The Great Indian Rupee Trick - Redux

A lot has already been written about why the Indian rupee has gone into a free-fall. Some of it is utter nonsense, such as stuff which claims rupee should actually be appreciating instead of depreciating. But, otherwise, the narrative has mostly been sane and restricted to the straight and narrow.

What, however, does not get written is Indian government's strategic intent, or the lack of it. Most analyses tend to paint the Indian government as a hapless bystander, hit athwart and stunned by debilitating global financial flows. The fact is this: the portends were strewn in the four winds many moons ago. But, our policy makers were busy frying other fish.

Authorities have been blaming "global conditions" for the rupee volatility. This is an euphemism for Federal Reserve Bank's loud thinking about ending its accommodative monetary policy, or now known as "tapering" in the international bond markets. In essence, it implies the Fed is thinking aloud about when to start reducing (or tapering off) its $85-billion-a-month bond buying programme. 

Arguably, if this does materialise (as some are convinced that it might in September or October), then interest rates in the USA are bound to rise from their current near-zero levels. Plus, that would also imply an improvement in the US economic prospects, because the Fed has categorically stated that it would "taper" only if unemployment rates fall and inflation bumps up.

Now, given all the problems with the Indian economy -- widening current account deficit, slowing economic growth, stubbornly high consumer inflation, stagnant industrial production, a spike in short term foreign debt, growing reliance on populist measures, corruption scandals and impending elections -- the US bond market definitely looked more interesting. Therefore, as soon as news started filtering in about "tapering", investors dumped Indian stocks and bonds and rushed to get back into dollar assets, such US treasury bonds.

This rush to sell Indian assets, take the rupees and exchange them for dollars, created a spike in demand for dollars, leading to the rupee's fall. As the rupee started to fall, more investors started getting out because staying on would mean a further erosion of yields. This self-perpetuating crisis was fed a bit of fuel by emergency measures implemented by Reserve Bank of India.

One leg of the strategy should have been to encourage flow of foreign direct investment which is typically sustainable and long term in nature. But they made a complete mess of it.

But the point here is that the Fed has been talking about "tapering" for quite some time. Sample Fed chairman Ben Bernanke's testimony to the joint economic committee of the US Congress on May 22: "At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes." (read it here)

On the same day, the Fed released the minutes of the meeting of the Federal Open Markets Committee (the round table of Fed knights that sets the interest rate) held on April 30 and May 1. This is the paragraph that showed up on investors' radars with a loud bleep: "Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September...A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome. One participant preferred to begin decreasing the rate of purchases immediately..." (read the full text of the minutes here)

Fed chairman Bernanke testimony to the US House of Representatives on July 17 had similar strains (read it here). Please note: he never once mentioned that the Fed had decided to withdraw the accommodative measures, leave alone finalising a date to begin the tapering off. He only reiterated that the economy was doing well, there was still some distance left to cover, that the expansionary strategy would continue even after Fed began  "tapering off" and so on.

In addition, many Fed governors had been debating the same point -- about the appropriate timing of the Fed's "exit strategy" -- in their various speeches for months. 

It is, therefore, surprising that while the whole wide world, its grandmother and all the portfolio investors could feel their antennae tingling, the Indian government and its various policy-making arms were oblivious to these developments. There was no counter-strategy, no emergency measures. Nothing.

Forget the past six months. Ever since Fed launched its expansionary monetary policy and flooded the global markets with excess liquidity, it was well known that this money would flow back as soon as there were hints of increases in US bond yields. And, yet they dithered. 

A columnist in Washington Post also said:  "The Fed has telegraphed the tapering and eventual end of its QE policies with with increasing specificity for months now, so you would expect, in a perfectly rational world, for currency and bond markets to have long ago priced in plans of Bernanke & Co. The wild thing about the most recent bout of market volatility in the last few weeks is there's been no earth-shattering news about the prospects for the Fed tapering and then ending its bond purchases. Both US economic data and comments out of senior officials have been broadly consistent with where they were a month ago." (read the column here).

There's only option left now: pray.

When Harry Met Keynes

The financial crisis of 2007-08 has sparked a renewed interest in the Bretton Woods compact, which created a "prosperous" world for about 20-30 years. Academics across the world have been wondering whether the world needs a new agreement and new institutions to meet the demands of a new economic order. The perception is that the 44-nation Bretton Woods discussions, which gave birth to the multilateral institutions World Bank and the International Monetary Fund, were held in a generally conducive and collegial atmosphere. This is not true. A new book on the Bretton Woods discussions -- The Battle of Bretton Woods by Benn Steil --  shows how the talks were held in a generally combative atmosphere.

My review of the book was carried by Business Standard (http://goo.gl/s758Q). Here it is:

In a rare photo op, the heads of the World Bank and the United Nations flew to violence-scarred East Africa recently. There was nothing spectacular about this visit - it showcased two ageing international bureaucrats posing together and providing sound bites about how their respective institutions were willing to work together to bring peace to this war-ravaged region, also known as the Great Lakes region. It could well be a convergence of coincidences: both dignitaries happened to be there at the right time, and both were born in Korea.

But there was another bit of detail that made this visit interesting and historic: this was probably the first time these two multilateral institutions were actually seen working together and promising to enhance this co-operation in future. Though they had made similar noises in the past, they unfailingly broke their promises. Both institutions, with unwieldy and terribly insular bureaucracies, have been distrustful of each other.

The genesis of this strife and suspicion towards each other can be found in the circumstances surrounding the birth of the World Bank along with its sister institution, the International Monetary Fund (IMF). Both these multilateral agencies were the outcome of a post-Depression meeting comprising 44 nations in a small New Hampshire town called Bretton Woods. The meeting, which was held in Mount Washington Hotel, was aimed at creating a lasting post-war global economic compact - an agreement that would lay down the long-term blueprint for global economic prosperity.

In reality, the conclave turned out to be a contest between two powers: the United Kingdom, a waning imperial power keen to reverse its ebbing national self-esteem; and the United States of America, the global superpower eager to leave its imprint on the global economy.

At first sight, the dice seemed loaded in favour of the UK team, which included the first celebrity economist of modern times, John Maynard Keynes. His formidable reputation, his distaste for intellectual lightweights, his irascible temper, and his sharp tongue gave the British side a psychological advantage. Keynes had been planning to create an international currency union, which would launch its own international currency - "bancor", an alternative to the all-powerful dollar - and lend to indebted countries such as Britain.

But the American side had a surprise: Harry Dexter White, a dogged and industrious bureaucrat who enjoyed the confidence of Henry Morgenthau Jr, then Treasury secretary. White, a Harvard-trained economist, had been hatching a plan to create an international stabilisation fund. This fund would not only lend dollars to debtor countries, but also stabilise currency movements across the world by convincing countries to peg their currencies to the dollar and, in turn, peg the dollar to a fixed gold price.

When Keynes' and White's plans collided at Bretton Woods, the result was the birth of the IMF. History shows that the discussions took place in a collegial atmosphere, but author Benn Steil's latest version injects an undercurrent of understated hostility, marked by a sparring match between two monumental intellects, and egos.

Differences even crept up as to where to locate the IMF - Keynes felt New York (in close proximity to the UN's Economic and Social Council) was ideal, but his suggestion was railroaded by the US' preference for Washington, DC. The dividing lines were also quite pronounced about the IMF's future role.

A book that describes in detail such a conference, its leading characters, and changing moods and directions is usually as dull as dishwater. There are quotes from agendas, memos, official correspondence, file notings, research papers and personal letters. What saves the day, or adds colour, is the insight into the character of White, whose personal papers were made public only recently. He was believed to be a Russian spy and was accused of passing on the details of the Treasury department's plans and former US president Franklin Roosevelt's thoughts to his contacts in the Russian embassy. Mr Steil has refrained, sensibly, from dwelling too much on Keynes' homosexuality and its presumed impact on policy making, as some right-wing historians have tried vainly in the past.

The book's over-reliance on minutiae can be crushing, but given the renewed interest in economic history - especially the Great Depression and the creation of the Bretton Woods institutions - Benn Steil cannot be faulted for his timing.

THE BATTLE OF BRETTON WOODS
John Maynard Keynes, Harry Dexter White, and the Making of a New World Order
Benn Steil
Princeton University Press
449 pages; $29.95

Heady Days For Finance

The Economic Times today carried an Op-ed piece written by me. Here it is.

Heady Days For Finance

Exciting proposals to overhaul the financial services sector are on the table — implement them

The financial services sector could be in for exciting times, if proposals now on the table are anything to go by. Many changes are being proposed and if these get implemented, the sector is in for massive churn. Spoiler alert: some legal hurdles could still play spoilsport.

First out of the gates is likely the issue of new bank licences. A range of new players is likely to get a shot at opening new banks. Banking is still considered a coveted business segment in India despite many risks and overwhelming regulation. This is because of two reasons. One, a growing economy will need credit to expand and build new infrastructure. In India only banks can offer savings bank deposits, which work out cheaper than other sources of finance. 

The real fun and games can be expected to kick off when the changes suggested by the Finance Sector Legislative Reforms Commission, a body set up by the finance ministry to look into the raft of laws and structures in financial services and suggest ways to recast them, are implemented. Going by the approach paper released by the commission recently, some of the changes have the potential to be a game-changer.

Under the proposed structure, the financial sector will have seven main pillars. Two proposals stand out. One is to convert the Reserve Bank of India into a pure-play monetary authority (with debt management of government bonds housed in a separate, independent office), one that will enforce consumer protection and micro-prudential laws in banking and payment systems. The second is to create a unified financial regulatory agency by collapsing different financial sector regulators into it: Sebi, Irda, PFRDA and the Forward Markets Commission.

The proposed structure is likely to create a completely new architecture for financial services regulation. The new design will be achieved primarily through re-visiting the sector’s existing legal framework, which is at odds with the changed financial landscape. As the approach paper mentions, the sector is governed by 60 Acts and multiple rules and regulations. According to the paper: “The superstructure of the financial sector governance regime has been modified in a piecemeal fashion from time to time, without substantial changes to the underlying foundations... The piecemeal amendments have generated unintended outcomes including regulatory gaps, overlaps, inconsistencies and regulatory arbitrage.” 

In all the changes being contemplated, there are two legislation-related challenges. 

• The commission is duty-bound to re-examine legislation governing central banking. The RBI Act was enacted in 1934 and is still a ‘temporary’ piece of legislation. But the real issue seems to be designing the right framework that enhances RBI’s independence as a monetary authority, insulated from the executive’s short-term outlook and pressures.

The commission does promise to “…draft a monetary policy law emphasising the issues of independence, enumerated objectives, enumerated powers, and accountability mechanisms.” The RBI Act has to be overhauled since it seems to have been designed to give control to the government, like the power to appoint the governor and his deputies, power to vary their tenure, power to issue directions (after ‘consultation’ with the governor), and so on. The challenge, of course, is marrying independence with accountability. The approach paper says that one of the strategies used globally is inflation targeting. However, RBI has rejected this time and again primarily because most of the factors influencing inflation in India are outside the central bank’s controls.

RBI’s website says: “The formulation, framework and institutional architecture of monetary policy in India have evolved around these objectives – maintaining price stability, ensuring adequate flow of credit to sustain the growth momentum, and securing financial stability.” Enumerating these can be tricky; as goalposts, they need to be moved around every time the landscape alters. 

• The commission has to remember that states also have varying degrees of interest in financial services. These could have a disruptive influence on the normal functioning of financial services. The Andhra government’s intervention in microfinance is a recent example.

The confusion arises because of the legal framework. The Constitution empowers states to legislate on moneylending and moneylenders. As a consequence, there are 22 Acts on money-lending enacted by different states (some states like Andhra and Orissa, have two Acts). However, provisions of these acts, which deal mainly with registering, licensing and regulating moneylenders, are mostly ignored, especially when the moneylenders are politically connected. The conflict heightens when the formal banking system encroaches. A technical working group was set up by RBI in 2006 to study the legislative framework for moneylenders. This group mentioned the need to modify existing legislation, but shied away from suggesting an overhaul of the framework. The commission now has the chance to do so, even if that requires Constitutional amendments. 

Boost Savings, Now

The alarm bells should start ringing any time now. An important component of the economy has been sinking and needs to be rescued urgently. This critical piece is “savings” and within this overall head, household savings is the one critical sub-component that needs close watching and nurturing.

While it is true that one of the primary reasons behind the current economic slowdown is the tardy rate of capital expansion – or, investment in infrastructure as well as plant and machinery -- all attempts to stimulate investment activity are likely to come to a nought if savings do not grow.  Without any growth in the savings rate, it is futile to think of any spurt in investment and, consequently, in the overall economic growth. If we source all the investment funding from overseas, it might be plausible to contemplate investment growth without any corresponding rise in savings rate. But, that is unlikely to happen.

Within the overall savings universe, the sub-component “household savings” is most critical. It provides the bulk of the savings in the economy with private corporate savings and government saving contributing the balance. The worrying factor is the near-stagnation in household savings over the past 8 years or so. What’s even more disconcerting is the fact that household savings remained almost standstill during the go-go years of 2004-08.

This seems to be counter-factual.  There are many studies that show that there is a direct relationship between overall economic growth and household savings. Therefore, at a time when India’s GDP was growing by over 9% every year, the household savings rate stayed almost constant at close to 23% of GDP. There was, of course, an increase in absolute terms, but it remained somewhat fixed as a proportion of the GDP.  

*As percentage of GDP at current market prices

What is responsible for this contradictory movement? The sub-group on household savings, formed by the working group on savings for the twelfth plan set up by the Planning Commission and chaired by RBI deputy governor Subir Gokarn, has this to say: “...a recent study...had attributed the decline in the household saving ratio in the United Kingdom during 1995 to 2007 to a host of factors such as declining real interest rates, looser credit conditions, increase in asset prices and greater macroeconomic stability...While recognizing that one of the key differences in the evolving household saving scenario between the United Kingdom and India is the impact of demographics (dependency ratio), anecdotal evidence on increasing consumerism and the entrenchment of (urban) lifestyles in India, apart from the easier availability of credit and improvement in overall macroeconomic conditions is perhaps indicative of some ‘drag’ on household saving over the past few years as well as going forward.”

India has another additional facet: a penchant for physical assets (such as bullion or land). Post the monsoon failure of 2009, and the attendant rise in price levels which has now become somewhat deeply entrenched, Indians have been stocking up on gold. Consequently, savings in financial instruments dropped while those in physical assets shot up. This is also disquieting for policy planners because savings in physical assets stay locked in and are unavailable to the economy for investment activity.

There is a counter view which says that higher economic growth does not necessarily lead to higher savings. According to a paper published by Ramesh Jangili (Reserve Bank of India Occasional Papers, Summer 2011), while economic growth doesn’t inevitably lead to higher savings, the reciprocal causality does hold true. “It is empirically evident that the direction of causality is from saving and investment to economic growth collectively as well as individually and there is no causality from economic growth to saving and (or) investment.”

Whichever camp you belong to, it is beyond any doubt that savings growth is a necessary pre-condition for promoting economic growth. The Planning Commission estimates that an investment of $1 trillion or over Rs 50 lakh crore will be required for the infrastructure sector alone. And, a large part of this critical investment will have to be made from domestic savings.

With savings -- particularly household savings – currently languishing, preliminary forms of the crisis is already showing up across different places. For instance, the lack of incremental addition to the savings reservoir is resulting in a liquidity crisis of sorts, thereby constraining the central bank’s actions. With deposit growth trailing credit growth, Reserve Bank has been forced to focus its efforts on ensuring adequate liquidity in the system. Hence, the repeated cuts in reserve requirements over the past few months.

The government has one Budget before it sets out for the 2014 general elections.  Reserve Bank has two shots before that -- its mid-quarter review on December 18 and the third quarter sometime in end-January, early February. Some solutions will be required to make households save more.

Traditionally, tax breaks were used to lure in savers. With the precarious state of the fiscal, policy experts will have to find innovative ways to provide tax breaks without jeopardising the fine balance. Second, inflation has to brought under control to wean households away from physical assets. Finally, ways must be found to ensure that some legacy savings sources – such as pension, insurance -- become more attuned to investor needs. Today, the real return from these sources is negative or just marginally positive.

Published as an Op-Ed in The Economic Times (December 13, 2012)

Football Politics

It was 1980 and a sultry Calcutta, August 16, afternoon. Tensions were running high in the city: the cops had marshalled their forces and the lumpen armies had sharpened their arsenals. Two bitter rivals were facing off  -- East Bengal versus Mohun Bagan, bringing the summer of the Calcutta football season to a crescendo. Like thousands of fans, I too trudged a dusty path to the verdant Eden Gardens, hoping to catch a classic derby from the concrete bleachers.

Hope brings prayers to the lips; but loyalty, a sense of belonging to a cause or a club can dredge up the ancient tribal instincts. And violence is what emerges from the churn. At the end of the game, 16 dead bodies were laid down next to each other, club affiliations be damned. Hundred others were bludgeoned and bloodied, but fortunate to have escaped the mindless soccer savagery.

But, what really topped the absurdity scales that day was the match result: Mohun Bagan-0 -- East Bengal-0. It was one of the worst displays of football I've ever seen. Poor skills, pathetic gamesmanship, appalling strategy. And, yet it provided so much conviction to fans that they ended up killing 16 and injuring hundreds of others.

That day was eventful for other reasons. I, for one, stopped watching Indian football from that day. I have never ever watched a Mohun Bagan-East Bengal match after that dreadful day; not on telly, leave alone the thought of going to the stadium. Skipped the parts about them in the local newspapers too. Sometimes, and these are rare occasions, I feel I have been a bit too harsh on my adolescent and youthful pre-occupations. Not worth it, my left side would shout out any such rising doubts.

But, as with family traits, the lessons of 1980 seem to have got scattered and weakened with the passage of time. A fresh resurgence of violence broke out again during a Mohun Bagan vs East Bengal game yesterday (read here and here). It's the same story. Reprise 1980 with one thankful omission: nobody died.

I have often wondered what could fan such passions? How can people still brave the elements and watch such dreary stuff? Improving satellite connections have weaned me off. Whenever I've tried to watch a similar derby on the box, I've immediately switched channels. The local stuff seems to be playing out in excruciating slow-mo, compared with the outstanding quality of European and Latin American soccer now available at the press of a button!

Which brings the mind back to mindless violence. I have often thought about that fateful August day of 1980 and inevitably concluded that the violence was the outcome of a new voice, a new sense of  empowerment sanctioned to a new section of lumpens co-opted by the then new ruling party. Cut to 2012 and the violence seems to be the handiwork of a new set of lumpens, patronised by a new political party. According to unconfirmed reports, the police have recovered a large and shocking cache of arms from fans (read here).

Who says it's just a game!

Investment Must Lead The Way For Economic Revival

The Reserve Bank of India was once again at the center of a expectations led rally -- that it would cut repo rates on October 30, while announcing its second quarter review of the 2012-13 monetary policy. Instead, RBI cut the cash reserve ratio (CRR). Here is my op-ed piece in The Economic Times, carried the next day:

The rate cut lobby should be worried for two reasons. The first one is obvious: despite their high-decibel clamour, RBI governor D Subbarao has not relented an inch. He is steadfast about holding interest rates till the rate of inflation blinks first.

In short, his message remains unchanged: interest rates won't budge till inflation does. But the second reason is far more worrisome. It depicts a state of economic stagnation that even deep rate cuts cannot remedy. The pointers lie in the second quarter review of the 2012-13 monetary policy.

Subbarao once again cut the cash reserve ratio (CRR, a mandatory provision that requires banks to maintain a fixed portion of their deposits with RBI) by 25 basis points, down to 4.25%, releasing an additional Rs 17,500 crore of funds into the system, which the central bank fondly hopes will result in credit growth to productive sectors.

This is the fourth time in the last one year that RBI has cut CRR; in fact, in the last 12 months, CRR has been pared down by 175 basis points. That is not all. Further, the central bank has cut statutory liquidity ratio, another mandated reserve that requires banks to invest a portion of their deposits in government securities, cut the benchmark repo rate by 50 bps in April and made liquidity available through export refinance schemes. Outside the policy framework, the central bank has been conducting open-market operations regularly and daily liquidity adjustment exercises.

It is, therefore, a bit surprising that despite the RBI's repeated emphasis on pumping additional rupees into the economy, attention seems to be still focused on petitioning for a cut in the repo rate, rather than worrying about drying up liquidity. And, significantly, this recurring deficit in liquidity is symptomatic of another economic crisis: slowing down of economic growth.

Apologists will argue that cutting rates is probably the only elixir for reviving growth. If that is indeed true, then the economies of US, Europe and Japan should have been growing at supersonic speeds, given their near-zero nominal interest rates. Look at the malady — the liquidity shortage — first.

The policy document of Tuesday states, "The wedge between deposit growth and credit growth, in conjunction with the build up of the Centre's cash balances from mid-September and the drainage of liquidity on account of festival-related step up in currency demand, have kept the systemlevel liquidity deficit high, with adverse implications for the flow of credit to productive sectors and for the overall growth of the economy going forward."

Data released by RBI on October 26 shows that aggregate deposits with the banking system has grown (on a year-on-year basis) by only 13.9%, compared to 17.5% growth in the previous comparable period. However, credit has grown by 15.9% (against 19.5% in the previous period).

While the wedge between deposit and credit growth seems to have narrowed during Q2 2012-13, compared to the wide gap that existed during Q1, the difference is still cause for worry. For one, the slowing down deposits growth is a direct manifestation of the slowing down savings rate in the economy. The continuing high inflation rates have dampened real interest rates, making financial instruments (such as fixed deposits) relatively unattractive compared to physical assets (such as gold).

Alower savings rate is bound to translate into a lower investment rate. It is by now common knowledge that one of the ways to kick-start growth in the economy is to rejuvenate the investment climate. In fact, some of the government's recent policy pronouncements have focused on improving the pace of investments in the economy. And, without the investment rate looking up, the savings rate is unlikely to improve, thereby worsening the feedback loop.

Therefore, the RBI policy document makes it clear that the recent spurt of feel-good announcements is not enough to warrant a cut in interest rates. The statement does not mince words, "...recent policy announcements...that have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions."

In the meantime, the CRR cut is not only expected to boost liquidity but is also likely to have some salutary effect on lending rates as well. While the RBI is loath to directly signal lower interest rates in the system right away, lest they rekindle inflationary expectations once again, the CRR cut is an apt signalling tool: it might still induce some banks to lower their lending rates, depending on each individual bank's balance sheet. This way, Governor Subbarao can still tick both the inflation and growth boxes on his to-do list.

Hormones And The Trading Floor

Here is the review of an interesting book that I wrote for Business Standard. The book is titled "The Hour Between Dog and Wolf: Risk-Taking, Gut Feelings and the Biology of Boom and Bust" and it's been written by a Wall Street banker turned neuroscientist, John Coates.

Folklore is full of stories about shape shifters, men turning themselves into wolves or other fierce beasts at the stroke of midnight on a full moon night. What probably gave birth to the myth was the chilling sight of vicious, bloodthirsty marauders on the rampage in ancient times. These intruders often wore wolf skins (or bear skins in some cases) for protection against the cold — and, maybe, to generate a sense of dread. Whatever it was, the ploy seems to have succeeded and a horror story was born, giving rise to a cottage industry of books and movies about imaginary werewolves.

A link was created between the shifts in lunar patterns and changes in physiognomy. While the apocryphal might seem absurd to the untrained eye, there is a whole lot going on just below the surface. The symbolism of man turning into beast has held the interest of assorted scholars for centuries. At the same time, philosophers and scientists began to peer inside the mind, trying to figure out whether the brain had any role in all this.

And now Wall-Street-trader-turned-neuroscientist John Coates comes racing down these old, familiar neural paths with a new gig in town. He shows how human beings think with their bodies in addition to their brains. Using the familiar setting of a bank’s dealing room, Mr Coates explores the impact risky situations can have on the mind as well as on the physiology. He shows how, when confronted with the threat of risk, biology takes over and transforms us into different people. Hence the analogy between dog and wolf.

Mr Coates shows how there is feedback loop mechanism between the body and the brain, and the two act on each other to prepare the entire being for responding to different situations — elation, depression, fear, grief, rage and so on. Using the events that led to the financial crisis in 2008, Mr Coates tracks the different desks and their dealers on the trading floor. The sequence of events and the reaction of the traders – we do not know for sure whether they’re real or fictional – set the stage for him to build his hypothesis.

Ask anybody on the Street about the reasons behind the 2008 financial crisis, and nine out of ten will probably tell you that untrammelled greed caused it all. Mr Coates, however, has a different take. He argues that the frequency of financial meltdowns has increased over the past few decades. One of the reasons is the fundamental change in the nature of the markets — deregulation, opening up of new markets across the globe (especially Asia), lower interest rates, relaxed margin requirements and easy liquidity. But there is another pressing reason: traditional partnerships on Wall Street and London have been replaced by corporate structures that have (supposedly) shifted the priorities from long-term stability to short-term profits.

But, importantly, the market volatility ensuing from these changes has been heightened on both sides of the curve, primarily due to the traders’ biological reactions to enhanced opportunities and threats that occur far too frequently now than in the past. Mr Coates believes that the risk curve might have been amplified because of hormonal build-up in the body of the traders, thereby shifting their risk preferences to extreme levels.

This is what he says: “...under the influence of pathologically elevated hormones, the trading community at the peak of a bubble or in the pit of a crash may effectively become a clinical population. In this state it may become price and interest-rate insensitive, and contribute greatly to the violence and intractability of runaway markets...”

Therefore, the familiar exercise of risk modelling now needs to add another important variable to the stew pot — the clinical state of the trading community under extreme scenarios. This leaves room for a sequel: how to assign values to different emotional states.

It’s an interesting book written from an interesting perspective. Given the huge success of books attempting to decipher what’s going on inside the skull – the popularity of Vilayanur Subramanian Ramachandran’s books (Phantoms in the Brain, for example) is ample testimony to this phenomenon – Mr Coates has a novel approach. He has married his two familiar stomping grounds, the brain and the trading floor. But then, the thesis accords a secondary role to another critical ingredient in the mix: the role of perverse incentives. Seen in that context, it might be a bit too glib to explain away all that has happened to only hormones and changes in the body’s chemical balance. There is one way to test this hypothesis: try explaining it to those in the manufacturing sector who have lost their jobs because of the excesses in financial services.

Two Moral Dilemmas

My piece on the two glaring moral dilemmas in the Indian economy was carried on its Op-Ed page by The Economic Times. The first dilemma is about projects with long gestation period being denied long term funds, even though they exist in the economy and are actually being used to fund the government's fiscal deficit. The second one is about long terms sources of savings are being not deployed in long term investments, in the name of safety, and thus yielding negligible returns.

Read the piece here: http://bit.ly/Sje6oL

India At The Bottom Of Fitch Heap

India is now the worst country, in terms of credit ratings, among all the countries that make up "Emerging Asia", according to rating agency Fitch.

In simple terms, this means that if you are a global lender, wanting to lend some money to countries, then Fitch feels Mongolia or even Sri Lanka stand a better chance of repaying your principal and interest than India! And the developed Asian countries -- Australia, Japan, Singapore, Hong Kong and New Zeakland -- are, of course, in a completely different league altogether.

Here is where India stands:

Source: Fitch Ratings (Asia-Pacific Sovereign Credit Overview, dated September 6, 2012)






India, as you will notice, is at the bottom of the heap with a "BBB-" rating. The only other country with a similar rating is Indonesia, but it's outlook is "Stable" and hence better than India's "Negative". So, overall, that puts India behind Indonesia and at the bottom of the league tables.

There's now a suggestion among some of the global economistas and commentators that Indonesia should replace India as the "I" in BRICS.

 

Okay, granted that credit rating agencies are not exactly paragons of virtue or prescient in predicting value destruction. Examples abound: the sub-prime loan crisis is the best example. So, are the ratings given to Greece, Spain or  Italy just before they went bust! While you may or may not agree with this rating, it is a subject for another debate. But, that still doesn't take away from the central point that we're up shit creek without a paddle? Fitch just added another hole to this wobbly boat!

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.