Thingalaya, Moodithaya and Shetty examine various aspects of financial inclusion and the challenges and progress of the movement in India in their comprehensive book
Today, in almost all seminars on banking, talking about inclusive banking has become axiomatic if not a fad. Maybe after a decade of competitive banking, where banks have focused on return on capital and return on assets, somewhere inside is a feeling of guilt that the poor have been left out. It is not surprising that bankers spend a lot of time talking on how it is necessary to bring about inclusion and policy makers go a step ahead and relate the same to inclusive growth.
But what exactly does this financial inclusion mean? Have we really made any strides here? Thingalaya, Moodithaya and Shetty attempt to address these issues in their book, Financial Inclusion and Beyond. Thingalaya, a banker-academic obviously has the advantage of personal experience on the subject.
Inclusion basically means having access to a bank account, bank facilities such as remittance, credit, financial advice and probably insurance. The authors look at demand and supply side factors in this context. On the demand side, they point out that awareness, interest rates, need for collateral, social status and information asymmetry (where some get to know more and some less about defining issues) may actually be keeping potential borrowers out of this framework. The supply factors that make banks reluctant to lend are almost mirror images such as insistence on collateral, limited access to all villages, procedures, language and staff attitude.
Then they examine different parameters to gauge inclusion, which is a bit cumbersome given the limited availability of data. Population per branch or accounts per population size are the ones normally referred to, while there are extensions such as loans given based on occupation, status, etc. Of late, the concept of no-frills accounts has caught on, which helps the un-bankable people to access banks. A lot of data from the National Sample Survey is used here, which, unfortunately, tends to be dated in the current context.
The authors have carried out a survey on financial inclusion in four districts—Anantpur (Andhra Pradesh), Madurai (Tamil Nadu), Udupi (Karnataka) and Kasaragod (Kerala). The survey throws up some results and there is reason to believe that Tamil Nadu is a kind of laggard in terms of inclusion. Some of the thoughts that emanate from the study are that men are covered relatively more than women; religion, perhaps, does not matter; education plays a role in all states except Andhra Pradesh, while ownership of land has a positive correlation with access to banks. There is, however, no clear relation with occupation. Further, some of the reasons for exclusion are awareness or low comfort. An interesting finding is that around half the respondents were left out voluntarily, meaning they were not really interested.
Looking ahead, the authors suggest that to improve financial inclusion there should be more points of contact to begin with. Second, the concept of a financial supermarket, Gramin Vikas Soudha, should come up, where a villager gets not just finance, but also other farm inputs and daily-use items. Third, credit should be a part of any development plan undertaken by the government right to the panchayat level. Lastly, there should be a lead district manager who should be in charge of such an initiative.
The book does not make suggestions much different from what we read in the speeches of bankers. But it is always good to have everything in one place. As one of the authors was a banker, the book should have touched on other banker’s perspectives such as banks’ reluctance to experiment, administrative hassles in lending, creation of non-performing loans, impact of such lending on profit margins, etc. Given the problems that microfinance institutions face today, this would have added value. A survey of bankers would have helped in this context, as it would have provided the other view on why inclusion is still a mirage in our society.
After all, banks are commercial units. They have to deliver profits and cannot be run on philanthropic grounds. Covering these aspects would have added some zing to the otherwise matter-of-fact approach taken in this book.
The Academic Foundation, which provides a channel for such research projects, should encourage authors to make their books argumentative and represent both sides, or else such books would have a restricted academic audience, which should not be the case.
Tuesday, November 22, 2011
Will savings rate deregulation help banks? Business Standard 9th November 2011
Debate page
Free pricing helps banks manage their costs more efficiently because they can fine-tune them depending on their requirements
Deregulation of interest rates on savings deposits is probably the last mile in interest rate reforms in India. Though the timing may be debated, banks will surely see something good in this move. For the system as a whole these deposits constitute a little less than a quarter of overall funds — they have increased from around 21 per cent in FY00 to 25 per cent in FY06 and moved down to 23 per cent in FY10. There are four reasons for banks to cheer.
First, the freedom to price around a quarter of available funds gives them better control over an important section of their funds. Second, free pricing helps banks manage their costs more efficiently because they can fine-tune them depending on their own requirements and market conditions. The fact that these deposits are almost constant can give most banks flexibility in pricing, although ironically the mirror image would offer scope for competition to dip into them. Third, banks can increase or decrease this reservoir of funds to the extent that is possible based on their own requirements. This will foster competition between banks and enable them to compete with liquid mutual funds, which are the direct alternative. Also by changing terms of transactions like minimum balance, charges for services and so on, they can encourage or discourage such deposits. Finally, as a consequence of these three factors, asset-liability management becomes easier since banks can factor movement in these deposits to match maturity of assets.
Though it is true that these deposits have been an almost constant factor for the banking system, these dynamics may change gradually once customers see differential interest rates. One cannot conjecture whether this proportion of 23 per cent will move up or down when rates change. This was also observed when banks started very short-term deposits of 15 days and above — a move to get customers to roll over these deposits at a rate that was higher than the savings account rate. Customers did move funds to banks offering higher rates on these deposits. By offering higher rates on savings accounts, there could be migration to these deposits not just within the bank, but also across banks. This will cut administrative costs. Therefore, at the micro level, banks will have scope to play with their balance sheet more effectively.
Individuals usually hold cash at home for liquidity, savings deposits for security and convenience, and term deposits for income. While funds may be swapped between banks or across deposits, the overall amount of deposits may not change if rates are increased, given the profile of customers who are already exposed to various alternatives. Therefore, at the macro level the impact may be minimal since it should be recognised that liquid debt funds tend to give higher post-tax yields. Similarly, if the rates come down, customers may not actually withdraw substantially from this account.
We have already seen disparate reactions from banks. The large ones have been silent, while some smaller ones have increased these rates. This will really be the challenge for banks at the micro level where the share of savings accounts is lower, as in the case of foreign banks (about 15 per cent) and old private banks (around 19 per cent). Those that are already at 23-24 per cent may not really have scope to do so, based on past trends in terms of garnering deposits. The onus will be on banks to actually manage this portion of funds.
So, is it good for the banking system? Certainly yes, since it gives banks the freedom to manage their funds more adroitly. The consequences of the impact on the amount of deposits may not change but as long as it is market-determined, the system will be efficient. The real challenge is for the Reserve Bank of India when interest rates come down substantially — as they did in 2002-2005 when term deposits gave returns of around five per cent. Logically, the savings rate should have also come down proportionately to close to nil in case a spread of, say, 400-500 basis points is to be maintained as is the case today.
This may be tough to accept.
Free pricing helps banks manage their costs more efficiently because they can fine-tune them depending on their requirements
Deregulation of interest rates on savings deposits is probably the last mile in interest rate reforms in India. Though the timing may be debated, banks will surely see something good in this move. For the system as a whole these deposits constitute a little less than a quarter of overall funds — they have increased from around 21 per cent in FY00 to 25 per cent in FY06 and moved down to 23 per cent in FY10. There are four reasons for banks to cheer.
First, the freedom to price around a quarter of available funds gives them better control over an important section of their funds. Second, free pricing helps banks manage their costs more efficiently because they can fine-tune them depending on their own requirements and market conditions. The fact that these deposits are almost constant can give most banks flexibility in pricing, although ironically the mirror image would offer scope for competition to dip into them. Third, banks can increase or decrease this reservoir of funds to the extent that is possible based on their own requirements. This will foster competition between banks and enable them to compete with liquid mutual funds, which are the direct alternative. Also by changing terms of transactions like minimum balance, charges for services and so on, they can encourage or discourage such deposits. Finally, as a consequence of these three factors, asset-liability management becomes easier since banks can factor movement in these deposits to match maturity of assets.
Though it is true that these deposits have been an almost constant factor for the banking system, these dynamics may change gradually once customers see differential interest rates. One cannot conjecture whether this proportion of 23 per cent will move up or down when rates change. This was also observed when banks started very short-term deposits of 15 days and above — a move to get customers to roll over these deposits at a rate that was higher than the savings account rate. Customers did move funds to banks offering higher rates on these deposits. By offering higher rates on savings accounts, there could be migration to these deposits not just within the bank, but also across banks. This will cut administrative costs. Therefore, at the micro level, banks will have scope to play with their balance sheet more effectively.
Individuals usually hold cash at home for liquidity, savings deposits for security and convenience, and term deposits for income. While funds may be swapped between banks or across deposits, the overall amount of deposits may not change if rates are increased, given the profile of customers who are already exposed to various alternatives. Therefore, at the macro level the impact may be minimal since it should be recognised that liquid debt funds tend to give higher post-tax yields. Similarly, if the rates come down, customers may not actually withdraw substantially from this account.
We have already seen disparate reactions from banks. The large ones have been silent, while some smaller ones have increased these rates. This will really be the challenge for banks at the micro level where the share of savings accounts is lower, as in the case of foreign banks (about 15 per cent) and old private banks (around 19 per cent). Those that are already at 23-24 per cent may not really have scope to do so, based on past trends in terms of garnering deposits. The onus will be on banks to actually manage this portion of funds.
So, is it good for the banking system? Certainly yes, since it gives banks the freedom to manage their funds more adroitly. The consequences of the impact on the amount of deposits may not change but as long as it is market-determined, the system will be efficient. The real challenge is for the Reserve Bank of India when interest rates come down substantially — as they did in 2002-2005 when term deposits gave returns of around five per cent. Logically, the savings rate should have also come down proportionately to close to nil in case a spread of, say, 400-500 basis points is to be maintained as is the case today.
This may be tough to accept.
Small Towns, Big Problems: Business World 22nd October 2011 (Book Review)
Paromita Shastri's books addresses the issues regarding the pace of urbanisation in small town cities and the urgent need to reform municipal financial practices and policy making
In the federal governance structure that we follow, the last layer — or rather the last mile — is always a challenge as it gets the least attention both in terms of resources as well as discussion. This is the point that is brought out clearly by Paromita Shastri in her book How India’s Small Towns Live or Die. We are all aware that the pace of urbanisation in India, though less than that in other emerging markets, is still impressive enough to be a brownie point for the nation. But Shastri says this achievement is more for the metropolitan cities rather than the 4,500 smaller towns struggling to maintain a semblance of respectability.
The problem is twofold. First, there are few resources available to these cities, and that is poorly administered. As a result, the entire story of urbanisation is besmirched. In fact, most of the migration is to larger cities — mainly metros, as the other towns do not fare better than their rural counterparts in terms of amenities or opportunities.
Shastri studies 29 such towns, across spread eight states, each of which actually had an inherent competitive advantage in terms of being a centre for handicrafts and small-scale industry or agriculture markets or status of pilgrimage centre, and so on. Yet, almost universally, their administration was sub-optimal, and they had problems of raising financial resources. India’s Constitution has left it to the states to address this issue, which, in turn, set up state finance commissions. Invariably, these towns are dependent on transfers from states and have a limited radius within which they can operate in terms of raising their own revenue. Hence, municipal finances vary across states as there are varying rules, unlike for states which have a single formula for devolving funds from the Centre.
It is not surprising that the ratio of municipal funds to total state domestic product was just 0.63 per cent in 2002 — the latest date for which information is available. The major problem here is the availability of data. Most of these town bodies do not maintain basic accounts, and concepts of double entry book-keeping are missing. The author puts it nicely when she says municipal bodies are handicapped by birth — that is aggrandised by weak finances and fiscal over-dependence. That they are dependent on state governments is a kind of subversion of the process of democratic decentralisation.
Shastri paints a dismal picture, though the extent varies. Haryana is better off than, say, Himachal or Rajasthan, while the southern states do relatively better. As these bodies cannot raise resources by borrowing, they work within the contours. The problem is compounded as most of the funds available through ‘own collection’ or grants from states are spent in salaries and maintenance. Consequently, there is hardly any money left for development purposes.
We have had the Jawaharlal Nehru National Urban Renewal Mission (JNNURM) project, which tried to address the issue of urban development, but the author considers it to be a non-starter. While a lot of emphasis was put on e-governance, accounting practices, tax reforms, user charges and provision of basic services, the non-metro towns have not really made too much progress, which makes the scheme a bit of a disappointment.
The author suggests there is an urgent need to reform the finances and bring in the best practices, especially when politics is not a major issue. Public-private partnership would be a way out. However, she does warn that the constant bickering within the body — between councilors and executives are major roadblocks.
How would one rate this book? It is academic in nature, and is a good project considering that besides a study by the Researve Bank of India, there is not much literature on the subject. Even though much of the data used in this book is about a decade old, the author surmounts this by her own studies. Surely, the book has enough that our policymakers should study and address
In the federal governance structure that we follow, the last layer — or rather the last mile — is always a challenge as it gets the least attention both in terms of resources as well as discussion. This is the point that is brought out clearly by Paromita Shastri in her book How India’s Small Towns Live or Die. We are all aware that the pace of urbanisation in India, though less than that in other emerging markets, is still impressive enough to be a brownie point for the nation. But Shastri says this achievement is more for the metropolitan cities rather than the 4,500 smaller towns struggling to maintain a semblance of respectability.
The problem is twofold. First, there are few resources available to these cities, and that is poorly administered. As a result, the entire story of urbanisation is besmirched. In fact, most of the migration is to larger cities — mainly metros, as the other towns do not fare better than their rural counterparts in terms of amenities or opportunities.
Shastri studies 29 such towns, across spread eight states, each of which actually had an inherent competitive advantage in terms of being a centre for handicrafts and small-scale industry or agriculture markets or status of pilgrimage centre, and so on. Yet, almost universally, their administration was sub-optimal, and they had problems of raising financial resources. India’s Constitution has left it to the states to address this issue, which, in turn, set up state finance commissions. Invariably, these towns are dependent on transfers from states and have a limited radius within which they can operate in terms of raising their own revenue. Hence, municipal finances vary across states as there are varying rules, unlike for states which have a single formula for devolving funds from the Centre.
It is not surprising that the ratio of municipal funds to total state domestic product was just 0.63 per cent in 2002 — the latest date for which information is available. The major problem here is the availability of data. Most of these town bodies do not maintain basic accounts, and concepts of double entry book-keeping are missing. The author puts it nicely when she says municipal bodies are handicapped by birth — that is aggrandised by weak finances and fiscal over-dependence. That they are dependent on state governments is a kind of subversion of the process of democratic decentralisation.
Shastri paints a dismal picture, though the extent varies. Haryana is better off than, say, Himachal or Rajasthan, while the southern states do relatively better. As these bodies cannot raise resources by borrowing, they work within the contours. The problem is compounded as most of the funds available through ‘own collection’ or grants from states are spent in salaries and maintenance. Consequently, there is hardly any money left for development purposes.
We have had the Jawaharlal Nehru National Urban Renewal Mission (JNNURM) project, which tried to address the issue of urban development, but the author considers it to be a non-starter. While a lot of emphasis was put on e-governance, accounting practices, tax reforms, user charges and provision of basic services, the non-metro towns have not really made too much progress, which makes the scheme a bit of a disappointment.
The author suggests there is an urgent need to reform the finances and bring in the best practices, especially when politics is not a major issue. Public-private partnership would be a way out. However, she does warn that the constant bickering within the body — between councilors and executives are major roadblocks.
How would one rate this book? It is academic in nature, and is a good project considering that besides a study by the Researve Bank of India, there is not much literature on the subject. Even though much of the data used in this book is about a decade old, the author surmounts this by her own studies. Surely, the book has enough that our policymakers should study and address
Getting out of low-growth trap: Economic Times, 15th October 2011
If one were a student of Economics in the last five decades or so, there would definitely be some inclination towards either John Maynard Keynes or Milton Friedman. Acrimonious debates have typified discussions by these schools with each one often claiming that the other is only a special case of their own line of thought. But today, ironically, we have a situation where governments and monetary authorities are asking the other to take affirmative action as they do not have a solution.
The world economy is in a fragile state now. The quick recovery from the financial crisis through monetary easing and Keynesian spending was assumed to be the beginning of a new era of prosperity, but the euro region crisis has elevated the crisis from the financial system to sovereign failures. Let us look at the US first. The Fed took it upon itself to resuscitate the economy after the financial crisis and what followed were rounds of quantitative easing: QE1 and QE2. The basic idea was to provide liquidity to the system at a time when banks did not trust one another. Interest rates were lowered to almost zero to encourage spending. Yet, growth is sluggish and could be around 1.4% this year with unemployment rate closer to the double-digit mark.
This is what Keynes would have called the liquidity trap where interest rates reach a plateau and don't matter. The solution is for the government to spend. But the government cannot spend as debt levels are too high and it has just gotten away from a possible theoretical default and raked up controversy over the downgrade . Fiscal solutions are weak. The euro region has a different set of problems as it is a combination of 17 countries. Fiscal deficits in the rogue nations have spoilt the party, and the ECB, Germany and European Financial Stability Fund (EFSF) have pooled in resources and support along with IMF to help them out.
The problem here is the high ratio of debt-to-GDP . Greece tops with over 140%, followed by Italy with 120%, and Ireland and Portugal with over 90%. Governments are being asked to follow austerity as they have built up large levels of debt that will be hard to service. This has meant that governments have to cut expenditure and raise taxes , which is deflationary as the countries slip into a recession that will exacerbate the deficit. The ECB has to risk inflation by lowering rates, as this is the only way in which it can lower the cost of borrowing in a region where there is general 'trust deficit' . But lower rates will help to lower credit default swap rates for governments as well as private bond rates. Keynes will not work here and the ECB has to look closer at the inflation tradeoff.
Amid such a scenario, there is a new brand of Economics that has come to fore, Regulatory Economics, which will further impede the growth process . Following the financial crisis, Basel-III is on the anvil, which though will be implemented over a period of time (spread during 2013-19 ). It will tighten the requirements for capital (tier I) and liquidity, both of which were the main issues at the time of the financial crisis. This means that banks today are even more reluctant to lend as they shore up their capital and liquidity. This has been the issue in the US where low interest rates do not inspire lending as banks have to attend to these requirements. The western nations are, hence, definitely in a difficult state where policy application is a challenge .
How about the developing countries ? Here, the issues are different. While growth in countries like India and China is still strong, the problem of inflation remains with central banks furiously pursuing aggressive monetary policies. This has, in a way, put brakes on the demand for credit that is expected to slow down the pace of overall growth. Therefore, once again, there is a downward thrust on growth as central banks counter consumer inflation rates of 5.4% in China, 8.6% in India, 9% in Russia, 6.9% in Brazil and 5.3% in South Africa.
These governments have embarked on a policy of fiscal stimulus rollback and can look in only one direction: reduction of deficits. Hence, if no affirmative action is taken , then the slowdown can degenerate into a recession that will be slow and painful. Presently, no one wants to appear playing truant as Trust Economics has come into vogue. The solution is really for every entity to give in a bit and accept a tradeoff. US should continue to spend to provide demand notwithstanding its debt - sounds heretical after all the ado about the downgrade - as we need some benign neglect to revive the global economy.
ECB must lower rates for whatever it is worth. China should be more responsible and help foster global trade through exchange rate adjustments and other emerging markets must spend to keep business up. In short, both Keynesianism and monetarism should be pursued as 'deviant fiscal behaviour' , and inflation is better than prolonged stagnation.
The world economy is in a fragile state now. The quick recovery from the financial crisis through monetary easing and Keynesian spending was assumed to be the beginning of a new era of prosperity, but the euro region crisis has elevated the crisis from the financial system to sovereign failures. Let us look at the US first. The Fed took it upon itself to resuscitate the economy after the financial crisis and what followed were rounds of quantitative easing: QE1 and QE2. The basic idea was to provide liquidity to the system at a time when banks did not trust one another. Interest rates were lowered to almost zero to encourage spending. Yet, growth is sluggish and could be around 1.4% this year with unemployment rate closer to the double-digit mark.
This is what Keynes would have called the liquidity trap where interest rates reach a plateau and don't matter. The solution is for the government to spend. But the government cannot spend as debt levels are too high and it has just gotten away from a possible theoretical default and raked up controversy over the downgrade . Fiscal solutions are weak. The euro region has a different set of problems as it is a combination of 17 countries. Fiscal deficits in the rogue nations have spoilt the party, and the ECB, Germany and European Financial Stability Fund (EFSF) have pooled in resources and support along with IMF to help them out.
The problem here is the high ratio of debt-to-GDP . Greece tops with over 140%, followed by Italy with 120%, and Ireland and Portugal with over 90%. Governments are being asked to follow austerity as they have built up large levels of debt that will be hard to service. This has meant that governments have to cut expenditure and raise taxes , which is deflationary as the countries slip into a recession that will exacerbate the deficit. The ECB has to risk inflation by lowering rates, as this is the only way in which it can lower the cost of borrowing in a region where there is general 'trust deficit' . But lower rates will help to lower credit default swap rates for governments as well as private bond rates. Keynes will not work here and the ECB has to look closer at the inflation tradeoff.
Amid such a scenario, there is a new brand of Economics that has come to fore, Regulatory Economics, which will further impede the growth process . Following the financial crisis, Basel-III is on the anvil, which though will be implemented over a period of time (spread during 2013-19 ). It will tighten the requirements for capital (tier I) and liquidity, both of which were the main issues at the time of the financial crisis. This means that banks today are even more reluctant to lend as they shore up their capital and liquidity. This has been the issue in the US where low interest rates do not inspire lending as banks have to attend to these requirements. The western nations are, hence, definitely in a difficult state where policy application is a challenge .
How about the developing countries ? Here, the issues are different. While growth in countries like India and China is still strong, the problem of inflation remains with central banks furiously pursuing aggressive monetary policies. This has, in a way, put brakes on the demand for credit that is expected to slow down the pace of overall growth. Therefore, once again, there is a downward thrust on growth as central banks counter consumer inflation rates of 5.4% in China, 8.6% in India, 9% in Russia, 6.9% in Brazil and 5.3% in South Africa.
These governments have embarked on a policy of fiscal stimulus rollback and can look in only one direction: reduction of deficits. Hence, if no affirmative action is taken , then the slowdown can degenerate into a recession that will be slow and painful. Presently, no one wants to appear playing truant as Trust Economics has come into vogue. The solution is really for every entity to give in a bit and accept a tradeoff. US should continue to spend to provide demand notwithstanding its debt - sounds heretical after all the ado about the downgrade - as we need some benign neglect to revive the global economy.
ECB must lower rates for whatever it is worth. China should be more responsible and help foster global trade through exchange rate adjustments and other emerging markets must spend to keep business up. In short, both Keynesianism and monetarism should be pursued as 'deviant fiscal behaviour' , and inflation is better than prolonged stagnation.
Don’t rubbish the poverty criterion, Financial Express 22nd October 2011
Government bashing is easy because every action of it can be questioned as there are multiple ways of looking at issues. The Budget and monetary policies are two statements that always have critiques, depending on how we want them to be structured. The latest controversy for the government is the poverty line. Who is poor in India? This is relevant from the point of view of coverage under various government schemes as well as economic surveys of the government where we get to know how the country has progressed.
The definition of people who are poor is nebulous. In India, we follow the nutrition criteria and the cut-off of R32 a day in urban areas has come under sharp criticism. There is a World Bank definition of $1 a day or $1.25 a day at PPP (purchasing power parity). Based on these numbers, everyone has their own estimate of the number of poor. The Indian definition has less poor as the national poverty line is 28.6% compared with 41.5% for the World Bank (Economic Survey 2010-11). Then there is the Tendulkar Committee Report and the one from the Planning Commission that arrive at different cut-offs—poverty levels based on the Tendulkar committee (from where the R32 cut-off comes) are 37.2% in 2004-05. Finally, there was the Arjun Sengupta Report that created a stir as it spoke of 77% being poor based on a R20 cut-off, which included some basic services, too (2004-05).
The important thing is what we take into account when calculating who is poor. Should it be only food intake or even other amenities like housing, clothing, education etc? Hence, it becomes a challenge for the evaluator. It is, thus, necessary to upfront define what we mean by a poverty line. Once we move away from basic food, then it becomes difficult to work out costs on shelter or clothing, as they vary substantially across the country depending on the region or state. To take this issue sequentially, let us look at what is required for an individual family to just about live with no luxury of any sort to remain at the fringe of survival. The accompanying Table calculates the cost of various items that are necessary going by prices in Delhi for September 2011 as provided by the ministry of consumer affairs. A family of four is considered here.
The Table shows that at current prices, a family earning R3,800 a month is the basic amount that is required for survival in terms of food. This allows for the concept of tea being consumed regularly for the family and limited variety as well as quantity of vegetables in the form of potatoes and absence of any meat/fish. This amount can rise to, say, R4,000 in case of price aberrations. The cut-off of R32 a day comes close to this amount, because for a family of four, total expenditure is R3,840. Here again, we are assuming that all four are working. Therefore, an evaluator should be asking a question to a household of four members whether or not they earn R3,800 a month. If they do, then this will address the issue of basic food consumption and nothing more.
Thus, there is some merit in the cut-off of R32 a day in case we are talking of only food, with the assumption that facilities like water supply, education and health are taken care of by public systems. This leaves the issue of certain capital costs such as clothing, shelter, transport and maybe a minimum amount of utensils and cosmetics like soap/toothpaste that are required. Here one can impute a rental value of R1,000 in a distant suburb in an urban area and another R300 for electricity, and R700 for transport and other miscellaneous expenditure. Adding the two, a sum of R6,000 a month can be the cut-off for one on the precipice for absolute deprivation. This amount comes within the range of $1-1.25 a day, which works out to R6,000-7,500 per annum. The present amount of R3,800 a month would hold for a just about basic existence with support from public systems that may not exist.
So, how do we look at these numbers? First, let us not just condemn the government’s number of R32 a day per person. There is some sense in it and it is a good cut-off for the government to consider for BPL (below poverty line) supply of foodgrains or any other anti-poverty programme. In fact, the MGNREGA also assures a minimum wage of R100 a day, which covers one member of a family for a fixed number of days, and which assumes that the person’s other requirements are being addressed by the existing systems. Second, the criteria for defining poor should be made broader. It would be transparent to have two poverty lines—one of ‘absolute deprivation’ and the other defining the ‘margin of respectability’. As can be seen, even with R7,500 per month or $1.25 a day, the standard of living is still sub-optimal when compared with the level of living of the poor in other countries. The Centre’s aim must be to tackle deprivation while the state should look for means to improve the respectability of the community through effective supply programmes of health, education, clothing and affordable shelter.
Therefore, while one may still be critical of whether these numbers are adequate to keep a family actually alive, given that the poor in, say, a developed country like the US (family income of R22,350 per annum) is affluent compared to the Indian counterpart, let us not just criticise the government for such an estimate. Alternatives can be worked out and we can reach a consensus.
The definition of people who are poor is nebulous. In India, we follow the nutrition criteria and the cut-off of R32 a day in urban areas has come under sharp criticism. There is a World Bank definition of $1 a day or $1.25 a day at PPP (purchasing power parity). Based on these numbers, everyone has their own estimate of the number of poor. The Indian definition has less poor as the national poverty line is 28.6% compared with 41.5% for the World Bank (Economic Survey 2010-11). Then there is the Tendulkar Committee Report and the one from the Planning Commission that arrive at different cut-offs—poverty levels based on the Tendulkar committee (from where the R32 cut-off comes) are 37.2% in 2004-05. Finally, there was the Arjun Sengupta Report that created a stir as it spoke of 77% being poor based on a R20 cut-off, which included some basic services, too (2004-05).
The important thing is what we take into account when calculating who is poor. Should it be only food intake or even other amenities like housing, clothing, education etc? Hence, it becomes a challenge for the evaluator. It is, thus, necessary to upfront define what we mean by a poverty line. Once we move away from basic food, then it becomes difficult to work out costs on shelter or clothing, as they vary substantially across the country depending on the region or state. To take this issue sequentially, let us look at what is required for an individual family to just about live with no luxury of any sort to remain at the fringe of survival. The accompanying Table calculates the cost of various items that are necessary going by prices in Delhi for September 2011 as provided by the ministry of consumer affairs. A family of four is considered here.
The Table shows that at current prices, a family earning R3,800 a month is the basic amount that is required for survival in terms of food. This allows for the concept of tea being consumed regularly for the family and limited variety as well as quantity of vegetables in the form of potatoes and absence of any meat/fish. This amount can rise to, say, R4,000 in case of price aberrations. The cut-off of R32 a day comes close to this amount, because for a family of four, total expenditure is R3,840. Here again, we are assuming that all four are working. Therefore, an evaluator should be asking a question to a household of four members whether or not they earn R3,800 a month. If they do, then this will address the issue of basic food consumption and nothing more.
Thus, there is some merit in the cut-off of R32 a day in case we are talking of only food, with the assumption that facilities like water supply, education and health are taken care of by public systems. This leaves the issue of certain capital costs such as clothing, shelter, transport and maybe a minimum amount of utensils and cosmetics like soap/toothpaste that are required. Here one can impute a rental value of R1,000 in a distant suburb in an urban area and another R300 for electricity, and R700 for transport and other miscellaneous expenditure. Adding the two, a sum of R6,000 a month can be the cut-off for one on the precipice for absolute deprivation. This amount comes within the range of $1-1.25 a day, which works out to R6,000-7,500 per annum. The present amount of R3,800 a month would hold for a just about basic existence with support from public systems that may not exist.
So, how do we look at these numbers? First, let us not just condemn the government’s number of R32 a day per person. There is some sense in it and it is a good cut-off for the government to consider for BPL (below poverty line) supply of foodgrains or any other anti-poverty programme. In fact, the MGNREGA also assures a minimum wage of R100 a day, which covers one member of a family for a fixed number of days, and which assumes that the person’s other requirements are being addressed by the existing systems. Second, the criteria for defining poor should be made broader. It would be transparent to have two poverty lines—one of ‘absolute deprivation’ and the other defining the ‘margin of respectability’. As can be seen, even with R7,500 per month or $1.25 a day, the standard of living is still sub-optimal when compared with the level of living of the poor in other countries. The Centre’s aim must be to tackle deprivation while the state should look for means to improve the respectability of the community through effective supply programmes of health, education, clothing and affordable shelter.
Therefore, while one may still be critical of whether these numbers are adequate to keep a family actually alive, given that the poor in, say, a developed country like the US (family income of R22,350 per annum) is affluent compared to the Indian counterpart, let us not just criticise the government for such an estimate. Alternatives can be worked out and we can reach a consensus.
Sargent, Sims and RBI Financial Express, 12th October 2011
It has become almost a fashion that the Nobel Prize winners get their reward long after they have made their contribution. It is said in a wry manner that seldom do the winners actually get to enjoy this recognition in their prime and end up ruminating over the same in their twilight years. Also, some of the winners become famous after the award while being in the shadow for most of their careers. However, the field of economics has been different, as it does recognise economists in their prime and for very relevant reasons. This holds especially for Thomas Sargent and Christopher Sims, who are just too relevant in this uncertain world of financial and country crises. Their theories have added method to the madness around us, thus signalling to policymakers as to what should be done.
Their relevance today is for all central banks and governments as they seem to be quite unsure of what should be done given the low level of credibility in a situation of economic downturn. How do we go around framing policies when there is a two-way symbiotic relation between economic variables and policies? For example, central banks base their policies on what they expect economic agents to do, while these agents base their decisions on the basis of what they expect the central bank to do. Therefore, every step taken in this game is based on expectations of the behaviour of the other. One is not sure of whether one or both will get it right. How then does one reach equilibrium, considering that each of the participants is one step ahead of the other all the time?
This is where Thomas Sargent took off on the efficacy of policy changes that are expected and unexpected in the now famous theory of Rational Expectations, along with Robert Lucas, way back in the 1970s. Let us suppose that all of us now expect RBI to increase interest rates later this month. We, as rational economic beings, adjust our decisions based on this rate hike. Now when this rate hike takes place, we see that it is ineffective as it no longer matters as decisions have already factored in these changes. Therefore, Sargent would say that for policy to have its effect, it must be unexpected. In simple language, this means that RBI should, say, raise rates by 50 bps instead of an expected 25 bps if the market is expecting the latter. Intuitively, we can see that when we expect a 25 bps increase in interest rates, we may increase our demand for credit beforehand and hence dent RBI’s move when it happens, which is aimed at controlling growth in credit.
The same holds for tax policies of the government. Sims talks of shocks while Sargent stresses on systemic policy shifts that matter. Both ways, there is a challenge for policymakers, especially when they target, say, inflation. Should we lower tax rates? The crude oil customs rate was lowered by the government around three months ago, but that did not help as prices continued to be rigid. Similarly, RBI has increased interest rates to curb inflation, but the impact has not been satisfactory and this is where we have another theory of efficient markets that comes in the way. If markets are efficient, then they take into account all factors that move it automatically so that the price discovered imbibes the same, which, in the context of expected policy responses, is already subsumed. Therefore, we do need systemic policies to counter the same and not just single shots at rate hikes. Maybe this is what RBI has been pursuing for the last 18 months or so with sustained increases in rates.
The quandary for policymakers is quite interesting. By raising rates, we can impact inflation with a lag of two years (based on their studies). However, the impact on GDP is immediate, as spending stops immediately and hence this is the starting point of the problems as it takes a substantially longer time period for this reversal to upswing.
But the question for, say, RBI, or even the Fed, is whether or not the market is really efficient. If it is, in the theoretical sense, then it may not matter. But in the current context, where there is asymmetric information and varied expectations based on numerous conjectures, an optimal solution will still not be forthcoming, thus opening up the scope for systemic policy steps, which, though not unexpected, are still effective.
These economists have used a lot of econometric modelling to prove their theories and, given the nebulous and symbiotic relation between the two sets of factors, RBI should probably build a strong theoretical basis for its policy actions based on empirical evidence. This will explain, if not resolve, the ongoing debate of the tenuous relationship between interest rates and inflation, where the majority view is gravitating towards the school that given the lags involved, we may just about be shooting in the dark.
Also, to address the issue of providing shock therapy to the markets to be more effective, maybe there should be no official communication on the central bank’s view of interest rates as we have an official statement coming in every 45 days. This may just make the statements more powerful in terms of effect, which is what monetary policy is all about.
Therefore, a combination of systemic policies with shock elements could be the prescription.
Their relevance today is for all central banks and governments as they seem to be quite unsure of what should be done given the low level of credibility in a situation of economic downturn. How do we go around framing policies when there is a two-way symbiotic relation between economic variables and policies? For example, central banks base their policies on what they expect economic agents to do, while these agents base their decisions on the basis of what they expect the central bank to do. Therefore, every step taken in this game is based on expectations of the behaviour of the other. One is not sure of whether one or both will get it right. How then does one reach equilibrium, considering that each of the participants is one step ahead of the other all the time?
This is where Thomas Sargent took off on the efficacy of policy changes that are expected and unexpected in the now famous theory of Rational Expectations, along with Robert Lucas, way back in the 1970s. Let us suppose that all of us now expect RBI to increase interest rates later this month. We, as rational economic beings, adjust our decisions based on this rate hike. Now when this rate hike takes place, we see that it is ineffective as it no longer matters as decisions have already factored in these changes. Therefore, Sargent would say that for policy to have its effect, it must be unexpected. In simple language, this means that RBI should, say, raise rates by 50 bps instead of an expected 25 bps if the market is expecting the latter. Intuitively, we can see that when we expect a 25 bps increase in interest rates, we may increase our demand for credit beforehand and hence dent RBI’s move when it happens, which is aimed at controlling growth in credit.
The same holds for tax policies of the government. Sims talks of shocks while Sargent stresses on systemic policy shifts that matter. Both ways, there is a challenge for policymakers, especially when they target, say, inflation. Should we lower tax rates? The crude oil customs rate was lowered by the government around three months ago, but that did not help as prices continued to be rigid. Similarly, RBI has increased interest rates to curb inflation, but the impact has not been satisfactory and this is where we have another theory of efficient markets that comes in the way. If markets are efficient, then they take into account all factors that move it automatically so that the price discovered imbibes the same, which, in the context of expected policy responses, is already subsumed. Therefore, we do need systemic policies to counter the same and not just single shots at rate hikes. Maybe this is what RBI has been pursuing for the last 18 months or so with sustained increases in rates.
The quandary for policymakers is quite interesting. By raising rates, we can impact inflation with a lag of two years (based on their studies). However, the impact on GDP is immediate, as spending stops immediately and hence this is the starting point of the problems as it takes a substantially longer time period for this reversal to upswing.
But the question for, say, RBI, or even the Fed, is whether or not the market is really efficient. If it is, in the theoretical sense, then it may not matter. But in the current context, where there is asymmetric information and varied expectations based on numerous conjectures, an optimal solution will still not be forthcoming, thus opening up the scope for systemic policy steps, which, though not unexpected, are still effective.
These economists have used a lot of econometric modelling to prove their theories and, given the nebulous and symbiotic relation between the two sets of factors, RBI should probably build a strong theoretical basis for its policy actions based on empirical evidence. This will explain, if not resolve, the ongoing debate of the tenuous relationship between interest rates and inflation, where the majority view is gravitating towards the school that given the lags involved, we may just about be shooting in the dark.
Also, to address the issue of providing shock therapy to the markets to be more effective, maybe there should be no official communication on the central bank’s view of interest rates as we have an official statement coming in every 45 days. This may just make the statements more powerful in terms of effect, which is what monetary policy is all about.
Therefore, a combination of systemic policies with shock elements could be the prescription.
Let’s not be overawed : 5th October 2011 Financial Express
That the fiscal deficit was going to be exceeded was a foregone inevitability once the government reduced duties on oil products a few months ago, which would result in a fall of around R50,000 crore in tax revenue. The slowdown in growth in industry is indicative of excise collections getting under pressure while other collections like corporate tax and customs would be in the fuzzy zone for some time. The only way the situation could have been saved is by the denominator increasing to maintain the ratio at around 4.6% for the year. With the government/RBI now announcing a calendar for government borrowing of an additional R53,000 crore, the markets have been spooked. How serious is the issue?
The fiscal deficit ratio is the one which is under the control of the government to a large extent as it has the power to monitor the expenditure towards the end of the year, depending on how the revenue collections fare. Often in the past, project expenditure is scaled down to ensure that the ratio is maintained while the sluggish nature of approval of projects in the normal course adds to the comfort level. Admittedly, this will be a challenge, considering that some part of the NREGA allocation would have been spent by now. Therefore, there is a strong possibility of the budget still being manageable notwithstanding these slippages.
The fiscal deficit ratio of 4.6% was budgeted on the assumption that GDP at current market prices would grow by 14% in FY12. In real terms, GDP was projected to increase by 9%, consistent with 5% inflation. The way things have turned out, real GDP will grow by possibly 8% now, while inflation would average 9% for the year, thus bringing the nominal growth rate to 16%. The higher inflation rate will hence be quite fortuitous for the budget. This higher base will cushion the higher numerator, which will be higher by around R50,000 crore. The fiscal deficit ratio hence will be around 5% of GDP for the year under these conditions.
The only joker in the pack, so to say, would be the disinvestment programme, where the government started off with hopes of raising R40,000 crore and little progress has been made so far. While the market may not be exciting for raising money at this point of time when global markets are also gloomy, given the uncertain conditions in the euro area, any action of the government by itself can propel investors at a time when there is a drought in the market. But, certainly, this can upset calculations further, which could take the ratio to 5.5%, depending on the revenue shortfall on this score.
How about the money markets? Bond prices have been quick to respond, which is but natural, given that there will be an excess supply of paper, which, in turn, will depress bond prices and increase yields. But yields may not really soar to substantially higher levels if one looks at past trends. During June-August 2008, 10-year yields scaled the 9% mark and touched 9.32%, but this was not a year when borrowings were excessive. It was caused by tight monetary conditions, in terms of both liquidity and interest rates, at a time when there was a global financial crisis and RBI too had been aggressive in the market. Interest rates surely are high today given high inflation (which was subdued at that time). But liquidity is relatively easy, which is comforting in this situation. Also, traditionally, bond yields react more to liquidity conditions than the policy stance on interest rates.
RBI has already scaled down its projection for credit growth by 1 percentage point, which intuitively means that, on a base of R35 lakh crore as of March 2011, there would be a potential release of R35,000 crore for banks, assuming that deposits continue to grow smartly. In fact, the picture up to the first week of September shows that there is a large gap between incremental deposits and credit by around R1,30,000 crore, which is indicative of a twin phenomenon of growing deposits and subdued credit conditions. Therefore, liquidity should not really be an issue, though banks will not be too comfortable with declining bond prices as it would mean a hit on their mark-to-market valuation of their investment portfolio at the end of the year. Hence, their concern would be of a different kind, given that liquidity could be positive as long as growth in credit does not accelerate—which is anyway RBI’s goal, given its aggressive monetary policy stance.
All this means that while there will be a fiscal slippage, and our dream of moving towards the 3% fiscal deficit mark is still far away, conditions will not be too bad. Globally, too, deficits are high, with governments struggling to keep it under control. In fact, the new way of thinking everywhere is that higher deficits are useful to keep economies afloat. There is no reason why things should be different here in India.
The fiscal deficit ratio is the one which is under the control of the government to a large extent as it has the power to monitor the expenditure towards the end of the year, depending on how the revenue collections fare. Often in the past, project expenditure is scaled down to ensure that the ratio is maintained while the sluggish nature of approval of projects in the normal course adds to the comfort level. Admittedly, this will be a challenge, considering that some part of the NREGA allocation would have been spent by now. Therefore, there is a strong possibility of the budget still being manageable notwithstanding these slippages.
The fiscal deficit ratio of 4.6% was budgeted on the assumption that GDP at current market prices would grow by 14% in FY12. In real terms, GDP was projected to increase by 9%, consistent with 5% inflation. The way things have turned out, real GDP will grow by possibly 8% now, while inflation would average 9% for the year, thus bringing the nominal growth rate to 16%. The higher inflation rate will hence be quite fortuitous for the budget. This higher base will cushion the higher numerator, which will be higher by around R50,000 crore. The fiscal deficit ratio hence will be around 5% of GDP for the year under these conditions.
The only joker in the pack, so to say, would be the disinvestment programme, where the government started off with hopes of raising R40,000 crore and little progress has been made so far. While the market may not be exciting for raising money at this point of time when global markets are also gloomy, given the uncertain conditions in the euro area, any action of the government by itself can propel investors at a time when there is a drought in the market. But, certainly, this can upset calculations further, which could take the ratio to 5.5%, depending on the revenue shortfall on this score.
How about the money markets? Bond prices have been quick to respond, which is but natural, given that there will be an excess supply of paper, which, in turn, will depress bond prices and increase yields. But yields may not really soar to substantially higher levels if one looks at past trends. During June-August 2008, 10-year yields scaled the 9% mark and touched 9.32%, but this was not a year when borrowings were excessive. It was caused by tight monetary conditions, in terms of both liquidity and interest rates, at a time when there was a global financial crisis and RBI too had been aggressive in the market. Interest rates surely are high today given high inflation (which was subdued at that time). But liquidity is relatively easy, which is comforting in this situation. Also, traditionally, bond yields react more to liquidity conditions than the policy stance on interest rates.
RBI has already scaled down its projection for credit growth by 1 percentage point, which intuitively means that, on a base of R35 lakh crore as of March 2011, there would be a potential release of R35,000 crore for banks, assuming that deposits continue to grow smartly. In fact, the picture up to the first week of September shows that there is a large gap between incremental deposits and credit by around R1,30,000 crore, which is indicative of a twin phenomenon of growing deposits and subdued credit conditions. Therefore, liquidity should not really be an issue, though banks will not be too comfortable with declining bond prices as it would mean a hit on their mark-to-market valuation of their investment portfolio at the end of the year. Hence, their concern would be of a different kind, given that liquidity could be positive as long as growth in credit does not accelerate—which is anyway RBI’s goal, given its aggressive monetary policy stance.
All this means that while there will be a fiscal slippage, and our dream of moving towards the 3% fiscal deficit mark is still far away, conditions will not be too bad. Globally, too, deficits are high, with governments struggling to keep it under control. In fact, the new way of thinking everywhere is that higher deficits are useful to keep economies afloat. There is no reason why things should be different here in India.
Sunday, October 2, 2011
Again, The Good Ol’ Debt Trap: Book Review in Business World 3rd September 2011
Bust: Greece, The Euro, And The Sovereign Debt Crisis
By Matthew Lynn
For history buffs, the Acropolis is the bastion of western civilisation. For music aficionados, it is a reminder of the famous music concert of Yanni. On 4 May 2010, as a financial crisis unfolded in Greece, the structure witnessed an important turn in history. Multitudes of people climbed its portals to hoist banners featuring the hammer and sickle, which was antithetical to what the European nation stood for. Syntagma Square in central Athens became a riot square of opposition. Journalist Matthew Lynn tracks the story of Greece’s meltdown in Bust and unveils the fault lines that were evident but ignored as the crisis was fomenting. There were several rogues in the kitchen, but the bond players started the mess, and played out the acts in vivid technicolour.
Lynn says the problem was basically with the concept of the euro, which was more a political convenience rather than an economic solution. The seed idea dates back to Napoleon Bonaparte, Victor Hugo and John Stuart Mill, and its ultimate creation under the aegis of Brussels and Frankfurt was a victory of the implausible over the rational and, hence, had to be short lived. The irony was not lost when European Central Bank president Jean-Claude Trichet had been revelling in the glory of the euro just about a month before the drama was staged. A decade was a long time for such episodes to be played, as Greece, not known for its honesty, kept fudging its numbers and promised to be a good boy when entering the euro. The community was only too keen to have as many members under it, and closed its eyes. The drachma, which no one would touch, was alchemised into the euro as the country gained acceptance.
Lynn feels that there was always a difference between Europe’s north and south, and two variants of the euro could be a solution to the current crisis. Germany is the proverbial conservative player, which set the rules and followed them assiduously. While it was known that the rich would pay for the poor, Spain and Ireland misused the largesse available through the common low interest rate policy on buildings, which was not sustainable.
As the crisis exploded, there was acrimony as Germans felt they should not be helping cheats, while the Greeks went back to Nazi history to say continuance of support was reparation. Bringing in the IMF to play the bad cop helped the German cause and the Euro ego as the possible collapse of the currency was more a threat to the concept, than the Euro economy.
Lynn takes us through the events as if in fiction without being judgemental. He explains the complexities of the fiasco where French banks held Spanish, German and Italian debt. So, no one could be allowed to fail, else all would go down. Devaluation could not happen because of a single currency and neither could one inflate to lower the value of debt as Zimbabwe did.
Lynn poses some interesting queries on brea-king up the euro. If Greece was kicked out, it would go bankrupt and its creditors could suffer. So, restructuring was necessary. The other option is to have Germany exit as its Deutsche Mark is stronger than the euro. The mark will appreciate, but Germany’s exports will not suffer as quality is a distinguishing factor anyway. But the euro will collapse as it will be dominated by the French and Italians who the Dutch or Austrians do not trust. That is the rub.
Lynn concludes by leaving us ruminating on three lessons. First, do not put politics before economics. Second, let markets decide the outcome (means: let Greece go bust). Last, be suspicious of all grand schemes such as the euro, which do not leave room for error. He ends by saying that the West’s intellectual dominance started in ancient Athens also died, probably, here. That is the touch of a journalist, which leaves you thinking.
By Matthew Lynn
For history buffs, the Acropolis is the bastion of western civilisation. For music aficionados, it is a reminder of the famous music concert of Yanni. On 4 May 2010, as a financial crisis unfolded in Greece, the structure witnessed an important turn in history. Multitudes of people climbed its portals to hoist banners featuring the hammer and sickle, which was antithetical to what the European nation stood for. Syntagma Square in central Athens became a riot square of opposition. Journalist Matthew Lynn tracks the story of Greece’s meltdown in Bust and unveils the fault lines that were evident but ignored as the crisis was fomenting. There were several rogues in the kitchen, but the bond players started the mess, and played out the acts in vivid technicolour.
Lynn says the problem was basically with the concept of the euro, which was more a political convenience rather than an economic solution. The seed idea dates back to Napoleon Bonaparte, Victor Hugo and John Stuart Mill, and its ultimate creation under the aegis of Brussels and Frankfurt was a victory of the implausible over the rational and, hence, had to be short lived. The irony was not lost when European Central Bank president Jean-Claude Trichet had been revelling in the glory of the euro just about a month before the drama was staged. A decade was a long time for such episodes to be played, as Greece, not known for its honesty, kept fudging its numbers and promised to be a good boy when entering the euro. The community was only too keen to have as many members under it, and closed its eyes. The drachma, which no one would touch, was alchemised into the euro as the country gained acceptance.
Lynn feels that there was always a difference between Europe’s north and south, and two variants of the euro could be a solution to the current crisis. Germany is the proverbial conservative player, which set the rules and followed them assiduously. While it was known that the rich would pay for the poor, Spain and Ireland misused the largesse available through the common low interest rate policy on buildings, which was not sustainable.
As the crisis exploded, there was acrimony as Germans felt they should not be helping cheats, while the Greeks went back to Nazi history to say continuance of support was reparation. Bringing in the IMF to play the bad cop helped the German cause and the Euro ego as the possible collapse of the currency was more a threat to the concept, than the Euro economy.
Lynn takes us through the events as if in fiction without being judgemental. He explains the complexities of the fiasco where French banks held Spanish, German and Italian debt. So, no one could be allowed to fail, else all would go down. Devaluation could not happen because of a single currency and neither could one inflate to lower the value of debt as Zimbabwe did.
Lynn poses some interesting queries on brea-king up the euro. If Greece was kicked out, it would go bankrupt and its creditors could suffer. So, restructuring was necessary. The other option is to have Germany exit as its Deutsche Mark is stronger than the euro. The mark will appreciate, but Germany’s exports will not suffer as quality is a distinguishing factor anyway. But the euro will collapse as it will be dominated by the French and Italians who the Dutch or Austrians do not trust. That is the rub.
Lynn concludes by leaving us ruminating on three lessons. First, do not put politics before economics. Second, let markets decide the outcome (means: let Greece go bust). Last, be suspicious of all grand schemes such as the euro, which do not leave room for error. He ends by saying that the West’s intellectual dominance started in ancient Athens also died, probably, here. That is the touch of a journalist, which leaves you thinking.
Lag effect of rate rise worries apex bank: Economic Times 28th September 2011
Every time the Reserve Bank of India (RBI) increases interest rates, a plethora of voices are heard. Industry laments that their profits get squeezed affecting growth. Bankers aver that their interest margins come under pressure and non-performing assets (NPAs) get perversely affected. The RBI is concerned more on the transmission mechanism as credit growth continues with only the GSec market being responsive.
At times, bankers openly state that they will not alter rates. What has been the past experience? The increase in repo rate affects banks as they borrow from RBI which affects the call and CBLO markets where the repo rate is the benchmark. Today banks are borrowing around Rs 20,000-50 ,000 crore, while the daily trade volume in the call, CBLO and repo is around Rs 70,000-80 ,000 crore.
The transmission process is quite direct here. Deposits are slow to react to rate hikes, and it is only the incremental deposits which are affected as rates are increased in those tenure buckets where funds are required. Further, a large proportion of deposits (35-40 %) are CASA which buffers the overall cost impact. Now, between FY06 and mid-FY 09 the RBI raised the repo rate by 300 bps, yet the cost of deposits of a set of 71 banks increased from 4.52% to 6.22% with a lag of over a year. Subsequently in FY09, the RBI scaled down the repo rate by 275 bps and later increased the same by 200 bps in the next two years.
Yet, the cost of deposits has been declining continuously from 6.22% in FY09 to 5.54% in FY10 and 5.07% in FY11. Quite clearly, the higher deposit rates of last year have not yet shown in the cost of deposits as there is a lag of 1 year in actual transmission. The return on advances reacts almost instantaneously and the 300-bps increase was reflected in an increase of 230 bps to 10.51% up to FY09. But it declined subsequently even as the RBI raised rates in FY10 and FY11 to 9.28% and 9.24%, respectively.
This really means that banks have not increased their return to retain business. Therefore , a lot depends on the lag effect in FY12 when cost of deposits and return on advances would increase. Net interest margin declined continuously from 3.01% in FY06 to 2.48% in FY10, before increasing to 2.90% in FY11, which means that in net terms, borrowers have started bearing the higher interest cost.
Profitability too has been stable with return on assets vacillating between 0.98% and1.07%. The RBI has maintained that the transmission mechanism of interest rates is sluggish and has, therefore, been aggressive. The return on advances for FY12 would witness an upward thrust with the lag effect of 200-bps increase in rates in the last two years striking harder and faster than that in deposits, especially as the latter slowed down in FY11.
The impact on corporate profits can be gauged by the results of a set of 1,401 non-financial companies. Growth in both PBT and PBIT had accelerated in FY07 (36-38 %) when the RBI increased rates and stabilised at around 27% in FY08 when rates remained unchanged.
Profits declined in FY09 and were robust in FY10 with the base year effect kicking in. However in FY11, growth slowed down to 16-17 %. On asset quality, additions to gross NPAs increased sharply in FY09 (47.8%) and FY10 (33.1%) and moderated subsequently. These were also the years when industrial production slowed down to 2.5% and 5.3%, respectively. The financial crisis had its impact in FY09 when overall GDP growth was impacted.
Therefore, there may be a tendency for NPAs to increase when conditions are challenging and would indirectly be related to interest rates. GSec rates have moved in consonance with the repo rate though with less than unitary elasticity. The yield on 10-years GSec rose by around 50 bps when the repo rate was changed by 125 bps in FY07. The decline in yield by almost 90 bps in FY09 was less than commensurate with the net decrease of 150 bps invoked by the RBI, while the increase in the last two years has again been around half the increase in the repo rate.
Clearly, there are other factors at work affecting the yields. Four conclusions may be drawn. First, the impact on cost of deposits comes with a lag while the cost for borrowers increases immediately. Second, corporate profits have shown some signs of stress last year and will face challenging times in FY12 as fresh investment will be impacted as we have reached the inflexion point.
Third, bank profitability will be under pressure depending on the impact on interest margins and, more importantly, provisions for NPAs. Lastly, the GSec market is the most responsive one and the rates respond , though not commensurately. The story of interest rate impact may just change this year compared with the earlier ones when resilience was shown at all ends.
At times, bankers openly state that they will not alter rates. What has been the past experience? The increase in repo rate affects banks as they borrow from RBI which affects the call and CBLO markets where the repo rate is the benchmark. Today banks are borrowing around Rs 20,000-50 ,000 crore, while the daily trade volume in the call, CBLO and repo is around Rs 70,000-80 ,000 crore.
The transmission process is quite direct here. Deposits are slow to react to rate hikes, and it is only the incremental deposits which are affected as rates are increased in those tenure buckets where funds are required. Further, a large proportion of deposits (35-40 %) are CASA which buffers the overall cost impact. Now, between FY06 and mid-FY 09 the RBI raised the repo rate by 300 bps, yet the cost of deposits of a set of 71 banks increased from 4.52% to 6.22% with a lag of over a year. Subsequently in FY09, the RBI scaled down the repo rate by 275 bps and later increased the same by 200 bps in the next two years.
Yet, the cost of deposits has been declining continuously from 6.22% in FY09 to 5.54% in FY10 and 5.07% in FY11. Quite clearly, the higher deposit rates of last year have not yet shown in the cost of deposits as there is a lag of 1 year in actual transmission. The return on advances reacts almost instantaneously and the 300-bps increase was reflected in an increase of 230 bps to 10.51% up to FY09. But it declined subsequently even as the RBI raised rates in FY10 and FY11 to 9.28% and 9.24%, respectively.
This really means that banks have not increased their return to retain business. Therefore , a lot depends on the lag effect in FY12 when cost of deposits and return on advances would increase. Net interest margin declined continuously from 3.01% in FY06 to 2.48% in FY10, before increasing to 2.90% in FY11, which means that in net terms, borrowers have started bearing the higher interest cost.
Profitability too has been stable with return on assets vacillating between 0.98% and1.07%. The RBI has maintained that the transmission mechanism of interest rates is sluggish and has, therefore, been aggressive. The return on advances for FY12 would witness an upward thrust with the lag effect of 200-bps increase in rates in the last two years striking harder and faster than that in deposits, especially as the latter slowed down in FY11.
The impact on corporate profits can be gauged by the results of a set of 1,401 non-financial companies. Growth in both PBT and PBIT had accelerated in FY07 (36-38 %) when the RBI increased rates and stabilised at around 27% in FY08 when rates remained unchanged.
Profits declined in FY09 and were robust in FY10 with the base year effect kicking in. However in FY11, growth slowed down to 16-17 %. On asset quality, additions to gross NPAs increased sharply in FY09 (47.8%) and FY10 (33.1%) and moderated subsequently. These were also the years when industrial production slowed down to 2.5% and 5.3%, respectively. The financial crisis had its impact in FY09 when overall GDP growth was impacted.
Therefore, there may be a tendency for NPAs to increase when conditions are challenging and would indirectly be related to interest rates. GSec rates have moved in consonance with the repo rate though with less than unitary elasticity. The yield on 10-years GSec rose by around 50 bps when the repo rate was changed by 125 bps in FY07. The decline in yield by almost 90 bps in FY09 was less than commensurate with the net decrease of 150 bps invoked by the RBI, while the increase in the last two years has again been around half the increase in the repo rate.
Clearly, there are other factors at work affecting the yields. Four conclusions may be drawn. First, the impact on cost of deposits comes with a lag while the cost for borrowers increases immediately. Second, corporate profits have shown some signs of stress last year and will face challenging times in FY12 as fresh investment will be impacted as we have reached the inflexion point.
Third, bank profitability will be under pressure depending on the impact on interest margins and, more importantly, provisions for NPAs. Lastly, the GSec market is the most responsive one and the rates respond , though not commensurately. The story of interest rate impact may just change this year compared with the earlier ones when resilience was shown at all ends.
RBI must intervene: Financial Express 27th September 2011
The stock market is known for its inherent volatility and, since July 1, has shown annualised volatility of 22% as against 8% in the forex market. In September, however, this difference has narrowed down, with stock market volatility being 26% and forex 12%. Clearly, the forex market has become a more interesting market with various forces at work that have made an otherwise staid market into one which has provoked concern and discussion.
The spot merchant forex market has a turnover of around R3,000 crore a day while the OTC forward registers trades of R5,000 crore. The inter-bank spot and forward markets clock around R15,000 crore each while the F&O turnover on the exchanges is another R70,000 crore. The price discovery process is robust, as the market knows best.
Given the volumes traded and wide-scale participation, there can be no case of manipulation. Therefore, in a free market economy, ideally a sharp depreciation in the currency should be allowed to prevail.
However, if you were the central bank, this stance may not be possible. Theoretically, two sets of factors drive the exchange rate. The first is the physical demand and supply for dollars, and the other is the fallout of the euro-dollar relationship. Both the components are fuzzy today. The demand is not unusual as while the trade deficit has widened, it is still under control. Besides, this cannot affect the rate on a daily basis. On the supply side, the FII flows matter as there is a one-to-one correspondence here. These flows have been fairly erratic on a daily basis, but more stable when aggregated over months.
The euro-dollar relation is more complex. Global uncertainly pervades this relation on a real time basis. The Eurozone is in all kinds of trouble. The rogue nations are on the precipice of default and the trust deficit between nations is at an all-time high. Any news on the default of any nation or the discovery of high debts on their balance sheets is driving the euro down vis-Ã -vis the dollar, even though nothing much happens on the dollar end. Further, any announcement of a possible stimulus in the US or the absence of one could drive the dollar up or down. In this situation, the rupee takes a hit as part of the transmission mechanism.
A regression analysis of the rupee movement with the euro-dollar movement (with lags) and absolute FII flows on a daily basis since June shows that around 30% of the variation in the rupee-dollar rate since June can be explained by these two factors. The euro-dollar rate, with current and two-day lags, has an influence of around 0.40%, thereby meaning that three days of dollar strengthening by 1% can lead to a 0.4% fall in the rupee. In the month of September, the dollar strengthened by around 5.4% (until September 22), which can explain just over 2% of this variation. The impact of FIIs, on the other hand, is quite marginal at 0.00037 (i.e. $1,000 million net inflows will cause rupee appreciation of 0.37%). The important point is that around 70% of the variation cannot be statistically explained and is attributable to ‘sentiment’. This is why RBI intervention is called for.
RBI’s concern as a regulator is to intervene in any market when there is too much volatility. Bond price volatility is addressed through some large banks while stock prices are addressed by the insurance companies. For the forex market, when sentiment is quite adverse, direct intervention could be justified. The depreciation that we are witnessing has some important implications that can justify intervention if RBI is convinced that it is not being driven by only fundamentals.
First, the boost to exports that depreciation provides is unlikely to materialise since the global markets and world trade have slowed down. Therefore, halting this depreciation will not have an adverse impact.
Second, the chance of imported inflation is there, as imports would continue to flow at a higher cost. Rupee depreciation has already negated the phenomenon of declining global commodity prices. RBI is trying hard to control inflation through repo rate hikes. Letting in imported inflation will be contradictory to its own stance. In fact, imported inflation will not be just through higher cost of imports but also derived inflation where commodity prices are based on a global price discovery process. Third, rupee depreciation will hit our external debt servicing quite hard. This year, there are around $25 billion of outflows, which already mean an additional burden of R10,000 crore for the economy. Fourth, in the first four months of the year, there have been $12.3 billion of ECB approvals compared with $23 billion of inflows last year. A depreciating rupee adds to the future burden. Fifth, companies now wishing to borrow will have to pay a higher risk premium in the euro market.
Under these conditions, there is a strong case for intervention by RBI to control the falling rupee. While India is better placed than other nations in terms of growth, there are still concerns on inflation. Unchecked rupee depreciation, which is not driven by fundamentals, is not a good sign, as it upsets the wobbly apple cart. Sustained intervention with guidance on a target range will help to assuage the market greatly.
The spot merchant forex market has a turnover of around R3,000 crore a day while the OTC forward registers trades of R5,000 crore. The inter-bank spot and forward markets clock around R15,000 crore each while the F&O turnover on the exchanges is another R70,000 crore. The price discovery process is robust, as the market knows best.
Given the volumes traded and wide-scale participation, there can be no case of manipulation. Therefore, in a free market economy, ideally a sharp depreciation in the currency should be allowed to prevail.
However, if you were the central bank, this stance may not be possible. Theoretically, two sets of factors drive the exchange rate. The first is the physical demand and supply for dollars, and the other is the fallout of the euro-dollar relationship. Both the components are fuzzy today. The demand is not unusual as while the trade deficit has widened, it is still under control. Besides, this cannot affect the rate on a daily basis. On the supply side, the FII flows matter as there is a one-to-one correspondence here. These flows have been fairly erratic on a daily basis, but more stable when aggregated over months.
The euro-dollar relation is more complex. Global uncertainly pervades this relation on a real time basis. The Eurozone is in all kinds of trouble. The rogue nations are on the precipice of default and the trust deficit between nations is at an all-time high. Any news on the default of any nation or the discovery of high debts on their balance sheets is driving the euro down vis-Ã -vis the dollar, even though nothing much happens on the dollar end. Further, any announcement of a possible stimulus in the US or the absence of one could drive the dollar up or down. In this situation, the rupee takes a hit as part of the transmission mechanism.
A regression analysis of the rupee movement with the euro-dollar movement (with lags) and absolute FII flows on a daily basis since June shows that around 30% of the variation in the rupee-dollar rate since June can be explained by these two factors. The euro-dollar rate, with current and two-day lags, has an influence of around 0.40%, thereby meaning that three days of dollar strengthening by 1% can lead to a 0.4% fall in the rupee. In the month of September, the dollar strengthened by around 5.4% (until September 22), which can explain just over 2% of this variation. The impact of FIIs, on the other hand, is quite marginal at 0.00037 (i.e. $1,000 million net inflows will cause rupee appreciation of 0.37%). The important point is that around 70% of the variation cannot be statistically explained and is attributable to ‘sentiment’. This is why RBI intervention is called for.
RBI’s concern as a regulator is to intervene in any market when there is too much volatility. Bond price volatility is addressed through some large banks while stock prices are addressed by the insurance companies. For the forex market, when sentiment is quite adverse, direct intervention could be justified. The depreciation that we are witnessing has some important implications that can justify intervention if RBI is convinced that it is not being driven by only fundamentals.
First, the boost to exports that depreciation provides is unlikely to materialise since the global markets and world trade have slowed down. Therefore, halting this depreciation will not have an adverse impact.
Second, the chance of imported inflation is there, as imports would continue to flow at a higher cost. Rupee depreciation has already negated the phenomenon of declining global commodity prices. RBI is trying hard to control inflation through repo rate hikes. Letting in imported inflation will be contradictory to its own stance. In fact, imported inflation will not be just through higher cost of imports but also derived inflation where commodity prices are based on a global price discovery process. Third, rupee depreciation will hit our external debt servicing quite hard. This year, there are around $25 billion of outflows, which already mean an additional burden of R10,000 crore for the economy. Fourth, in the first four months of the year, there have been $12.3 billion of ECB approvals compared with $23 billion of inflows last year. A depreciating rupee adds to the future burden. Fifth, companies now wishing to borrow will have to pay a higher risk premium in the euro market.
Under these conditions, there is a strong case for intervention by RBI to control the falling rupee. While India is better placed than other nations in terms of growth, there are still concerns on inflation. Unchecked rupee depreciation, which is not driven by fundamentals, is not a good sign, as it upsets the wobbly apple cart. Sustained intervention with guidance on a target range will help to assuage the market greatly.
The lay of the land: Financial Express 15th September 2011
Conventional economic theory talks of four factors of production—land, labour, capital and enterprise—that are required for growth. To this has been added technology, while the more fertile minds have appended others, like human capital. However, theories have been floated for all factors except land, which was exogenously given. And, ironically, land has been one of the most controversial issues when discussing economic progress in the country. The land laws date to 1894 and evidently are anachronistic and controversial as it transcends into a social issue that is quite characteristically captured by realpolitik.
The problem with land is that there are an equal number of interested and antagonistic parties. The Sardar Sarovar Dam is an evergreen story, while the escapades of Tata Motors or Sterlite are more recent. There are companies that want to buy land and use the same for mineral exploration or setting up their units. The owners are either landlords or poor people with marginal but contiguous units of land who would sell, though they do not quite know what it best for them. Then there are the ubiquitous environmentalists who will always find a reason to block such deals. Add to this the group of activists who are anti-industry about everything and the battlefield gets dense.
At another level, there are various levels of government that come in the way of land ownership, with the laws being nebulous on the extent to which the Centre has the power to overrule the state and local bodies. Given that the
governments are from different parties across these governing units, there will be conflict.
The current Land Acquisition Bill, if enacted, will provide guidelines for future land deals. To touch on the major contours, this is how the new proposed rules look. The Bill talks of resettlement and rehabilitation of the affected people. There are rules governing the acquiescence of 80% of the owners, while multi-cropped areas are now on the shopping displays. Separate rules apply for rural and urban land and state governments can have their own rules. However, government purchase is out of the ambit and can be done for public purpose. Compensation has been fixed at four times or twice the market value in rural and urban areas, respectively. The creation of a land bank would address the issue of land being purchased and not used for 10 years.
The country is in the midst of taking off on a high growth trajectory and the current use or rather restricted access to land has led to overcrowding and other accompanying disadvantages that go with rapid urbanisation and industrialisation. While factors such as capital, enterprise, technology and capital are available either within the nation or
outside, the same does not hold for land. Indian companies have looked towards the outside world to buy land with the minerals or setting up business as the current antiquated laws are inhibitive. Quite evidently, we need to have land laws in place that offer enterprise the factor of production which is intrinsic for growth. The current Bill is therefore welcome.
It is true that greater use of land does lead to environment degradation and displaces the owners who could be illiterate and at a disadvantage. But, this is a tradeoff to accept because any form of development will have to be at the expense of the environment as one cannot generate power, or bring about consumerism without investment in factories or offices that have to be located on land. To counter the environment issues, the concerned governments should lay down the rules of the game in parallel so as to mitigate these effects.
Could there be problems along the way? Definitely yes, as the current rules lay down the ground rules and will have to address the issue of valuation, which is important in any market. Also getting 80% of the people to agree to sell will be a challenge and, to begin with, there would be a lot of suasion, which may not always be ethical, especially where the projects are large. The government would have to further look at this issue as land prices are always opaque as the official and market rates vary considerably even in metropolitan cities.
The current content of the laws can be debated as being pro-industry or anti-poor, but a start has to be made. The current guidelines make it easier to acquire land though the cost of this factor is bound to increase, which can be accepted as being the price that is discovered in the market. In fact, having the ground rules set helps in creating a market for land, which can, at some later point of time, also lead to a vibrant secondary market with the proliferation of financial derivative products. Currently, it is expected that the cost of production would increase with the fixed cost component moving up, which will get reflected in the price of the product—be it housing or factory output. But then, if it is the true reflection of the price of this vital commodity, i.e. land, so be it.
The problem with land is that there are an equal number of interested and antagonistic parties. The Sardar Sarovar Dam is an evergreen story, while the escapades of Tata Motors or Sterlite are more recent. There are companies that want to buy land and use the same for mineral exploration or setting up their units. The owners are either landlords or poor people with marginal but contiguous units of land who would sell, though they do not quite know what it best for them. Then there are the ubiquitous environmentalists who will always find a reason to block such deals. Add to this the group of activists who are anti-industry about everything and the battlefield gets dense.
At another level, there are various levels of government that come in the way of land ownership, with the laws being nebulous on the extent to which the Centre has the power to overrule the state and local bodies. Given that the
governments are from different parties across these governing units, there will be conflict.
The current Land Acquisition Bill, if enacted, will provide guidelines for future land deals. To touch on the major contours, this is how the new proposed rules look. The Bill talks of resettlement and rehabilitation of the affected people. There are rules governing the acquiescence of 80% of the owners, while multi-cropped areas are now on the shopping displays. Separate rules apply for rural and urban land and state governments can have their own rules. However, government purchase is out of the ambit and can be done for public purpose. Compensation has been fixed at four times or twice the market value in rural and urban areas, respectively. The creation of a land bank would address the issue of land being purchased and not used for 10 years.
The country is in the midst of taking off on a high growth trajectory and the current use or rather restricted access to land has led to overcrowding and other accompanying disadvantages that go with rapid urbanisation and industrialisation. While factors such as capital, enterprise, technology and capital are available either within the nation or
outside, the same does not hold for land. Indian companies have looked towards the outside world to buy land with the minerals or setting up business as the current antiquated laws are inhibitive. Quite evidently, we need to have land laws in place that offer enterprise the factor of production which is intrinsic for growth. The current Bill is therefore welcome.
It is true that greater use of land does lead to environment degradation and displaces the owners who could be illiterate and at a disadvantage. But, this is a tradeoff to accept because any form of development will have to be at the expense of the environment as one cannot generate power, or bring about consumerism without investment in factories or offices that have to be located on land. To counter the environment issues, the concerned governments should lay down the rules of the game in parallel so as to mitigate these effects.
Could there be problems along the way? Definitely yes, as the current rules lay down the ground rules and will have to address the issue of valuation, which is important in any market. Also getting 80% of the people to agree to sell will be a challenge and, to begin with, there would be a lot of suasion, which may not always be ethical, especially where the projects are large. The government would have to further look at this issue as land prices are always opaque as the official and market rates vary considerably even in metropolitan cities.
The current content of the laws can be debated as being pro-industry or anti-poor, but a start has to be made. The current guidelines make it easier to acquire land though the cost of this factor is bound to increase, which can be accepted as being the price that is discovered in the market. In fact, having the ground rules set helps in creating a market for land, which can, at some later point of time, also lead to a vibrant secondary market with the proliferation of financial derivative products. Currently, it is expected that the cost of production would increase with the fixed cost component moving up, which will get reflected in the price of the product—be it housing or factory output. But then, if it is the true reflection of the price of this vital commodity, i.e. land, so be it.
Why do we want more banks? 31st August 2011: Financial Express
RBI’s revised draft guidelines for new banks are a step towards the latter’s final fructification though there is a rider that the Banking Regulation Act has to be amended for the same. We will have to wait beyond October. Having new banks in the arena will be refreshing just as it was when the Narasimham Committee Report’s recommendations were adopted in the nineties. The success of new banks was mixed with the institution-backed ones along with a group-backed bank emerging ahead while several others got absorbed through acquisitions due to non-viability.
RBI has focused a lot on regulation to ensure that the ownership of these banks is in the right hands and that there is little exposure to the sensitive sectors such as real estate and capital markets. By insisting on R500 crore of capital, it does keep out the smaller players, but then that is understandable because we need banks with deep pockets which can meet other aspirations of domestic banking. Besides, from the point of view of monitoring banks, a smaller set of large banks is more convenient. Also, there are strict guidelines on the exposure norms which will ensure that there is no cronyism. How will the landscape of banking change assuming that we have some big players coming in?
On the positive side, having new banks will help to spread banking to the masses. We can see large corporate houses and NBFCs qualifying for the same, which will really help to expand the overall banking structure with the requisite technology. There was a sea change in the way in which banking was conducted in the nineties and the new set will increase competition and improve efficiency. By RBI insisting on 25% of the branches being in rural unbanked areas, these banks will support the drive towards financial inclusion.
NBFCs, in particular, should find this route useful as they already have strength in specific niche segments and by adhering to the compliance standards laid down by RBI they can actually reach out for the deposit base, which today is a high-cost one. They have their own distribution networks, which can be harnessed to take a firmer hold on this turf. It must be pointed out that banks have the advantage of accessing current and savings deposits, which are stable in terms of rollovers.
There are, however, some challenges for the new banks. They have to compete with well-established banks and bringing in incremental innovation is a task. Further, they could be pressurised by the norms for inclusive banking. We already have around 87,000 bank branches in the country.
Rural branches clock around R14 crore of deposits per branch while urban/metropolitan ones do R116 crore. Similarly, rural branches bring in an average credit ticket of R8.5 crore per branch while urban/metropolitan branches get in R96 crore. Clearly, there will be pressure on profit margins for these new players, especially so as they are beginning their business on this slippery note. Also, the priority sector adherence will be a tough one for new entrants unless allowed in a phased manner. It may be advisable to treat the priority sector commitments on line with those for foreign banks and include export credit as an option.
An issue to be debated is why we want more banks in the country. If it is to bring in more capital and foster competition, then we are on the right track. Large business houses with deep pockets are just the panacea that we are looking for given that if we are talking of credit growing at 20% per annum in the next 5 years, we are looking at incremental funds of almost R40 lakh crore which has to be supported by 10% CAGR.
The existing banks can certainly provide support given that they are well-capitalised, but with prudential regulation becoming stiffer, new banks are the answer.
However, bringing in the inclusive banking compulsion can be inhibiting. If we want to target the un-bankable class, then the approach should be different. We already have a large banking network in the rural areas which can bring about financial inclusion; it is not necessary to create fresh infrastructure. Instead, this would have been an appropriate time to actually bring in a new category of banks which would be dedicated to this niche group with different minimum capital requirements. This could have provided an opportunity for either existing players in the NBFC or the cooperative banking system to transform into a niche bank for this purpose. A thought that can be pursued is to see if these new entrants can acquire existing banks so that financial strength is delivered without recreating the infrastructure.
It must be reiterated that the Indian banking system is regulated quite closely through the SLR (25%) and priority sector compulsions (40%), with restrictions on sectoral lending. While these are prudential measures, at some point they can conflict with commercial considerations. So, a dualistic approach that separates inclusive banking from general banking may be a suggestion to consider.
RBI has focused a lot on regulation to ensure that the ownership of these banks is in the right hands and that there is little exposure to the sensitive sectors such as real estate and capital markets. By insisting on R500 crore of capital, it does keep out the smaller players, but then that is understandable because we need banks with deep pockets which can meet other aspirations of domestic banking. Besides, from the point of view of monitoring banks, a smaller set of large banks is more convenient. Also, there are strict guidelines on the exposure norms which will ensure that there is no cronyism. How will the landscape of banking change assuming that we have some big players coming in?
On the positive side, having new banks will help to spread banking to the masses. We can see large corporate houses and NBFCs qualifying for the same, which will really help to expand the overall banking structure with the requisite technology. There was a sea change in the way in which banking was conducted in the nineties and the new set will increase competition and improve efficiency. By RBI insisting on 25% of the branches being in rural unbanked areas, these banks will support the drive towards financial inclusion.
NBFCs, in particular, should find this route useful as they already have strength in specific niche segments and by adhering to the compliance standards laid down by RBI they can actually reach out for the deposit base, which today is a high-cost one. They have their own distribution networks, which can be harnessed to take a firmer hold on this turf. It must be pointed out that banks have the advantage of accessing current and savings deposits, which are stable in terms of rollovers.
There are, however, some challenges for the new banks. They have to compete with well-established banks and bringing in incremental innovation is a task. Further, they could be pressurised by the norms for inclusive banking. We already have around 87,000 bank branches in the country.
Rural branches clock around R14 crore of deposits per branch while urban/metropolitan ones do R116 crore. Similarly, rural branches bring in an average credit ticket of R8.5 crore per branch while urban/metropolitan branches get in R96 crore. Clearly, there will be pressure on profit margins for these new players, especially so as they are beginning their business on this slippery note. Also, the priority sector adherence will be a tough one for new entrants unless allowed in a phased manner. It may be advisable to treat the priority sector commitments on line with those for foreign banks and include export credit as an option.
An issue to be debated is why we want more banks in the country. If it is to bring in more capital and foster competition, then we are on the right track. Large business houses with deep pockets are just the panacea that we are looking for given that if we are talking of credit growing at 20% per annum in the next 5 years, we are looking at incremental funds of almost R40 lakh crore which has to be supported by 10% CAGR.
The existing banks can certainly provide support given that they are well-capitalised, but with prudential regulation becoming stiffer, new banks are the answer.
However, bringing in the inclusive banking compulsion can be inhibiting. If we want to target the un-bankable class, then the approach should be different. We already have a large banking network in the rural areas which can bring about financial inclusion; it is not necessary to create fresh infrastructure. Instead, this would have been an appropriate time to actually bring in a new category of banks which would be dedicated to this niche group with different minimum capital requirements. This could have provided an opportunity for either existing players in the NBFC or the cooperative banking system to transform into a niche bank for this purpose. A thought that can be pursued is to see if these new entrants can acquire existing banks so that financial strength is delivered without recreating the infrastructure.
It must be reiterated that the Indian banking system is regulated quite closely through the SLR (25%) and priority sector compulsions (40%), with restrictions on sectoral lending. While these are prudential measures, at some point they can conflict with commercial considerations. So, a dualistic approach that separates inclusive banking from general banking may be a suggestion to consider.
American crisis, Asian concerns: 24th August Financial Express
The protests by Anna Hazare come at a time when the world economy is also battling a credibility issue, with a global slowdown being conjectured for the current year. One thought that hits us is whether or not these protests will have any wider ramifications for our economy. The global slowdown has evoked a mixed response with arguments being on both sides, with a distinct tilt towards a neutral situation for us. How about the current political and social unrest? Will it upset the clichéd apple cart?
There are two aspects to this protest. The first is whether or not foreign investment will be affected, and the other is whether the domestic economy will witness a backlash. The protests so far are more political in nature, which, at its exaggerated best, has probably some traces of the scent of the jasmine backlash in Tunisia, Egypt and the rest. Hopefully, it does appear that it will remain confined to demonstrations with the more affluent sections of society also using this opportunity to be seen with the rest. The interesting conjecture here is its implications for the economy.
Growth in the economy is driven by three sectors: agriculture, industry and services. Agricultural output is impervious to what happens in Delhi as long as the pricing policy is correct and the FCI is in action. Therefore, there should be no concern from this quarter. Industry is more worried about interest rates, demand and policies. Currently, the concern is that interest rates will drive back consumerism and investment, which is not good news. RBI is evidently looking at inflation to consider interest rate decisions. Therefore, there should be no impact of such demonstrations. Policies are of course important for industry and this is where there can be concern because important discussion time is being used up on the governance issue rather than economic affairs. There are important policies on pension reforms, insurance, FDI in retail, and so on, which will obviously miss the bus as Parliament time is diverted to Ramlila grounds.
There are two ways of looking at it. A more cynical view is that these policies have been on the agenda anyway for long without really derailing growth and hence should not matter. While this is true to the extent that immediate prospects may not be affected, further deferment of such issues will come in the way of future progress. This is so because once Bills are held back, it takes a long time to get them back on the discussion table. One can recollect the infamous FCRA amendment, which has been pending since 2003 and has not seriously been discussed as sessions close and the papers have
to be reintroduced. Therefore, definitely in the medium run, growth will be held back as long as there is a status quo on the policy approach, which is not desirable.
The services sector is a dominant one, with around 45% of its output coming from the unorganised segment, which is largely insulated from any such thought-based revolution. The rest of the sector will be driven by the normal course unless there are any disruptions physically, which, though not expected, cannot be ruled out. We have seen that events like strikes or blockages of transport take their impact on the movement of goods and people, which eventually affects certain sectors like transportation or tourism. But, assuming that the movements will be largely peaceful, as this is the core of the ideology here, disruptions should be minimal.
This then turns attention to foreign investors. Here, again, there is a pragmatic way of looking at things. India has not really been anywhere close to high on the World Bank’s chart of doing business and remains in a static state—notwithstanding economic reforms—when it comes to other morality and governance indices used globally. This, in a way, is a comfort because a peaceful relentless move against such issues should not stop foreign investment from coming in. Portfolio investors will still prefer to look at the future growth convictions in the Indian economy, which is strong even today in a world that is sliding down the grease pole. With strong growth numbers still expected in such adversity from India, it remains an attractive market for all purposes.
Foreign direct investment, on the other hand, has been coming in good numbers this year, and evidently the
opportunities that exist are an ex post vindication of the economy’s prospects. Gross inflows have been $13.4bn in the first quarter as against $5.7bn last year. Therefore, foreign perception of Indian markets should remain unaltered here. In fact, governance standards would definitely improve in the aftermath of what is happening today.
Hence, it may be concluded that it should be business as usual except for some further delays in discussing Bills that anyway do not solicit broad consensus. Our economy is fairly mature and resilient to such occurrences and there is an inherent strength that has been displayed in the working of the economy. Our policymakers have been pursuing policies quite independently with a single-minded focus—be it RBI, finance ministry or Planning Commission. We have seen that even a change of government with different ideologies has not derailed the broader vision or growth path. Quite clearly, Ramlila or any other venue should not come in the way.
There are two aspects to this protest. The first is whether or not foreign investment will be affected, and the other is whether the domestic economy will witness a backlash. The protests so far are more political in nature, which, at its exaggerated best, has probably some traces of the scent of the jasmine backlash in Tunisia, Egypt and the rest. Hopefully, it does appear that it will remain confined to demonstrations with the more affluent sections of society also using this opportunity to be seen with the rest. The interesting conjecture here is its implications for the economy.
Growth in the economy is driven by three sectors: agriculture, industry and services. Agricultural output is impervious to what happens in Delhi as long as the pricing policy is correct and the FCI is in action. Therefore, there should be no concern from this quarter. Industry is more worried about interest rates, demand and policies. Currently, the concern is that interest rates will drive back consumerism and investment, which is not good news. RBI is evidently looking at inflation to consider interest rate decisions. Therefore, there should be no impact of such demonstrations. Policies are of course important for industry and this is where there can be concern because important discussion time is being used up on the governance issue rather than economic affairs. There are important policies on pension reforms, insurance, FDI in retail, and so on, which will obviously miss the bus as Parliament time is diverted to Ramlila grounds.
There are two ways of looking at it. A more cynical view is that these policies have been on the agenda anyway for long without really derailing growth and hence should not matter. While this is true to the extent that immediate prospects may not be affected, further deferment of such issues will come in the way of future progress. This is so because once Bills are held back, it takes a long time to get them back on the discussion table. One can recollect the infamous FCRA amendment, which has been pending since 2003 and has not seriously been discussed as sessions close and the papers have
to be reintroduced. Therefore, definitely in the medium run, growth will be held back as long as there is a status quo on the policy approach, which is not desirable.
The services sector is a dominant one, with around 45% of its output coming from the unorganised segment, which is largely insulated from any such thought-based revolution. The rest of the sector will be driven by the normal course unless there are any disruptions physically, which, though not expected, cannot be ruled out. We have seen that events like strikes or blockages of transport take their impact on the movement of goods and people, which eventually affects certain sectors like transportation or tourism. But, assuming that the movements will be largely peaceful, as this is the core of the ideology here, disruptions should be minimal.
This then turns attention to foreign investors. Here, again, there is a pragmatic way of looking at things. India has not really been anywhere close to high on the World Bank’s chart of doing business and remains in a static state—notwithstanding economic reforms—when it comes to other morality and governance indices used globally. This, in a way, is a comfort because a peaceful relentless move against such issues should not stop foreign investment from coming in. Portfolio investors will still prefer to look at the future growth convictions in the Indian economy, which is strong even today in a world that is sliding down the grease pole. With strong growth numbers still expected in such adversity from India, it remains an attractive market for all purposes.
Foreign direct investment, on the other hand, has been coming in good numbers this year, and evidently the
opportunities that exist are an ex post vindication of the economy’s prospects. Gross inflows have been $13.4bn in the first quarter as against $5.7bn last year. Therefore, foreign perception of Indian markets should remain unaltered here. In fact, governance standards would definitely improve in the aftermath of what is happening today.
Hence, it may be concluded that it should be business as usual except for some further delays in discussing Bills that anyway do not solicit broad consensus. Our economy is fairly mature and resilient to such occurrences and there is an inherent strength that has been displayed in the working of the economy. Our policymakers have been pursuing policies quite independently with a single-minded focus—be it RBI, finance ministry or Planning Commission. We have seen that even a change of government with different ideologies has not derailed the broader vision or growth path. Quite clearly, Ramlila or any other venue should not come in the way.
Wednesday, August 24, 2011
Building alternative MFI model: Economic Times 22nd August 2011
The evolution of microfinance in India can be put in a theoretical context. There is a case of the existence of 'asymmetric information' where the lender has little in his armory to know that the borrower will repay the loan. In the absence of a clear credit evaluation process, this asymmetry will continue to exist. When there is such asymmetry in availability of information, we run the risk of 'adverse selection'. As long as we are dealing with communities that are known to perform, it will work. But, as we scale up this trust model, then we run the risk of selecting the wrong people.
This triggers default and the reason attributed can be high rates being charged in the face of adverse economic conditions for the borrowers. This has a backward linkage with the MFI and lending bank creating financial chaos. The MFIs cannot use strong-arm techniques to recover money. Borrowers now know that if they borrow, they do not have to repay as there is a constituency which will speak for them when the time comes. This raises the issue of 'moral hazard'.
The MFI's Yunus model appeared to be a panacea for the so-called unbankable people and the rate of 30% charged did not raise a stink as these poor people were anyway borrowing from the moneylender at a higher rate. As they had no collateral to offer except peer pressure, banks did not find this social collateral acceptable. With an increase in suicides on account of strong-arm tactics used by the MFIs for non-repayment of loans, regulatory action is being taken to bring this system back on the rails. Is there any alternative way out?
There are some interesting models being experimented with to make MFI credit work. Some of the names that come to mind are Rangde and Milaap - both are startups that have pursued some innovative techniques. The model here aims at targeting investors who are willing to put in money with no expectation of a return on capital or a minimal of 2%. Funds gathered are then lent to MFIs or NGOs that have been carefully screened on the basis of past performance.
The final cost to the borrower varies from 8% (for Rangde) to 12-18% (Milaap). Basically, these startups cover their costs with zero profit. The MFIs add their cost to this and are able to lend money at a substantially lower rate than other MFIs. This model has worked with virtually negligible NPAs and is able to deliver credit at a cost comparable with what, say an SME, gets funds from a bank.
In the earlier system, MFIs had a genuine point of paying substantially high cost for credit from banks, which actually pushed up costs. The lower cost of final credit here is evidently due to sourcing of cheaper funds from investors. Prima facie, there is nothing amiss in this model as the organisations are registered with the RBI and their activities are known. But the issue is whether this model is scalable. Tackling communities within specific geographies is easier to accomplish than widening the canvas.
Where does one get such philanthropic funds from to scale up operations? And further, while the model has worked well so far, it still does not tackle the problems of asymmetric information, adverse selection and the moral hazard. Banks with their superior credit evaluation skill-sets still encounter problems of NPAs in the organised sector where information is relatively more transparent. Logically, it appears that the system has to crack at some point of time, either in flow of funds or NPAs.
The thought which comes here is to address the two issues together: cost of funds and adverse selection. A way out is to first make relatively large sets of funds available for this purpose. The government is evidently the entity that can make these sources available as philanthropy has its limits. Corporates would prefer to create trusts with their names embossed rather than donate anonymously to these organisations.
While there will be some noise on the fiscal front, central and state governments can actually proportionately keep aside these funds for this purpose. Besides, the government is already subsidising agriculture by keeping rates at 7% and taking on the interest rate differential burden of banks. In fact, given the success of entities like Rangde and Milaap, these could be one-time allocations for specific geographies as it may be assumed that the money would largely return to the lending institution.
These funds could be given to either banks or panchayats or organisations like Milaap and Rangde. Banks have the skill-sets of evaluation and are located in rural areas. With funds coming in at zero cost, they could actually lend to MFIs or directly to the borrowers at a low cost.
Panchayats would be another option, given that they actually have knowledge of their people and hence the issues of asymmetric information and adverse selections are simultaneously addressed here. For governments, these are capital expenditures and hence will be analogous to the project expenditures incurred by them. For society, the basic lending cost of say 8-18% charged by banks to the MFIs actually comes down substantially, which can make a difference.
Quite clearly, the MFI space is one of interest and challenge as it offers better living standards to the poor people. Solutions need to be found within the contours of retaining the sanctity of the financial system in which they operate. Organisations like Rangde and Milaap need to be complimented for showing the way and we need to embellish their operational models with strong financial support to ensure that they are sustainable and scalable.
This triggers default and the reason attributed can be high rates being charged in the face of adverse economic conditions for the borrowers. This has a backward linkage with the MFI and lending bank creating financial chaos. The MFIs cannot use strong-arm techniques to recover money. Borrowers now know that if they borrow, they do not have to repay as there is a constituency which will speak for them when the time comes. This raises the issue of 'moral hazard'.
The MFI's Yunus model appeared to be a panacea for the so-called unbankable people and the rate of 30% charged did not raise a stink as these poor people were anyway borrowing from the moneylender at a higher rate. As they had no collateral to offer except peer pressure, banks did not find this social collateral acceptable. With an increase in suicides on account of strong-arm tactics used by the MFIs for non-repayment of loans, regulatory action is being taken to bring this system back on the rails. Is there any alternative way out?
There are some interesting models being experimented with to make MFI credit work. Some of the names that come to mind are Rangde and Milaap - both are startups that have pursued some innovative techniques. The model here aims at targeting investors who are willing to put in money with no expectation of a return on capital or a minimal of 2%. Funds gathered are then lent to MFIs or NGOs that have been carefully screened on the basis of past performance.
The final cost to the borrower varies from 8% (for Rangde) to 12-18% (Milaap). Basically, these startups cover their costs with zero profit. The MFIs add their cost to this and are able to lend money at a substantially lower rate than other MFIs. This model has worked with virtually negligible NPAs and is able to deliver credit at a cost comparable with what, say an SME, gets funds from a bank.
In the earlier system, MFIs had a genuine point of paying substantially high cost for credit from banks, which actually pushed up costs. The lower cost of final credit here is evidently due to sourcing of cheaper funds from investors. Prima facie, there is nothing amiss in this model as the organisations are registered with the RBI and their activities are known. But the issue is whether this model is scalable. Tackling communities within specific geographies is easier to accomplish than widening the canvas.
Where does one get such philanthropic funds from to scale up operations? And further, while the model has worked well so far, it still does not tackle the problems of asymmetric information, adverse selection and the moral hazard. Banks with their superior credit evaluation skill-sets still encounter problems of NPAs in the organised sector where information is relatively more transparent. Logically, it appears that the system has to crack at some point of time, either in flow of funds or NPAs.
The thought which comes here is to address the two issues together: cost of funds and adverse selection. A way out is to first make relatively large sets of funds available for this purpose. The government is evidently the entity that can make these sources available as philanthropy has its limits. Corporates would prefer to create trusts with their names embossed rather than donate anonymously to these organisations.
While there will be some noise on the fiscal front, central and state governments can actually proportionately keep aside these funds for this purpose. Besides, the government is already subsidising agriculture by keeping rates at 7% and taking on the interest rate differential burden of banks. In fact, given the success of entities like Rangde and Milaap, these could be one-time allocations for specific geographies as it may be assumed that the money would largely return to the lending institution.
These funds could be given to either banks or panchayats or organisations like Milaap and Rangde. Banks have the skill-sets of evaluation and are located in rural areas. With funds coming in at zero cost, they could actually lend to MFIs or directly to the borrowers at a low cost.
Panchayats would be another option, given that they actually have knowledge of their people and hence the issues of asymmetric information and adverse selections are simultaneously addressed here. For governments, these are capital expenditures and hence will be analogous to the project expenditures incurred by them. For society, the basic lending cost of say 8-18% charged by banks to the MFIs actually comes down substantially, which can make a difference.
Quite clearly, the MFI space is one of interest and challenge as it offers better living standards to the poor people. Solutions need to be found within the contours of retaining the sanctity of the financial system in which they operate. Organisations like Rangde and Milaap need to be complimented for showing the way and we need to embellish their operational models with strong financial support to ensure that they are sustainable and scalable.
Comforting if the ‘ifs’ hold: Financial Express 6th August 2011
One issue which has been a matter of conjecture even more than whether or not Lady Gaga performs in Mumbai is the true state of the economy. There are a plethora of estimates from various agencies, which, though useful, are utterly confusing, given the wide ranges. Therefore, it is only appropriate that the Prime Minister’s Economic Advisory Council (PMEAC) has come up its forecasts. Coming from the PMO, it appears to be relatively more authentic as the government certainly knows more than others on the data as well as its own finances and policies.
Let us see how we should read between the numbers presented by the PMEAC. Bringing down the GDP growth rate to 8.2% from 9% assumed in the Budget is realistic, but what is important is as to how this number would affect other variables. In particular, the fiscal numbers deserve scrutiny at a time when the fiscal deficit ratio has been increased marginally from 4.6% to 4.7% of GDP. Is this possible? There are two parts to this ratio, the numerator and denominator. The denominator has been assumed to remain unchanged with growth of 14% in nominal terms for GDP at market prices, which can be broken up into 8.2% real GDP growth and 5.8% inflation. But, by the government’s own admission, the inflation rate will remain at 9% till October and come down to 6.5% by March 2012. If this is so, then the average for the year has to be higher at around 8%, which will mean growth of around 16% in nominal GDP.
The slippage in fiscal deficit has been assumed to be just 0.1%, which amounts to around R9,000 crore; this is difficult because of three reasons. The first is that the government has given away around R50,000 crore in taxes on oil products. Second, lower GDP growth will mean lower production too. In particular, industry is to grow by 7.2% now, which will lower excise and corporate tax collections. Third, the Budget talks of R40,000 crore of disinvestment, which may not happen as the market so far has been at best stagnant. Therefore, the fiscal deficit ratio has to be higher than 4.7% if ceteris paribus conditions prevail.
The only way to meet this mark is for further expenditure cuts, which cannot be ruled out as this was also done in FY11. If this happens, then we can see infrastructure growth taking a back seat, as this is normally the area where allocations are reduced to meet fiscal targets. But, based on the GDP sectoral projections made by the PMEAC, the sector, community and personal services, is to actually grow at a higher rate of 8.5%. Therefore, we have the curious case of one part of the trinity—fiscal deficit, government expenditure or GDP (nominal) actually moving out of the loop as internal consistency is difficult.
The growth rates for agriculture and industry appear to be realistic. However, the projection for services is aggressive at 10% as the services sector may not grow at such a high rate when the sectors that it supports, i.e., agriculture and industry, are growing slowly. Intuitively, it may be seen that any slippage here will get reflected quite sharply in the GDP number.
The other interesting projection made is that the investment rate is to increase, albeit marginally, from 36.4% to 36.7% in FY12. This is significant because in a rising interest rate environment, one would have expected investment to take a knock. The resilience of investment to interest rates is a major take away. Further, it also means that the higher interest rate policy followed by RBI is expected to affect consumption more than investment. Therefore, growth of consumer goods including automobiles backed by finance would be affected more by higher interest rates than investment, which, in a way, is comforting as future growth prospects are addressed.
The external sector is to be the flag bearer at a time when the global economy is in a state of flux. Exports are to grow by 32%, which will be awesome as it will come over a high base year number while the deficit will widen. Given that the current account deficit is going to rise only marginally, to 2.7%, there is quite a bit of elbow room here. But the high point will be foreign investment where capital flows through FDI (gross of $35 billion and net of $18 billion), FIIs (muted at $14 billion) and borrowings ($35 billion). This is not bad news except for the higher external commercial borrowings, which will exert pressure on the external debt situation.
So, what are we to make of these numbers? Growth will be subdued and could take a dip if the assumptions made are violated. The interest rate hikes and their impact appear to be factored though the optimism on investment is still significant. The external sector will provide strength, which, prima facie, appears feasible. India will remain a fast growing economy in depressed global world, though periodic review of the fiscal picture will be essential to gauge the progress.
Let us see how we should read between the numbers presented by the PMEAC. Bringing down the GDP growth rate to 8.2% from 9% assumed in the Budget is realistic, but what is important is as to how this number would affect other variables. In particular, the fiscal numbers deserve scrutiny at a time when the fiscal deficit ratio has been increased marginally from 4.6% to 4.7% of GDP. Is this possible? There are two parts to this ratio, the numerator and denominator. The denominator has been assumed to remain unchanged with growth of 14% in nominal terms for GDP at market prices, which can be broken up into 8.2% real GDP growth and 5.8% inflation. But, by the government’s own admission, the inflation rate will remain at 9% till October and come down to 6.5% by March 2012. If this is so, then the average for the year has to be higher at around 8%, which will mean growth of around 16% in nominal GDP.
The slippage in fiscal deficit has been assumed to be just 0.1%, which amounts to around R9,000 crore; this is difficult because of three reasons. The first is that the government has given away around R50,000 crore in taxes on oil products. Second, lower GDP growth will mean lower production too. In particular, industry is to grow by 7.2% now, which will lower excise and corporate tax collections. Third, the Budget talks of R40,000 crore of disinvestment, which may not happen as the market so far has been at best stagnant. Therefore, the fiscal deficit ratio has to be higher than 4.7% if ceteris paribus conditions prevail.
The only way to meet this mark is for further expenditure cuts, which cannot be ruled out as this was also done in FY11. If this happens, then we can see infrastructure growth taking a back seat, as this is normally the area where allocations are reduced to meet fiscal targets. But, based on the GDP sectoral projections made by the PMEAC, the sector, community and personal services, is to actually grow at a higher rate of 8.5%. Therefore, we have the curious case of one part of the trinity—fiscal deficit, government expenditure or GDP (nominal) actually moving out of the loop as internal consistency is difficult.
The growth rates for agriculture and industry appear to be realistic. However, the projection for services is aggressive at 10% as the services sector may not grow at such a high rate when the sectors that it supports, i.e., agriculture and industry, are growing slowly. Intuitively, it may be seen that any slippage here will get reflected quite sharply in the GDP number.
The other interesting projection made is that the investment rate is to increase, albeit marginally, from 36.4% to 36.7% in FY12. This is significant because in a rising interest rate environment, one would have expected investment to take a knock. The resilience of investment to interest rates is a major take away. Further, it also means that the higher interest rate policy followed by RBI is expected to affect consumption more than investment. Therefore, growth of consumer goods including automobiles backed by finance would be affected more by higher interest rates than investment, which, in a way, is comforting as future growth prospects are addressed.
The external sector is to be the flag bearer at a time when the global economy is in a state of flux. Exports are to grow by 32%, which will be awesome as it will come over a high base year number while the deficit will widen. Given that the current account deficit is going to rise only marginally, to 2.7%, there is quite a bit of elbow room here. But the high point will be foreign investment where capital flows through FDI (gross of $35 billion and net of $18 billion), FIIs (muted at $14 billion) and borrowings ($35 billion). This is not bad news except for the higher external commercial borrowings, which will exert pressure on the external debt situation.
So, what are we to make of these numbers? Growth will be subdued and could take a dip if the assumptions made are violated. The interest rate hikes and their impact appear to be factored though the optimism on investment is still significant. The external sector will provide strength, which, prima facie, appears feasible. India will remain a fast growing economy in depressed global world, though periodic review of the fiscal picture will be essential to gauge the progress.
What's wrong with our statistics? Business Standard JUly 25, 2011
Irony by definition is laced with dark humour, but it would be more like black humour when one views data systems in India. Less than a week after the Reserve Bank of India (RBI) expressed concern over the quality of data, the Central Statistics Office drastically reduced the Index of Industrial Production (IIP) growth number for capital goods for April to 7.3 per cent from 14.5 per cent when it was initially announced. Such revisions are quite bizarre and have a deeper implication because such high-frequency data is used for high-frequency monetary policy stances. The RBI’s frustration is palpable because the April number would have provided the justification for increasing interest rates based on robust investment growth. But, now it turns out that capital goods production was, at best, stable.
One may recollect that for a long time we had spoken about our base years being anachronistic at 1993-94, and bringing forward the base year to 2004-05 was pragmatic. For some reason, the GDP, IIP and Wholesale Price Index (WPI) indices were changed sequentially. A statement often made was that there was high volatility in the growth numbers that would be addressed by the new series. Though having a new series is necessary, the larger issue is whether it addresses the question of volatility. Volatility in the jargon of financial markets economics means the standard deviation of the growth rates. Now, the annualised volatility for the IIP old series was 16.4 per cent and it has increased to 22.6 per cent in the new series. For the WPI series, the annualised volatility was 11.5 per cent and 10.2 per cent respectively. So there has been improvement in the WPI, but not the IIP. Curiously, when the same volatility is reckoned on annual data, then the IIP volatility changes from 2.96 per cent to 4.76 per cent and 1.67 per cent to 2.42 per cent for WPI, meaning that the older series fares better!
Three conclusions can be drawn here. First, the volatility argument does not hold. Second, the fluctuations in growth rates will vary based on seasonal trends as well as base year effects. Third, the problem is with our data collections systems and processes.
What are the problems with our data? There are basically two areas that need to be addressed. The first concerns farm prices. Today prices come from the mandis, where both transactions and prices are opaque. Agricultural Marketing Research & Information Network (AGMARKNET), the official source of data shows prices within a rather wide range that is not helpful. Further, the single numbers that are displayed vary significantly from what commodity exchanges like NCDEX collect from the ground level. In fact, the volatility of prices is much higher for exchange prices compared with the WPI because the latter are based on modal values that do not vary very often. Further, since farm products are seasonal, they do not enter the mandis every month but are traded widely all the same, which moderates the WPI numbers because they are dependent on the quotes received from mandis. The solution is to have electronic mandis where all transactions are recorded so that we have actual prices that can be weighted by the trades that take place.
The other pertains to manufactured goods. If one looks at metals, our WPI shows that prices are increasing when globally prices are falling based on World Bank data. India is a price taker in all metals except iron and steel. Therefore, there should not be such differences in price changes. The problem in manufacturing is exacerbated by the fact that one-third of total manufacturing comes from the unorganised sector where it is difficult to get timely information. Even for the organised sector, the WPI index for a particular product often does not change for weeks because of non-availability of data after which there is a sudden spike in prices. One way out is to make it mandatory for all firms to record every transaction at the factory gate. By linking this to tax filing, firms will be compelled to report accurately the true picture. Admittedly, this is a challenge considering that even unaudited results of firms are not always filed on time.
This being the case, what should be our approach? First, we need to move away from providing high-frequency data if we are unable to vouch for its sanctity. While revisions happen everywhere, changing growth rates by 50 per cent is dangerous for policymakers.
Second, we need to electronically connect all the mandis and have a database in which all firms registered with the Registrar of Companies have to mandatorily enter their production and price numbers.
Third, we need to look at other leading indicators when taking policy decisions based on monetary data that is generally more accurate because it comes from a smaller universe of commercial banks.
Fourth, whenever we interpret data, we should never look at single month data points to eschew the trap of base year and seasonal influences. It would be better to look at cumulative numbers, especially for the real sector. When we look at annual IIP growth rates, we do not look at March over March, but the average of 12 months over the same of the previous year. This automatically factors in the so-called volatility due to inaccuracies or seasons.
Finally, the RBI should seriously think of going back to two policies with need-based Keynesian intervention. While adopting global practices like the Federal Reserve is progressive, other authorities do not have distorted images in the form of inaccurate data like we do. We will have to wait some more time to reach these levels.
One may recollect that for a long time we had spoken about our base years being anachronistic at 1993-94, and bringing forward the base year to 2004-05 was pragmatic. For some reason, the GDP, IIP and Wholesale Price Index (WPI) indices were changed sequentially. A statement often made was that there was high volatility in the growth numbers that would be addressed by the new series. Though having a new series is necessary, the larger issue is whether it addresses the question of volatility. Volatility in the jargon of financial markets economics means the standard deviation of the growth rates. Now, the annualised volatility for the IIP old series was 16.4 per cent and it has increased to 22.6 per cent in the new series. For the WPI series, the annualised volatility was 11.5 per cent and 10.2 per cent respectively. So there has been improvement in the WPI, but not the IIP. Curiously, when the same volatility is reckoned on annual data, then the IIP volatility changes from 2.96 per cent to 4.76 per cent and 1.67 per cent to 2.42 per cent for WPI, meaning that the older series fares better!
Three conclusions can be drawn here. First, the volatility argument does not hold. Second, the fluctuations in growth rates will vary based on seasonal trends as well as base year effects. Third, the problem is with our data collections systems and processes.
What are the problems with our data? There are basically two areas that need to be addressed. The first concerns farm prices. Today prices come from the mandis, where both transactions and prices are opaque. Agricultural Marketing Research & Information Network (AGMARKNET), the official source of data shows prices within a rather wide range that is not helpful. Further, the single numbers that are displayed vary significantly from what commodity exchanges like NCDEX collect from the ground level. In fact, the volatility of prices is much higher for exchange prices compared with the WPI because the latter are based on modal values that do not vary very often. Further, since farm products are seasonal, they do not enter the mandis every month but are traded widely all the same, which moderates the WPI numbers because they are dependent on the quotes received from mandis. The solution is to have electronic mandis where all transactions are recorded so that we have actual prices that can be weighted by the trades that take place.
The other pertains to manufactured goods. If one looks at metals, our WPI shows that prices are increasing when globally prices are falling based on World Bank data. India is a price taker in all metals except iron and steel. Therefore, there should not be such differences in price changes. The problem in manufacturing is exacerbated by the fact that one-third of total manufacturing comes from the unorganised sector where it is difficult to get timely information. Even for the organised sector, the WPI index for a particular product often does not change for weeks because of non-availability of data after which there is a sudden spike in prices. One way out is to make it mandatory for all firms to record every transaction at the factory gate. By linking this to tax filing, firms will be compelled to report accurately the true picture. Admittedly, this is a challenge considering that even unaudited results of firms are not always filed on time.
This being the case, what should be our approach? First, we need to move away from providing high-frequency data if we are unable to vouch for its sanctity. While revisions happen everywhere, changing growth rates by 50 per cent is dangerous for policymakers.
Second, we need to electronically connect all the mandis and have a database in which all firms registered with the Registrar of Companies have to mandatorily enter their production and price numbers.
Third, we need to look at other leading indicators when taking policy decisions based on monetary data that is generally more accurate because it comes from a smaller universe of commercial banks.
Fourth, whenever we interpret data, we should never look at single month data points to eschew the trap of base year and seasonal influences. It would be better to look at cumulative numbers, especially for the real sector. When we look at annual IIP growth rates, we do not look at March over March, but the average of 12 months over the same of the previous year. This automatically factors in the so-called volatility due to inaccuracies or seasons.
Finally, the RBI should seriously think of going back to two policies with need-based Keynesian intervention. While adopting global practices like the Federal Reserve is progressive, other authorities do not have distorted images in the form of inaccurate data like we do. We will have to wait some more time to reach these levels.
Saturday, July 30, 2011
Their debt, our woes: 30th July Financial Express
The Greek tragedy, which turned out to be quite a farce, is not an isolated instance of distortion in the financial markets. Uncle Sam appears to be the imminent threat today with President Obama striving to have the debt limit of $14.3 trillion enhanced. A payment of $29 billion in interest is due in August. Given the size of the US debt problem, the PIGS story appears to be merely a short tale in an epic of indebtedness. Now, whether or not the limit is enhanced will be more of a political issue with the President having the right to bypass Congress as a last resort. But, more importantly, the fact that the US government can default highlights the fact that the global financial system is not really stronger even after emerging from the crisis of 2008. Lehman and Bear Stearns were institutions that shook the financial markets, but a US government default will damage the credibility of the sole superpower and anchor currency.
A US government default will mean that all holders will have to reconsider their options. The outside world holds around $4.5 trillion of the total debt, which is a little over 30% of the total. Clearly, they would get jittery at this prospect and the country likely to be affected the most would be China, which holds $1.16 trillion. China and the US are now symbiotically bound. If the US defaults then China’s holdings get affected. However, the US cannot afford to default because it will then find it difficult to find buyers for its debt in the future, for which China is a major customer. A fall in the value of these reserves will mean losses to be written off that can be quite substantial. A lower value of reserves will compress money supply, which, in turn, will mean pressure on interest rates. Higher rates impact investment and growth.
The second constituent of the market that would be affected will be the pension funds, provident funds and insurance companies that have to perforce invest in triple-A-rated paper. Any erosion in value would mean a withdrawal, which, in turn, will mean large-scale selling of treasuries that will spur up interest yields in the market. Lastly, this panic will affect around $4 trillion of treasuries that are held as collateral in the futures market—repo, OTC derivative, etc. A default will induce a haircut on these values, leading to a tailspin the market.
The issue may be seen as being more of a political dilemma where the Republicans want an expenditure cut as against Obama who would like to see taxes increased. This impasse has meant that the financial markets remain on the edge. Various packages are being spoken of in terms of expenditure cuts and the rating agencies are intransigent about anything less than $4 trillion in debt to retain the triple-A status.
What does this mean for the world? Even in case a default is eschewed, there will be a certain loss of credibility in the dollar and the global system will have to look for alternatives. Currently, with the dollar being the anchor currency, the US has the prerogative to follow the policy of benign neglect to supply dollars to the world where there is belief that the currency is strong. However, now with doubts being raised, we have to look at another currency. The euro was to be the alternative but given the entanglements with the debt crisis and the existence of a common currency has inextricably put the better performing nations in a compromising position. The euro tangle is one where no one can let the rogue nations sink as it would affect every bank’s and hence nation’s balance sheet.
The recent restructuring of Greek debt turned quite farcical. In the new package, Greece borrows 35 billion euros and buys 30-year bonds, which will be worth 100 billion euros on maturity, which is used to repay the investor. WSJ has estimated that the total loss for EU banks can be around 14 billion euros. This comes shortly after the stress tests were carried out by the European Banking Authority that found only eight banks to be deficient in capital (maintaining core tier-1 capital of 5%) out of a set of 90 banks, but surprisingly did not take into account the most vital stress test of Greek default.
The situation is hence quite fluid for the financial markets. While credibility is the main factor, the implications for global growth are compelling. An overall slowdown in global growth as well as trade cannot be ruled out, as the onus will be more on the emerging nations to provide an impetus. Countries like India and China, which have been the bastions of growth in the past, are trying hard to fight inflation and deflate their economies. In such a situation, growth prospects appear to be muted.
But, on the positive side, we can see this entire process being part of a cleansing process where nations will put their fiscal balances in order. Keynesian pump priming, which worked in 2008 and 2009, has to be reviewed now as it also means building debt, which can shake the edifice of credibility as well as future growth. These episodes should be lessons to be imbibed as we work on modifying, if not creating, a new global financial order against the background of the financial crisis that started with Bear Stearns in 2008 and culminated with Uncle Sam’s sorrows.
A US government default will mean that all holders will have to reconsider their options. The outside world holds around $4.5 trillion of the total debt, which is a little over 30% of the total. Clearly, they would get jittery at this prospect and the country likely to be affected the most would be China, which holds $1.16 trillion. China and the US are now symbiotically bound. If the US defaults then China’s holdings get affected. However, the US cannot afford to default because it will then find it difficult to find buyers for its debt in the future, for which China is a major customer. A fall in the value of these reserves will mean losses to be written off that can be quite substantial. A lower value of reserves will compress money supply, which, in turn, will mean pressure on interest rates. Higher rates impact investment and growth.
The second constituent of the market that would be affected will be the pension funds, provident funds and insurance companies that have to perforce invest in triple-A-rated paper. Any erosion in value would mean a withdrawal, which, in turn, will mean large-scale selling of treasuries that will spur up interest yields in the market. Lastly, this panic will affect around $4 trillion of treasuries that are held as collateral in the futures market—repo, OTC derivative, etc. A default will induce a haircut on these values, leading to a tailspin the market.
The issue may be seen as being more of a political dilemma where the Republicans want an expenditure cut as against Obama who would like to see taxes increased. This impasse has meant that the financial markets remain on the edge. Various packages are being spoken of in terms of expenditure cuts and the rating agencies are intransigent about anything less than $4 trillion in debt to retain the triple-A status.
What does this mean for the world? Even in case a default is eschewed, there will be a certain loss of credibility in the dollar and the global system will have to look for alternatives. Currently, with the dollar being the anchor currency, the US has the prerogative to follow the policy of benign neglect to supply dollars to the world where there is belief that the currency is strong. However, now with doubts being raised, we have to look at another currency. The euro was to be the alternative but given the entanglements with the debt crisis and the existence of a common currency has inextricably put the better performing nations in a compromising position. The euro tangle is one where no one can let the rogue nations sink as it would affect every bank’s and hence nation’s balance sheet.
The recent restructuring of Greek debt turned quite farcical. In the new package, Greece borrows 35 billion euros and buys 30-year bonds, which will be worth 100 billion euros on maturity, which is used to repay the investor. WSJ has estimated that the total loss for EU banks can be around 14 billion euros. This comes shortly after the stress tests were carried out by the European Banking Authority that found only eight banks to be deficient in capital (maintaining core tier-1 capital of 5%) out of a set of 90 banks, but surprisingly did not take into account the most vital stress test of Greek default.
The situation is hence quite fluid for the financial markets. While credibility is the main factor, the implications for global growth are compelling. An overall slowdown in global growth as well as trade cannot be ruled out, as the onus will be more on the emerging nations to provide an impetus. Countries like India and China, which have been the bastions of growth in the past, are trying hard to fight inflation and deflate their economies. In such a situation, growth prospects appear to be muted.
But, on the positive side, we can see this entire process being part of a cleansing process where nations will put their fiscal balances in order. Keynesian pump priming, which worked in 2008 and 2009, has to be reviewed now as it also means building debt, which can shake the edifice of credibility as well as future growth. These episodes should be lessons to be imbibed as we work on modifying, if not creating, a new global financial order against the background of the financial crisis that started with Bear Stearns in 2008 and culminated with Uncle Sam’s sorrows.
Thursday, July 14, 2011
Challenging the poverty dimension of inflation: Economic Times 13th July 2011
A perverse, yet novel reason put forward to explain high inflation is that the poor are eating more as they are becoming less poor. The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) has been extolled for being responsible for higher consumption, which in a way is a vindication of high inflation. The extended logic used here is that if the poor are eating more and we are paying high prices, then there is nothing amiss.
There are two thoughts here. The first is that higher demand per se, especially of food items, has to be met by augmenting supplies; and this holds for any good or service. If people want more mobile handsets, industry produces more of them, which leads to lower prices.
Therefore, ideally if people are less poor and demand more food, then we should produce more food at a lower cost. This is the duty of any economy that works and hence we cannot sit back and take pride in such a development as it is a reflection of the failure of the system to deliver if there are persistent supply imbalances. However, for the sake of argument, let us suppose that this theory has a basis and prima facie makes sense.
This leads to the second issue. Do the numbers really add up? The MGNREGS allots around .`40,000 crore on an annual basis, and while the code speaks of an allocation of 60:40 for wages: materials, it has turned out to be 70% for wages. Therefore, there is an additional income of .`28,000 crore. Let us suppose that all this money is actually spent and nothing is saved as the people are poor and think only of the present. Here one cannot be sure whether or not this income will lead to additional spending or will merely substitute other sources of funding.
This is so because on an average, the MGNREGS in reality provides 37 days of employment to households when they are entitled to 100 days, which means that this becomes an income supplement when they are between two harvest seasons. In the extreme case, it will fully substitute other sources of income or else they will spend the money progressively on non-food items.
Now, the consumption pattern in the country points towards around 36% of expenditure going into food items and another 7% or so into clothes, which would be the areas the farmers would be looking at. This means that around 85% of their incomes would go into food as an approximation (36 divided by 43). Total consumption expenditure on food was estimated to be .`16.20 lakh crore for the country by the CSO in FY10 while the MGNREGS money of .`24,000 crore (i.e., 85% of .`28,000 crore) will be the maximum that can be spent on food items.
Now, this amount works out to 1.5% of total food consumption (or 1.7% in case the entire .`28,000 cr is spent on food products), and considering that farm output has increased by 6.6% in FY11, one cannot really see a mismatch between demand and supply for food items in general.
At the next stage we can get down to the micro level and examine whether this theory can still hold. Out of the.`28,000 crore being spent on food products, CSO data shows that around 25% is spent on cereals and pulses, where prices showed a decline or marginal increase.
Besides, they would be covered under the public distribution system where prices have remained unchanged. Fruits and vegetables account for another 26.5% and the problem is not higher demand but high losses on account of absence of storage facilities. The Union Budget admitted that around 40% of the crop is wasted due to the absence of logistics support.
Another 21% is spent on milk products, where the higher price is due to higher cost of production (i.e., animal feed such as oilcakes and fodder) while another 12% is on meat/poultry products where prices have increased due to higher cost of animal feed. There is hence reason to believe that this higher purchasing power would not have significantly affected the demand picture, given that the problem is still on supply and cost factors.
Therefore, either way the theory that inflation in FY11 has been caused by the poor becoming less poor does not hold. The problem is on the supply side as also our inability to manage surpluses. India is traditionally in surplus when it comes to cereals, horticulture, sugar and deficient in pulses and oilseeds. The curious case here is that when production of pulses and oilseeds increase, prices move downwards and we also simultaneously lower our imports as we do not store them for the rainy day.
On the other hand, when production declines, we import more. Given that we import around 15-20% of our pulses requirement and 55% of edible oils, international prices are also influenced by this demand. Hence, inflation gets imported into our system. The wastage in horticulture is now quite well known and the country struggles to create the storage facilities to harness the production levels. Therefore, to use diminishing poverty as a factor causing inflation is neither an explanation nor an excuse.
There are two thoughts here. The first is that higher demand per se, especially of food items, has to be met by augmenting supplies; and this holds for any good or service. If people want more mobile handsets, industry produces more of them, which leads to lower prices.
Therefore, ideally if people are less poor and demand more food, then we should produce more food at a lower cost. This is the duty of any economy that works and hence we cannot sit back and take pride in such a development as it is a reflection of the failure of the system to deliver if there are persistent supply imbalances. However, for the sake of argument, let us suppose that this theory has a basis and prima facie makes sense.
This leads to the second issue. Do the numbers really add up? The MGNREGS allots around .`40,000 crore on an annual basis, and while the code speaks of an allocation of 60:40 for wages: materials, it has turned out to be 70% for wages. Therefore, there is an additional income of .`28,000 crore. Let us suppose that all this money is actually spent and nothing is saved as the people are poor and think only of the present. Here one cannot be sure whether or not this income will lead to additional spending or will merely substitute other sources of funding.
This is so because on an average, the MGNREGS in reality provides 37 days of employment to households when they are entitled to 100 days, which means that this becomes an income supplement when they are between two harvest seasons. In the extreme case, it will fully substitute other sources of income or else they will spend the money progressively on non-food items.
Now, the consumption pattern in the country points towards around 36% of expenditure going into food items and another 7% or so into clothes, which would be the areas the farmers would be looking at. This means that around 85% of their incomes would go into food as an approximation (36 divided by 43). Total consumption expenditure on food was estimated to be .`16.20 lakh crore for the country by the CSO in FY10 while the MGNREGS money of .`24,000 crore (i.e., 85% of .`28,000 crore) will be the maximum that can be spent on food items.
Now, this amount works out to 1.5% of total food consumption (or 1.7% in case the entire .`28,000 cr is spent on food products), and considering that farm output has increased by 6.6% in FY11, one cannot really see a mismatch between demand and supply for food items in general.
At the next stage we can get down to the micro level and examine whether this theory can still hold. Out of the.`28,000 crore being spent on food products, CSO data shows that around 25% is spent on cereals and pulses, where prices showed a decline or marginal increase.
Besides, they would be covered under the public distribution system where prices have remained unchanged. Fruits and vegetables account for another 26.5% and the problem is not higher demand but high losses on account of absence of storage facilities. The Union Budget admitted that around 40% of the crop is wasted due to the absence of logistics support.
Another 21% is spent on milk products, where the higher price is due to higher cost of production (i.e., animal feed such as oilcakes and fodder) while another 12% is on meat/poultry products where prices have increased due to higher cost of animal feed. There is hence reason to believe that this higher purchasing power would not have significantly affected the demand picture, given that the problem is still on supply and cost factors.
Therefore, either way the theory that inflation in FY11 has been caused by the poor becoming less poor does not hold. The problem is on the supply side as also our inability to manage surpluses. India is traditionally in surplus when it comes to cereals, horticulture, sugar and deficient in pulses and oilseeds. The curious case here is that when production of pulses and oilseeds increase, prices move downwards and we also simultaneously lower our imports as we do not store them for the rainy day.
On the other hand, when production declines, we import more. Given that we import around 15-20% of our pulses requirement and 55% of edible oils, international prices are also influenced by this demand. Hence, inflation gets imported into our system. The wastage in horticulture is now quite well known and the country struggles to create the storage facilities to harness the production levels. Therefore, to use diminishing poverty as a factor causing inflation is neither an explanation nor an excuse.
Are T-bill futures a good idea? Financial Express 11th July 2011
Futures on 91-days’ T-bill is an interesting development, considering that there is scepticism attached to money market derivatives, given the lacklustre response to the IRFs twice over. But, this one can be different because it does address, to a large extent, the concerns that thwarted the growth of the IRF market.
If we look at the structure of the market, the primary market has issues every week of, say, R8,000-10,000 crore depending on the RBI’s calendar. The buyers are banks, mutual funds, corporates and other institutions and some state governments. The secondary market does not inspire too much of trading and at best registers around R2,000 crore a day, which obviously has to change. This may be contrasted with, say, trading of around R20,000 crore a day in the cash segment of the stock market. Overall outstanding on such paper would be around R80,000-90,000 crore, though there is considerable churning of such bills as they expire every 91 days, which, in turn, are replaced by fresh issuances. This makes it an interesting underlying product as there is a virtual rollover of paper on a regular basis. How then will the derivative product on this underlying work?
For any market to work for a derivative product, we need to have large number of players—hedgers and speculators besides the arbitragers. The actual holders would be interested in such an instrument as hedgers. In FY12 so far there has been a movement of a little over 100 bps in the primary yield on 91-days T-bills, which means that the prices of these bills have been coming down. Intuitively, in such an environment of rising interest rates, this is a big risk that is being carried in the books of the holder and there is need to hedge it. This is where the investors or speculators could come in and take an opposing view on movement in interest rates. Hence, holders of such instruments would be shorting their futures, so as to buy back at a lower rate and provide cover for their loss on portfolio. At times, when the volatility in interest rate has been high and uncertain, given that one is still not too sure of RBI’s view on interest rates, this is a very useful option for interest rate hedging. As a corollary, it makes a sensible investment option.
T-bill futures have the potential to actually set benchmarks for short-term instruments such as commercial paper, certificates of deposits and other treasury bills. 91-days T-bills futures will hence help enable them to take positions based on their holdings of pother instruments. Corporates who are dealing with floating rate bonds would find this attractive as they are able to benchmark and hedge or trade based on interest rate perceptions. In fact, even within the T-bills market there have been major shifts in yields on other maturities which are above 50 bps for 14-days and around 75 bps for 182- and 362-days bills in the last three months. A major improvement over the IRFs is that there is no delivery and all transactions are cash settled, meaning thereby that one does not have to go running around for the right security to deliver. The absence of securities transactions tax will also help in further lowering costs along with lower margins, which provide greater leverage to investors.
In fact, this instrument should also attract attention from the retail end as one can actually take advantage of interest rate movements, especially in an era of rising interest rates. Deposit holders normally get into the instrument and have their interest rate locked for a fixed tenure. In an increasing rate environment, one can actually start playing on T-bill futures to derive the benefit of hedging or making a profit. The advantage for this derivative segment is that one can directly trade on the NSE platform just like one does for, say, shares.
A vibrant futures market in the IRF segment including T-bills has the potential to make the financial markets more buoyant. Futures typically trade a multiple times that in the physical or cash markets. In stock markets, for example, we have trades of around 6-7 times the cash segment, which, on its own, could mean comparable numbers for this segment. Commodity futures generate business volumes of around R60,000-70,000 crore a day while currency derivatives clock R30,000 crore a day. Quite clearly, the money market, which has a large underlying of GSec paper, corporate bonds, T-bills, CPs and CDs, should be able to match the same once they set acceptable benchmarks for other instruments, given that there is a large mass of GSecs which banks hold on to that always run the risk of MTM losses in a regime of rising interest rates. The IRFs were to address this issue, but the contract structures were a deterrent. Hopefully, we have gotten the product right this time as the initial trading volumes look more respectable than it were when the initial IRFs were launched.
If we look at the structure of the market, the primary market has issues every week of, say, R8,000-10,000 crore depending on the RBI’s calendar. The buyers are banks, mutual funds, corporates and other institutions and some state governments. The secondary market does not inspire too much of trading and at best registers around R2,000 crore a day, which obviously has to change. This may be contrasted with, say, trading of around R20,000 crore a day in the cash segment of the stock market. Overall outstanding on such paper would be around R80,000-90,000 crore, though there is considerable churning of such bills as they expire every 91 days, which, in turn, are replaced by fresh issuances. This makes it an interesting underlying product as there is a virtual rollover of paper on a regular basis. How then will the derivative product on this underlying work?
For any market to work for a derivative product, we need to have large number of players—hedgers and speculators besides the arbitragers. The actual holders would be interested in such an instrument as hedgers. In FY12 so far there has been a movement of a little over 100 bps in the primary yield on 91-days T-bills, which means that the prices of these bills have been coming down. Intuitively, in such an environment of rising interest rates, this is a big risk that is being carried in the books of the holder and there is need to hedge it. This is where the investors or speculators could come in and take an opposing view on movement in interest rates. Hence, holders of such instruments would be shorting their futures, so as to buy back at a lower rate and provide cover for their loss on portfolio. At times, when the volatility in interest rate has been high and uncertain, given that one is still not too sure of RBI’s view on interest rates, this is a very useful option for interest rate hedging. As a corollary, it makes a sensible investment option.
T-bill futures have the potential to actually set benchmarks for short-term instruments such as commercial paper, certificates of deposits and other treasury bills. 91-days T-bills futures will hence help enable them to take positions based on their holdings of pother instruments. Corporates who are dealing with floating rate bonds would find this attractive as they are able to benchmark and hedge or trade based on interest rate perceptions. In fact, even within the T-bills market there have been major shifts in yields on other maturities which are above 50 bps for 14-days and around 75 bps for 182- and 362-days bills in the last three months. A major improvement over the IRFs is that there is no delivery and all transactions are cash settled, meaning thereby that one does not have to go running around for the right security to deliver. The absence of securities transactions tax will also help in further lowering costs along with lower margins, which provide greater leverage to investors.
In fact, this instrument should also attract attention from the retail end as one can actually take advantage of interest rate movements, especially in an era of rising interest rates. Deposit holders normally get into the instrument and have their interest rate locked for a fixed tenure. In an increasing rate environment, one can actually start playing on T-bill futures to derive the benefit of hedging or making a profit. The advantage for this derivative segment is that one can directly trade on the NSE platform just like one does for, say, shares.
A vibrant futures market in the IRF segment including T-bills has the potential to make the financial markets more buoyant. Futures typically trade a multiple times that in the physical or cash markets. In stock markets, for example, we have trades of around 6-7 times the cash segment, which, on its own, could mean comparable numbers for this segment. Commodity futures generate business volumes of around R60,000-70,000 crore a day while currency derivatives clock R30,000 crore a day. Quite clearly, the money market, which has a large underlying of GSec paper, corporate bonds, T-bills, CPs and CDs, should be able to match the same once they set acceptable benchmarks for other instruments, given that there is a large mass of GSecs which banks hold on to that always run the risk of MTM losses in a regime of rising interest rates. The IRFs were to address this issue, but the contract structures were a deterrent. Hopefully, we have gotten the product right this time as the initial trading volumes look more respectable than it were when the initial IRFs were launched.
Yield curve not based on real market conditions: Economic Times 6th July 2011
The government debt market trades almost as much as the cash segment on NSE at around Rs 15,000 crore a day. The size of the market is large with outstanding central government paper of around Rs 25 lakh crore, with net annual addition of around Rs 3.5 lakh crore of paper. Yet, there are some interesting statistics on the topography of trade that takes place in this market. More than 80% takes place in paper with a residual maturity of 10 years and above, despite the fact that around 38% of fresh paper being issued has over 10 years maturity, with an equal share for papers with 5-10 years maturity. What does this indicate? The market is still narrow in terms of trade taking place. A curious factor is that the difference in yields on 1 year and 10 year paper is around 15-20 bps.
Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.
Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.
First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .
Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.
Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .
At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.
Contrast this with the markets overseas and the picture is startling . On an average, based on Bloomberg data, for the last month, the difference between these tenures was around 280 bps in the US, 270 bps for UK and 150-160 bps in Germany. For 5 years, this spread was 140 bps, 150 bps and 85 bps, respectively. In our case, it was slightly inverted with a spread of 20 bps. Quite clearly, the Indian picture is a manifestation of a weak market. While the US and the UK are relatively more indebted than Germany , India , too, is a high debt nation. Yet, the yield spreads indicate a different picture. One of the two conclusions that come from these numbers is that the market is immature and the yield curve is not actually based on real market conditions.
Trading is at the higher end of the spectrum and even the 10 year paper cannot be accurately benchmarked. In the absence of this curve, developing a corporate yield curve becomes difficult as this involves a risk premium over the non-existent G-Sec yield. The second is that the government is getting funds at 8-8 .30% discount, at the worst of times for long tenures. With repo rate at 7.25%, which is a single day rate, the spread of just 100 bps or so for 10 years is good money, especially in a rising interest rate regime where corporate spreads for top-rated firms are 125-200 bps higher. Both these anomalies need to be corrected.
First, we need to have a well-defined yield curve in the G-Sec space. While the government is definitely spreading across its issues, the secondary market is trending to the higher maturities . To get the curve, interest has to be created among the participants. At the institutional level, can we actually think of making banks hold differing maturity of securities linked to the tenure of their deposits? Alternatively , banks may be incentivised in terms of the valuation of securities based on short term and long term. This would be an unconventional way of creating liquidity. The other is to bring in retail interest .
Individuals that go in for savings in fixed deposits or small savings do look at time horizons of up to 5-6 years, which can go up to 10 years. By providing them with access in smaller denominations and perhaps tax benefits, this process can be hastened. To facilitate such trading, it would also be necessary to provide a trading platform that can be done on the online stock exchanges, which provide access to equities and mutual funds. Third, the government should earmark borrowing maturities with its usage. Borrowing for infra projects can have higher maturity, while the same for meeting revenue expenditure or short-term projects should be of lower maturity. In this manner, the government can help in creating short-term paper.
Fourth, another unconventional way of creating a market is for RBI to periodically declare which are the securities that can be traded. This could be contrived to create liquidity in a tenure . Variants can be of directing specific securities for the purpose of repo so that other securities also get traded in the secondary market. Alternatively , there can be debt funds which invest only in bonds with maturities of 1-9 years. The existence of market makers could spur activity here. A well developed G-Sec market will help set benchmarks needed for the corporate debt market to grow. Globally , corporate debt markets provide funds with banks investing in the same. Migration to this mode would be possible only if there are exit options .
At present, attention is given to getting institutional players and providing more efficient trading and settlement platforms. Evidently, we have to move to the next level of generating liquidity, which should set the tone of our agenda for the next 2-3 years.
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