Why Banking Frauds Are So Frequent At PSU Banks

The terrain that is Indian banking turns tricky when government’s shareholder action in PSU banks starts impinging on RBI’s regulatory regime

It’s difficult not to detect a sense of déjà vu in the Nirav Modi scam, especially in all the hand-wringing and ex post facto zeal in setting up committees and investigations. Scams are a recurring motif in Indian banking, and the Punjab National Bank (PNB) case fits into the broad template of all previous stings.

In the search for solutions, a steady crescendo of drum-beats has been advocating whole-scale privatization of public sector (PSU) banks as a cure-all panacea. Implicit in the suggestion is the assumption that scams are the exclusive preserve of PSU banks. While it is true that the extent of scams and corruption is highest in PSU banks, data shows Indian private banks are not entirely immune.

The history of Indian banking over the past 50 years is littered with examples of failed private banks that were forcibly merged with stronger public sector banks (and with even stronger private banks recently—such as Bank of Rajasthan with ICICI Bank Ltd). This was done to safeguard depositors’ monies and to avoid systemic disruption. Here are a few random examples: Bank of Bihar was merged with State Bank of India in 1969; Hindustan Commercial Bank with PNB in 1986; Bari Doab Bank Ltd with Oriental Bank of Commerce in 1997; Kolkata-based United Industrial Bank merged with Allahabad Bank in 1989-90; Bank of Karad with Bank of India in 1994. The word merger has a volitional ring to it, but truth be told, there was nothing voluntary about these mergers.

Private banks have no special genes making them immune to scams and frauds. Global Trust Bank had to be merged with Oriental Bank of Commerce after its net worth was wiped out due to systemic fraud perpetrated by insiders. Even voluntary mergers in the post-reforms era are designed to escape distress and seek shelter with a stronger bank.

On balance, though, the larger proportion of scams in PSU banks does beg the question: why do they recur? One immediate reason could be the blurred lines of control and command. The government is the owner of PSU banks and exercises its shareholder rights capriciously: random appointments and transfers of chief executives, influencing appointment of board members, rationing out capital allocation in the name of fostering efficiency are some of the arbitrary control levers. The terrain turns tricky when government’s shareholder action starts impinging on Reserve Bank of India’s (RBI’s) regulatory regime. Bank senior executives, politically seasoned in picking up conflicting signals, reflexively align with the government even if it means contravening RBI’s regulatory framework.

For example, in the PNB fraud case, the bank’s core banking system (CBS) was not linked to its SWIFT system, thereby allowing officers to clandestinely issue letters of undertaking to Modi’s companies and confirming them with counter-party banks overseas through the SWIFT system.

This is despite RBI exhorting banks to link CBS with SWIFT; yet, PNB chose to violate these orders. It is, therefore, odd that none of the members of PNB’s governance troika—board, RBI or its all-powerful shareholder—pulled up the management or even sought an action taken report.

Former RBI governor Raghuram Rajan writes in his book, I Do What I Do: “Today, a variety of authorities…monitor the performance of public sector banks… It is important that we streamline and reduce the overlaps between the jurisdictions of the authorities, and specify clear triggers or situations where one authority’s oversight is invoked.”

RBI is tasked with detecting infirmities, but has no authority to enforce its own orders, administer remedial measures or even deliver swift punitive action. The central investigative agencies are tasked with following up on investigations and pursuing legal recourse. The political pulls and pressures on these agencies, as well as the Indian legal system’s long-drawn processes, provides swindlers with enough escape routes (pun intended), and is never a deterrent.

There is a likelihood that diminished incentives to regulate and supervise could be leading to weakened supervision and vigilance: most of it has become detection (after the event investigation) rather than prevention, which is to create systems and processes that raise alarms before the event or while transactions are taking place.

Flawed risk-mitigation design, which puts excessive focus on credit or market risks, has taken away attention from operation risk, leaving it susceptible to breaches. In addition, there is excessive dependence on manual supervision, at both external and internal levels. The sheer volume of transactions makes it impossible to manually control and supervise.

In the end, no matter what the design, somebody will always attempt to finesse the system. Blame corrupt politicians and bureaucrats, or the steadily disintegrating moral fibre of Indian businessmen, bankers and other white-collar professionals (as pointed out in this article), but scams are here to stay. The trick will be to construct a process design that prohibits anybody taking advantage of the system for sustained periods. And that will require dismantling some of the entitlement rights of the majority shareholder.

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

Fault Lines in the Indian Banking Industry

Both the PNB fraud and the Rotomac case underline how fund diversions were overlooked, but what’s distressing is how no alarm bells were sounded, no red flags were raised

Two things occur with metronomic regularity in the Indian banking sector: scams and committee reports. One, perhaps, follows from the other.

The Indian banking story, whether pre- or post-nationalization, has been an unfortunate hostage to a long catalogue of scams and frauds. The discovery of each scam is usually followed up with a flurry of committees and reports, rule reversals and a systems overhaul. A few years lapse in all this frenetic activity, a sharp light is focused on the scam area and just about when everybody starts getting complacent, another scam hits the industry. The entire round-robin league is replayed all over again.

The modus vivendi is common: exploit the system’s weakest link. There is another common thread in all the scams: diversion of funds. Both the Punjab National Bank (PNB) and Bank of Baroda (BoB) scams—the Nirav Modi and Rotomac cases, respectively—underline how fund diversions were overlooked; what’s distressing is how no alarm bells were sounded, nor red flags raised, despite an obvious piling up of operational, human and market risks that have debilitated two of India’s stronger public sector banks. Unfortunately, this seems to have become the default template for Indian banking scams, underscoring wide gaps in the regulatory framework. A cursory glance at scams since 1990 show how each episode methodically leveraged regulatory and supervision gaps.

The Harshad Mehta scam coincided with the dawn of India’s economic reforms. Mehta exploited the manual and antiquated settlement systems in trading of government securities. Taking advantage of a few pliant bank officers, Mehta conducted gilts trade between different banks using forged documents and diverted proceeds to prop up untenable equities positions. The scam-tainted large public sector banks (State Bank of India), foreign banks (Standard Chartered), small private banks (Bank of Karad, now extinct), corporate behemoths and sundry securities markets intermediaries.

A decade later, Ketan Parekh—ironically Harshad Mehta’s protégé—replicated almost the same methods: divert funds from the banking system through fraudulent methods to sustain equity market positions. KP would obtain pay-orders from Ahmedabad-based Madhavpura Mercantile Cooperative Bank without providing sufficient collateral. He would discount these pay-orders with Bank of India in Mumbai and use the proceeds to ramp up shares. The house of cards eventually collapsed when bear traders hammered KP’s favourite stocks and Madhavpura’s outstanding pay-orders exceeded its ability to repay Bank of India.

Here’s another familiar story: Sanjay Agarwal, former CEO of Lloyds Brokerage, created portal Home Trade in 2000 but was forced to go on the run a year later. Agarwal had inserted himself into the world of cooperative banks, promising to invest in gilts on their behalf and delivering lucrative trading returns. Instead, he diverted the money without delivering the securities or providing the promised returns. The charade continued till one of the cooperative banks complained about not receiving the promised securities.

In recent times, Winsome Diamonds and Jewellery Ltd allegedly used standby letters of credit to divert Rs7,000 crore. Winsome Group promoter Jatin Mehta shares another common strain with Nirav Modi: both have ostensibly become citizens of Saint Kitts and Nevis islands in the Caribbean, which does not have an extradition treaty with India.

Many more similar banking scams have occurred and gone undetected for long periods till the final moment of denouement. One trend is unmistakeable: money is diverted out of the banking system with the active connivance of either the bank’s senior management or a couple of rogue officers. This is what makes both the PNB and BoB cases incredulous: with Reserve Bank of India (RBI) putting so much emphasis on anti-money laundering mechanisms, and with an increasing number of prosecutions against either money laundering or diversion of bank funds, it is indeed curious how both the banks persisted with lax risk mitigation and supervision frameworks.

This also then begs the question: how is it that so many similar scams occur with such frequency, especially when RBI is such a hands-on regulator and supervisor? Every small action needs RBI approval, be it a CEO’s annual bonus, bank management’s decision to nominate a senior executive to the board or to open a branch in a city. Yet, copycat scams continue with ineluctable monotony.

Each time a scam occurs, committees are set up and numerous studies take place. Even now, post the PNB scandal, RBI has set up a committee under chartered accountant Yezdi H. Malegam to examine the increasing number of frauds in the banking system, the measures that will be needed to prevent them (including technological solutions), the role and efficacy of various audits currently conducted in banks to mitigate such frauds and the growing divergence between RBI and bank assessments on asset quality.

Many similar committees were set up earlier and voluminous reports submitted; yet, sadly, they are never enough to prevent future scams.

Next episode: what could be the probable reasons for the recurrence of such scams.

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

Hierarchy Of Rights: Citizens vs Institutions

The state, its myriad institutions and the corporate sector—both in private and state-owned spaces—have been provided a hierarchical status greater than citizens

The large hole discovered recently in Punjab National Bank (PNB) has got people asking: How did a diamantaire take out so much money from the banking system, so easily, when ordinary customers are made to jump through several hoops or provide copious documentation for a simple transaction?

The incident has once again highlighted the asymmetrical and uneasy relation between institutions and ordinary Indian individuals, in which the dice seems to be loaded against ordinary citizens. As examples later illustrate, this unequal relationship is not restricted to a few isolated cases but is endemic and, in some senses, also epitomizes the mistrust between state and citizen.

On paper, all Indians are created equal but inequalities have been stitched into the nation’s variegated relationships and transactions, such as deep-rooted gender inequalities or caste-based social discriminations. In particular, the state, its myriad institutions and the corporate sector—both in private and state-owned spaces—have been provided a hierarchical status greater than citizens. It seems the Indian republic, with its all modernist aspirations, is unable to shake off its feudal legacy and provide an equitable balance between institutions and individuals. The state’s role as a patron (or mai-baap) seems to rub off easily on various other institutions.

The mistrust is underscored every time there is a fraud, anywhere and by anybody, in the banking system. The Reserve Bank of India (RBI) insists all banks re-initiate the know-your-customer (KYC) process afresh, forcing all customers to compulsorily re-submit identity documents. Past submissions of same documents are disregarded. This process seems to indicate all citizens are guilty till they provide KYC papers repeatedly. The tyranny of Aadhaar, unleashed by all financial sector participants, has magnified the state of wariness. Hopefully, champions of Financial Resolution and Deposit Insurance (FRDI) Bill, specifically using depositors’ funds to bail out shaky banks, will now have occasion to rethink their position.

The unequal relation between state and individual is extreme in taxation. Tax notices routinely sent out by the income tax department start with the premise that the individual assessee is guilty and leave no room for doubt that the department could be mistaken; the tenor of these notices is intimidating, and the onus for proving oneself innocent lies with individual assessees. Even the redressal mechanism is loaded against the individual and mainly designed to deal with large corporates.

Apart from the PNB incident, examples abound of how such inequalities have become institutionalized. Assume a customer owes the electricity company money for consuming power. There is a tariff structure for consumers that is decided between power supplier and power regulator. If for some reason the consumer is unable to pay for one month, the power company’s representative arrives at the door and demands immediate payment or threatens disconnection. Logic and economic sense suggests that user charges must be paid. Otherwise, utilities cannot function. But, what happens when the same power company (or any other company) defaults on bank loans? In the language of RBI, the loan is recognized as overdue only when “interest and/or instalment of principal remain overdue for a period of more than 90 days”. Which means any company can afford not to repay its loans for 90 days without getting penalized. The question begs itself: if companies can avoid repaying loans for 90 days, why are ordinary citizens hounded at the end of 30 days?

A citizen’s helplessness is best manifested through the healthcare system. A division bench of the Bombay high court recently instructed the Maharashtra government to balance the rights of patients with the rights of hospitals and doctors while bringing in legislation to regulate clinical establishments. The court was hearing a 2014 petition, which it has converted into a public interest litigation, on hospitals detaining patients over disputed bills. As mentioned in earlier instalments of this column, public-private-partnerships in healthcare have benefited mostly the private entrepreneur, with active connivance of the state, and squeezed individuals.

On occasion, the regulator has had to step in to correct an inconsistency. Credit bureaus till recently did not allow citizens to access their own credit records without paying a fee. Credit card issuers and all other economic agents submit data on a citizen’s creditworthiness to credit information companies and could access the same before granting a loan or a credit card. But the individual could neither access the submitted data nor dispute the data, without paying a fee. In September 2016, RBI decreed that all credit information companies had to provide a free full credit report to individuals once a year. But the process remains cumbersome.

Globalization’s annual summit has over the past couple of years focused on social themes—from inequality to this year’s “creating a shared future in a fractured world”. Last year, discussions on how to eradicate inequality ranged from higher taxes on the rich to universal basic income; the World Economic Forum piped in with its own solution: “Move away the focus from plain wealth creation towards accomplishing a combination of other goals, producing more inclusive development.” Next year’s theme should be on redrawing the balance of power between individuals and all institutions.

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

RBI’s Studied Silence Over External Vulnerabilities

Critics are questioning the wisdom of the RBI after a 25 basis point reduction in benchmark interest rates fell short of capital market expectations

The Reserve Bank of India’s (RBI) 25 basis point reduction in benchmark interest rates fell short of capital market expectations. They were expecting a deeper cut but the Monetary Policy Committee (MPC) played safe, given uncertainty surrounding the future inflationary path. Critics are questioning the wisdom of the central bank and its MPC.

MPC members surely deserve to be cut some slack. But, in the general din over low food inflation, insufficient interest rate cuts and RBI’s unchanged neutral policy stance, the central bank’s policy statement omitted mention of a small crimp: a tsunami of portfolio flows, another possible source of inflationary pressures. The central bank’s studied silence about external vulnerabilities raises many questions.

This rush of foreign currency has forced RBI to take steps which have disappointed overseas debt markets and investors: for instance, rules have been tightened for issuing masala bonds through introduction of maturity floors and interest rate caps. This comes when masala bonds were gaining popularity with both issuers and investors. In another (though seemingly unrelated) circular, the RBI has sought to elongate the maturity profile of investments by foreign portfolio investors (FPI) in government bonds. Capital markets regulator, Securities and Exchange Board of India (Sebi), followed through with another circular, ordering a temporary stop to future masala bond issuances.

The RBI has probably sensed higher risk—in terms of both rates and exposures—in the opening of masala bond floodgates, especially after offshore arms of certain Indian companies raised foreign currency loans in overseas markets and then on-lent the proceeds to domestic entities as rupee bonds. This structure defeats the entire purpose of shielding Indian borrowers from exchange rate volatility since it provides original lenders with an indirect claim on domestic assets.

Sebi’s rationale is that FPI investments in corporate bonds have reached close to the limit of Rs244,323 crore. This ceiling includes all rupee-denominated bonds, offshore or on-shore. The regulator’s circular also states that masala bond investments can resume only after limit utilization falls below 92%.

RBI’s rear-guard action also probably stems from the combined effect of two other reports—its own report on India’s external debt and the annual External Sector Report from the International Monetary Fund (IMF). Both sound circumspect about India’s rising short-term foreign debt levels. The IMF reports states: “Given that portfolio debt flows have been volatile and the exchange rate has been sensitive to these flows and changes in global risk aversion, attracting more stable sources of financing is needed to reduce vulnerabilities… Further initiatives on creating a more conducive business environment, particularly the implementation of long-standing labour market and power sector reforms, are necessary to attract greater FDI flows.”

FPI investments in equity and debt markets saw combined net inflows of Rs171,581 crore till July end. This is six times more than the Rs27,055 crore invested by FPIs during the same period of 2016. This surge had rupee appreciating by almost 5.8% between 2 January and 31 July.

Such large inflows put RBI’s absorption skills to the test. First, it has to intervene in the foreign exchange market to absorb foreign currency inflows so that portfolio investments do not push up the rupee-dollar rate beyond its sustainable and economic value. The resultant overhang of rupee liquidity then requires a second defensive action: the RBI has to mop up liquidity through a variety of instruments. For example, in the 11 working days between 17 July and 29 July, RBI absorbed Rs405,228 crore. Sterilization has its costs, especially when central banks sell high-yield domestic instruments while buying relatively low-yielding foreign currency assets. There are also fiscal implications.

The central bank’s woes do not end here: it needs to calibrate another two-step dance. The RBI’s remonetization exercise is still far from complete but it is unable to accomplish that at full tilt, given the wash of domestic liquidity. At the same time, it has to ensure that there is enough liquidity to make up for lost productivity during demonetization. Both will require precision and fine-tuning. Plus, it needs to ensure there’s just enough liquidity to keep yields soft.

There’s another dilemma. The FPI investment limit in corporate bonds was fixed when the exchange rate was below Rs50 to a dollar and common sense dictates a re-calculation of the limit. But the central bank is not doing that just yet, given that its hands are full trying to staunch current inflows.

Times like these are ripe for conspiracy theories. There are misgivings that RBI’s efforts could be an indirect attempt to ensure borrowers do not export the domestic bank credit market to offshore centres. While bank credit growth remains anaemic, Bloomberg data shows Indian companies raised $8.9 billion through overseas bond sales till July, 63% higher than the previous year. It is believed many companies took advantage of tightening spreads and used foreign currency bond sales to refinance domestic bank exposures, thereby intensifying balance of payments risks.

The MPC statement omits mention of external sector developments. Hopefully, the RBI will separately provide a more comprehensive communication that details the risks and the mitigation measures.

The article originally appeared in Mint newspaper on August 9, 2017, and can also be read here

It’s All In The Sequencing

There is silence on how the digital payments universe will foster competition, spur innovation and design a regulatory framework to protect consumers

Public policy discussions globally have often debated the role and sequencing of regulatory reforms in the series of structural changes necessary for introducing market dynamics to state-controlled economies. In India, post 1991 reforms, this critical issue was not adequately deliberated; worse, the government’s piecemeal approach to reforms and policy planners’ disregard for prioritizing regulatory reform inevitably led to regulatory capture and crony capitalism.

The demonetisation exercise is another pertinent example of how non-systemic reforms, without preceding regulatory reform, lead to chaos and economic dislocation. The withdrawal of 86% currency overnight was accompanied by a steady stream of shifting narratives: launched initially to curtail counterfeiting and currency hoarding, the objective soon segued to facilitating a digital payments infrastructure. But the lack of any planning before introducing this coercive shock, or the absence of preparatory infrastructure build-up and roll-out, has nullified all initial benefits.

Digital payments values and volumes went up between 8 November and 31 December 2016 because people had no other options. A recent research report from securities firm Motilal Oswal estimates that digital payments reduced substantially by May. For example, Motilal Oswal’s calculations show cumulative value of transactions across all digital payments channels during May at Rs111.55 trillion, down from the December 2016 peak of Rs131.45 trillion. The report disregards the Rs180.73 trillion spike during March, attributed primarily to seasonal phenomena.

Even a senior executive from the National Payments Corporation of India (NPCI) was quoted in this newspaper as saying the December spike in digital payments had ebbed by April.

So, what has demonetisation achieved? Observers cite two tangible, but divergent, results: a political victory through electoral gains in Uttar Pradesh and deepening agricultural distress leading to widespread farmer unrest. While there is no detailed, granular research linking demonetisation and these two outcomes, there is one noteworthy collateral benefit though: casting a wider net exposes the asymmetrical regulatory landscape in the payments and settlement ecosystem.

Soon after demonetisation, the Ratan Watal committee on digital payments advanced its deadlines and rushed through its report submission. Another committee of chief ministers was set up by Niti Aayog under Andhra Pradesh chief minister N. Chandrababu Naidu. This committee spawned another committee for digital payments security under IT secretary Aruna Sundararajan. Niti Aayog has set up another committee helmed by chief executive officer Amitabh Kant to “enable 100% conversion of government-citizen transactions to the digital platform”. Meanwhile, the ministry of electronics and information technology (Meity) has issued its own guidelines to facilitate adoption of electronic payments and receipts for various government services. Before all this, in June 2016, the Reserve Bank of India (RBI) had set up an inter-regulatory working group on fintech and digital payments, though the fate of this committee is not yet known. Besides, demonetisation also occasioned a host of other private reports.

Predictably, such a surfeit of committees and reports has led to overlaps and repetition. A cursory reading might even give the idea that committees are competing among themselves to say the same things. However, the burst of reports and recommendations in the first flush of demonetisation seems to have petered out: nobody seems to be listening and there doesn’t seem to be any urgency to implement many of the suggestions.

For example, the Watal committee’s recommendation of carving payments regulation out of RBI’s jurisdiction and making it into an independent body met with resistance from the central bank; eventually, finance minister Arun Jaitley announced the setting up of a payments regulatory board in his 2017-18 Budget speech (to replace the existing Board for Regulation and Supervision of Payment and Settlement Systems, or BPSS) on the lines suggested by the committee, but with one critical exception: the board will have three members from RBI and an equal number from the government, thereby diluting its independent status.

Many other skews in the regulatory architecture have been pointed out but remain unresolved. For example, as owner and operator of the retail digital payments network, the NPCI is a provider of critical infrastructure; but, simultaneously, it also competes with users by pushing its own payment products and services. In addition, its entire equity capital is owned by 56 banks, which automatically puts non-bank payment service providers at a distinct disadvantage and raises questions of infrastructure neutrality.

There is also complete silence on how the digital payments universe and its regulators will foster competition, encourage innovation and design a regulatory framework to protect consumers. Currently, allowing only banks to access the payments network—and denying that to non-banks—seems to be the default regulatory design.

The attention of policy planners and administrators might have been temporarily diverted to the other elephant in the room: goods and services tax, which goes live from 1 July. But, GST’s success is also predicated on a robust and secure digital payments network; an ad hoc digital payments network spells only provisional success for GST.

The above article was originally published in Mint newspaper and can be read here as well

The Reserve Bank of India Is Changing Again

While RBI’s central board has certain powers, these have been rarely used to oppose finance ministry action

Time was when the Reserve Bank of India (RBI) resembled more a Soviet rationing officer than a conventional central bank. Mercifully, 1991 and economic reforms ended all that; the RBI got down to conventional central banking, which included moving the economy slowly out of administered interest rates, ending automatic monetization of government debt and shrinking its autarchic footprint. After a 26-year hiatus, there are misgivings that RBI could be lapsing into some of its old habits.

In the now defunct central banking format practised by RBI, all credit over Rs1 crore was rationed. Under a scheme called Credit Authorization Scheme, the RBI vetted all large loan proposals. Even though the floor was raised gradually over time, RBI continued to have a say in how much banks could lend to whom, and at what rate. The RBI was also the implementer (and custodian) of the government’s illiberal measures: banks had to compulsorily invest 40% of deposits in low-priced government securities and keep 20% with RBI as a cash reserve. Of the balance 40% left for lending, 40% had to be mandatorily lent at concessional rates, leaving “commercial” banks with only 24% of deposits to play around with. No wonder average lending rates ranged between 16-18% and non-performing assets were rarely recognized, leave alone provisioned.

These are now part of the nation’s sepia-tinted economic history. The RBI has been easing controls for the past 26 years, even though it has retained numerous other controls as part of its mandate to ensure monetary and financial stability. The overall process has not always been smooth or linear. Economic disruptions, both exogenous and endogenous, have occasionally forced the RBI to slow down or undertake course correction.

In recent months, there are suspicions that RBI’s reform mandate may have changed. The central bank’s role in the demonetization exercise sowed the first seeds of doubt. While the RBI’s central board has certain powers, these have been rarely used to oppose government action. Then, as well as now, the RBI would have gone along with the decision. But, here’s the crucial difference: governor and deputy governors could have used different platforms to speak their mind about the extreme decision. They would have made attempts to explain the economic shock to citizens. Instead, RBI’s March report on the macro-economic impact of demonetisation is an exercise in politesse.

Perhaps RBI doesn’t want to speak out because collateral damage from demonetisation has kept it incredibly busy.

Demonetization led to a liquidity surge, forcing the RBI to step in. Banks had no alternative route to deploy this liquidity, given the uncertainty created by demonetisation and industry’s non performing assets (NPA) induced aversion to bank credit. The RBI implemented a four-stage liquidity management programme, using different instruments at different times. Surplus liquidity also depressed debt yields. Around the same time, on 14 December, the US central bank Federal Reserve raised interest rates leading to outflow of foreign portfolio investment (FPI) from Indian debt markets—Rs46,087 crore went out during the last three months of 2016. This continued in January too. Consequently, the rupee-dollar exchange rate also mirrored these trends, depreciating initially and then staying range-bound for a month.

Then, suddenly around end-January, yields on the 10-year government bond started perking up. Foreign portfolio investment inflows also rushed in—Rs51,679 crore during February-April. By end-April, the rupee had also appreciated by almost 6.5% from the lows of 24 November.

The rupee’s appreciation has hurt exporters. But, more importantly, a 6.5% movement in such a short time is a sign of untreated volatility and should have been countered by the RBI. But, tackling the demonetization-led liquidity surge has probably left the RBI with little or no fire-power. Ordinarily, faced with such a predicament, the RBI would have used another weapon: talking the market down. But, neither the RBI governor nor his deputies has spoken a word over the past few months.

Two conclusions arise: either the RBI agrees with the current rupee value (which most economists think is over-valued) or it is scared to speak out. The government’s distaste for former RBI governor Raghuram Rajan’s public speeches was well publicized. RBI’s top brass has delivered only nine public speeches between January and May this year, compared with 23 last year.

Management of stressed assets is another example where the RBI seems to have abandoned characteristic central bank detachment. The RBI is stepping into the mud-pit of stressed assets to help banks recover sticky loans; this includes even taking commercial decisions regarding selection of credit rating agencies. This could expose RBI to serious risk, including reputational risk.

It might be instructive here to recall how Rajan spent his last days in office staving off pressure from the finance ministry, which insisted that the RBI use its balance-sheet to recapitalize public sector banks. At that time, deputy governor Viral Acharya (then professor with Stern School of Business) had criticized it in a Bloomberg story, saying, “At a minimum, it looks opaque and devious…could be perceived as an attack on central banking independence.”

At a time when globalization is in peril, the RBI seems to be voting for a dubious global trend: ceding autonomy to the political executive without a fight.

The above article was first published in Mont newspaper on May 31, 2017, and can also be read here

No Quick-Fix Solutions for Accumulated NPAs

The amendment to the Banking Regulation Act has failed to provide relief from the government’s latest scheme for cleaning up accumulated NPAs

Those expecting immediate relief from the government’s latest scheme for cleaning up accumulated non-performing assets (NPAs) might have to wait some more. Going by some statements and interviews to media, it may have seemed that a quick-fix was at hand. Nothing could be further from the truth: what has accrued over so many years is unlikely to vanish with the mere snapping of fingers.

The government’s latest weapon against NPAs is an amendment to the Banking Regulation Act, 1949, which is expected to invest banks with some freedom in resolving bad loans without inviting the prosecutorial gaze of central investigative agencies.

NPAs have become a stumbling block in all attempts to re-ignite the economy. Bank credit growth has slowed, affecting capacity creation and expansion—bank credit grew only 5.1% during year to March 2017, against 10.3% in the previous year. The Reserve Bank of India’s (RBI’s) latest Financial Stability Report shows stressed assets (sum of gross NPAs and restructured assets) at 12.3% of assets by September-end 2016. After factoring in demonetisation’s adverse impact and the prolonged economic stasis, this ratio would have further deteriorated by March 2017. This has forced banks to turn risk-averse.

The amendment to the Banking Regulation Act is therefore expected to provide some relief. Unfortunately, the measure has failed to generate unstinted optimism as expected. The reason is that some bugs exist that could slow down progress in the short run.

At one level, the entire exercise is designed as a signalling system, indicating the government’s and the central bank’s resolve to straighten out what seemed like an intractable problem. It also signals that both parties are prepared to support banks’ attempts to resolve this crisis.

But the government itself nullified this confidence-building exercise with another adverse signal—two senior bankers heading two large public sector banks (PSBs) were transferred to smaller entities, signalling a demotion. This was done overnight, without informing either the individual bank boards or the autonomous Banks Board Bureau. Trust plays a large role in any signalling exercise and the latest order just chipped away at the first step to building trust with bankers.

The second crimp is PSBs’ lack of balance-sheet muscle to tackle the volume of NPAs. The International Monetary Fund’s (IMF) 2017 Article IV report on India shows that while aggressive NPA recognition by PSBs turned their return on assets negative in 2015-16, aggregate provisioning coverage ratio still remained low, indicating weak capital bases. The IMF report also shows that PSBs are content writing off loans rather than recovering them—a commentary on the numerous, though deficient, stressed asset resolution mechanisms. The short point is this: banks are unlikely to get aggressive with NPA resolution unless there is capital within sight.

The government, on its part, has drawn up a three-pronged plan to meet its capital infusion responsibility: limited capital infusion depending on performance criteria, merging some of the larger banks, and asking banks to source balance capital from capital markets. All these measures are time-consuming and the pace of capital flow is likely to determine the speed of resolution.

The third problem lies in the wording of the amendment. The government has inserted Section 35AA in the Act, which states: “The Central Government may by order authorise the Reserve Bank to issue directions to any banking company or companies to initiate insolvency resolution in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.” This is followed by a paragraph stating, “Without prejudice to the provisions of section 35A, the Reserve Bank may, from time to time, issue directions to the banking companies for resolution of stressed assets.” The RBI will also create committees of experts to advise banks.

Two issues spring to mind immediately.

First, the amendment does not explicitly insulate bankers from future persecution, nor is there any implicit signal. The Prevention of Corruption (Amendment) Bill, 2013, which includes provisions for such a shield, is stuck in Rajya Sabha. Therefore, till there is clarity on where the buck stops—the Centre, the RBI, the committee of experts appointed by RBI or the bankers—progress is likely to be slow.

Second, the amendment is unclear about how the Centre proposes to take the resolution forward: will the government monitor each individual asset resolution or provide an umbrella order enabling the RBI to calibrate its action depending on the merits of each case?

Both possibilities have consequences. In the first instance, there are risks of government being accused of cronyism. In the second, the central bank (or its appointed committee) will be exposed to scrutiny from investigative agencies, which may be detrimental for any central bank.

Finally, if all the above do fall into place, there is still one snag: capacity constraint at the National Company Law Tribunals. Of the 700 cases filed with the tribunals, only 70 have been admitted. Moreover, the National Company Law Appellate Tribunal has ruled (as reported by this newspaper) that the 14-day deadline for admitting or rejecting a proposal is not binding, though once admitted, the case has to be resolved in the mandatory 270-day period.

Make no mistake: there is definite movement towards resolution. But, as mentioned earlier, do not expect miracles.

This article was originally published in Mint newspaper on May 17, 2017, and can be read here

The world’s strongmen are eroding the autonomy of central banks. Exhibit A: India

Whatever the differences over the demonetisation fallout, there is near consensus over one collateral damage: the reputation of the country’s central bank, the Reserve Bank of India (RBI), has taken a severe beating after 86% of the country’s currency (by value) was withdrawn and not replaced on time. But, worse, there is a growing perception that the central bank buckled under government pressure and rubber-stamped demonetisation. Fingers are pointing at governor Urjit Patel for readily agreeing; this may be jumping to conclusions but governor Patel’s non-communicative mien has not helped matters.

Three former RBI governors have publicly lamented the erosion of the central bank’s relative autonomy. Former governor Y V Reddy expressed concern about the knocks the RBI is taking: “For the RBI, for a central bank, reputational risk is the worst risk…And if this is happening in the international opinion, I would say that it is a national problem now and it is not just a political issue.” Even Reddy’s predecessor, Bimal Jalan, chimed in with his concerns over threats to the RBI’s autonomy. The opening line of former deputy governor Usha Thorat’s recent op-ed was anguish-laden: “It is indeed a sad day to see one of the most respected public institutions in India becoming an object of ridicule and scorn.”

India is only playing catch-up

On closer scrutiny, though, this shouldn’t come as a surprise. India is only following a global trend. The world over, in countries with right-wing governments headed by perceived “strongmen,” the executive has locked horns with serving central bank governors, and in some cases even abrogated the relative autonomy of the central bank. India is only playing catch-up: the refusal to extend former governor Raghuram Rajan’s term, and the growing public perception of Patel’s inability to dissent, further reinforces the notion of India tacking on to a global trend.

Two recent examples testify to the global pattern’s prevalence. President-elect Donald Trump denounced US Federal Reserve chief Janet Yellen on his campaign trail, claiming she was playing politics with interest rates (translation: she was keeping interest rates deliberately low to help Hillary Clinton) and should be replaced. Whether he will follow through on that promise will be known only after Jan. 18.

In England, soon after securing the referendum supporting Brexit, Conservative Party grandees—notably Michael Gove and former foreign secretary William Hague—tore into Bank of England (BoE) governor Mark Carney. They were taking their cue from prime minister Theresa May who, at an earlier party conference, had slammed the BoE for the low interest rates and quantitative easing since it short-changed savers. Carney has since dropped dark hints of resigning.

The relationship between elected politicians and central bankers has always been fraught. The 2008 trans-Atlantic financial crisis has deepened the chasm with central banks being increasingly asked to take on quasi-fiscal responsibilities. This has resulted in increasing institutional friction.

In Japan, soon after prime minister Shinzo Abe assumed office in December 2012, he leaned on the Bank of Japan (BoJ) to print more money and to bump up its inflation target from 1% to 2%; both measures would require the BoJ to pursue an expansionary monetary policy. This, the government hoped, would provide the necessary growth stimulus to the economy and finally help Japan escape the pernicious deflationary trap that’s plagued the economy for over 10 years. BoJ governor Masaaki Shirakawa was initially reluctant and when the pressure continued to pile on, he resigned in February 2013, two months before he was due to retire.

The Hungarian president and head of the right-wing party Fidesz, Viktor Orban (who recently built barbed wire fences to keep out immigrants), used his majority powers in parliament to browbeat the central bank into submission. He even went to the extent of replacing the sitting governor with long-time Fidesz politician Gyorgy Matolcsy. Interestingly, Matolcsy currently faces myriad allegations of cronyism and misuse of public funds, including those of the central bank to window-dress the government’s fiscal health.

Closer home, Sri Lanka has been witnessing heightened tensions between central bank governor Indrajit Coomaraswamy and finance minister Ravi Karunanayake.

More than just monetary policy

Bank of Israel governor Stanley Fischer resigned ahead of his retirement date, sparking off rumours of differences with prime minister Benjamin Netanyahu. Fischer subsequently joined the Federal Reserve as vice-chairman. A year ago, he had delivered a speech on central bank independence, in which he made an interesting point, one that resonates with the Indian situation. He said: “…there is a distinction between the terms monetary policy independence and central bank independence. In the literature that developed before the global financial crisis, central bank independence referred to independence from political influences in the setting of monetary policy. But many central banks have roles outside monetary policy—in particular, bank regulation and supervision. These roles are in certain cases granted their own level of independence…”

This point has also been made by former governor Y V Reddy: “There are two types of confusion… my own suspicion is that the institutional identity of the RBI has been damaged… the RBI is the monetary authority, yes. But it is also a full-service central bank. It is in charge of many other things. The recent emphasis appeared as though monetary policy is the main function. The governor is accountable to monetary policy. Then he is not accountable to regulation, he is not accountable to currency coins? There is a confusion about relative importance. That relative importance is being decided more outside than within.”

Successive governments have found ways of corroding each of these different independent roles. For instance, under the previous Congress-led government, former finance minister Pranab Mukherjee (currently the country’s president) set up in 2013 a new financial sector monitoring body, called Financial Stability and Development Council, to be chaired by the finance minister. This was a clear intrusion; the central bank’s mandate includes financial stability. The RBI governor was put on par with other regulators, which betrays a flawed understanding of a central bank’s role and remit.

The Australian example is instructive. The governor of the Reserve Bank of Australia chairs the single integrated prudential regulator, the Australian Prudential Regulation Authority, as well as the Council of Financial Regulators.

Rule by fiat

The process of emasculating the RBI seems to have accelerated now. The surgical changes to RBI’s governance structure are telling: The government’s unwillingness to fill up vacant posts of independent directors is believed to have accelerated the passage of the demonetisation proposal and helped obtain the central bank’s acquiescence overnight. Ordinarily, the central bank would have debated and dissented, after assessing the logistical nightmare of not only distributing fresh cash to the wide network of bank branches across the country but also recalibrating and replenishing over 200,000 ATMs across the country.

Subsequent RBI submissions to parliament’s committee on finance disclosed that the central bank had acted on government advice.

Truth be told, the RBI Act does not empower the central bank with absolute autonomy, but the RBI does have relative autonomy allowing it to pursue certain monetary and regulatory functions with some degree of independence, free from political pressure. Saying “no” in the interest of avoiding short-term volatility and ensuring the economy’s long-term health is part of the job. Tinkering with this fine balance will have massive repercussions, including undermining investor confidence in various asset markets.

The article first appeared in www.qz.com on January 15, 2017, and can also be read read here

Don't Bank On It

Decoding Raghuram Rajan's antipathy towards industrial conglomerates.

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

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

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

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

Let me explain.

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

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

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

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

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

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

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

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

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

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

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

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

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

Busting Myths Around Raghuram Rajan's RBI

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 

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)

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/

A Tobin Tax For India

In its recent monetary policy document, the Reserve Bank of India has imposed strict maturity conditions on foreign portfolio investment in debt to get a better handle on risk. But a fiscal solution would be more elegant and effective

The nervousness is back, and so are direct physical controls. In an otherwise staid monetary policy document released on 3 February 2015, Reserve Bank of India governor Raghuram Rajan has inserted one small restriction: henceforth all foreign portfolio investors investing in debt instruments—issued by government or private sector companies—have to hold on to their investments for a minimum of three years.

The policy decision is a discreet admission of the risks confronting the Indian economy, as well as a hint of the Indian central bank’s anxieties.

But imposing administrative controls in this day and age—even if they are meant to mitigate risks—sends wrong signals, especially when alternative fiscal instruments are available to achieve the same results. Even the European Union has agreed to implement such a measure despite stiff opposition from Britain and Sweden: the magic bullet is called a Tobin tax.

India must also consider introducing such a tax With Finance Minister Arun Jaitley searching for newer sources of revenue, Budget 2015-16 (to be announced on February 28) will be the right vehicle for announcing this levy.

Named after American economist and Nobel laureate James Tobin, the tax is levied on financial transactions and is aimed at curbing speculation and volatility. Although the tax was originally proposed by Tobin in the 1970s for a post-Bretton Woods global financial system—to curb short-term currency speculation and its attendant risks to the economy (through high interest rates)—over time it has come to denote taxes on all kinds of financial transactions, with each country re-interpreting the concept in its own unique manner. For example, Italy imposed a variation of the tax on high frequency share trading in September 2013—a 0.02% tax on trades occurring every 0.5 seconds or faster. [1]

After years of discussions and dissent, 11 European countries—Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia—have also decided to introduce a financial transactions tax from 1 January 2016. [2] Under the finalised proposal, the 11 countries will impose a 0.1% levy on exchange of shares and bonds, and a 0.01% impost on derivative transactions.

However, Britain and Sweden have already voiced their dissent to the proposal and are likely to oppose its enactment. It is also not known whether Italy will continue with the tax on high-frequency trading after 2016.

The Tobin tax approach has been tried in other countries as well—such as Thailand, Brazil, Chile, and Malaysia—with mixed results. However, in Brazil and Malaysia (and, to some extent, in Chile) the tax is said to have achieved the desired results of curbing volatile short-term currency flows.

India already has a form of Tobin tax in place—the Securities Transaction Tax (STT). Introduced in 2004, the STT is levied on every transaction of securities listed on the stock exchanges and mutual funds. According to Budget documents, the STT helped net Rs. 5,497 crores revenue for the government during 2013-14. [3] The estimate for 2014-15 is Rs. 5,991 crores.

A Tobin tax could be levied on foreign portfolio investors who decide to cash out their investments in Indian bonds before a certain period. This has dual benefits—the investments stay for a longer and predictable period (thereby insulating the economy from egregious volatility), and earn additional revenue for the government as well.

This might be much more elegant than what the RBI is proposing. The RBI monetary policy document states: “…it is decided in consultation with Government that all future investment by FPIs in the debt market in India will be required to be made with a minimum residual maturity of three years. Accordingly, all future investments within the limit for investment in corporate bonds, including the limits vacated when the current investment by an FPI runs off either through sale or redemption, shall be required to be made in corporate bonds with a minimum residual maturity of three years. Furthermore, FPIs will not be allowed to invest incrementally in short maturity liquid/money market mutual fund schemes.” [4]

This is a direct administrative decree that not only transmits confusing signals to market participants but could also incur their displeasure. Rajan even admitted in a recent newspaper interview: “I generally believe we should not micro-manage. But the one place where I do make a strong exception is on financial stability. There are situations when market participants do not fully internalise the consequences of their action because they know they can leave before the consequences hit them.” [5]

One reason for the directive could be swelling short-term loans and the bunching up of repayments in the near future. However, data seems to indicate otherwise: according to external debt data till 30 September 2014, released by the Ministry of Finance, short-term debt is only 18.9% of the total external outstanding debt of about $456 billion. At the end of June, it was slightly higher at 19.6%. [6]

So, why is the RBI imposing this diktat now? Clearly, it is a bit jumpy about the consequences of an interest rate hike by the U.S. Federal Reserve Bank some time this year. When that happens, many global investors are expected to withdraw funds from emerging markets like India and invest in the U.S. instead.

Such an outflow could create pressure on the current account, the rupee exchange rate, and on domestic interest rates. India experienced this in 2013. Rajan wants to bullet-proof the balance-sheet not only before the event, but also prior to the announcement of the Budget at the end of February.

References

[1] Clinch, Matt, Italy launches tax on high-frequency transactions; CNBC, 2 September 2013, <http://www.cnbc.com/id/101002422#>

[2] European Commission, Proposal for a Council Directive implementing enhanced cooperation in the area of financial transaction tax, 14 February 2013, <http://ec.europa.eu/taxation_customs/resources/documents/taxation/com_2013_71_en.pdf>

[3] Ministry of Finance, Government of India; Revenue Budget, Budget Documents, <http://indiabudget.nic.in/ub2014-15/rec/tr.pdf>

[4] Rajan, Raghuram G, Sixth Bi-Monthly Monetary Policy Statement; 5 February 2015, <http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=33144>

[5] Sriram R., Bodhisatva Ganguli and Gayatri Nayak, ‘The War on inflation is still not won: RBI Governor Raghuram Rajan’, The Economic Times, 5 February 2015, <http://articles.economictimes.indiatimes.com/2015-02-05/news/58838165_1_rbi-governor-raghuram-rajan-urjit-patel-committee-inflation>

[6] External Debt Management Unit, Economic Affairs Department, Ministry of Finance, Government of India, India’s External Debt as at End-September 2014, December 2014, <http://finmin.nic.in/the_ministry/dept_eco_affairs/economic_div/ExternalDebt_Sep14_E.pdf>

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