Talking to strangers | Decoding strangers and how we can get it horribly wrong: Financial Express 6th October 2019

In 1938, Neville Chamberlain, then prime minister of England, went to Germany to meet Adolf Hitler to mediate on his political designs of starting a war. After meeting him, the PM was convinced that the double handshake meant all was well and there was jubilation back home. Lord Halifax, the foreign secretary, had a similar experience, and while the ambassador Nevile Henderson thought Hitler was insane, they firmly believed that war was not on his agenda. But history says otherwise. The message is that when we meet strangers, we can never gauge them right, as it is a challenge to understand people. Misreading them can have disastrous consequences.

Malcom Gladwell, in another remarkable book Talking to Strangers, takes us through what can be called an intellectual adventure into the darker side of human nature. He starts the book in a very interesting manner where he talks of a Sandra Bland, who is told to pull over by a white policeman for missing a light. There is a conversation which starts off gently and moves to another level where the cop arrests her for what seems to be an innocuous action. The woman commits suicide in jail three days later.

Gladwell bases his theory of not being able to gauge strangers on three simple thoughts — humans tend to ‘default to truth’, are never transparent and have to be judged against the context in which we live.

We can never make out when people are lying and always tend to default to the truth. Judges are in no better a situation as they take decisions based on what the lawyers argue in court. By looking at the face of the accused, the judge thinks that she has got the plot right. A parallel decision by an artificial intelligence-based programming in the US shows that machines make better decisions than humans, which is quite revealing as it means that often human judgments are incorrect.

It doesn’t stop at prime ministers and judges going wrong. Gladwell narrates the story of an intelligence agent, Ana Montes, who served in the US. It was known only after several years that she was a counterintelligence agent for Fidel Castro. Therefore, it is hard to detect how people behave as we always believe that the stranger is speaking the truth, which is not always the case.

Not doing so can be disastrous as we can take brash decisions. For example, Gladwell argues that Bernie Madoff, who ran the largest Ponzi scheme ever, was revered by all and the only person who suspected all along was Harry Markopolos, who, as a rule, suspected everyone — what is called a ‘holy fool’. But having holy fools in the market, though essential, can mean the end of Wall Street if everyone works on suspicion. There is a need to have a tradeoff between truth-default and the risk of deception.

Gladwell narrates a number of such stories to prove his point and the one on Khalid Sheikh Mohammad is quite interesting. KSM, as he was known, was instrumental in the 9/11 blasts and was arrested. Various torture measures were used to get the truth out of him, including sleep deprivation, walling and waterboarding, and quite expectedly none of them worked. Finally, they got him to confess in court and he did so admitting there was no duress. But the proceedings were criticised as insupportable due to confessions gained under torture. A 2008 decision by the United States Supreme Court also questioned the legality of the methods used to gain such admissions. On August 30, 2019, a military judge set a trial date of January 11, 2021, for Mohammed’s death penalty trial. Hence, the truth about a stranger is not hard and obvious, and we have to accept that there are limits.

Gladwell reveals an interesting statistic that in most countries, more than 50% of crimes occur in 3-5% of the land area, which does not really shift when police patrolling is increased, as there are factors at work controlling migration. He extends this fact to the measures put in place to curb crime by having police officers stop and check cars for guns, which actually helped curb incidences of violence. This then leads to the story from where the book started — the case of Sandra Bland. The cop meets a stranger and given the number plate and the nervousness exhibited, assumed something was amiss with her. The woman thought she was being targeted because of race. The altercation leads to raised voices and probably some physical use of force, which leads to the arrest and then suicide. The three rules of default to truth, transparency and context all created differing scenarios leading to the tragedy, as it shows that one can never decipher strangers.

Gladwell has the knack to knock at the darker sides of events and human behaviour and go behind why we behave the way we do. Experiments in psychological behaviour are often used to test his hypothesis, but hips powers of observation and interpretation continue to enchant the reader, which makes this book a must read once again.

Realistic teist: Getting a grip on the new liquidity framework: Financial Express October 1 2019

Realistic teist: Getting a grip on the new liquidity framework

By: Madan Sabnavis | 

Updated: October 1, 2019 7:10:42 AM

The framework now has given a realistic twist to managing liquidity. If RBI feels at any time that liquidity is getting tighter, it can go in for longer tenure repos of maybe even up to one year, which is more durable than the regular 14-day term repos but less permanent than an OMO. The draft proposed liquidity management framework (LMF) of the Reserve Bank of India (RBI) is timely, and even though the basic approach has not really changed, it is significant for the market. It also does bring into focus the process of transmission of policy rates quite well and, in a way, defines better the missing link.

In fact, the LMF is quite independent from the monetary policy, which decides on what the policy rate should be. However, the LMF is critical in making the repo rate change effective without regulatory or government intervention, which is refreshing.

The focus, so far, has been to nudge or force banks to bring about transmission. This has been done by both RBI and the government by speaking to them on the necessity of lowering their lending rates, with the latest tool being fixing the lending rate on certain loans to a market benchmark that also includes the repo rate. Theoretically, the repo rate affects 1% of NDTL (net demand and time liabilities) and hence does not really add or subtract much in terms of cost for banks and, therefore, does not really get reflected significantly in either the base rate or MCLR (Marginal Cost of Funds-based Lending Rate) formula. But the liquidity framework works better through the market to ensure that the transmission takes place and the call market is the starting point. Let us see how this works out.

The call money market is an interbank market where banks lend and borrow funds on an overnight basis depending on their liquidity conditions and requirements. This rate is based purely on demand and supply conditions, and is not driven directly by RBI. Ideally, the call rate will move in a regulatory constructed corridor and be just above the repo rate as banks go to this market when the repo window is closed to them because the 1% liquidity support is exhausted. Therefore, the change in repo will affect the call rate almost immediately. The reverse repo rate acts as the other end of the corridor when there is surplus liquidity. Hence, the reverse repo and repo rates become the limits for the call money market.

RBI can influence the liquidity in the market directly to guide the call rate. Ideally, RBI would be happy to let the market decide the rates, and not deal with banks on a daily basis. However, if it is left to the market, the possibility of the call rate soaring to higher levels (it was above 20% in the 1990s) or crashing close to nil cannot be ruled out. This is more so when the market knows there is no benchmark against which the prevalent rate can be assessed. Therefore, there is a need for supports in the market like the repo rate so that there is reduction in volatility in the market.

There is now the issue of how much money can be transacted in the liquidity adjustment facility (LAF) market. The 1% norm today comprises 25 basis points in overnight repo and the balance in the term repo market. The Committee feels there should no such limit that will give more flexibility to RBI to keep liquidity stable. It is suggested that, ideally, the system should be in a deficit of 25-50bps, which will be non-distortionary. As a corollary, the market can take over beyond this level. However, assuming that such thresholds are breached on either side, RBI can bring in durable liquidity through OMOs (open market operations), which is what is done to ensure that volatility is eliminated. By not having a limit on how much can be transacted through LAF, there is more flexibility given to RBI in maintaining rates in the market.

The proposed framework now has given a realistic twist to managing liquidity. If RBI feels at any time that liquidity is getting tighter, it can go in for longer tenure repos of maybe even up to 1 year, which is more durable than the regular 14 days term repos but less permanent than an OMO. The advantage here is that by using longer-term repos to manage liquidity, the yields on securities do not get affected. Today, when there are OMOs being conducted, there are shifts in the demand and supply of securities of various tenures, which affect their prices and hence yields. This can be eschewed by using only the repos as liquidity management tools where the overnight repo without a limit is used to manage temporary mismatches while the term repos of longer duration come into the frame when it comes to durable liquidity.

OMOs would then be interpreted as a way to induce permanent liquidity as the securities are not pledged to get money but bought by RBI. The same story gets replicated for the reverse repo when there is surplus liquidity. Forex deals/swaps are supplements to OMOs in this scenario.

Intuitively, the operations in the call market have a better linkage with other interest rates and hence would tend to guide the transmission process of interest rates. Once the liquidity framework is in place and known to all, banks will be able to adjust their interest rates to the call rate as all other tenures get repriced. Hence, while the liquidity operations are distinct from monetary policy with the purpose being very different, closer alignment becomes almost immediate as the targeted rate, which is the call money rate, is linked to the repo rate through the LAF framework and the overall state of liquidity which then drives the interest rate determination process.

Besides being a market-oriented solution for rate transmission, the market requires to know this framework so as not to be caught unawares. The step-up process from overnight repos to term repos to OMOs is predictable, which will make it easier to manage funds for all the players. There will hence be better pricing of products in the market as the call rates feed into other prices of instruments that will reduce the element of noise, which will be beneficial. This approach is, therefore, definitely pragmatic.

Loan melas: A blast from the past September 24th Business Line

The Centre’s direction on shamiana-like forums to disburse loans is reminscent of the past. But can banks handle the burden?

Being a public sector banker always has its challenges, as they are subject to rules of their owner, the government, unlike private banks which have substantial autonomy.

Anyone who lived in the 1970s-80s will recollect the ‘loan melas’ that were held post nationalisation of banks, where the objective was to ensure that everyone who wanted a loan would get it. It had created some controversy then, and it seems to be retro time today. The decision to hold such shamianas in 400 districts immediately to disburse loans to people in the ‘RAM’ category — retail, agriculture and MSMEs — has an uncanny resemblance with the old story. The immediacy is that this is the festival season, when demand for loans increases and should be addressed by banks and NBFCs. Banks should hence be pushing for such loans.

Added pressure

The difference however is that while five decades ago, this was more of a political ploy to win votes; but this time, it is an honest effort to resuscitate the SME sector, which has been through stressful times following demonetisation and GST implementation. This measure is also supposed to provide a boost to retail lending and auto and consumer durable loans are supposed to increase on this score, as these goods are typically bought in the coming months, which coincide with the festivals and harvest. Besides, this can be viewed as one of the several measures taken by the government to provide an impetus to the economy as the flow of credit appeared to be a cog in the wheel.

Coming at this time, it is a challenge, because making such arrangements and meeting targets involves a lot of executive time. The banking sector is presently dealing with NPAs, NBFC financing, bank mergers, low growth in credit due to demand conditions, etc. Now with additional pressure to have such credit monitored is a task. It has been stated that banks have to get five new customers for every one old customer, a task would require a lot of effort and hence will preoccupy all concerned branches of PSBs in these identified 400 districts. Will this become another of the sale of credit card episode, where a banking executive accosts a passenger in the airport and almost forces a card on him?

NPA numbers

Curiously, at a time when the NPA issue has come a full circle, the approach has been similar to what was done for the large assets in the infra space, called ‘restructured’ assets. From now on, bankers connot call the stressed assets of MSMEs NPAs till March 2020. This is a relief for the MSMEs, which get breathing time for the next six months or so, but banks have to work towards restructuring these loans so that post March 2020, they officially become performing assets. This was done under the corporate debt restructuring programme too, where larger assets which became impaired due to defective policies were not called NPAs. Hopefully this would be a one-time exercise, because if the same is rolled over for another year, it can become a habit. Therefore, the NPA numbers that would be revealed in March 2020 would not include these loans, and would hence be an understatement to an extent.

The third challenge for bankers is the OTS — one time settlement scheme — which was announced. For small-size loans, bankers can settle with the borrowers. While the score sheet would be the basis of going for such deals, the government has assured that there would be no future investigations, as this is an objective criteria used. The third challenge for bankers is the OTS — one time settlement scheme — which was announced. For small-size loans, bankers can settle with the borrowers. While the score sheet would be the basis of going for such deals, the government has assured that there would be no future investigations.

This is assuring, but the broader question is whether our banking culture is getting diluted. Often, farm loan waivers are announced; now, SMEs have entered the potential group of defaulters, as there is incentive not to repay loans in expectations of defaults being forgiven.

In fact, the so-called loan melas run the same risk of loans being forced on customers to meet targets which can then become an impaired asset, especially if the borrower knows that there can be an escape route in future. This is a serious issue for PSBs, because while there are serious talks of making these banks stronger and resilient with capital infusion, mergers, change in governance structures etc, the main business activity seems to get compromised often when the some section of the economy goes under. This not only affects the credit standards that are followed but also the intrinsic value of the business. One may hope that this would be a time-bound exercise with no renewal.

Loan melas: A blast from the past: Business Line 24th Sept 2019

The Centre’s direction on shamiana-like forums to disburse loans is reminscent of the past. But can banks handle the burden?

Being a public sector banker always has its challenges, as they are subject to rules of their owner, the government, unlike private banks which have substantial autonomy.

Anyone who lived in the 1970s-80s will recollect the ‘loan melas’ that were held post nationalisation of banks, where the objective was to ensure that everyone who wanted a loan would get it. It had created some controversy then, and it seems to be retro time today. The decision to hold such shamianas in 400 districts immediately to disburse loans to people in the ‘RAM’ category — retail, agriculture and MSMEs — has an uncanny resemblance with the old story. The immediacy is that this is the festival season, when demand for loans increases and should be addressed by banks and NBFCs. Banks should hence be pushing for such loans.

Added pressure

The difference however is that while five decades ago, this was more of a political ploy to win votes; but this time, it is an honest effort to resuscitate the SME sector, which has been through stressful times following demonetisation and GST implementation. This measure is also supposed to provide a boost to retail lending and auto and consumer durable loans are supposed to increase on this score, as these goods are typically bought in the coming months, which coincide with the festivals and harvest. Besides, this can be viewed as one of the several measures taken by the government to provide an impetus to the economy as the flow of credit appeared to be a cog in the wheel.

Coming at this time, it is a challenge, because making such arrangements and meeting targets involves a lot of executive time. The banking sector is presently dealing with NPAs, NBFC financing, bank mergers, low growth in credit due to demand conditions, etc. Now with additional pressure to have such credit monitored is a task. It has been stated that banks have to get five new customers for every one old customer, a task would require a lot of effort and hence will preoccupy all concerned branches of PSBs in these identified 400 districts. Will this become another of the sale of credit card episode, where a banking executive accosts a passenger in the airport and almost forces a card on him?

NPA numbers

Curiously, at a time when the NPA issue has come a full circle, the approach has been similar to what was done for the large assets in the infra space, called ‘restructured’ assets. From now on, bankers connot call the stressed assets of MSMEs NPAs till March 2020. This is a relief for the MSMEs, which get breathing time for the next six months or so, but banks have to work towards restructuring these loans so that post March 2020, they officially become performing assets. This was done under the corporate debt restructuring programme too, where larger assets which became impaired due to defective policies were not called NPAs. Hopefully this would be a one-time exercise, because if the same is rolled over for another year, it can become a habit. Therefore, the NPA numbers that would be revealed in March 2020 would not include these loans, and would hence be an understatement to an extent.

The third challenge for bankers is the OTS — one time settlement scheme — which was announced. For small-size loans, bankers can settle with the borrowers. While the score sheet would be the basis of going for such deals, the government has assured that there would be no future investigations, as this is an objective criteria used. The third challenge for bankers is the OTS — one time settlement scheme — which was announced. For small-size loans, bankers can settle with the borrowers. While the score sheet would be the basis of going for such deals, the government has assured that there would be no future investigations.

This is assuring, but the broader question is whether our banking culture is getting diluted. Often, farm loan waivers are announced; now, SMEs have entered the potential group of defaulters, as there is incentive not to repay loans in expectations of defaults being forgiven.

In fact, the so-called loan melas run the same risk of loans being forced on customers to meet targets which can then become an impaired asset, especially if the borrower knows that there can be an escape route in future. This is a serious issue for PSBs, because while there are serious talks of making these banks stronger and resilient with capital infusion, mergers, change in governance structures etc, the main business activity seems to get compromised often when the some section of the economy goes under. This not only affects the credit standards that are followed but also the intrinsic value of the business. One may hope that this would be a time-bound exercise with no renewal.

Transforming Systems | Tools for a better society of Britishers in India: Financial Express 23rd Sept 2019

There is a growing clamour all over the world that the objectives of a company can’t stop at just enhancing stakeholder value. The edifice called the new corporate social responsibility dictum is the starting point when we look at how companies operate beyond just profit indicators. They need to serve the broader interests of society and this is what Arun Maira focuses on in his book, Transforming Systems.
His experience as a former member of the Planning Commission enables him to cogently put forward the concept while his stint in a management consultancy firm makes the articulation forceful and compelling, though difficult to grasp at times.

The dominant idea, according to Maira, is not only “should the business of business be only business”, but that “countries, governments and civil society organisations should also be run on principles of business.” This becomes compelling given that while economies had been growing, systemic problems of social inequality and environmental sustainability have become less-tolerable? A new toolkit is required to attain these goals that go beyond the precepts of good business management and prevalent best practices in government as well as civil society organisations.

The exposition is in four parts. To begin with, one needs to redefine our goals in life to improve the world. This is necessary as a starting point and Maira narrates a different kind of fiction, where he gives examples of how some people decided to change their lives while working with the corporate world. He says these are real people with fictional names that add characteristic hues to their stories. Some ethical issues need to be discussed, which we can relate to — like difference between organisations designed for commitment rather than mere compliance. The challenges are in answering questions like: How does one scale up results in the social sector? Who are the leaders in the system?

The second part deals with the search for a new paradigm that logically follows how different systems are explored to achieve the objective of changing the world. Here, the consultant in Maira steps in and draws up scenarios for linking of purpose with organisation, processes and resources to build a virtuous circle. They all tend to get interlinked. This part gets technical and could get hard for the reader as it deals with complex structures and purposes.

At the third stage, which deals with reorienting our minds, Maira brings in principles of Piketty to hammer home the point that the job of a corporate is to also play a role in changing society, given the level of inequality that exists especially in countries like India. The onus is on us to redefine these new guiding principles. Here, the author takes us through various paradigms under the ‘conventional’ and ‘system’ approaches. There would now be a difference in the way in which we see and work on things. The words which we use change from ‘engineering’ to ‘gardening’, ‘constructing’ to ‘generating’, ‘controlling’ to ‘catalysing’, etc. From being away from the system, we become a part of it. Instead of ‘markets’ we think of ‘communities’. Efficiency transcends to equity and income is looked at as a ‘feeling’ rather than a ‘fact’. Finally, as individuals we change from having more to being happy, and move from ‘I’ to ‘we’, competing to supporting, speaking to listening, etc. With this change in mindset, business enterprises would become more ethical and work for a bigger goal.

The fourth part is about leadership, where Maira clubs various types under different headings. Since independence we followed a system where the central government dominated with centralised planning that fully controlled all economic forces and did not allow others to rise. Here he draws an analogy to “buffaloes wallowing in a pond”. The second is ‘peacocks strutting’, where the rich dominate and one has to wait for the trickle down effects, which seldom happen. The rich become richer and have a disproportional influence over the state of governance and policy in the country as they fund parties and take over media and companies and it is their opinion that is sought by the media and the government. He then talks of the model of leadership where the ‘tigers’ growl’ and the others cower, which is typical of dictatorial regimes where opposition disappears and people lose freedom. Here, too, those at the top thrive at the expense of others. The last is what he calls ‘fireflies arising’, where there are multitude of small leaders with a vision and enterprise, who have a passion to do things in an ethical way. This is the new ideal system according to him.

The book, in a way, is quite complex to grasp and gets technical at times as it deals with a utopian objective. The drive is to move us to becoming more humane when we strive for profit. This is a challenge given that all companies these days talk of shareholders and are judged by the same. Their activity towards making society better is more or less restricted to annual reports, as it is mandatory to do so. But seldom do they go beyond compliance.

Maira’s views can be contested because the pursuit of profit, as long as it is done in an ethical manner paying obeisance to the law of the land, cannot be criticised as governments have their role to play and cannot transfer their responsibilities  to companies. Often the inability of the government to deliver makes them pass the onus to corporates, which may not be right.

Understanding the investment slowdown: Financial Express Sept 20 2019

The pace of growth in investment would be slow as far as the private sector is concerned. There will be pressure on the government to provide a fiscal stimulus by expanding the fiscal deficit and enabling additional investment. A direct push of an additional 0.5% of GDP as capex for the next three years will help expedite the process and create backward linkages.

The investment rate in the country has been declining quite significantly over the last six years or so. The gross fixed capital formation (GFCF) rate had peaked at 34.3% in FY12 and then came down to 28.6% in FY18, before registering a marginal recovery to 29.3% in FY19. The story is still an enigma because in the last few years various states have held investment extravaganzas where several MoUs have been signed—for example, Gujarat’s 28,360 MoUs, Tamil Nadu’s worth Rs 3 lakh crore, Karnataka’s Rs 4.5 lakh crore, Uttar Pradesh’s Rs 2.28 lakh crore, Maharashtra’s Rs 12.1 lakh crore, and so on. Yet this rate has stagnated. To better understand this phenomenon, the sources of investment over this time period may be examined in some detail.

The accompanying table shows the distribution of capital formation across various institutions. The two dominant sources of investment in the country have been the household sector and private non-financial companies, which together had a share of 78.3% in FY12, which came down to 74.4% in FY18. Interestingly, the share of private non-finance companies increased by 4% during this period, while that of households declined by 7.9%. Therefore, there was some substitution between the two. The household segment also comprises the unorganised sector entities and hence includes small and medium-sized enterprises (SMEs). It would be possible to surmise that this segment had invested progressively lower amounts in this period.

Private non-financial companies, which are the conventional non-finance companies, increased their share by 4%. As these would be the larger companies in the organised sector, it is a positive sign in terms of what the corporates are doing.

The public sector had a secondary role to play, which, however, had increased in scope during this period. The first is general government, where the share went up from 10.2% to 13.7%, and will get accounted for under the capex of central and state governments. Clearly, during this period, the government has been relatively more aggressive in furthering investment. The PSUs—both financial and non-financial—have maintained their shares in total investment with a slight increase from 10.8% to 11.3%.

The table also shows the CAGR of GFCF for the period FY13-FY18, i.e. the last five years’ growth according to the source of investment. The overall growth in current terms was 6.7%. The comparable growth in nominal GDP during the same period was 11.4%. Therefore, it was but natural that the GFCF rate had come down from 33.4% in FY13 (which is the base chosen for calculating the five years’ CAGR) to 28.6% in FY18.

This growth has been brought down by the household sector where it was just 3.2% while accounting for around one-third of total capital formation. The dual reforms of demonetisation and GST would partly explain why this ratio has declined on account of a slowdown in growth in investment. Private non-finance companies, on the other hand, have grown at 8.6%, which is higher than the sample average, and yet lower than growth in GDP. This may be attributed to a combination of factors involving stalled projects, non-viability of projects post clearance due to changing economic conditions, lower capacity-utilisation rates, and, more importantly, the sharp jump in NPAs of banks as well as referral of several large cases to the Insolvency and Bankruptcy Code (IBC). NPAs peaked at 9.66% in March 2018 after the AQR was put in place. Also, interestingly, the fact that several power and steel companies had been referred to the IBC meant that other companies that were planning to invest had paused in the hope of evaluating the sale of these assets, which also put on hold their fresh capex plans.

The leading sector has been the government, with a growth of 12% during this period, where there was a conscious push made within the confines of the fiscal space available. Here, too, it is the central government that commanded this initiative, as states have had their own set of problems tackling their fiscal numbers on account of UDAY, wherein distribution companies had passed on their debt to the states’ fiscal numbers, which came in the way of their capex plans.

In this context, let us also look at the sectors that have contributed to investment in this period. This information is provided by the CSO for gross capital formation, which also includes change in stocks for the said period. Of the 10 identifiable broad sectors (besides miscellaneous category), seven had witnessed a fall in share. The significant declines were in agriculture (7.7% to 7.2%), mining (2.3% to 1.5%), manufacturing (18.3% to 17.2%), construction (7.4% to 4.2%), real estate (23.9% to 21.9%) and trade hotels repairs (10.6% to 10.1%). Virtually, all non-service sectors witnessed a decline in shares. The fall in the share of agriculture is significant as this was higher in crops; this is indicative of diminishing interest in farming due to growing vicissitudes of crop outcome and prices. This has to be addressed for the viability of the sector in the long run.

The sectors that had improved their shares are public administration (from 7.7% to 10.2%, which is the effort put in by the government relentlessly in the last four years), followed by transport, communication etc, where both communication services and transport witnessed an increase. The former was due to the emphasis put on railways where there were new doses of investment and the latter was due to the telecom revolution that involved a flurry of investment activity commensurate with the progress made on the spectrum side.

Reviving investment on the side of the private sector will be gradual as several issues have to be addressed. First, the financial system involving banks and NBFCs has to get back to normalcy. The latter have been a useful source of finance for the household segment in particular, which includes SMEs. Second, the IBC resolution process has to witness more resolutions with attractive realisations.

Third, capacity-utilisation rates have to show an improvement across the board. The RBI data (FY19) reveals an improvement that is encouraging, though does not gel with the low IIP growth witnessed in the year. Fourth, banks need to regain confidence in lending so that there is a willingness to lend, which is lacking today due to the NPA issue as well as the fear of being haunted by the investigative agencies in case loans go wrong. Fifth, in case of manufacturing, there has to be a revival in demand for companies to think of investing in capital.

Hence, the pace of growth in investment would be slow as far as the private sector is concerned. There will be pressure on the government to step in and provide a fiscal stimulus by expanding the fiscal deficit and enabling additional investment. So far, the focus has been on removing the cogs that are in the way of the private sector, which is commendable. But a direct push of an additional 0.5% of GDP as capex for the next three years will definitely help expedite the process and create backward linkages.

Why linking deposit rate to external benchmark has to be considered: Financial Express 17th Sept 2019

The price of any commodity should ideally be determined in the market. However, often, there is a preconceived notion of how prices should behave. We want stock prices to go up, commodity prices to come down, exchange rate to be steady, and interest rates to come down. These preconceived notions can, then, have a bearing on actual price if there is regulatory power. Let us see how this works.

When it comes to, say, commodity prices, there is the eternal conundrum of whether the farmer should get a higher price, or the consumer should pay a lower price. Today, while the MPC is happy that inflation is down, the income of farmers has been affected, which has affected spending. The reverse of the two can cause political upheaval. But, there is no control over prices as there are myriad players. The same holds for currency. RBI can intervene in the market, and augment supplies to stabilise the rupee, or, conversely, withdraw dollars to ensure there is no further appreciation. But, being a market-determined rate, RBI cannot force the price in any direction by notification, which was the case in the pre-1992 days.

However, when it comes to cost of capital, there has been constant lament that interest rate transmission is not happening, and while the interest rate is no longer controlled (remember the MLR), the options tried were PLR, base rate, and the multiple MCLR system, where the latter two were formula-driven. With the market not quite being amenable, the mandatory link with a benchmark is the final regulatory push that compels banks to fall in line. Curiously, when it comes to interest rates, just like, say, a farm product, there are two sides, too—a saver and a borrower. The die has been cast in favour of the borrower, who should pay less on loans if the interest rate comes down. Ideally, the choice should have been with banks whether or not to link with benchmarks, but after quite singularly bringing in a regulatory formal-based base rate and MCLR, the benchmark is the third on the book shelf of the library that will now rule the market.

The central bank, as the monetary authority, seems to be better-placed when it has regulated banks to use the market benchmark route as it makes monetary policy more effective. RBI had been expressing its angst against transmission, especially since 110 bps cut in rates did not make banks budge much. Now, there is no choice once a benchmark has been selected. But, interestingly, after the last cut by 35 bps, the 10-year Gsec, which is market-driven, has actually remained intransigent in the 6.5% range, and not come down. Hence, if banks had linked retail loans to the 10-year Gsec, even the latest dictate would not have helped as the lending rate would have remained unchanged, as the market, which is driven by other factors, has not moved in accordance with this change. Hence, there are limits to which the benchmark would work.

How about the banks? They are probably riding the horns of a dilemma. Which benchmark to use? Which loans to include besides retail and SME? As deposits are presently not linked with the benchmark concept (except for a specific bank, which has linked savings rate), how do they manage their liabilities? Linking assets to the benchmark, and not the liabilities will strain the bank’s P&L. But, if the deposit rate is also linked to a benchmark in course of time, then customers would be in a quandary as they go in for bank deposits on the assurance of a fixed known return. Now, if it is also made variable, then they would have to bear the volatility in returns, which was not part of their plan. How about the spread over the benchmark, which also has to be anchored for 3 years? If banks want to play safe, they have to choose the benchmark that reacts either the most or least to the repo rate change—Tbill or Gsec, depending on their appetite. The rules are not yet open about whether deposits too can be linked to the same benchmark in phase 2, if, at all, there will be one. This cannot be changed and holds for all customers, and, hence, has to be done with careful thought. Next, the spread over the benchmark should be clear. Here, banks will need to work out their costs, and the possible margins that they would like to maintain, just like what was assumed when working out their MCLRs. This would be the basic lending rate, specified as xxx bps over the benchmark. Wild swings in the benchmark can, however, mean volatility in earnings, especially in a regime of declining interest rates.

How about customers? Intuitively, they would be better off when rates are moving downwards as there would be substantial gains in their EMIs or interest outflows. But, in a rising interest rate scenario, which cannot be ruled out as every economy goes through these phases, there would be challenges in maintaining these outflows. In FY20 so far, the 10-year GSec has moved between 6.45-7.43%, which is almost 100 bps. The 364-day Tbill moved between 5.74%- 6.5%, which is almost 75 bps.

An interesting observation here is that when the financial crisis erupted, which was based on large scale defaults on home loans, it was precisely because the interest rate cycle had turned upwards, and pressurised borrowers, which caused them to default, and leave their homes and keys. While such an occurrence has been looked at today as being a black swan incident as it looks very unlikely that there can be thousands of home owners defaulting at the same time, it is a possibility that cannot be ruled out as interest rates on home loans, which is what is being driven by the government, is going to be variable.

The new interest rate setting model, based on benchmarks, will be a new experience. Hopefully, customers should continue to have a choice of going in for a fixed or floating rate, as it can affect them adversely when the cycle moves up, just as they benefit when it comes down. Also, the critical part of linking the deposits to the external benchmark has to be taken as this one-sided-linkage creates challenges on their interest spreads. As retail and SMEs also tend to move in large numbers, when it comes to response to lower interest rates, and the new dispensation comes in the downward movement regime, the response in upward movements would require close monitoring. From the point of view of monetary policy, this will go down as the final salvo being fired.