The Sixth Pay Commission will raise government salaries. What about cutting the flab?
The Prime Minister was critical of the pay packages of corporate honchos some time ago and a debate on the subject was ignited. Now there is news that the Sixth Pay Commission has something to say about pay structures in the government sector, with the thrust being unidirectional. Quite naturally there is umbrage, given the mindset about the functioning of the public sector.
The main objective of a Pay Commission, broadly defined, is to revise the pay structure of government employees with every decade; and the justification, among other factors, is to establish some kind of parity with the private sector. The impact of the past Pay Commissions has been manifold — they have reduced the incentive for the better candidates interested in joining the bureaucracy, made lower level government staff far better paid than their private sector counterparts, with no accountability, and put the central and state government finances in jeopardy.
The Fifth Pay Commission, which was implemented in 1997, recommended an increase in the total benefits for central government employees, which automatically translates into higher packages for state-level employees. When salaries go up across the board, the first victim is the fiscal deficit, as expenditure goes up with no corresponding increase in revenue.
In the private sector, pay hikes are related to profit and performance, but when it comes to the government — since there are no profits and the performance system is cloudy — there is no way to quantify the net gain.
To reduce this burden, the Fifth Commission had sought to reduce the total size of the bureaucracy by 30 per cent over a ten-year period and to abolish all unfilled positions, numbering about 350,000, in 1996.Downsizing, computerisation and transfers were spoken of. However, as expected, while the pay increases were instantaneous, the job cuts did not materialise. The Commission recommended contractual assignments; this was implemented only for retired personnel, while regular employees continued to retain their tenures.
The Fifth Pay Commission involved an additional outlay of Rs53,000 crore to the government and was termed by the World Bank as the ‘largest single economic shock’ for India.
In fact, in 2000, 13 states did not have the money to disburse the salaries of their employees!
The Sixth Pay Commission will cover around 4.5 million central government employees involving an expected additional outlay of Rs20,000 crore for the government.
But should there be an enforceable obligations charter for such recommendations? The central government per se does not make profits and so it remains a debit item.
But enhancing efficiency can reduce the overall cost structure that should be linked to these pay hikes.
In the private sector there is a pay-performance payoff, which needs to be put in place in government functioning, too.
The issue that arises is how obligations can be met, along with pay increases in government jobs.
Instead of getting into the micro numbers for various components of the salary, the Commission should have been more innovative in devising the obligation scales.
Ideally, the higher salary hike allocation for every department should have been linked with the number of staff to be laid off or redeployed.
In addition, the performance-linked pay should have been defined at each and every level for various departments.
Also, a definite plan for dealing with non-officials is essential, since the ratio of officers to clerks/peons/hamals could go up to 1:5.
It is agreed today that at the higher level, officials are paid less for the work they do, while at the lower level, where the flab lies, it is the other way around.
Instead of making these amendments, there are fears that the Sixth Commission will very likely do what the Fifth Commission did, later pleading helplessness at being able to implement only part of the package.
To conclude, it is worth recalling John Maynard Keynes, who at the time of the Great Depression had espoused higher government expenditure even on worthless jobs like digging up holes to fill them up to raise demand in the country by offering money to spend.
Pay Commissions’ largesse has often turned out to mimic such policies, where people are paid more for moving files or tea cups. Ironically, a larger government administration also gets reflected in the GDP of the country under the service sector and provides valuable purchasing power to people.
How does this sound as the ultimate clinching argument?
Monday, October 29, 2007
Sunday, October 21, 2007
Objective View of Capital Controls: Financial Express: 22nd October 2007
Indians as a rule are crazy about cricket, but this is overshadowed by our obsession with the stock market. Understandably so, as several interest groups—the salaried class, politicians, investment banks, mutual funds, banks, brokers, bureaucrats, the media (some TV channels survive on stock markets)—have investments in this market and would like to see the Sensex move upward without a correction.
This helps everybody, as money being invested keeps multiplying while changing hands. It is but natural that investors have taken umbrage to the move by the Securities & Exchange Board of India (Sebi) to control funds coming into the country through participatory notes (PNs). Even the finance minister had to placate markets the following day (though there was no need to do so) and clarify that the government was not against the concept of PNs, who have a very important role to play.
The decision to come down on PNs is probably controversial, but it will help the government control two nagging problems that have been quite elusive. The first relates to controlling the quality of funds coming in, while the second is exercising control over capital inflows, which have created innumerable problems for the Reserve Bank of India (RBI). By accomplishing these two objectives, the government would have also managed to control the proverbial bubble, which we all know is going to burst, though we never know when. PNs are basically investments used by foreigners not registered in India. They operate through foreign institutional investors (FIIs), who are registered with Sebi. FIIs buy Indian shares and issue PNs, which are purchased by entities whose names remain unknown. It is also suspected that Indians themselves could be making such investments to eschew identity as well as find a tax shelter. Also, a lot of laundered money could come in and RBI has always been critical about such money.
But investors don’t like such announcements, even though it seems quite logical to have some discipline in these operations. While the legitimacy of these funds has not come up this time, the government fears that these funds are looking for short-term gains (and could destabilise the markets when they withdraw) and hence provide some kind of irrational boost to share prices.
In fact, the Sensex has risen by over 35% in the last two months, ostensibly due to a large flow of FII funds, with PNs contributing significantly. If this were true, then any responsible regulator would take pre-emptive action lest it be caught napping when things go awry. This should be remembered by critics, who always feel markets should be allowed to work freely—they are never perfect to be allowed this luxury.
What exactly did Sebi do? Firstly, it issued a discussion paper seeking to ban any issue of PNs of FIIs against underlying derivatives, ie, futures and options, while restricting the issue of PNs in the cash segment. This has quite naturally hit the market hard as it has been interpreted as being regressive. The notional value of PNs is around 52% of the FIIs’ account assets. Excluding underlying derivatives, the share was 35%.
Is this a good move? Probably not for the market or FIIs, as they are directly affected by these measures. The stock market fell by over 330 points by the end of the first day, echoing this sentiment after recovering from a fall of over 1,700 points (that means a major erosion of market capitalisation!). But if one looks at this dispassionately, one will realise that there was inherently nothing amiss in the thought process. Funds of a short-term nature tend to be destabilising and given that the ascent witnessed in this market in the last month was due to these funds, it is natural to be concerned.
The other issue, which the finance minister claims to be the more important one, is even more interesting and relates to trying to stem the flow of capital. This comes on top of the curbs placed by RBI not a long time ago on the external commercial borrowing channel of finance. However, the major source of these forex flows into the country in the last year was on account of foreign direct investment rather than portfolio investment.
To the extent that PN investment would come down by these announcements, there would definitely be some clamp down on such inflows. This move, hence, brings to the forefront an interesting theme being tested by the government relating to capital controls. One is not too sure if capital controls are a solution, or even part of the solution, but given that liberalising capital outflows has not helped, the imposition of controls could be worth a try.
Coincidentally and ironically, just one day after this explanation was given, the International Monetary Fund placed on its website its latest World Economic Outlook, which says global experience reveals that capital controls do not really work. If this is the case, then placing curbs on both the ECB and PN routes may not really serve the purpose, though RBI can always say that it cannot be blamed for not trying.
This helps everybody, as money being invested keeps multiplying while changing hands. It is but natural that investors have taken umbrage to the move by the Securities & Exchange Board of India (Sebi) to control funds coming into the country through participatory notes (PNs). Even the finance minister had to placate markets the following day (though there was no need to do so) and clarify that the government was not against the concept of PNs, who have a very important role to play.
The decision to come down on PNs is probably controversial, but it will help the government control two nagging problems that have been quite elusive. The first relates to controlling the quality of funds coming in, while the second is exercising control over capital inflows, which have created innumerable problems for the Reserve Bank of India (RBI). By accomplishing these two objectives, the government would have also managed to control the proverbial bubble, which we all know is going to burst, though we never know when. PNs are basically investments used by foreigners not registered in India. They operate through foreign institutional investors (FIIs), who are registered with Sebi. FIIs buy Indian shares and issue PNs, which are purchased by entities whose names remain unknown. It is also suspected that Indians themselves could be making such investments to eschew identity as well as find a tax shelter. Also, a lot of laundered money could come in and RBI has always been critical about such money.
But investors don’t like such announcements, even though it seems quite logical to have some discipline in these operations. While the legitimacy of these funds has not come up this time, the government fears that these funds are looking for short-term gains (and could destabilise the markets when they withdraw) and hence provide some kind of irrational boost to share prices.
In fact, the Sensex has risen by over 35% in the last two months, ostensibly due to a large flow of FII funds, with PNs contributing significantly. If this were true, then any responsible regulator would take pre-emptive action lest it be caught napping when things go awry. This should be remembered by critics, who always feel markets should be allowed to work freely—they are never perfect to be allowed this luxury.
What exactly did Sebi do? Firstly, it issued a discussion paper seeking to ban any issue of PNs of FIIs against underlying derivatives, ie, futures and options, while restricting the issue of PNs in the cash segment. This has quite naturally hit the market hard as it has been interpreted as being regressive. The notional value of PNs is around 52% of the FIIs’ account assets. Excluding underlying derivatives, the share was 35%.
Is this a good move? Probably not for the market or FIIs, as they are directly affected by these measures. The stock market fell by over 330 points by the end of the first day, echoing this sentiment after recovering from a fall of over 1,700 points (that means a major erosion of market capitalisation!). But if one looks at this dispassionately, one will realise that there was inherently nothing amiss in the thought process. Funds of a short-term nature tend to be destabilising and given that the ascent witnessed in this market in the last month was due to these funds, it is natural to be concerned.
The other issue, which the finance minister claims to be the more important one, is even more interesting and relates to trying to stem the flow of capital. This comes on top of the curbs placed by RBI not a long time ago on the external commercial borrowing channel of finance. However, the major source of these forex flows into the country in the last year was on account of foreign direct investment rather than portfolio investment.
To the extent that PN investment would come down by these announcements, there would definitely be some clamp down on such inflows. This move, hence, brings to the forefront an interesting theme being tested by the government relating to capital controls. One is not too sure if capital controls are a solution, or even part of the solution, but given that liberalising capital outflows has not helped, the imposition of controls could be worth a try.
Coincidentally and ironically, just one day after this explanation was given, the International Monetary Fund placed on its website its latest World Economic Outlook, which says global experience reveals that capital controls do not really work. If this is the case, then placing curbs on both the ECB and PN routes may not really serve the purpose, though RBI can always say that it cannot be blamed for not trying.
Wednesday, October 17, 2007
The New Moral Hazard, DNA, September 2007
The phrase moral hazard is back in vogue today. Moral hazard in the financial sector is a situation where a deviant institution continues to take risky decisions knowing fully well that it will be helped out by the system in case of failure. Hence, banks can give into indiscretion in case they know that the cost of failure will finally be sorted out by the central bank. Now, the actions of monetary authorities across the world to tackle the sub-prime crisis have actually created this moral hazard. Let us see how this has happened.
The sub-prime crisis was a case where mortgage banks lent to home buyers with limited credit credentials at low rates and then sold them forward for securitization against which securities were issued to investors. As interest rates went up, the threat of default increased. Hedge funds were asked to put forth more money and when they tried to sell the mortgage backed securities their value had fallen. As no one knew where the risk lay and banks were reluctant to lend to one another and the funds dealing with these securities went bus. The Fed and the ECB started providing funds in the market to ensure that liquidity ws available which sent the signal that the monetary authority was willing to intervene to eschew a crisis.
The critics felt that this kind of intervention creates a moral hazard as institutions will use this as a precedent to be more reckless in future knowing that they will not be punished and a solution will be forthcoming from the Fed or ECB. To top it all the discount rate at which the Fed lends money directly to banks was also lowered which prompted all the big ones like Citi, Wachovia, JP Morgan Chase and Bank of America to borrow. And recently the Fed rate has been hiked on grounds of preventing the possibility of a recession in future and is not directly related to bailing out any institution.
Come over to UK now, and the Bank of England has done a similar act of protecting the Northern Rock Bank which though a mortgage bank had a different sort of problem. Its assets were secure but its funding channel got choked as it depended on the capital market and the commercial paper market for funds. This created a stir which got reflected in its stock value and was followed by deposit holders queuing up for their money. The BOE then entered to rescue the bank by not only providing insurance for the deposits but also providing funds against the security of the mortgages which were held.
Two questions arise here. Should these institutions be bailed out and the second is whether the central banks are justified in helping them out? The answer is equivocal here. If financial entities go overboard then it is not unlike a manufacturing concern which makes huge losses has no recourse. Hence for a bad business decision the consequences must be the same.
However, there are two points here. The first is that banks deal with public money and hence cannot be allowed to fail. Secondly, the fear of a contagion arises once one bank is allowed to fail. Therefore, the answer to the question posed earlier about whether the central bank should help out, the answer is yes. The central bank cannot stand by and let the crisis spread. If that is so, is there any way out? Here the Indian case needs to be put in the right perspective.
The Indian banking system is well governed with rules being placed on the lending pattern of banks. Lending to risky ventures like capital markets, commodities and real estate are ‘sensitive sectors’ and is not widely encouraged and is monitored closely. As over three quarters of the banking system is in the public sector, it helps to enforce this discipline.
We have however, had our own share of banking crisis, which have never really escalated to any kind of a contagion. Global Trust Bank had failed following the Ketan Parekh scam but the RBI found a way out through a merger with a public sector bank, Oriental Bank of Commerce. IFCI has been bailed out through financial infusion and subsequent equity sale. The lesser known Benaras State Bank was amalgamated with Bank of Baroda which in turn protected the deposit holders. But, yes, in case of the Ketan Parikh related Madhavpura Bank, the RBI did resort to provide finance to cooperative banks for short tenures to ensure that banking activities were not affected. But earlier following the Harshad Mehta scam in the mid-nineties, both Bank of Karad and Metropolitan Banks were liquidated.
Therefore, the RBI has also changed it approach to bank failures from a strict liquidation regimen just as we embarked on reforms to a more practical merger policy to one of accommodation depending on the circumstances.
An issue which comes to the forefront now is whether the sub-prime crisis could be repeated in India. We do not have such lending but given the large increase in the share of mortgages in the bank portfolio, there is a similarity. Also the fact that this portfolio has been built at a time when interest rates were low and are being re-priced today with higher interest rate regimes does highlight a payment problem for borrowers. Protracted repayment schedules and higher interest costs could affect the ability of borrowers to repay, which was the same with the sub-prime episode. But, the difference that can be seen today is that property prices are still high, which will prevent the value of the collateral from declining which was the case in USA.
The answer hence is quite clear. To begin with whenever public money is involved, the governance needs to be strong. Once in place, a failure should be protected to restore confidence of the public as well as safeguard their interests. But, this should hold only when public funds in deposits are involved, and not investors putting their money in hedge funds where the risks are known beforehand. There is hence need to distinguish between the two.
The sub-prime crisis was a case where mortgage banks lent to home buyers with limited credit credentials at low rates and then sold them forward for securitization against which securities were issued to investors. As interest rates went up, the threat of default increased. Hedge funds were asked to put forth more money and when they tried to sell the mortgage backed securities their value had fallen. As no one knew where the risk lay and banks were reluctant to lend to one another and the funds dealing with these securities went bus. The Fed and the ECB started providing funds in the market to ensure that liquidity ws available which sent the signal that the monetary authority was willing to intervene to eschew a crisis.
The critics felt that this kind of intervention creates a moral hazard as institutions will use this as a precedent to be more reckless in future knowing that they will not be punished and a solution will be forthcoming from the Fed or ECB. To top it all the discount rate at which the Fed lends money directly to banks was also lowered which prompted all the big ones like Citi, Wachovia, JP Morgan Chase and Bank of America to borrow. And recently the Fed rate has been hiked on grounds of preventing the possibility of a recession in future and is not directly related to bailing out any institution.
Come over to UK now, and the Bank of England has done a similar act of protecting the Northern Rock Bank which though a mortgage bank had a different sort of problem. Its assets were secure but its funding channel got choked as it depended on the capital market and the commercial paper market for funds. This created a stir which got reflected in its stock value and was followed by deposit holders queuing up for their money. The BOE then entered to rescue the bank by not only providing insurance for the deposits but also providing funds against the security of the mortgages which were held.
Two questions arise here. Should these institutions be bailed out and the second is whether the central banks are justified in helping them out? The answer is equivocal here. If financial entities go overboard then it is not unlike a manufacturing concern which makes huge losses has no recourse. Hence for a bad business decision the consequences must be the same.
However, there are two points here. The first is that banks deal with public money and hence cannot be allowed to fail. Secondly, the fear of a contagion arises once one bank is allowed to fail. Therefore, the answer to the question posed earlier about whether the central bank should help out, the answer is yes. The central bank cannot stand by and let the crisis spread. If that is so, is there any way out? Here the Indian case needs to be put in the right perspective.
The Indian banking system is well governed with rules being placed on the lending pattern of banks. Lending to risky ventures like capital markets, commodities and real estate are ‘sensitive sectors’ and is not widely encouraged and is monitored closely. As over three quarters of the banking system is in the public sector, it helps to enforce this discipline.
We have however, had our own share of banking crisis, which have never really escalated to any kind of a contagion. Global Trust Bank had failed following the Ketan Parekh scam but the RBI found a way out through a merger with a public sector bank, Oriental Bank of Commerce. IFCI has been bailed out through financial infusion and subsequent equity sale. The lesser known Benaras State Bank was amalgamated with Bank of Baroda which in turn protected the deposit holders. But, yes, in case of the Ketan Parikh related Madhavpura Bank, the RBI did resort to provide finance to cooperative banks for short tenures to ensure that banking activities were not affected. But earlier following the Harshad Mehta scam in the mid-nineties, both Bank of Karad and Metropolitan Banks were liquidated.
Therefore, the RBI has also changed it approach to bank failures from a strict liquidation regimen just as we embarked on reforms to a more practical merger policy to one of accommodation depending on the circumstances.
An issue which comes to the forefront now is whether the sub-prime crisis could be repeated in India. We do not have such lending but given the large increase in the share of mortgages in the bank portfolio, there is a similarity. Also the fact that this portfolio has been built at a time when interest rates were low and are being re-priced today with higher interest rate regimes does highlight a payment problem for borrowers. Protracted repayment schedules and higher interest costs could affect the ability of borrowers to repay, which was the same with the sub-prime episode. But, the difference that can be seen today is that property prices are still high, which will prevent the value of the collateral from declining which was the case in USA.
The answer hence is quite clear. To begin with whenever public money is involved, the governance needs to be strong. Once in place, a failure should be protected to restore confidence of the public as well as safeguard their interests. But, this should hold only when public funds in deposits are involved, and not investors putting their money in hedge funds where the risks are known beforehand. There is hence need to distinguish between the two.
Monetisation is key, not exports data: Economic Times 17th October 2007
A major concern today is the appreciating rupee as it has created a dual problem of affecting exports and creating monetization issues for the RBI. The situation is not very different from what the Euro zone is facing where the Euro is strengthening against the dollar, albeit more freely, and the fear of loss of competitiveness lingers. It is the same feeling in India too with the exporters getting worried that their competitiveness will be eroded in case the rupee continues appreciating.
But, surprisingly so far, the rupee appreciation has not quite led to a fall in exports and the present growth rate is steady at a high level of close to 20%. But, the exporters are saying that this growth would not be sustainable in the face of an appreciating rupee as they are compromising on profit. There is again talk on the various options of hedging for the exporters. The RBI on the other hand is trying hard to control this appreciation but is having a problem with excess monetization and the issuance of new MSS bonds.
In this context it would be interesting to do a bit of statistical analysis of the experiences of the flow of foreign exchange on the exchange rate and money supply and that of the exchange rate on exports growth. This way it may be seen whether the exporters or RBI have a bigger problem on hand. The last four years or 48 months are considered starting from October 2003 to September 2007, which is further bifurcated into two periods of 34 and 14 months. The first period is up to June 2006 while the second period is from July 2006 onwards when the rupee started appreciating continuously against the dollar. The matrix of results is provided in the Table below.
To avoid the use of statistical jargon, the results have been provided in simple language. The overall strength of the relationship between the variables called ‘coefficient of determination’ is denoted by high, medium and low. The direction of impact as well as the significance of the impact of the primary variable is also captured as is the impact of the ‘other variables’ which are not specified. Hence, if exports are affected by say world demand, then it comes under ‘other variables’.
Quite clearly the two periods show contrasting pictures. Firstly, the period up to June 2006 shows that the exchange rate movements are not really driven by forex inflows. This can be rationalized on grounds of RBI intervention which has ensured that the market oriented rate was not reached. Further, while the direction sounds okay, i.e. more forex inflows cause an appreciation (appreciation goes with a negative sign as we are paying fewer rupees for a dollar), it is not statistically significant. Secondly for money supply there is a strong explanation and the impact too is significant. The third observation is that there are contrary images seen when exports are juxtaposed with exchange rate movements. Exchange rates don’t explain exports much as there are evidently other factors which drive them such as demand factors, price movements, status of units (whether SEZ or not), ability to take a hit on profits etc.
The post June 2006 period is the one where the appreciation took place in a continuous manner. Statistically, a small sample is not ideal, but notwithstanding this limitation, we get a different set of results. All the three relationships hold: forex inflows affect exchange rates and money supply; and exports are explained partly by the exchange rate movements. The impact appears to be in the right direction for all the three relationships, including the one for appreciation and rising exports.
Some interesting points that emerge from the data are that the RBI has bigger problems on hand with rising forex inflows than the exporters. Exports so far have not really been affected by the rupee appreciation even when lags of up to 4 months are considered. In fact, the relationship is still not strong and the explanatory power is not significant. However, the direction is still negative meaning thereby that a lower value of the rupee (appreciation) is associated with rising exports. As a corollary, the conclusion would be that the RBI should concentrate more on tackling the monetization part of the dollars rather than stem the appreciation.
But, surprisingly so far, the rupee appreciation has not quite led to a fall in exports and the present growth rate is steady at a high level of close to 20%. But, the exporters are saying that this growth would not be sustainable in the face of an appreciating rupee as they are compromising on profit. There is again talk on the various options of hedging for the exporters. The RBI on the other hand is trying hard to control this appreciation but is having a problem with excess monetization and the issuance of new MSS bonds.
In this context it would be interesting to do a bit of statistical analysis of the experiences of the flow of foreign exchange on the exchange rate and money supply and that of the exchange rate on exports growth. This way it may be seen whether the exporters or RBI have a bigger problem on hand. The last four years or 48 months are considered starting from October 2003 to September 2007, which is further bifurcated into two periods of 34 and 14 months. The first period is up to June 2006 while the second period is from July 2006 onwards when the rupee started appreciating continuously against the dollar. The matrix of results is provided in the Table below.
To avoid the use of statistical jargon, the results have been provided in simple language. The overall strength of the relationship between the variables called ‘coefficient of determination’ is denoted by high, medium and low. The direction of impact as well as the significance of the impact of the primary variable is also captured as is the impact of the ‘other variables’ which are not specified. Hence, if exports are affected by say world demand, then it comes under ‘other variables’.
Quite clearly the two periods show contrasting pictures. Firstly, the period up to June 2006 shows that the exchange rate movements are not really driven by forex inflows. This can be rationalized on grounds of RBI intervention which has ensured that the market oriented rate was not reached. Further, while the direction sounds okay, i.e. more forex inflows cause an appreciation (appreciation goes with a negative sign as we are paying fewer rupees for a dollar), it is not statistically significant. Secondly for money supply there is a strong explanation and the impact too is significant. The third observation is that there are contrary images seen when exports are juxtaposed with exchange rate movements. Exchange rates don’t explain exports much as there are evidently other factors which drive them such as demand factors, price movements, status of units (whether SEZ or not), ability to take a hit on profits etc.
The post June 2006 period is the one where the appreciation took place in a continuous manner. Statistically, a small sample is not ideal, but notwithstanding this limitation, we get a different set of results. All the three relationships hold: forex inflows affect exchange rates and money supply; and exports are explained partly by the exchange rate movements. The impact appears to be in the right direction for all the three relationships, including the one for appreciation and rising exports.
Some interesting points that emerge from the data are that the RBI has bigger problems on hand with rising forex inflows than the exporters. Exports so far have not really been affected by the rupee appreciation even when lags of up to 4 months are considered. In fact, the relationship is still not strong and the explanatory power is not significant. However, the direction is still negative meaning thereby that a lower value of the rupee (appreciation) is associated with rising exports. As a corollary, the conclusion would be that the RBI should concentrate more on tackling the monetization part of the dollars rather than stem the appreciation.
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