banking practices. While the postal department is undoubtedly the only organisation with the largest physical presence in the country, is that a necessary and sufficient condition for granting a banking licence?

This is not to say that the postal department hasn't done a great job. The postal department has played a stellar role in stitching disparate parts of the country into a cohesive whole, managed to reach the earnings of migrant workers from one corner of the country to their families in another corner, tended to the fires of communications across languages and regions, and much much more.

But does all this still qualify for a banking licence? I don't think so. I had earlier written about it in a guest column for magazine Outlook (read here). 

Political pressure forces the postal department to sell most of their products below cost of production, thereby painting the bottom-line luxuriantly red and requiring infusion of fresh funds from the government every year. This is the main reason why the postal department should not be given a banking licence. The postal deficit for the past two years and this year's budgeted deficit are given below (in rupees crore):

2011-12            2012-13               2013-14 (Budgeted)

5716                  5838                       6717

The government, as things stand, needs to infuse large doses of capital into public sector banks every year (Rs 16,000 crore has been earmarked for government owned banks and financial institutions during 2013-14). Therefore, adding another colossal institution which is likely to absorb large amounts of cash every year is diverting additional amounts of the government's limited resources, which could be better used for development purposes.

Postal departments in many other countries launched banking services at various times in the past -- such as, Deutsche Postbank in Germany (which is now owned to the extent of 94% by Deutsche Bank), Japan Post, Postbank N.V. in The Netherlands which has since been acquired by ING Bank, POSBank in Singapore which has been bought over by DBS Bank. The lesson from the above examples is clear -- all the postal banks had to be acquired by private banks. The two exceptions might be China -- The Postal Savings Bank of China -- and Brazil's postal services, which had to tie-up with a private bank (Bank of Brazil) to gain access to financial products and  services.

With such a wealth of experience available globally, a rethink might be necessary before allowing India Post to diversify into banking services. An alternative strategy would be leverage the same network to allow marketing of third party products.

Revenue Foregone Argument Is Woebegone

Finance minister P Chidambaram has the unenviable task of reviving an economy after it was ruined systematically for over 36 months. One of the items high on his to-do list is to reduce the deficit, either by cutting expenditure or by increasing revenue collection. Forget the expenditure cut bit, primarily because it's political hara-kiri. In a chat with journalists on Monday, he expressed a view that companies paying an effective tax rate of 24-26% -- against the applicable rate of 30% plus surcharge -- might deserve a second look.



Courtesy: Wikipedia



While reporting on the FM's thoughts, newspaper Business Standard pitched in with a line on "tax foregone" because of deductions granted to the corporate sector (read here). It seems the reporter has added that one line, because no other paper has carried a similar sentence or attributed any such comment to the FM.

Revenue foregone is being equated with revenue squandered, especially in Delhi television studios and punditry columns. The rumblings are familiar: the bill for “revenue foregone” is huge, spend some of that money instead on the poor. The argument is inevitably drawn around the traditional rhetorical lines – tax foregone benefits only the rich (such as industry) while subsidies only benefit the poor. Therefore, the argument goes: abolish all exemptions, tax industry at a higher rate and use the incremental revenue to increase the subsidy budget. This is not only a specious argument but is dubious economics as well. Swaminathan S.A.Aiyar rightly calls it "claptrap" (read here).

It might be instructive to see why the rhetorical argument about revenue foregone can be misleading. For one, the numbers in the revenue foregone statement are based on a clutch of assumptions (for example, projections for 2011-12 are based on revenue foregone during 2010-11) and notional calculations. Therefore, to assume that it is indeed money “diverted” from necessary developmental expenditure is a bit of a stretch. Second, it assumes that all the revenue foregone is actually in the nature of funds granted to favoured entities, which could have rightfully been used for development purposes. That’s also somewhat fallacious. What cannot be denied is the fact that if no exemptions were granted, the government’s revenue collection would have been substantially larger. But, economic policy is all about balancing between different priorities.

The finance ministry tables a separate statement on “Revenue Foregone under the Central Tax System” along with the budget papers every year. This document reveals some of the government’s policy preferences through the lens of taxation. The document states: “Tax preferences may be viewed as subsidy payments to preferred taxpayer. Such implicit payments are referred to as “tax expenditures” and it is often argued that they should appear as expenditure items in the Budget. In this context, the basic issue is not one of tax policy but one of efficiency and transparency – programme planning requires that the policy objectives be addressed explicitly; and programme budgeting calls for the inclusion of such outlays under their respective programme headings. Tax expenditures are spending programmes embedded in the tax statute.”

Taken as such, the argument then boils down to choosing between one subsidy and another. Let’s look at what tax breaks to industry achieve, especially various direct tax exemptions. The debate on revenue foregone usually trains the spotlights on corporates. In the table on “major tax expenditure on corporate tax payers” projected for 2011-12, the largest chunk – Rs 36,468 crore (Rs 33,243 crore actually foregone in 2010-11) -- is taken up by the item “accelerated depreciation”.

Now, this is a tax break provided to companies which are investing in acquiring fresh assets. In a sense, accelerated depreciation basically provides a trade-off: it reduces taxable income in the current period in exchange for increased taxable income in the future, with the pointed objective of encouraging asset creation in the present to generate employment and income. This is a legitimate tax incentive used worldwide for motivating businesses to purchase new assets. This not only results in higher productive capacity for the economy but also increases employment opportunities. Had this money gone as a social sector subsidy, it would have been used up for consumption.

The next big chunk is claimed by “deduction of profits of undertakings engaged in generation, transmission and distribution of power (section 80-IA)” – Rs 8316 crore estimated in 2011-12 against Rs 7581 crore in 2010-11. This should be self-explanatory, given the huge power deficit in the country.

What is unmistakeable is the fact that many tax exemptions are targeted towards creating industrial assets, which will generate value, provide employment and become instruments of economic growth. This was followed even at the state level during the long Left Front rule in West Bengal. Most subsidies, on the other hand, induce consumption and do not encourage asset creation.

The data released throws up another big revelation: the effective tax rate (the actual tax paid as a proportion of the total taxable income) during 2010-11 for 2113 public sector companies is lower than the tax rate for the 457,157 private sector companies in the sample: 22.28% versus 24.61%, respectively. Incidentally, the report also states that the effective tax rate for the corporate sector as a whole has been steadily rising – from 20.55% for 2006-07 to 24.1% for 2010-11 – seeming to indicate that a large number of exemptions are being gradually phased out.

Therefore, the conclusion that all tax exemptions are largesse handed out to the wealthy may seem a bit hasty. There is no denying the fact that governments over time – and cutting across party lines -- have used the instrument of tax policy to reward their most-favoured industrial groups. But, then that doesn’t turn all tax exemptions into villains. Just like leakages in some of the current entitlement programmes do not diminish the merit of all targeted development plans.

What, however, should be debated is whether the implementation of the policy framework in achieving the stated objectives is actually as rigorous as the original intention. Or, there should be focused debate on whether some exemptions have been created to benefit some favourite industrial groups, instead of demanding that all exemptions be abolished.

Will RBI Join The Give-Away Party?

With a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems counter-intuitive

It’s odd, but somehow the heart goes out to RBI governor Y V Reddy. Yet again, the bill for the party will end up on his desk. Given the pile-up of other issues that require the governor’s full-time attention, the additional cost of reining in the after-effects of finance minister P Chidambaram’s budget jamboree is sure to extract a heavy toll.

Sure, the FM has done what he had to, given the circumstances. Some may even argue that his hand was probably forced to a certain extent by a party diktat. The Rs 60,000-crore farm loan waiver and his petulant response to repeated questions about it betray some of the occupational hazards of framing a budget during election times. But, to his credit, he has still tried to focus on the larger issue at hand — keeping the economy humming and trying to insulate it, as far as possible, from the shock waves of an impending global slowdown. This he has tried to achieve through two measures — trying to ensure that consumption growth in the economy continues apace and that the engine of industrial production does not slow down. At this stage, he is keen to achieve these ends with the help of some fiscal stimulus.

Look at what the FM is up against — the average growth of industrial production has dropped from 11% at the end of the last fiscal year to a monthly average of 9% till November. In December, it was only 7.6% and, if the average industrial production growth rate tends to stay between 5-7% in the second half of the year, the average rate for the year is likely to be below even 9%. That’s a sharp drop from the previous year. The main items dragging the index down have been consumer durables and the auto sector.

The Economic Survey also forecasts that the year is likely to end with an overall real GDP growth of 8.7%, a full 100 basis point lower than the previous year’s 9.7%. Add to this the fear of the unknown — no fix on the extent of the sub-prime damage in the western economies and the resultant economic slowdown, or the degree to which this event will impact the Indian economy.

So, how will the finance minister achieve the twin objectives? For the consumer, he has done two things — made goods cheaper by cutting excise duty and providing them with more spending power by restructuring income tax slabs. With an eye to the industrial production index in particular, he has reduced excise duty on small cars and two-wheelers (sales of which had been hit the hardest). He has also cut the median excise duty rate to spur consumption of daily household items. Given that a large part of the growth impetus during past few months, in the face of slowing down consumption, has been predicated on investment, the FM has introduced some policy changes in the budget to keep the momentum going — removed some long-standing glitches to facilitate higher trading volumes in corporate bonds, promised to develop a bond and currency derivatives market, extended tax breaks for construction of hospitals and hotels.

It’s too early to figure out whether this combination will indeed work in spurring higher consumption levels and therefore keep the industrial shop floors buzzing. But one thing is certain: not addressing the real issues is unlikely to sort out the inflation issue or immediately bring people back into the consumption mode. Take the pressures on the food economy. Is it going to go away with the Rs 60,000-crore farm debt waiver?

Unlikely, since the farmer still has no solutions on sourcing improved inputs (such as seeds or fertilisers) or even an efficient and reliant system for selling his produce. There is also no appreciable investment in improving the infrastructure which delivers agricultural produce from the farm gate to our plates. Therefore, despite the FM’s pious statements about inflation in his budget speech — “Keeping inflation under check is one of the cornerstones of our policy” — food inflation (spurred on to some extent by global factors) is likely to continue to haunt the economy for some more time to come. The Economic Survey observes: “The behaviour of agricultural prices, including essential consumption items, will be critical, given falling poverty and rapidly rising per capita income…Domestic supply management is…critical to stabilising inflation expectations, moderating pressures for upward revision in wages and prices, and containing pressures for cost push inflation through monetary and fiscal accommodation.” 

Second, will lower car and two-wheeler prices (assuming all the auto producers do agree to pass on the duty cuts) really inspire consumers to be liberal with their wallets? Again, doubtful. A careful look at the auto industry sales figures reveals that it was actually lower interest rates that catalysed record sales of the past couple of years. Once rates hardened, sales also dropped. Therefore, to get those motorbikes and tiny cars rolling out of the shop once again, what’s needed is not only a firm control on current inflation, but on expectations of what it’ll be in the future. Since the fiscal design does not explicitly state how it will lower inflationary expectations — and hence interest rates — in the next few months, the efficacy of the entire package is on test.

But, beyond that, the RBI will have its own set of headaches arising out of the budget and other public policy. For one, its authority as an enforcer of credit discipline in the banking system seems to have been undermined once more by a trigger-happy government. Second, the pay commission’s award is surely going to add another little twist to the on-going inflation story.

In addition, the RBI has used monetary policy in the past few months to bludgeon runaway demand and bring inflationary pressures under control. With such a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems   counter-intuitive. Unless, of course, the RBI also decides to join in the pre-election giveaway party.

Published as an Op-Ed in The Economic Times (March 6, 2008)