Interesting time for banks, if only...Financial Express 13th December 2012

The banking space is always full of activity, with RBI in particular being under the lens not just for the decision on interest rates but the financial environment as well. It is not surprising that the Banking Law Amendment Bill has raised interest once again for not being passed.

The Bill, when viewed along with the passage of changes in the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, reads well for the banking sector as it addresses the issues of both capital and asset quality (subsumed under prudential banking) in a limited manner. We all know that for sustaining growth of 8% per annum in the future, bank credit has to increase by over 20% per annum. This requires capital for banks, which will progressively pose a challenge given that we are moving over to Basel III, where the capital and liquidity requirements are more pressing. Therefore, having new banks makes a lot of sense as this will bring in the capital that is required. The next stop would be for RBI to work out the game-plan and set the ground rules. There are a number of corporate houses like Tata, L&T, Birla, etc, that are prepared to start such outfits or have their own NBFCs converted to a bank.
The second area where the Bill has focused on is the voting rights privilege. Increasing it to 10% for public sector banks (PSBs) and 26% in private banks is pragmatic as it provides more incentives to involve shareholders in the running of the bank, which improves transparency as well as governance and efficiency. This could be a useful step in moving further towards disinvestment of public sector banks as we get used to more private participation in the affairs of the bank. Third, RBI will have more powers to regulate acquisitions in this space. This does not really matter much as RBI is already quite powerful and we may not be seeing such activity concerning large banks. More likely, this would be for weaker or smaller banks, where there would not be any serious issue.
Fourth, the question of banks and ARCs being allowed to convert outstanding debt owed to them to equity or bidding for immoveable property that has been put for auction is useful for them as it means that they will address the critical part of NPAs. Banks should be pleased with this move as they are offered more options at a time when their NPAs have increased and they have been saddled with progressively increasing restructured assets. Discussions on these issues have, by and large, been more or less according to the script, which over months has managed to garner a reasonable level of acceptance. However, the issue that has become controversial pertains to allowing banks to enter the commodity futures market. This would have probably been one of the most revolutionary decisions taken by the government because given the pro-cyclical nature of growth of NPAs with agricultural production and industrial growth, there is a pressing need for a cover to be procured by banks. At present, agriculture has crop and weather insurance, which provides cover to the farmers, though not to the bank as recovery would still be its job.
As bank lending is predominantly against the existence of a commodity somewhere in the input-output matrix for a company or directly for farmers, there is a commodity price risk that is carried on its books. At the pre-harvest stage, the farmer carries a price and volumetric risk, of which the latter is covered by the insurance company. The bank lends to the farmer for inputs and the latter’s ability to repay the loan depends on the price at the time of harvest. Intuitively, it can be seen that the bank is better off in case the farmer hedges his price risk on a commodity exchange. However, today, farmers cannot access this market due to the absence of knowledge as well as their trading lot size, which is too small. A solution is for banks to act as aggregators for farmers as it pays them to hedge their risk in the eventuality of the crop failing. The banker only needs to convey the quantity of crop involved to the central treasury which puts in the order. This is what RBI had recommended in the draft report on warehouse receipt finance in 2005.
The same analogy can be carried for non-farm products, where often banks are impacted by volatility in prices of specific commodities like oilseeds, sugarcane, steel, aluminium, wheat, crude oil, etc. Here, banks can provide cover for themselves in case they take a corresponding position in the commodity derivative market with active trading in farm products on exchanges like NCDEX and energy products on MCX. Most of these products are offered on these exchanges or have proxy products that may be used. In fact, banks would be better off in case ‘options’ were permitted in this market as futures protects against downside risks while options lets one exit when conditions are better at the time of settlement of contract. But this needs the Forward Contract Regulation Act (FCRA) to be changed, which is another Bill pending in Parliament.
The FCRA Amendment Bill seeks to give autonomy to the Forward Markets Commission (FMC), which, in turn, would give it power to introduce new products which will include options and indices (intangibles). Therefore, for banks to be allowed into the commodity market, it would also be necessary to amend this Bill so that options are permitted as in the capital market. An interesting corollary here is that banks could also take proprietary trading positions in this segment, just like they do in the capital market. RBI would, however, have to set the regulatory processes to ensure that there is controlled trading that does not distort their own business models. This may still be a long way off.
The impasse in Parliament is ostensibly on account of futures trading by banks. Logically, the other elements that have been agreed upon should be passed immediately so that work can begin, especially on the issue of new banks being permitted, while the issue of futures trading can be separately debated. Or else we will have to wait again for a longer time period, which is not desirable for the banking system as we always seem to be returning to the starting line of a race that never seems to begin.

Need to rethink priority sector lending: Financial Express November 8th 2012

Inclusive banking is desirable, but by forcing it on financial institutions, we could be making it tough for banks

A major issue confronting our financial system is the quality of assets. This has been exacerbated by the economic downturn, which is typically when loans stop performing. While restructuring is a way out for some cases, it poses conundrums for the lending institution as well as the regulator. An issue that comes up here is asset quality and priority sector lending. So far, with all the talk of inclusive growth, there are fixed norms for lending to vulnerable sectors. But, if one looks beyond the conventional commercial banking system, this problem is even scarier.
Within commercial banks, a little less than half of the non-performing assets (NPAs) originate in the priority sector (whose share in total credit is around 31-33%), and given that this sector is held sacrosanct, seldom do bankers raise objections and instead defend the concept as being necessary. In FY12, 4.4% of outstanding priority sector advances were classified as non-performing, while the same for non-priority sector was 2.4%. Further, growth in these NPAs was much higher than that in loans to this sector. Clearly, there are problems associated with such finance.
The accompanying table provides the picture of NPAs for various cooperative banks that are seldom analysed, which provide support to the rural economy and the small & medium enterprise (SME) segment.
The table shows that we have a large network of cooperative banks in the urban and rural spaces that offer various credit facilities to agriculture and SMEs. These banks have assets equivalent to around 12-15% of the commercial banking system, which is quite significant given that they address sections that would not qualify with commercial banks. Further, while the urban cooperative banks are profitable, the same does not hold at the rural level.
The significant aspect is the high levels of NPAs, which, at the level of rural development banks, is quite disastrous. Clearly, the business model does not work well at this level. The recovery ratios are also quite low and vary between 39.4% for PACs to 91.8% for SCBs. Given that these loans are directed mainly to farm-based borrowers, the problem is actually with the sector rather than the banks.
Two questions may be posed here. The first is whether the concept of priority sector lending is anachronistic in a regime where banks are answerable to their shareholders and adhere to prudential norms relating to bad assets and capital. Forcing banks to lend in areas where the probability of assets turning bad is higher may not be right. One reason why foreign banks do better is that they have less exposure to this segment.
The second relates to reforms in cooperative banking. Having NPA levels of 41.7% for PACs, 34.3% for SCARDBs, and 11.6% for DCCBs is definitely not viable. While there is a committee that has spoken about revamping them and providing more capital, the question to be answered is whether or not there are ways in which such lending is addressed. At the level of cooperative banks, the skill sets for evaluation of loans may be missing. But for commercial banks it is more the compulsion than the absence of skill sets that engenders such quality of assets.
Four solutions could be looked at, which should probably progress simultaneously. If banking has to be profitable and viable at the same time, the concept of priority sector should not be forced on banks and this level has to be brought down. In fact, it was suggested by the Narasimham Committee also a long time ago when financial reforms were invoked.
Second, the government should create a fund to compensate banks for such loans that are vulnerable to the vagaries of nature and tend to get magnified when there is a drought. This is a challenge given the fiscal constraints that already exist, but diverting a part of the MGNREGA expense for this purpose could be an idea as this will qualify as development expenditure. To lower this burden, various state governments could be asked to chip in.
Third, the government could impose an NPA cess on all borrowings so that a fund is created automatically by any bank on its loans, which can be used to make provisions or write-offs for NPAs. This will push up the cost of funds for borrowers, but in a way they would be made to subsidise the vulnerable sections. An extension could be to have a cess on all tax collections, which can also help. Interest earned for banks in FY12 was around R6.5 lakh crore. Assuming 70% from advances of which two-thirds from non-priority sector, interest would be around R3 lakh crore. A 1% cess on this would yield R3,000 crore.
The other solution is to allow credit default swaps on loans, which is not allowed today. The advantage here is that the risk involved in this lending can be mitigated by a third party. The issue, of course, will be that the CDS price will be high for farm loans that carry greater risk than, say, one to an SME. But, if bank loans are brought under this fold, it will help them to cover their risk theoretically at least. Mutual funds, foreign banks, NBFCs, insurance companies (which already are in the business of providing crop insurance and weather insurance to farmers) could be possible sellers of protection.
Inclusive banking is certainly desirable, but by forcing it on financial institutions, we could be making it tough for banks, especially when they are more susceptible to turning into NPAs. So far, we have skirted the issue as it sounded politically correct. But with the incidence of such lending turning unsatisfactory, alternative routes have to be explored or else we will get caught in a contradictory world where the best practices of BIS have to mingle with the pro-nationalisation thought process of the 1970s and 1980s, which looks irreconcilable as of now.

Is a foreign governor better for RBI? Financial Express 4th December 2012

The appointment of Mark Carney as the Governor of the Bank of England is interesting for several reasons. This is the first time in the history of the bank that an outsider has been chosen on account of his profile being the best. But, getting in an external candidate for the job does raise certain issues, which would be more relevant when it comes to a country like India. Given that we have an external economic advisor, does a foreign central bank governor make sense?

To begin with, the advantages of having a non-resident governor could be looked at. First, a governor of a central bank who has run the affairs of the bank successfully certainly qualifies for candidature. If the performance has been exemplary, one quite clearly qualifies for a set of countries that have similar structures, such as Canada and England—both developed countries. But the same may not hold true if a central banker from a developed country were to be considered for a country like ours where conditions are vastly different and priorities less aligned to those pursued in the West.

Second, the outsider can bring in a fresh way of thinking to central banking, especially when this sector is in a state of flux. Experiences from other central banks’ handling of crises-like situations are always helpful when drawing up strategies for the domestic central bank. The crises witnessed in the US and the euro regions provide sufficient case studies that have been seen through by central banks via different strategies. These are real life experiences and not just from the text book.

Third, any outside governor brings along a certain modicum of independence, which is good since they would be free from past baggage, which can help in running the central bank. Often, one gets bogged down by pressures by the government or industry houses, especially in developed economies, where policy can be guided by them. Therefore, a corollary is that if a country is looking for the best person to run a difficult role such as heading the central bank, it should not matter where the person comes from.

While surely there are advantages in having an outsider, there are a good number of reservations for such a selection, which holds true more in developing countries such as India, and could also hold true for some western economies. First, an ‘outsider is an outsider’ and would not be aware of local conditions and would find it hard to reconcile the various brands of economics in practice across this group of countries. This makes adjustment to the environment, both within the organisation and outside, difficult. This holds more so in case the two geographies are vastly different, such as a developed and a developing country. An example here is the complex financial system like India’s, which has rigorous concepts such as priority sector norms and SLR, as well as NBFCs, cooperative banks, which makes coordination for an outsider more challenging.

This leads to the second point. There would be a tendency for the outsider to use models that are considered to be ideal and may not gel well with the local conditions. An example here is the pursuance of monetary policy that has to reconcile with fiscal goals that are quite different. Further, the financial systems are complex, and structured products, which were popular in the US though not so much in other countries, could be a puzzle for a central banker who has not dealt with them in his own regime.

Third, following from the second, in emerging markets in particular, the concept of an independent central bank is hard to pursue as there has to be harmonious working with fiscal policy. Asking the government to lower the fiscal deficit by reducing subsidies may make a lot of economic sense, but could be a difficult choice when development levels are low. A non-accommodative monetary policy would create frictions in working. In such situations, lasting an entire tenure would be difficult for a central banker, who could often be on the opposite side. Anecdotal experience shows that, finally, government power prevails and the governor has to accept or quit. The latter could be destabilising.

Fourth, from an ideological viewpoint, the post of a central banker is very crucial for any country—like, say, the head of the defence sector—and should be led by a citizen. A foreigner could be appointed as an advisor for the experience brought along, but the governor surely should be domestic.

On balance, it may be argued that while the British case has a greater probability of succeeding, the same may not hold true for emerging markets, including India. Governors of RBI have generally had some exposure to working in the government, which is helpful as they are practical and know how policies function. Working of the two arms becomes easier when there is understanding. Having a very independent governor can be an issue, especially if there is intransigence in aligning with other government policies. One must remember that the monetary arm of the government, the central bank, cannot work in isolation as its job is to harmonise the financial sector with the requirements of the real sector, where growth takes place. The situation is akin to a corporate where all departments have to work together in harmony, and a person who is home-grown would have an advantage.

Further, whenever one speaks of having a foreign governor for the central bank, an option always exists where home-grown experts actually work in foreign organisations such as IMF, World Bank or Bank for International Settlements where there is exposure to global best practices, which is of essence today in banking, with the Basel norms virtually dictating the rules of the games for all banking systems. Therefore, there may be no real requirement to look outside; in-house certainly looks the better option.

The Big Bank Theory: Book Review in Business World 3rd December 2012

Veteran financial journalist,Tamal Bandyopadhyay reconstructs the story of HDFC bank's growth into one of the sturdiest banks in India

 

A Bank For The Buck :The story of HDFC Bank By Tamal Bandyopadhyay Jaico books Pages: 344 Price: Rs 395

 

Writing the biography of an institution is a challenge. If it is to record its history, the objective is clear and the path is one of documentation. But if it is to tell the story of a dynamic organisation that epitomises innovation, the narrative sets paradigms. Else, the story runs the risk of having a limited audience, being familiar to those associated with the organisation, and the names may not mean much for the lay reader. So, reconstructing the growth of HDFC Bank — arguably the steadiest bank here — is prima facie an unexciting story. It does take one of the most accomplished banking journalists to add the necessary zing to the story.

Tamal Bandyopadhyay starts by talking about the ‘dirty dozen’ that set up the Bank, cherry picked by Deepak Parekh — who for all purposes — has been the ‘producer’ of this potboiler. Parekh, who carved the HDFC Bank story out, is technically an outsider, but he has steered right from its start through the entire mergers and takeovers to where it is today. Aditya Puri, managing director and CEO of HDFC Bank since its inception, is more of the ‘director’ of this saga.

Arguably the cleanest private bank in India by far, HDFC Bank has seldom strayed from the path except for a brief deviation on the forex derivative tryst, where the penalty was just Rs 15 lakh. It was more of a reputation hit. There was also the Roopalben Panchal case where it was caught on the wrong foot, but recovered as fast as it slipped. The bank was created by foreign bankers who had to deal with several tradeoffs in terms of pay cuts, risk and giving up good positions on foreign lands. The idea was to provide services of a foreign bank and create relationships and distribution channels of nationalised banks — the best of both worlds.

Getting the team in place was the hard work of Parekh, but getting in like-minded people made the concept work. Their initial days before the main office came up make interesting reading, but this is the joy or travail of creating organisations. HDFC Bank, unlike its closest competitor ICICI Bank, was not an innovator or risk taker, but an astute follower that blended commerce with prudence to be known as the bank with the best quality of assets. Minimising risks and running a diversified book allowed it to “eat well, sleep well”. The focus was always on net interest margins and enlarging the Casa (current and savings account) component in deposits.

Bandyopadhyay vividly narrates how the bank acquired customers. It started with Siemens and went about systematically from being a corporate-to-retail bank to enlarge its perimeter. The small and medium enterprises came much later. The bank also had its brushes with bad assets, including microfinance firms, but it was manageable given the low exposure. More importantly, it was swift to make an exit.

HDFC Bank will also be remembered as the only bank to be involved in a series of mergers, starting with Times Bank and then Centurion Bank. The process of physical and cultural integration was a challenge well accomplished given that Times Bank followed public sector giant SBI while HDFC Bank had a foreign bank tilt.

Bandyopadhyay says the bank is ‘doing ordinary things, the extraordinary way’. The same can be said of his narrative as well; he keeps the reader engaged. While he gets Puri’s colleagues to talk about him, the tilt is definitely positive. It would have been interesting to hear from detractors, which is important especially when the leader has been so successful. On a lighter side, it would have been interesting if the author had either discussed with Parekh or provided his own view on having the same MD & CEO since the bank’s inception and how it fits with the concept of corporate governance that has been epitomised by the bank. Also, Bandyopadhyay does not ‘choose’ as to who should be credited for HDFC Bank’s success: Parekh or Puri — as a journalist, he could toss the coin.

The borrowers take: Book review Business World 26th November 2012

David Graeber, an anthropologist, explains the evolution of debt through various societies and the way it is perceived today

Madan Sabnavis

 

Debt: The First 5,000 Years By David Graeber Penguin(Allen Lane) Pages: 544 Price: Rs 799

 

 

Discussing debt has become a favourite with authors post the sovereign debt crises that made writings on such topics good business. But rarely do we get to read an anthropologist’s take on debt and that is why David Graeber makes a mark with this extremely interesting book. Graeber explains the evolution of debt through various societies and the way it is perceived today. While typically one’s sympathies lie with the creditor, he prompts us to look at it from the debtor’s point of view. At times, when he raises a moralistic issue where he justifies the non-repayment of debt if the money is spent on the poor, Graeber provokes debate.

His views on debtors are quite novel. First, he says, countries were colonised and made to pay for developments they did not ask for. Can such debt be justified? Second, indebtedness also increased during wars and the loser became indebted when it was made to pay for reparations. Last, after the Opec crisis in the 1970s, oil producers earned truckloads of dollars which were lent to dictator countries at high interest rates, which were then embezzled. Later, elected governments were left with the overhang, which could not be repaid. How do we judge these situations?

Graeber is fairly caustic on the US, which urges third world countries to open up markets while running the world’s highest levels of debt. He does not miss a chance to chastise entities such as the IMF, which bully borrowers into following their western-oriented policies — a view echoed often by Joseph Stiglitz.

The author goes back in time to tell the story of how the concept of debt evolved. He delves into religions, which are invariably ambivalent when it comes to viewing debt. Debt is transformed into a sense of guilt that leads to self loathing. While religions are not against markets in general, they object to debt on commercial grounds. To tell the story of debt, one needs to know the language of the market place.

Graeber distinguishes between debt as a concept in a human and commercial economy. It varies across cultures. In Madagascar, an exchange is a way of cancelling debt, which ends a relationship between two individuals. In Nigeria, people lend neighbours stuff that has to be repaid in kind or cash at a later time. Societies expect a balancing of the equation. So, all transactions are viewed as a way of settling a debt. Taking this anthropological study further, Graeber goes into ancient Irish society where slavery came into being on similar grounds and slaves became a currency. Bonded labour was an outcome of a loan being settled through generations. This is also not uncommon in India. In ancient societies, the same was extended to prostitution, which was a way of repaying debt.

The commercial or money economy then changed the landscape of debt. From around 1825 onwards to 1971, the age of capitalism commenced with the dictates of Adam Smith catching on. An extended form was military intervention of the US in Vietnam, which led to an increase in its own debt. And that is ironically being financed now by emerging countries. Even today, it creates armies across the globe, whose maintenance is being financed by the rest of the world. So there is a contradiction between political imperative of establishing capitalism and its own need to limit its horizon.


The concept of debt as it has evolved has encompassed various emotions across ages — sin, guilt and redemption. What Graeber does is to expose the manner in which debt has been created and these relations exploited for the betterment of certain sections of society, while others, such as the US, get away easily. He shows this is not anything new but has been in existence for long, and even argued by religions. This is a refreshing and compelling treatise on debt written by someone who calls himself an anarchist.

Should gold loans be banned? Financial Express 30th November 2012

In the light of the need for financial inclusion, loans against gold are useful for both individuals as well as the SME segment, where the small entrepreneur can obtain loans easily
In a capital-scarce economy, where access to credit is limited, though growing, gold loans look like a good option provided the ground rules are put in place. Also, since we are talking a lot about financial inclusion, this particular mode of lending is effective for a number of low-income households who buy and hoard ornaments as part of tradition.
Gold loans are typically structured as secured loans where the holder gives gold or ornaments as a security and a gets a proportion of value of the same as a loan. The interest rate varies across banks and NBFCs who finance through this mode. Also, this is a quicker process relative to other personal loans and often is considered to be more dignified as the borrower need not give references, thus revealing his monetary status to others known to them.
Prima facie, this is analogous to the pawn system that exists in unorganised markets with a transparent face. It is a win-win situation for both the lender and borrower. The lender has collateral that can be easily converted to cash and since the loan given is a fixed percentage of value, the downside risk is limited unless the price of gold falls sharply. But given that these loans are normally for a shorter tenure, such a sharp decline in value would be an exception. Therefore, for the borrower, it is a good source of finance as it eschews the elaborate processes that would otherwise be involved in personal loans.
Also, since this security is provided upfront, the borrower need not have any major worry of having other property attached as the transaction involves only the ornaments or gold that is given to the lender.
In the light of the need for financial inclusion, this is useful for both individuals as well as the SME segment, where the small entrepreneur can obtain loans easily. In the case of SMEs, very often the owner has to pledge personal effects, which is limited when gold loans are taken. Therefore, such loans should be encouraged and there is no case for banning or restricting the proliferation of these loans.
From the regulatory standpoint, the safeguards have to be put in place as this business expands. Typically, there are three risks involved, of which two can be addressed. The price volatility in gold should be hedged by the lender simultaneously. Given that the FCRA Bill is likely to be passed, options trading would most probably be available, and hedging would be even more effective. Second, based on past price movements, RBI should fix the margin-lending norms, with a buffer so that any sudden decline in value of the collateral should still be above the threshold level. The lender should also have the right to call for additional collateral when such triggers are reached.
The third risk relates to the higher demand for gold, which has macro-economic implications for the country. But in a free market economy where one can buy imported cheese and motor vehicles, logically there can be no physical restriction on the purchase of gold.

Issues like food prices, PDS can hurt cash transfers plan in food: Economic Times, 29th November 2012

Cash transfers will become a reality soon, and one area that the government is going to align with this mechanism is the Public Distribution System (PDS).
While, prima facie, it appears to be a good idea, given that it removes quite a bit of inefficiency in the present system, there are certain issues that have to be addressed before we go in for the same as they could become obstacles in the implementation of this scheme.

First, the UID scheme provides an identity for a person, but by itself does not tell us whether the person is actually poor or not and whether or not requires to be subsidised. The present system of ration card is based on self-declaration where one mentions the household income to obtain ration. One of the inefficiencies in the system is that this benefit is not well-targeted, which means that the beneficiaries are not always those who are intended to get the benefit.
This leads to adverse selection that has to be addressed in the early stages before going in for cash transfers as, once implemented, it will be difficult to withdraw the unintended beneficiaries. Has this system of identifying the income of families been put in place?
Second, the PDS system provides essentially rice and wheat, along with sugar and cooking oil, which is delivered at a fixed price by the government. The procurement prices are fixed by the government, as is the issue price.
Therefore, both the farmer and the consumer are protected through these prices. Now, the consumer will get a cash transfer equivalent to the value of the quantity of these commodities.
While there can be a debate on how this money will be spent by the household, there are intrinsic problems in arriving at the right amount of money to be given to households.
Let us look at some retail prices at the extreme levels as presented by the ministry of agriculture for some of these proxy products for October 2012. The price of coarse rice varied from 16 per kg in Agartala to 33 per kg in Chennai. In case of wheat, it was between 14 per kg in Ludhiana to 36 per kg in Chittoor.
For sugar, the price varied from 31 per kg to 42 per kg in Ludhiana and Guntur respectively. For groundnut oil, the price band was as wide as 80-205 in Guwahati and Ernakulam. Clearly, we need a firm set of prices for various geographies as well as have differential cash transfers.
Are these systems in place? Presently, the issue prices are fixed. But once we move to cash transfers, the inflation rates in various centres have to be readjusted periodically. Do we have statistical tools in place for the same?
Third, today, we have an open-ended procurement scheme for wheat and rice where FCI procures as much as is offered. This is used for PDS, creating a buffer and a strategic reserve. Now, with cash transfers taking place, the PDS would be redundant. In that case, we would have to redefine the procurement system as the farmers' position would change as they cannot sell without a limit to the FCI.
 The concept of minimum support price (MSP) will get diluted as farmers cannot be assured of selling to the government at an assured price as the existing scheme has to be changed, else, the FCI will be loaded with over 60 million tonnes of annual procurement that cannot be used for distribution with around 32 million tonnes required as buffer in July as per the norms.
The farmers lobby will not be too satisfied with this move and it could be politically-sensitive. As a corollary, the role of FCI has to be reviewed as we have a large organisation that will no longer be relevant beyond the role of holding on to the buffer and strategic stocks.
Fourth, with the FCI now holding on to stocks only for emergencies, the warehouse spaces under its purview need to be put to commercial use. For this, the organisation has to create a viable business model as the space has to be handed over to the private sector. Today, the FCI has around 34 million tonnes of warehousing capacity that is used along with those of CWC and SWCs to hold on to the food grain stock in the country.
Given that either the FCI or the warehousing corporations will have excess space and have to let go, they have to learn to become commercial entities, which is a challenge given that so far they have run like government entities. Has this work begun at the ground level?
Last, we have around five lakh fair price shops spread across the country that enable the PDS. Once cash transfers are in place, these shops would become redundant. Have we thought of what will happen to these outlets considering that, on an average, they involve deployment of 2-3 persons, which means 10-15 lakh jobs? While most deal with other products too, the same may not be sustainable and they would have to be compensated.
Today, one of the main fears of FDI in retail is what will happen to the small retailers. Here, we have a government action that could pose a similar threat to these shops.
Clearly, while cash transfers are a sensible option for a country like ours, we do need to address these issues before implementing this scheme, else, we would run into certain contradictions as all these issues are intertwined and gigantic structures have been built that also involve political compulsions that cannot be separated. Unless we address them, we may just end up putting the cart before the horse.
 

CRR cut won't have much impact on liquidity or interest rates: Economic Times 14th November 2012

The RBI's stance on interest rates has come under discussion in the recent past. Banks have argued for a rate cut to enable them to lower interest rates. In the same breath, some have also debated in favour of a CRR cut on the grounds that this will enable them to lower rates. The FM has been asking the RBI to take action, while the RBI has been selective this year in terms of lowering the repo rate (April) and the CRR (February, March, September and October). The RBI evidently sees interest rates and inflation more from a macro view and implicitly looks at real interest rates. But, how do banks react to rate cuts? Are they really sensitive to rate changes or are they just asking for more?
As a corollary, how do liquidity and G-Sec yields respond? A repo rate change alters the base rate, directly depending on the bank's borrowing from this window. The deposit rates movement is quite discretionary as the bank has a choice to pass on the benefit or simply add to the bottom line. In case of CRR, banks have to perceive it as an increase in the supply of funds to be able to lower rates. But if they get invested in G-Secs, then CRR action may not really matter.
Let us look at the first year — October 2010 to October 2011. The repo rate was increased by 250 bps during this period. Banks increased the deposit rate (for one year as reported by the WSS-RBI), by 125 bps, while the base rate of banks increased by 233 bps. Quite clearly, any rise in interest rates gets reflected less in deposit rates, while base rates increase by almost the same range. G-Sec yields rose by 77 bps, which is the market perception on risk-free bonds, indicating a premium of around minimum 150 bps on commercial lending.
The repo rate was lowered in April by 50 bps, while changes in CRR were invoked prior to this move and subsequently in September. On a partial equilibrium analysis basis, the base rate moved down by around 18 bps by October, while deposit rate moved down by 25 bps. These changes, however, may not be attributed to just the repo rate cut as the CRR was also reduced periodically. Looking at CRR reductions now from February onwards — there were two successive cuts in February and March. The deposit rates did not change till October after the September relaxation in CRR, while the lending rate went down gradually by 17 bps till September, before another CRR cut was invoked.
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Therefore, CRR cuts did not change the structure of interest rates significantly, though base rates were relatively more responsive. Banks have hence held on to deposit rates in this situation. Curiously, liquidity, too, was not really affected on all the three occasions, as the amount released got absorbed in the system almost immediately.
Lending from RBI remained high in February and March (Rs 1,40,000-1,50,000 a day) and was at lower, though still high levels till June (Rs 90,000-1,00,000). The notional benchmark of 1% of NDTL being the ideal amount traded on this window was breached.
The conclusion is that CRR cuts do not really matter much in terms of impact on liquidity or interest rates, especially, when there is a large liquidity deficit in the system. The G-Sec market has been more responsive with the 10-year yield moving downwards by 45 bps since April, when repo and CRR cuts were brought in. The market hence is more alert to policy changes and reacts well as per economic theory. Therefore, what has been observed is that banks do react to repo rate hikes with alacrity and raise deposit rates by less than the base rates, which improves profit margins. But, when CRR is reduced or repo rate is cut, there is some level of intransigency in rates.

Also, CRR reduction certainly does not ease liquidity and is more of a signaling device, which is picked up, albeit, quite mildly by banks. The G-Sec market is more robust in comparison. Hence, even if one would like to throw the onus on RBI for getting the economy started through rate cuts, the reaction of banks is not certain, because somewhere, they do, even though they may not admit it, look at the true economic cost of capital when deciding on their interest rates. Relentlessly asking the RBI to lower rates is one part of the story, but the reaction from the system is certainly more interesting.

How about real estate futures? Business Standard 12th November 2012

Madan Sabnavis: How about real estate futures? They could offer investors high, stable returns and, importantly, a transparent benchmark of prices Madan Sabnavis / Nov 12, 2012, 00:30 IST When inflation is close to 10 per cent most of the time and an investor wants to maximise returns, the nominal return should be more than the inflation rate. Typically, the stock market is considered the best bet, while government securities (GSecs) give the most conservative yield, though the relative risks are proportional. Bank deposits are somewhere in between. One area that has not been looked at closely is the real estate market.The National Housing Bank (NHB) tracks an index called the Residex, which looks at residential housing prices over 15 centres. This has been reckoned from 2007 onwards, and is tracked on a quarterly basis. Now, there are some very interesting observations over the 4.25 years ending March 2012. First, 11 of the 15 centres gave an average compound return that was positive against the Sensex, which declined around 3.5 per cent. In fact, nine centres gave returns between 12 and 20 per cent. Also Read Related Stories News Now - Markets gain as Nov inflation eases - Growth will be a bigger challenge in FY14: SBI - Life insurance policy sales fall 8.22 pc in FY12: Govt - Air India Express to get its act together to fight competition - Land Bill to address old land disputes More Second, Hyderabad, Jaipur, Kochi and Bangalore are  centres that reported negative returns. Third, the highest return was clocked by Chennai at 30 per cent, followed by Faridabad with 20 per cent and Bhopal with 18.3 per cent. Mumbai gave a return of 16.3 per cent and Delhi 13 per cent. Clearly, this is one avenue that the investor has not seriously considered, given the capital outlay involved. These returns cover inflation adequately, which averaged 7.6 per cent on a compound basis during the period. Against these returns, the average price volatility, which is a symbol of risk, was 42 per cent for the Sensex, while it was above 30 per cent in two cities, between 20 and 30 per cent in five cities and between 10 and 20 per cent for eight cities. Clearly, real estate appears to be less volatile than the stock market and, hence, less risky, prima facie, in terms of idiosyncrasy. This becomes important because it also relates to risk-return tradeoff. The GSec market, on the other hand, had a volatility of just five per cent, but gave a yield of 6.7 per cent, which does not cover inflation. The idea that needs to be worked on is whether we can think of going in for real estate “futures” in the same manner that the forex derivative market has evolved. This will give individuals an opportunity to actually start investing in this market, ultimately helping in efficient price discovery, which is absent today. The contract will be on the Residex – which NHB announces – so the settlement price will also have to be declared by NHB. It has to be non-deliverable and cash-settled. Who will buy and sell these futures contracts? Individual investors can go long if they expect prices to move up, or go short if prices are expected to fall. Real estate agents and builders would also be keen to cover their risk as hedgers as will buyers of property, who can benchmark their own exposure to property with these indices. This way, they are covered as either buyers or sellers. The advantage for the investor or speculator would be that unlike today, when the person borrows money to invest, this will be based on a margin calculated by the commodity exchange, which will be much lower than the cost of the project. The minimum lot size could be fixed at Rs 10 lakh, depending on the location. Currently, there is no way of hedging risk when it comes to property. Once a buyer contracts for a price and starts paying instalments, and the price comes down, there is an implicit loss that can be covered on the exchange now (though this has not really been prevalent in recent times when prices move only in one direction). The same holds for developers who would have actually borrowed in the unorganised market at very high interest rates. They run a relatively higher risk given that capital investment is higher. This risk can be lowered through hedging positions on the exchange. The same holds for second-hand property, which will automatically be linked with the Residex. The interesting part will, of course, be the daily settlement prices that have to be either polled by the exchange or declared by NHB. While this may not be possible on a daily basis, a weekly quotation can be attempted. With trading widening, there would be a tendency for the futures traded prices to feed back into the spot prices of property, thus making it more efficient, since it will be based on market forces and not on the builders/real estate companies, as is the case today. Prevailing prices today are opaque because property dealers are able to hold on to unreasonable prices at a time of a decline in the market. While the structuring of the contract has to be designed carefully by the commodity exchange, the Forward Contracts (Regulation) Act needs to be amended to allow for indices to be traded. This is not allowed currently, but would go a long way in the development of other products, too, which will add to the efficiency of the system. Given that the government has announced that it would be running this Act through the Parliament, there is a good chance that if passed, the Forward Markets Commission, would have the power to put intangibles on the table, which will include indices — which is what the Residex is. But, the real estate sector will surely get better organised and transparent, which is the need of the day.

Got Your Lovemark? Buisness World 29th October 2012

Three professors of marketing, 39 companies and innumerable challenges and solutions, The New Emerging Market Multinationals is an excellent collection of ideas and examples that should inspire companies in emerging markets looking to build brands and markets anywhere. The authors, Amitava Chattopadhyay, Rajeev Batra and Aysegul Ozsomer, take challenges faced by companies beyond classrooms and analyse experiences of 39 EMNCs (emerging market MNCs) that have risen to pose a challenge to their peers in developed markets, the triad MNCs or TMNCs.

The challenge for these firms was to build global businesses and global brands in the same breath. Business in developed markets would need a strong brand presence, which, in turn, cannot be established unless the business is large and brings in the numbers to be accepted as a brand. This symbiotic relation is the clue for success for any company in a new geography. The authors explore how this really happened.

The reasons were four-fold: such expansion was a chance occurrence for some, while for software firms, Y2K brought in opportunities. Others went abroad to lower the risk of business cycles, while the last group went out to learn global standards to match TMNCs operating at home. These EMNCs, which were earlier satisfied being low-margin, high-volume suppliers for private labels and OEM goods, moved to the next level by acquiring licences and technological competencies to establish in these regions.

The book talks of four types of strategies that have been used for this purpose. The first is to leverage existing low-cost structures and become cost leaders. Second, harness existing resources and knowledge of home consumers and apply them elsewhere. The third: combine these low-cost advantages to develop niche offerings in other emerging markets. The last is to take these capabilities and build branded businesses in developed markets. An insight provided by the authors is that markets are typically divided into premium brands, mass market and no-brand economy segments. The trick is to work in the areas that give best returns. The premium brand segment provides returns of 12-15 per cent, while the mass market offers 3-5 per cent. The economy segment gives just about 1-2 per cent, and it is just impossible to compete with the Chinese, who are present everywhere making competition difficult. Brands, hence, have to be build to grab attention and change image.

These real life experiences serve as a guide for companies looking to enter developed countries. At times, it becomes more like a textbook as the authors explain how strategic competencies are built on four pillars, which include mixing the right blend of labour and capital (Nano car), conversion of fixed overheads to variable costs (Airtel with Siemens), lowering of raw material, distribution and marketing costs (Apollo uses IT while Natura of Brazil ties up with university talent rather than develop in-house research) and, finally, organisation culture. The examples make for interesting reading.

The authors are, however, less certain of the success levels in acquisitions. Their research leads them to believe that not more than 50 per cent of such acquisitions add value to the acquirer, be they TMNCs and EMNCs. Their approach to brand building is also fascinating, especially when they trace companies such as LG in the US; how it became a leader. It did not place products in Walmart but in Sears to register its brand as a premium one. Here, the authors feel the brand really matters and we need to identify with the best through colours, logos, shapes, etc., which denote quality, leadership and, above all, trust. Interestingly, they put the overall impact as a pyramid that starts from a trademark and evolves to a trust mark and matures to a lovemark. An innovative way.

The New Emerging Market Multinationals: Four strategies for disrupting markets and building brands By Amitava Chattopadhyay & Rajeev Batra with Aysegul Ozsomer Mcgraw Hill Pages: 335 Price: Rs 595

 

The language will matter more now: Financial Express: 27th October 2012

Will RBI show a desire to support the overall policy package being implemented by the finance ministry?October 29, 2012, is an important day from the point of view of RBI, for two reasons. The first is that there will be monetary policy action where even no change is an action of the central bank as the market is already busy discounting the same. The second is the wording of the document that throws light on the state of the economy, with its own take on certain developments that have taken place or will probably take place.Monetary policy today has actually been filtered down to only rate changes, ever since RBI started hiking them some two years back. In the past, there were announcements on prudential regulation, debt market, credit delivery, money market, cooperative banks and so on. But, today, these facets get just some perfunctory mention and do not even merit discussion as the focus is on rate cuts all the time. Also, any such structural change invariably leads to the setting up of working groups that bring out a draft report for public comments before being finalised, which is a part of the consultative process pursued by RBI. Therefore, monetary policy is actually rate policy.When it comes to rate stance now, the picture is quite straightforward. RBI has been maintaining a hawkish stance on rates on account of inflation, where different indicators have been used periodically: generalised WPI, core inflation, food inflation and CPI inflation. The message is that inflation is an issue and as long as we are in the territory of negative real rates, going back on rates may not be expected. This is pragmatic in a way because a closer examination of corporate performance in the last few quarters does reveal that inflation has been a factor affecting profitability more than interest costs. RBI has brought forward its own benchmark inflation rate now to 7% from 5% earlier. This means that the new normal is 7% and rate action should be expected once we break this barrier or the rate moves towards this number.What about CRR? Currently, liquidity may appear to be under pressure, though looking at the growth in deposits and credit so far this year does not give a similar picture. As of October 5, growth in deposits was 8.5% and 4.3% in credit. In incremental terms, the excess of deposits over credit was R2.9 lakh crore after adjusting for CRR, which is still higher than R2.6 lakh crore of investment in GSecs. Clearly, liquidity is not an issue today, though the repo borrowings have been higher than the 1% of deposits notional target of RBI. Add to this the clamour of banks to have CRR lowered, and RBI may come up with 25 bps cut in this reserve. This will provide additional R35,000 crore of funds to banks but, given that demand is low today, these may just flow into GSecs. CRR funds released get absorbed into the system quite rapidly and may not be available when there is revival in demand for credit during the so-called busy season, which should have begun. The moot question is whether or not banks will lower rates.The last time RBI lowered CRR unexpectedly, the range of the base rate has admittedly come down, though this has not been all pervasive. Given that demand for credit may be increasing at this time of the year, it would be interesting to see if banks do follow suit and lower rates this time around. Therefore, it all comes down to a CRR cut this time. Also, given the controversy on high CRR which earns no return, RBI could consider paying some interest on these funds, which will placate banks.But, the more interesting aspect of the policy will be how RBI views the economy and the action taken so far by the government through fiscal correction and reform, FDI policy and so on. Also, economic conditions have improved in a way, with the rupee looking fitter, and foreign funds have once again started flowing in—with the government providing assurances on GAAR and retrospective taxation.RBI has averred all through that fiscal action was necessary for things to move on its end. But on deeper thought, while this stance cannot be contested on theoretical grounds, there may still not be a link with the monetary system. The higher fiscal deficit so far on account of the subsidy bill has not led to excess demand for goods. In fact, one major grievance of industry is that demand has stepped down with even the auto segment witnessing lower production in August. Also, since RBI has never really spoken of excess demand as being the reason for inflation and pointed more to cost and structural factors, the linkage of policy with deficit can be debated.Also, given low demand for credit, there has never been a liquidity shortage caused by government crowding out private demand. But, notwithstanding these contra arguments, the government has done its bit by lowering its deficit target by adjusting fuel prices and also bringing about policy actions. Therefore, RBI’s stance on government action and state of the economy becomes even more important now.Given this situation, RBI may now be compelled to take some action, and hence while a repo rate cut would be against its own original stance on inflation, a CRR reduction would probably show its own commitment to growth. By doing this bit, it could become a part of the overall policy package being implemented by the ministry of finance—or rather to use the cliché, monetary policy will start talking to fiscal policy.

It will be hard for RBI to cut rates: Mint 23rd October 2012

If the central bank lowers rates when inflation is still high, it’s an admission its policy has not worked

 

Traditionally, monetary policy has been motivated by the twin goals of fuelling growth and containing inflation. Accordingly, we attribute a Keynesian face or a Friedman-like policy stance to it. Interestingly, in the last two years or so, there is a degree of skepticism about whether these theories really make sense when evaluating the efficacy of the monetary policy.

Further, two other dimensions have been added. The first is what has been called “pressure by the government” and the second is “market expectations”.

One is still not sure whether these two really affect policy formulation; but, given that the finance minister keeps making statements on the need to lower interest rates and the Reserve Bank of India (RBI) holds meetings with bankers, one never really knows if such things matter and become self-fulfilling. Also, in April, RBI lowered the repo rate, or the rate at which it gives short-term money to banks, with a caveat that we should not expect more rate cuts soon. This came at a time when the the finance minister spoke about lower interest rates after presenting the Union budget. There appears to be some merit in believing that these two factors also matter for RBI.

Given these motivations, what can we expect? Growth is stagnant. The recent positive industrial growth numbers should not cloud our vision that things have changed drastically. While a turnaround from negative to positive growth is good news, we need to wait and see if this is sustainable from now on. At best, one can say that growth has bottomed out.

There’s a status quo on inflation, too. Wholesale inflation rose 7.8% in September with all segments coming under pressure. Retail inflation is closer to 10%. Inflationary expectations are high, given that fuel prices have been increased and that the kharif (or winter) crop will be below optimal.

Now inflation is on the supply side but RBI has, in its various policies, taken a varied approach to inflation. At times, it was core inflation that was targeted; on other occasions, it was food inflation. More recently, it has spoken of retail inflation. Whichever way we look at it, none of these numbers has come down significantly to warrant a change in monetary stance.

Also, if RBI lowers rates when inflation is still high, then it is an admission that the policy has not worked; and that, as a corollary, its original approach was not right. Therefore, it is hard for RBI to lower rates.

The so-called pressure put by the government can be an important factor, considering that the government has done its bit for reforms and fiscal consolidation, albeit more through announcements than actions. With banks also looking at the regulator to lower rates and the cash reserve ratio (CRR) or the portion of deposits that banks need to keep with RBI, there is indeed pressure on the central bank.

Given all this, RBI could go in for a CRR cut, though admittedly liquidity is not an issue for the system today. Still, this will placate the market and leave the banks to decide on interest rates.

The CRR cuts have not, in the past, been very effective in lowering rates. While banks have claimed that they will be in a position to lower rates if CRR is lowered, past experience does not provide such an indication. Still, cutting CRR and leaving the policy rate intact should send the right signal to the market, though this may not be adequate to excite the market which is banking on a rate cut.

I expect a CRR cut of 25 basis points (0.25%) with no change in the policy rate. One basis point is one-hundredth of a percentage point. Also, some sort of payment on CRR balances can be thrown in as an icing on the cake to make banking stocks tastier.

Matching behaviour: Financial Express 22nd October 2012

The Nobel prizes show that behavioral economics has become the new hotbed of researchAfter bestowing the Nobel Prize to the EU for peace, it would not have been a surprise if the Nobel for Economics was given to the ECB, considering that this institution has done a lot to keep the eurozone from disintegrating. Evidently, the award has not gone to an institution but been conferred upon Alvin Roth and Lloyd Shapley, both of who have worked on a similar path albeit independently, to come up with their own theories on match-making that are distanced from prices. Normally, all demand and supply factors lead to a price determination, which then decides who is in and who is out. This is the efficient markets theory. However, at times prices do not matter and there may be a need for alternative systems to bring about equilibrium. Working on cases where prices do not matter is Roth and Shapley's way of looking at economic isues.They have looked at marriages, school allocations, jobs, hospitals and donations to prove their theory. At a very rudimentary level, when prices do not matter, school admissions are first based on the applications made by parents who express their choice through a pecking order. The school decides on who to take based on parents' preferences--such as distance from home, availability of transport, status of household etc while allotting seats. Based on matching the parents' criteria with their own, schools fill seats, through ‘first, second and third lists’. Does this work in India? On the face of it, matching theory does not work where prices decide the equilibrium. The starting point for the sellers' market is that there is a predetermined price which rations out the commodity that is available. As all commodities have a price, it is possible for the market to match demand with supply. If demand is high, then supply gets created as producers set in motion processes to optimise use of their capacity.But when it comes to non-commodities, it would work even if the price separates effective demand from desire, that is, when demand is greater than its supply. Schools, hospitals and similar services have an attached price, which decides the inclusion criteria. After that, ‘matching theory’ can be applied. For hospitals, it is more democratic and works on a first-in basis; no further criterion comes into play. In case of education, at the school level it is the fee or the donation that is the starting point. After the fee threshold, the matching takes place through a pecking order. First, those with a certain background are permitted entry based on maintenance of culture. Second, those who have to be given a seat based on recommendation are admitted. Last, there are the principles of matching that come into play in allocation. Therefore, even when price matters and lots of people qualify, the institution has other ways of discovering potential candidates. However, if the institution is publicly run, then the matching principles work from the start.An interesting area that can be explored is marriages in the Indian context. Roth and Shapley have discussed at length the so called couple discovery, which today is used in dating web sites. The Indian system of arranged marriages has long had this implicit arrangement wherein advertisement in dailies, which is also a revenue earner for dailies, helps to bring about such compatibility. These are all signalling mechanisms, which are similar to mechanisms created by another Nobel Laureate, Michael Spence, to create efficient markets in the presence of information asymmetry. The newspaper or dating site provides a signalling mechanism for concerned parties who then narrow down their choices and begin exploration of compatibility.In case of jobs, matching again takes place through a tangible medium, that is, employment agencies, consultants or advertisements. There is no pricing here, but there is an intermediary who decides which profiles fit the employer’s requirements and then takes the process forward through a short listing procedure. Various criteria such as qualification, salary drawn, designation , and experience are used.When it comes to choosing a doctor or any other professional, the matching takes place through a reputation check. While qualifications and price matter, one goes for a professional based on other people’s experiences. Hence, here it is the seller of the service who reaches out to the buyer by sending signals through the way in which clients are serviced. Therefore, all these theories of matching demand and supply assume different tones depending on the service one is talking of. Public services are more democratic and are open to all, generally on a ‘time preference’. But, in the case of private services, price is certainly the first criterion, which then would contest the views of Roth and Shapley. However, given that a supply gap exists for all such services, there is a rationing system that comes into play where these principles operate. Quite interestingly, the recipients of this prestigious award in recent years have been on the behavioural side which is practical. The day of the macro-theorist appears to be over. This could probably be indicating that there are few new theories on the macro front that have dominated economic thought. We still talk of Keynes, Friedman, Hayek or Sarjent, whose works were written prior to the eighties. We are yet to see new theories that explain what has caused the crises we see around us. This has raised more criticism and cynicism, but not sown the seeds of new economic ideas that provide a solution.

Not much sound in Kelkar Committee: Financial Express 6th October 2012

The Kelkar Committee’s recommendations on fiscal consolidation balance on the edge of either sounding clichéd or making impractical suggestions. The report goes on at length to say that India is in a precarious state and resembles its situation in 1991 when we had a crisis, which can be debated. It offers nothing really new and puts numbers to the fiscal impact of various measures that should be implemented. It talks of a fiscal deficit range of 5.2% to 6.1% depending on whether or not we choose to act.There are basically seven issues that come to mind here. First, the committee talks of reducing the gap between the economic cost and issue price of foodgrains. This is not really practical because both the policies are guided by different motivations. The ministry of agriculture fixes the minimum support price to ensure that the farmers get a better income every year, while the issue price has been pegged ostensibly to protect the vulnerable sections. Increasing the issue price is a logical option which has always been there, but has been desisted from on the grounds of protecting consumers from food inflation, especially when it is running at a double digit level. Therefore, the suggestion is just as logical and impractical as saying that the government should run a close-ended procurement programme.Second, the Committee talks at length about the fuel subsidy being a sore thumb. It does not recognise that while the reason for not raising prices could mainly be political, there has been a substantial inflation buffer provided through this route. Increasing prices are seriously inflationary and not only with a short-term effect, as claimed in the report.Third, it is a bit too pessimistic on disinvestment and concludes that not more than R10,000 crore would be garnered, which again can be contested. The government has already announced a fairly aggressive programme for disinvestment, which will probably take us closer to the targeted amount of R30,000 crore.Fourth, the committee has spoken of how the fuel subsidy bill will be exceeded as the targeted amount of R43,500 crore has already been nearly exhausted. An issue missed is that the budget had assumed a price of $115/barrel for the year, and the price has been lower for most of the year. Clearly, the budget had gotten its numbers wrong.Fifth, the Committee talks of ensuring there is no constraint on using MGNREGA to protect farm workers. It, however, says that the late monsoon had helped. But the first estimate of agricultural production shows shortfalls across the board, meaning that there will be financials stress in this sector which will necessitate more action from the government.Sixth, the report talks of savings in plan expenditure of R20,000 crore which can compensate for the higher outflow on other accounts. This is a surprising statement to make because, ideally, the committee should be pitching for this expenditure to ensure that the Keynesian fiscal action takes place meaningfully. While this could have become a habit based on past experience, we should definitely ensure that the money is not saved but spent as a part of conscious policy. It provides a cover by saying that this should not come in the way of social expenditure but should certainly be a result of cost savings through efficiency. Does this mean that there are these many leakages in the system?Last, the committee talks of how the fiscal deficit has crowded out the private sector. While this is a theoretical outcome, in our context, this has never really been proved in the last two years. RBI has never stated that it has raised rates because the government was borrowing too much. It was an anti-inflation stance that provoked such action. Second, liquidity has never been an issue as banks were never constrained to lend to the private sector because of paucity. RBI has supplemented well with open market operations to ensure that the mismatch was corrected. If the private sector could not get credit, it was because of the reluctance of banks to lend on account of fear of NPAs or due to higher interest rates. Also, core inflation has never gone beyond 5%, meaning that excess demand was missing across sectors to really blame excessive monetisation. Besides, with the investment deposit ratio being above 30% for most of the last 2 years, banks certainly were not constrained here.On the positive side, it has rightly observed that changes in fuel prices should be calibrated and in small measures. This it says is easier to be absorbed by the system rather than large increases. This is quite pragmatic as when inflation (CPI and food) is around 10%, it is imperative that input prices should not be increased substantially at one stroke.The other interesting thought from the report is the use of the ETF concept to sell government stake in PSUs. The idea of pooling the stake and then selling the same especially to retail investors has never been tested to see whether it will work, considering that several of such entities may not be the ones to catch investor attention. Nevertheless, it may be worth persevering with.The committee hence does speak a lot of theoretical sense but does not really add much to the practical side of implementation. Some of the theoretical conclusions like the impact of fiscal deficit are not really pertinent today. Quite clearly, while this report will provoke some discussion as everyone today is against subsidies, it will be surprising if these known solutions which have been reiterated here, will actually find utterance through implementation.

The MGNREGA effect on wages: Financial Express 29th September 2012

RBI’s data release on average daily wage rates for men in rural areas is quite an eye opener. Besides presenting various data points that show how people live across professions and states, it also sets a different perspective on other issues relating to wages that are spoken of in debates, including the impact of MGNREGA and the poverty definition.The data provided is over eight years across different occupations and states. The occupations, agro-related and others, cover 18 distinct groups. Some of the important takeaways are the following. First, wages vary across jobs significantly depending on the level of skill that is required for the same. The non-agriculture segment provides higher wages as seen in the case of masons (R256), carpenters (R212), well diggers (R212) that contrast with weeding and picking, which paid R133 as of March 2012. The herdsman’s job is the lowest with a pay of R95 as of March 2012. Second, the growth in wages over the last eight years is fairly good, at an average of between 12% to 21%, for cobblers and winnowers, respectively. This means that the increase in wages does adequately cover inflation over the period, and that there could be a higher gain considering that CPI for agricultural workers has averaged 7.5% during this period. However, as will be discussed later, a substantial part of this increase has emanated in the last 2-3 years, ostensibly on account of MGNREGA. Third, the wage profile across states presents stark variations across these professions.Kerala has the highest wages, which can be attributed more to the higher literacy rate where there is less labour available as also the fact that farming is not a major profession in this state. Tamil Nadu, Punjab, Haryana, Himachal Pradesh and Jammu & Kashmir are the states with higher wages. Scarcity can be the factor for J&K, while the agriculture focus has pushed up wages in Haryana, Punjab and Himachal. Tamil Nadu comes as a surprise, where wages are one of the highest across professions.Andhra Pradesh, Karnataka and Rajasthan provide wages just above the country average while Tripura, Meghalaya, Manipur and Assam have wages lower than the average. This is surprising because one would have expected wages to be higher in the north-eastern states where the supply of labour would compare favourably for the agricultural jobs but falls short in the case of non-farming related professions. However, the biggest surprises are Maharashtra and Gujarat, which are clearly the most industrialised states in the country but where wages are lower than the national average. This may be attributed to the fact that these tend to be states affected by shortfalls in rainfall, which, in turn, could make labour lose some bargaining power. Madhya Pradesh has virtually the lowest wages across all the professions.Two issues that merit debate relate to MGNREGA and poverty thresholds. One of the thoughts that have been expressed often is that MGNREGA wages have actually drawn labour away from the farm sector to public works. Data shows that MGNREGA wages for April 2012 ranged between a low of R91 in Tamil Nadu to a high of R190 in Haryana. The picture is hence not too clear. But a drill down through the time series reveals quite a bit. In agriculturally-rich states like Punjab, Haryana, and to a certain extent Himachal Pradesh, there has been a spurt in agriculture-related wages after 2009, which can be linked directly to MGNREGA. For the non-farming related jobs, there has been an increase, albeit more gradual, though there is a tendency for wages to move in a contemporaneous manner. Therefore, definitely a causal link could be established between MGNREGA wages and the general level of wages. This also means that to a large extent the adjustment for inflation has come about due to the competitive wage being offered by MGNREGA. This has been good for rural labour, which has also helped to improve their consumption levels. Also, this has caused demand to grow for both food and non-food items, which will necessitate supplies to increase at a comparable pace in the future.The other issue relates to poverty. There has been adequate controversy over what constitutes a poverty mark. Based on the wage data, it looks like farm labour has a greater possibility of falling into the poverty trap even today, assuming a single worker with a family of four to support, as certain categories still earn at the national average level—less than R130/day (based on R26 criteria) and R160/day (R32 criteria). The non-farm labourers are better off in general, though again this picture varies across states. Clearly, we need to focus on bettering the wages in rural areas to ensure that living is sustainable.MGNREGA benchmarks have helped to elevate the living standards of rural families and should hence be commended. While this programme works essentially between seasons and assures employment for a fixed set of days for families, the wage benchmarks, which have risen progressively, have been useful in improving the overall wage levels. The unevenness across states needs to be corrected or else there will be a tendency for migration, which, in turn, will aggrandise the supply of labour in specific fields. This has already been witnessed in cane crushing where wages have almost doubled in the last two years in states like Tamil Nadu.Going ahead, we can expect wages to move in line with inflation-adjusted MGNREGA wages, which will help to improve standards of living as well as reduce the inequality in incomes. This will help to reduce the incentive to migrate to urban areas, which will be useful for the rural economy.

The Progress Report: Business World Book reviews 17th September 2012

Two decades of reforms is a long enough period to do some introspection, especially today when there is an air of despondency with all fingers pointing in the direction of their absence. In fact, it is agreed today that more reforms is the only way out. There is a sense of déjà vu as we talk about those good old days of reforms that started in the nineties. There is also a counterview that the Indian growth story is exaggerated and that we are capable of growing only at 6 per cent and not in double digits. This is where these two books on reforms come in handy with their thought-provoking views on the impact of reforms.

Uma Kapila’s Two Decades Of Economic Reform is a compilation of 20 articles by eminent economists who have either worked on the government’s side in bringing about these reforms or have followed them very closely as their critics. The consensus is that economic reforms have been a turning point and there is no looking back (Deepak Mohanty). D. Subbarao talks about making the elephant dance again as the growth story is intact and we only have to get our act together by adding another chapter. The solutions offered by the central banker are well known and quite to the point. Subir Gokarn shows how reforms helped bring in certain resilience during the financial crisis while Arvind Panagariya illustrates how all states have gained from reforms as the poverty ratio has come down, even though the absolute number of the poor is still high. There are other incisive articles such as the one by Anand Sinha on legislative reforms. Manmohan Singh and Pranab Mukherjee eloquently explain how reforms have delivered superior solutions. But, is that really so? Because if they have, then it is only a matter of time before we will be back on track.

Amid the set of articles praising the economic performance, N.A. Majumdar provides a refreshing view. His article titled ‘From Friedman to Gandhi’ makes us stop and think because, while we extol the virtues of reforms and the proliferation of consumerism, there is a shadow alongside which we tend to often overlook. He shows how the first phase of reforms until 2004 was retrogressive, when we were soaked in the market theology of the World Bank and the IMF, skipped the basic issues of development, that is agriculture, and had a disdain for anything that had to do with the poor. The subsequent phase is when we have gone back to Gandhi, when even the financial crisis exposed the errors of unbridled capitalism. Now we are addressing the concerns of the poor, which is logical and fair. In fact, he argues that this entire business of targeting the public distribution system has exacerbated poverty in India, and terms it a development atrocity. He extends this logic to our interest rate policy, saying it is biased against the farmer who pays 12 per cent while top corporates get away with 6 per cent. Majumdar is clearly at odds with Bibek Debroy who maintains that we should listen to our “brains” and not our “bleeding hearts” and move ahead.

India’s Reforms:How they Produced Inclusive Growth By Jagdish Bhagwati, Arvind Panagariya OUP Pages: 312

The book also focuses on the farm sector and inclusive growth, with three stalwarts — Hanumantha Rao, V.S. Vyas and Ashok Gulati — writing on different aspects. Gulati argues that while we talk a lot about 4 per cent growth in agriculture, we have never made any attempt to create structures for the same, such as a 15 per cent rate of capital formation. He says we should be more pragmatic and bring in the essential linkages to make such goals more realistic. He suggests reforms in the system and points out how marketing practices as well as the Essential Commodities Act and the Agriculture Produce Marketing Committee need to change. These laws have long served their purpose and are now working against the interest of the sector by introducing rigidities. Vyas centres his discussion on the size of land holdings and the need to make agriculture more robust, while Rao asks us to be more patient as the road towards inclusive growth is slow and should be peaceful.

The rest of the articles are insightful but really do not go beyond the official view that reforms have taken us much ahead. The Five-year Plan perspective is well elucidated by Montek Singh Ahluwalia, while Vijay Kelkar provides his take on the disinvestment debate. There is a delightful piece by Kaushik Basu, who never disappoints as he distinguishes between harassment and non-harassment bribes and is sympathetic to those who have to give the former.

The other book on reforms, titled India’s Reforms: How They Produced Inclusive Growth by Arvind Panagariya and Jagdish Bhagwati, takes a different route to assess the impact of reforms. They are definitely pro-reforms economists who believe that this is the only way forward for the nation. They address two sets of issues through three articles by each. The first set includes reforms and democracy while the other is linked with trade, poverty and inequality.

They argue that reforms actually started in the seventies, got focus in the eighties and were well projected in a concerted manner in the nineties. Hence, to say that reforms were dictated by the IMF would not be fair, though the crisis could be called the tipping point. The authors use the case studies of progress in telecom and automobiles to show how prosperity has spread across the country.

They have dealth with the various issues using the Q&A approach: they take up issues raised by critics and make their point using facts. The focus here is on how electorates vote parties back to power because of the impact of growth and reforms. They have used the 2009 elections to show that the ruling coalition came back to power because of performance, which proves that not only did people benefit from the policies but also favoured the Congress in turn. This theory is supported by the view that in 2009, the incumbents in high-growth states won 85 per cent of the seats while it was just 52 per cent and 10 per cent in medium- and low-growth states. More importantly, there was no difference in the urban and rural areas. They also credit the NDA for the telecom revolution.

At another level, they show how the opening of the economy and foreign trade helped lower the incidence of poverty, though they agree that a lot more needs to be done. Their research showed that 1 per cent reduction in the tariff rate led to 0.57 per cent reduction in the poverty ratio.

Both these pro-reform books are extremely readable. Kapila’s collection is comprehensive, though there is a bias towards the establishment. Bhagwati and Panagariya, on the other hand, explore new hypotheses to show that reforms have actually delivered, which are extremely engaging, even if you do not agree with the approach, assumptions and conclusions.

Two Decades of Economic Reforms Edited by Uma Kapila Academic Foundation Pages: 392

 

Spare a thought for the middle class: Financial Express 27th September 2012

accounts for 70% of savings and is a major consumer of goods. It is also the most vulnerable when it comes to inflation. The argument that a certain class does not merit an incentive or benefit is really not on
A question that is now being asked is, who does the government work for? In simple terms, when we critically analyse the budget of the central government, how does one decide as to who should get what benefit? This is important because we have this unique situation where everyone is critical of what goes on in the budget. The usual target is ‘subsidy’ where we feel that the middle class benefits from LPG and the super-rich from diesel and, therefore, the concept is irrelevant. Further, the money that goes to the poor is full of leakages and hence should be better allocated. We are overly critical of the PDS and keep suggesting various ways to better the system. But, invariably, what we hear is the corporate view, which works on the assumptions that the government should work like a corporate entity and use economic judgement when making allocations. This rationale cannot be disputed if we treat the government this way. Governments, however, have to work on the basis of political and social compulsions and are good at spending and not earning because any revenue earning measure is subject to external conditions such as growth and incentives that have to be provided to all segments of society. Therefore, while we may pontificate on what is right or wrong, the government proceeds on its own to strike a balance. An interesting exercise that can be attempted is to see how the government manages the budget by giving various benefits and incentives to different sections of society. For convenience, we can assume that we have India Inc, the middle class (which also includes the rich households) and the poor. The exercise is not perfect as it is difficult to match numbers with various sections of society as there are overlaps. Further, it is accepted that the assumptions can be questioned as they may not really hold in absolute terms. But, nonetheless, we can see how these benefits flow to sections. The budget captures one important section called revenue foregone on account of all the tax concessions that are given. This is important as we normally focus on the expenditures and pass judgement. But by giving concessions on the tax front, benefits are being drawn by all. The government calls them ‘tax expenditures’. This approach has been criticised for not being accurate as it is based on certain assumptions that may not be right. This is admitted in the budget document as it assumes that certain patterns do not change when certain taxes change. Still, as we are talking of the year gone by, a large part must be true as in the past this number given is around right to the extent of 80%. The accompanying table broadly allocates various identifiable budget items under these broad headings. Some of the assumptions made here are: First, excise and customs concessions are for the corporate sector as they are the ones who demand the same. It is true that these do get reflected in some way through as lower prices for consumers, but it is difficult to allocate the same. It is only the counter intuitive statement that can be used here for devolving a part to the consumers on grounds that in case these duties were not reduced, then prices would have gone up further. Second, all income tax benefits go to the middle class. Third, food subsidy is only for the poor, though this may not be fully correct. Fourth, in the case of fuel subsidy based on Teri’s study for FY11, the subsidy has been broken up into what goes to LPG and kerosene, which are allocated to the middle class and poor respectively, while the amount for diesel has been further sub-divided for irrigation which goes to the poor, while the rest resides with the middle class. Fifth, fertiliser subsidy actually goes to the corporate sector and half has been put under that head rather than poor, though there can be an argument that if this was not there, it would have meant higher prices. The table shows that the largest benefits do flow to India Inc, which can be justified as this is the most productive sector that provides a boost to investment and growth. The private corporate sector accounts for 33% of gross capital formation and if the public sector is added, it would be 64%. Therefore, it is necessary to provide incentives here to ensure that the growth process keeps ticking.The poor do receive the second largest benefits directly through various programmes that are made available. This is a social necessity for the government and, as can be seen on the expenditure rather than the revenue side, this section does not pay taxes. The clue here is to enhance the delivery systems to ensure that these targeted segments receive the benefits and that there are few leakages. The middle class, comprising the household sector, contributes to 36% of capital formation, which is also significant. It also accounts for 70% of savings and is a major consumer of goods produced by India Inc. This segment is also the most vulnerable when it comes to inflation as it consumes all goods, unlike the poor who have access to only food items. Quite clearly this segment is also an important constituent of the economy whose needs have to be addressed.The government hence has to strike a balance across all segments, given their individual contribution to the economic development of the country. Therefore, the argument that a certain class does not merit an incentive or benefit is really not on, and fortunately, the government understands this.

Aligning sovereign rating with credit default swaps: Economic Times 26th September 2012

Efficient market hypothesis says that if markets are efficient then the price that is determined takes into account all the information that is available to the players including perceptions. Trading then takes place based on these prices as all market participants believe that they are the right ones and they are willing to put their money on the table based on these outcomes. Intuitively, the price traded is reflective of the perception of the subject that is involved. Now, if this concept is translated into the sovereign CDS (credit default swap) market, then we can say with confidence that the swap rates are the revealed rates at which players are actually buying and selling protection. High swap rates mean that there is a high perception of risk which has to be compensated while low rates mean there is less risk.
Now, these market perceptions can be juxtaposed with the ratings given by credit rating agencies. Rating agencies have their own models for determining what should be the rating accorded to a nation. The question asked is, what is the probability of default in servicing a debt emanating from a nation. There are subjective and objective factors that go into this decision. The CDS rate, on the other hand, is what the market thinks of the same risk. And, when one buys the swap, there is a cost involved which both the parties agree on. These rates are variable and change with the economic environment.
For an academic discussion, these swap rates can be compared with the ratings accorded by rating agencies to see if there is deviation in perception. The CDS rate has been taken for September 21. The AAA-rated countries are the UK, Switzerland, Sweden, the Netherlands and Germany whose 5-year CDS rate varies from 30 bps for Sweden to 60 bps for Netherlands. These should be the lowest rates as they are perceived to have the lowest risk in the market. However, the US has a lower rating but the swap rate is just 30 bps.
At the next highest level is the AA+ category which includes Austria. The country has a swap rate of 68 bps. But, France with the same rating has a CDS rate of 105 bps and the market views France as being more unstable to price the risk higher. The anomaly becomes starker when we look at, say, Japan which has a rating of AA- with a CDS rate of 83 bps while China with the same rating goes with 173 bps and Belgium with a rating of AA goes with 113 bps. The market is, hence, more confident about Japanese government bonds compared with, say, China, though the rating is the same. Korea is rated A, but has a swap rate of 80 bps which should have been closer to the AA sovereign rating. Curiously, Indonesia, with a swap rate of 142 bps, which is lower than China has a rating of BBB- and Italy with 320 bps has a rating of BBB+.

What is one to make of these anomalies considering that in both cases there is a risk assessment - one made by professionals and the other by market forces? Actual trading of risk is based on the market which finally could matter for those who seek or give cover. Since all governments do not raise money globally or have vibrant sovereign CDS markets for their bonds, the swap rate answers questions on risk perception when the market exists. Otherwise, the rating accorded by the agency is the only option to judge risk.