It has to be a hundred small steps: Financial Express: 16th August 2012

The new CEA understands the perils of unbridled capitalism and will have a balanced view on reforms

The problem with critics, including economists, is that they tend to think they know better than the government about what has to be done. This is understandable as the role of these professionals is to offer suggestions for improvement, especially when there is little response from the other end. We tend to overlook that when we debate doing away with non-merit subsidies or enhancing infrastructure spending, these options are very well known to the government officials as well. They cannot do what we think they should be doing simply because of the structure that exists.
Also, we tend to forget at times that governments are not corporate entities. Companies work to make money and enhance shareholder value and have to be efficient. Governments know how to spend and are not good earners as public economics is all about doing social good. Therefore, when we view government expenditure in particular, we tend to look at it as a corporate and bring in efficiency issues when such authorities are never too concerned about the same. Governments come into being based on politics, and electoral victories are based on promises that cannot be reneged. Therefore, every policy action has to be viewed from this angle.
This said, the appointment of a new Chief Economic Advisor (CEA) obviously brings in hope considering that Dr Raghuram Rajan comes with an impeccable CV—right educational and professional qualifications. He has been close to the PM while offering special advice and has written a report on the financial structure for the country. There is an IMF stamp, which could be an irritant in operational economic life as anyone with a liberal economic mind could be branded as being an ambassador of the West. The issue is, can he make a difference?
His predecessor, Dr Kaushik Basu, is one of the most brilliant economists, who had his nose to the ground when talking of policy. But his open talk on the pace of reforms gathering steam after 2014 did not go down well and, while the Economic Survey has become more academic than a collection of data points, he tried to blend with what can be called real-economics. His analysis of how India’s rating should be seen on a relative scale did not quite catch the attention of the rating agencies which are still threatening a downgrade. His view on subsidy being limited has not really been accepted, as government expenditure is often more about politics than economics.
Can a new CEA actually make a difference in this setting? We had the FM give way to the PM, who spoke tough on how things will change. But nothing really has taken off and the Sensex yo-yoed for a few days. Now the new FM is talking of putting on track road and power projects and clearing papers. These are essential, but only peripheral changes that can change the sentiment for only a day or two. This is more a case of bringing in efficiency in the system rather than changing it.
Balancing economics with politics requires a different mindset. The idea is not to upset the applecart by voicing opposition to diesel or food subsidy. These issues are political compulsions and cannot be changed overnight and hence a practical approach is required. The existing structures are defective, but the alternatives are less attractive. The UID could never have worked in a country where the poor do not have electricity to swipe their cards. Cash transfers are excellent theoretical models, which have worked in Brazil, but given our population and extent of poverty, can never be a solution when our mentality is to game the system. Besides, we have started one white elephant without thinking of the linkages with prices—what happens if food prices, which are currently controlled through PDS, start shooting up in the market when cash transfers take place?
Therefore, can Dr Rajan actually change the way the polity works or get the parties who would oppose any reform on issues which can be linked with a constituency? Can we really bring down the level of priority sector lending of banks when we are all talking of inclusion? Can we raise prices of LPG? Can we change land laws to enable a power plant to come up? Can we privatise banks that easily? Banning futures trading in commodities is a rule today and a political rather than an economic decision. Can we change this?
Therefore, the CEA has to be malleable and try and work slowly to have new ideas accepted. In fact, more than new ideas, it is the implementation that is important. If strategies for doing something which required sensitive consensus can be executed without getting obtrusive, then things may work. The job is tough as it has to balance one’s own beliefs with the reality.
Even in the corporate world, we never have any bank economist backing high interest rates as it goes against the bank’s profitability or an India Inc economist argue for higher corporate tax rates for better distributive justice, as it is against the capitalist ethic. By this logic too, the CEA should be toeing the line and suggesting changes that are palatable and hopefully acceptable over time rather than being critical of what is being done. That sounds fair.
Therefore, we should not expect anything revolutionary. But, going by Dr Rajan’s own approach in the ‘one hundred small steps’, one can be sure that he would use gradualism to make things move the right way. Despite his IMF lineage, he understands the perils of unbridled capitalism and hence will have a more balanced view on reforms, which will help to bring about change.

Sizing Up Services: Book Review Business World 13th August 2012

Ajitava Raychaudhuri and Prabir De delve into the causes of why there isn't enough emphasis placed on the export of services and make suggestions to tap this potential.

his book picks on a very interesting subject that has not been analysed in this manner before. We all know the services sector has grown to become the mainstay of our economy. Yet, we do not see the same emphasis on services when it comes to exports. Ajitava Raychaudhuri and Prabir De delve into the causes for the same and make suggestions to tap this potential. They do believe that, going by theory, we should be outsourcing services to countries where production costs are lower. But surprisingly things do not work that way and there are barriers, especially in the developed world, to ensure that their domestic concerns gain precedence. Also with the sophistication of services that are more technology-oriented, traditional low-skill services would have to play a secondary role.

The authors say three sectors have shown considerable advance in this context: communications, banking and insurance and IT services. These are also services where adequate support has been shown by foreign investors. But we have lost out in traditional areas such as transport, travel and tourism. There is, hence, some change that has taken place from labour-intensive to technology — and knowledge-intensive services, which, in a way, is positive.

Getting a bit theoretical, a luxury afforded to economists, the authors perform an econometric analysis to link trade in services with internal barriers. They conclude that the per capita income of the importing country is critical for services exports from India. Favourable exchange rates help unlock unrealised trade potential and, as a corollary, a more favourable exchange rate policy is needed to facilitate trade in services.

The authors link growth of trade in services to overall growth. As the services sector is already dominant, we need to harness it well as all these services affect other sectors and, while growing them through trade, we can create strong inter-linkages that improve productivity of enterprises. Liberalisation in trade and transportation services helps in global integration through higher trade and FDI, which ultimately reduces income disparities across countries.

At a broader level, the authors argue that as production and consumption of services is simultaneous, there is a significant transfer of know-how and technology across countries and emerging markets can get these skills fast and inexpensively through trade. Financial services and information and communication services are examples. This provides backward linkages to creating job opportunities in the skilled segment, which is needed for a growing economy like ours as traditional services such as transport or travel would be in the realm of unskilled labour. So, though data does not show that such export of services reduces poverty, the authors feel the link is strong and will emerge in future.

 

International Trade In Services In India: Implications For Growth And Inequality In A Globalising World ;By Ajitava Raychaudhuri & Prabir De;OUP

 

Under One Umbrella: Buisness World 13th August 2012

ndian agriculture has historically been subjected to several disadvantages — from the condition of areas under cultivation to productivity, and from indifferent policies through the value chain to weak marketing links. Neglected warehousing has added to our woes; in areas like horticulture, wastage could go up to 40 per cent of production. High dependence on monsoons and uncertain weather has made farming less attractive, leading to migration to urban areas.
However, while these factors could be considered to be extraneous to the system, the government’s pricing policy (through minimum support price) has distorted cropping patterns in favour of rice and wheat, leaving the country perennially in the deficit for pulses and oilseeds.

Also the system of open-ended procurement by the Food Corporation of India has meant that the government is the largest hoarder of foodgrain. Surplus in granaries often coexists with shortages in the market. Absence of consensus or fear of losing surpluses has meant that we have no defined policy on export of surplus farm products, be it rice or cotton. In this set-up, the credit system, too, has played a role in creating distortions in terms of flow of funds, repayments and marketing practices.

While banks are compelled to keep aside 18 per cent of their overall credit for the farm sector, they at times prefer to slip up on this target and deploy the funds in National Bank for Agriculture and Rural Development’s (Nabard’s) Rural Infrastructure Development Fund, which is a safer bet. Given the vicissitudes of nature, farming has a tendency to generate higher non-performing assets (NPAs) than other sectors (a fact borne out by the Reserve Bank of India’s Financial Stability Report). This creates issues for banks whose profitability is ultimately impacted by these assets.

Apart from this, monsoon failures lead to other interventions such as interest rate subvention or restructuring of loans and write-offs, which though they are supposed to be compensated by the government through the budget, are often delayed. As per the RBI’s own admission, there is still considerable dependence on the informal sector for loans for farmers. And where formal loans are available, transactions such as procedures, paper work, staff indifference, often access, when several rounds have to be made to procure the loans, act as effective barriers.

The informal sector does provide credit at a higher cost, but with added advantages such as buyback, supply of seeds, insurance, etc. The apprehension relating to the proliferation of corporate and contract farming (where there is less dependence on banks for finance as the contractor pays for it) has also come in the way of commercialisation of agriculture.

Hence, we are still operating on old existing systems and not willing to change significantly to really transform agriculture.

Systemic LoopholesAt the post-harvest stage, too, there is a major lacuna in terms of regulation when it comes to the warehouse receipt. Crops are typically grown once and made available throughout the year. The holding power is with the intermediary who is able to buy at a low price and regulate the prices through the year by controlling supply. There could be 6-10 intermediaries in the agri-value chain in India. Intuitively, the farmer gets only a fraction of the price, and studies have shown that in the case of horticulture, the farmer receives 30-35 per cent of the final price paid by the consumer.

This holding power can be transferred if the warehouse receipt is made negotiable and the banks are able to then lend money against this receipt. If this could be accomplished, the farmers would gain holding power and supply the product through the year. The cost would also come down as this process percolates. But while the Warehousing Development and Regulatory Authority is making the right sounds, not much is moving.

Therefore, Indian agriculture still has not really been able to grow in the desired manner on account of inadequate support by appropriate policies and the financial system to enable sustainability. Farmers also cannot sell their produce outside their territory as few states have passed the model Agricultural Produce Market Committee (APMC) acts.

With farmers being squeezed from all ends, it is really not surprising that farming is losing its sheen. And this will have serious repercussions for a country that has grand plans for food security for its large population. Focus on rice and wheat has improved distribution of these basic foodgrains, but this has come at the expense of other products that, too, are vulnerable to inflationary forces.

There is a need to revisit our approach to agriculture and farm lending and integrate all the pieces under one umbrella to make agriculture self-sustaining. There is no other way out.

‘Efforts to boost agri, rural activities have not lifted consumption’ Indian Express 6th August 2012

Two facts stand out from the NSS 68th Round on Household Consumption Expenditure Survey. The first is that rural households continue to be worse off than their urban counterparts in terms of monthly per capita expenditure (MPCE) and the second is that the richest in rural areas fare relatively unfavourably compared with those in urban areas. This suggests that the rural population remains disadvantaged vis-à-vis the urban folk in terms of employment, income and consumption. It is also a reflection of the limited attention that has been paid to the development of our rural economy which has made migration to the urban areas more attractive. It is significant that over the last 7-8 years, rural population consumption standard is still marginally lower than the urban population in the period June 2004-June 2005 in real terms while there is an almost status quo situation at current prices. Clearly the efforts that have been put in to boost agriculture and other rural activity in the small scale and services sectors have not been able to uplift the consumption levels here. The picture is even starker when one looks at the inequality levels across different levels of income. The poorest 10 per cent of the rural population consume around 72 per cent of that in urban areas. The poor are better off hence in the urban surrounding. Within the richer sections, i.e. top 10 per cent, the rewards are relatively lower as their consumption is just 45 per cent of that in the urban areas. Therefore, looked at from both ends, there are disadvantages in living in the rural areas as consumption levels are better across the borders. There are three implications here. The first is that the government has to focus on uplifting rural economic activity to ensure sustainability of Indian agriculture in particular, as farming has already become a less attractive proposition given the vagaries of nature. The second is that in a positive sense, industry could seek to make further inroads into the rural territory for selling their products as the richer groups which have spending power could be provided access to them. Lastly, the fact that the status quo has not really changed puts the debate of NREGA in a different light. Critics have argued that this programme has led to increase in spending that has impacted the demand-supply matrix. Quite clearly, notwithstanding such expenditure, rural consumption has not really increased relatively, and therefore, we must stop blaming this programme for our inept handling of our agriculture.

Don’t blame futures for inflation: Financial Express: 8th August 2012

The prospect of a monsoon failure and the accompanying sub-optimal harvest should ideally make us turn towards the futures market to pick up early signals of what the market has got to say. This will help in reckoning imports if the need arises so as to eschew the predicament of paying higher prices at a time when a drought-like situation is also being witnessed in the US, which can skew the markets.

However, the chequered history of commodity futures trading only indicates that if there is a drought, then there will be a ban on futures trading in some commodity. It happened in the past when a series of commodities were removed from the ambit of futures trading, thus reducing the basket to a lighter one. The ministry of consumer affairs as well as the Forward Markets Commission (FMC) have started making these noises, which is unfortunate. More so because if the regulator says that it will ban futures trading, it is an admission of regulatory failure as it means that it does not know how to control price movements and that something is amiss in the market—something which has never been proved. The market has its tools to ensure fair play, such as price limits, margins and open interest; and the surveillance of the exchanges has so far ensured that there has not been any manipulation. Besides, when we do not have such things happening in the forex or stock market, why should they be considered in the commodity futures market?
The latest ban was on guar seed and guar gum, products that have become famous due to futures trading. A minor product which is largely exported, it is also a proxy for monsoon and any shortfall in production results in large increases in prices. Ironically, while the government does not mind increasing prices of products through the MSP, regularly causing ‘inflation’, any market-driven price increase based on economic fundamentals is looked at with suspicion, especially if it is traded on the futures exchange. A shortfall in guar production last year caused prices to increase and the FMC banned futures trading. But, did prices come down after March? Not really, going by the WPI numbers, which continued to show an increase in April and May before coming down in June. Quite clearly, we have our grip on the understanding of futures trading.
Last year, there was a deficit in production in mustard, chana, and soybean—three products traded well on the commodity exchanges. Prices have risen on account of these shortfalls, given that India does not stock any of these products and relies on imports to a large extent for edible oils, where over 50% is procured externally. Mustard output was down by around 17%, chana 8% and soybean 4%. These products could become easy targets for the FMC if push comes to shove, which will be incorrect and further send wrong signals.
Interestingly, the price increase for products not traded on the bourses that are high are in the case of bajra, barley and ragi among cereals, masoor in pulses, vegetables, milk, eggs and meat products and groundnut/oil and palm oil (imported). Further, rice and wheat have witnessed an increase of between 7-7.5% despite India having an all-time-high record of production. Therefore, inflation on the farm commodity side has been largely driven by supply mismatches and placing the blame on futures trading would be erroneous.
The problem with agriculture is that it is a neglected zone and has become a political issue. Last year, the surplus production in rice and wheat was highlighted as being a manifestation of successful agricultural production, when in fact there was a decline of 5.6% in pulses and 5.2% in oilseeds, both of which are supplemented through imports (edible oils for oilseeds). Also, coarse cereals had registered a marginal decline in production. Quite clearly there is an obsession with rice and wheat and we take pride in the large stocks of these two products even if it means senseless hoarding of foodgrains by the government, which creates artificial shortages in the market at times. The relentless increase of MSPs and open-ended procurement schemes has totally skewed the cropping pattern. Instead of addressing these issues to correct the imbalances, there has been a diversion of attention to other issues, which includes constantly banning futures trading in commodities.
History shows that after futures trading in tur and urad were banned in 2007, the prices increased continuously aided by higher MSPs, which increased benchmark prices as well as supply shortfalls. The same was the case with soy oil, chana and potatoes when they were banned in 2008 and sugar in 2009. Bans hence do not really help to bring down prices.
It may be recollected that in 2007, the government had set up an expert committee which concluded that there was not much to show that futures trading caused inflation. Yet, these thoughts do always come up when inflation is high. It looks more likely that instead of admitting that we have ignored this sector by not creating alternative channels for irrigation, the blame has been turned on futures trading. The fact that the FMC is not independent but an arm of the Ministry makes it easier. All talk on making the FMC autonomous by getting through the FCRA is still a distinct hope as the bill has been scuttled once too often and as long as we have this mindset, we will never move ahead in either bringing in reforms or bringing about a transformation of Indian agriculture. Either way, we are losing.

The tyranny of the status quo? Financial Express: 1st August 2012

While there is a lot to be said for RBI maintaining its anti-inflation stance by not cutting rates, the need for govt affirmative action is becoming urgent RBI has probably done the appropriate thing in maintaining a status quo given that it has pursued its anti-inflationary stance for the last two-and-a-quarter years, with only one aberration in April 2012. Few expected any change, and hence it was not a surprise. Three significant thoughts come up here. The first relates to the stance on interest rates and what it means to us given that inflation will be the anchor for future policy decisions too. While food and fuel inflation are clearly out of RBI’s domain, it has spoken a bit on core inflation, which is around 5% currently and susceptible to volatile influences from global disturbances. So what are we to make of it? One, the RBI is not talking of any transmission mechanism as such, since this stance will not lower inflation. Second, it has real interest rates in mind, which appear to be low today given that at an 8% repo rate, borrowers are actually getting away with a lower real interest rate. Third, while one can keep expecting RBI to lower rates before every policy, and debate and conjecture the same, it actually should not be doing so until inflation is within its range. And that range has gone up now to 7%, and with a possibility of a drought, food inflation will continue to be in the double digit range. The second thought is that growth will be lower this year, at 6.5%, which sounds reasonable enough. For the first time, RBI has given this signal early and has not waited till December to lower its forecast. The gloomy monsoon and lackluster industrial performance so far does warrant a step down from 7.3%. The internals are still hard to fathom as nil growth in agriculture and moderate 3-4% growth in industry will require the service sector to do remarkably well to move to this mark. But yet, RBI does not think that lowering interest rates will help growth in any way, as its own studies have shown that interest costs have not choked growth in the past. It is the overall demand conditions that have to change for something to happen. Here, RBI is silent on how we are to change this situation. It has, in fact, asked the government to do its bit. Third, inflation is now expected to be higher, and on a point-to-point basis would be 7% by March. This again appears realistic with possibilities of further upward revisions in the coming months. The monsoon failure means high food prices on top of higher MSPs, which have already lent an upward bias. Fuel price revisions mean upward pressure on prices—this is what RBI has spoken of as part of fiscal consolidation. This means any such act will only impinge on inflation and reinforce RBI’s posture on interest rates. To top it all, the rupee is volatile, and with the possibility of a revival in commodity prices globally, the so-called core inflation will continue to keep the pressure up. Hence, the chances of interest rates being reduced on account of inflation coming down become progressively remote. RBI has sought to placate the markets by providing sops through the liquidity route. The cut in SLR, however, is more of a misnomer. Banks today hold on to 28% SLR and hence bringing it down from 24% to 23% does not affect the system’s liquidity given that this excess SLR of 4% has been voluntarily maintained by banks. Banks hold on to excess SLR either as a buffer that provides leeway for credit expansion or as a part of their own strategy to maintain the quality of their portfolio. At the margin, those with 24% SLR would benefit by getting these funds. Otherwise, this move is quite neutral in its impact and this reduction should be seen more as a conciliatory move by RBI to help banks without giving much away. RBI has anyway been active in the OMO segment, providing liquidity to banks, and hence this 1% reduction is largely symbolic. Besides, liquidity is not a major issue today given the dynamics of funds flow in banks. Under these conditions, maintaining the status quo sounds logical because we do not want to shake the apple cart. But the fear here is that we are moving towards, what Friedman would have called the ‘tyranny of the status quo’, where we do nothing and nothing happens. The government has been asked to do its bit. But, can it do anything that can move us out? The government now will have a task of balancing its budget as growth was estimated at 7.6% and will now be 6.5%. While higher inflation will make up partly, a shortfall is imminent. Add to this, the inaction on disinvestment and spectrum sale, and there are definite signs of fiscal slippage on the cards. A lot is being spoken on fuel subsidies, which is a small part of the overall picture. Real action is needed from the government, which is just not forthcoming. Hence, the overall economic scenario needs affirmative action to be taken. The possible drought has literally cast a cloud and the absence of any ideas to move the economy ahead is a concern. While it is true that a similar story is narrated elsewhere, the fact that we are less affected by the global downturn should inspire us. However, with every organ of the state throwing up its arms, the picture is not exactly encouraging—in fact, it is discouraging.

Reviving the animal spirit: Financial Express: 23rd July 2012

Only GoI can pump-prime the economy as only it can raise funds at 8-8.5% When the Indian cricket team was at its high, winning tournaments, everything we did was right and everyone was doing brilliantly. But when we lost to England and Australia, the reaction was typically Indian. Dhoni was a dummy captain, Sehwag only nicked, Dravid lost his reflexes, Sachin plodded for the record, Yuvraj was anyway an upstart, Gambhir was better at swearing than batting and our fast bowlers like Zaheer were a club cricketer’s delight. It is the same with our economy. Until 2011, we were the second-fastest growing economy whose story was around double-digit future growth. India Inc was an innovator and knew how to get through, FIIs just loved India and the inflows of FDI proved that our policies were in place. The government knew its numbers and 20% exports growth showed that we had arrived. Besides, we had so many dollars that everyone advised RBI what to do. We brought back Tobin and spoke of taxing dollars inflows. More importantly, we were isolated from global disturbances. March 2012 has changed the storyline. Nobody knows what to do, and the growth numbers belted out are hopes and not projections in a pessimistic scenario. The government is paralysed and cannot act. Industry is waiting for the proverbial Godot or action from the government, which is not forthcoming. RBI action on interest rates is now one of throttling growth while for 2 years it was in the right direction. Some have gone and written to say that our growth story really never was (a thought never expressed when we did 8%-plus) and we are a nation of 6% growth. Now, we are linked to the global disturbances and there is nothing to suggest that things are right. How do we move forward, practically speaking? There are two options. One is to wait and hope that things work out somehow. It always does. Like crude oil prices are coming down, which if not interrupted will improve the current account and probably stabilise the rupee. Lower oil prices will spare the government of the higher subsidy embarrassment, which, in turn, will fix the fiscal deficit in a way, if ceteris paribus conditions hold. That should inspire investors to come in. Inflation hopefully will be range-bound and the ubiquitous statistical base effect will ensure that prices are under control. RBI will most certainly not raise interest rates even though there could be a delay in lowering them, and if the deficit is under control, liquidity pressures will not be there and industry can start investing. The PM spoke of expediting projects, which is useful to incrementally add to optimism. The sounds made on GAAR and retrospective taxation could also work with a bit of luck and we could be on the upward climb, albeit with a struggle. This is one way out, which is benign inaction where the outcome depends a lot on good luck. Nations normally are not twice unlucky and so we can work on this premise. What could upset this rhythm is the resurfacing of the euro crisis or oil prices shooting up again. If that happens, then we risk slipping back. The other way out is to do something. The PM spoke of reviving animal spirits in enterprise. This was the Keynesian thought on what drives investment. He said that while theories on interest rate make sense, the real clue was industry picking up the ropes. Today, with stagnant demand and high interest rates and capacity buffer, animal spirits are at best of the whimper variety. The private sector cannot borrow at 16% plus, which is what the medium and small companies pay, and still remain viable. The only spirit that can be shown is by the government, which will be an extension of the Keynesian doctrine of pump-priming. It is still the only entity which can borrow at around 8-8.5% and hence accesses cheap capital. There are lots of ifs and buts today especially as any such expenditure will clash with liquidity dispersion and add to inflation demand. But hasn’t our high fiscal deficit also been pump-priming? But it did not deliver. So far, the pump-priming has been more in line with either maintaining consumption as in fuel subsidy or injecting liquidity, analogous to digging up holes to fill them up, i.e. MGNREGA. The money generated has taken care of existing consumption and not led to additional demand. Further, with higher inflation, most of these funds are being diverted to food and have not led to demand for industrial products. Therefore, priming has to be in project expenditure, which is announced and implemented right away. Suppose R10,000-20,000 crore is earmarked for power or roads. These projects should be implemented without delay so that there is activity being seen. PPPs are the right way, which should eschew the normal public procedures of bidding or else they would be non-starters. This will trigger similar actions in other sectors through backward linkages, which, in turn, could restart the growth process. Immediate changes in policy would help, but, practically speaking, this is not conceivable given the controversies surrounding them. In the absence of such affirmative action being taken by the government, it is unlikely to revive the animal spirits and we will be falling back heavily on time, à la Shakespeare’s great healer. But then the amplitude of the time period will be unknown and it will be leaving a lot to chance. The spirit has to be shown by the government.

Which inflation concept is right for RBI? Financial Express, 19th July 2012

The reference made to the ‘right concept of inflation’ by the RBI Governor really raises the broader issue of how monetary policy should be structured. There are basically two goals for a central bank: growth and inflation. If growth is to be superseded by inflation, then it is necessary to be sure about what kind of inflation we are targeting considering the multitude concepts of inflation in the country. There are basically two ways of looking at monetary policy targeting. The first is to look at a particular inflation number and work towards bringing it down. The other is to look at it from a theoretical or ideological standpoint and then use this basis for targeting inflation. This becomes important because, on its own, the inflation number we are targeting may not be influenced by monetary policy—which appears to be the case today as food inflation cannot come down by keeping interest rates high. We should bring in the theoretical concept of real interest rates to provide justification for such action. First, we need to understand the power and transmission mechanism of monetary policy. The armoury of monetary policy consists of various tools by which we are able to lower interest rates or cost of credit or augment the supply of funds with banks for lending purposes. Therefore, any measure invoked finally influences the bank’s ability to lend, which would be in terms of lendable resources with them or cost of lending. By altering these two, RBI can control the growth of credit, which, in turn, affects the demand for funds. The basic premise of monetary policy here is that when rates are increased, people borrow less and, hence, reduce demand for goods. How does this work? There are two sets of borrowers—individuals or retail—who borrow to buy houses, automobiles or consumer goods, which pushes up demand for the same as well as related inputs. The other is enterprise, where industry borrows to create capital goods, which, in turn, pushes up prices when supplies are not matched. Therefore, the transmission mechanism of credit policy is straightforward. This being the case, it helps to reduce excess demand forces, thus pushing down prices. Now, if we look at the structure of inflation in India, there are three components in the WPI where primary, fuel and manufactured products constitute the index. The primary product prices are driven by supply-demand factors. However, demand is rarely led by borrowed money as banks do not lend money for buying food. The same holds for fuel products, and hence irrespective of what we do to interest rates, these prices have their own determination mechanism. Where policy matters is in the case of prices of manufactured goods, which is also called core inflation. Here, RBI is actually lowering the demand for goods, which could lead to prices coming down. If people buy fewer houses now, the demand for what goes into houses like cement, steel, electric products, etc, would be reduced. So what should RBI target? From the point of view of efficacy of monetary policy, higher rates will work only if we are tackling core inflation. The other two components are either structural or driven by supply factors over which RBI has little control. The same holds for CPI, which has more consumer goods and services, and where interest rates matter very little. In fact, once we move from producer prices (which is largely in the WPI) to consumer prices (which is in the CPI), then the power of monetary policy declines. If this is so, then raising rates on grounds of inflation cannot be justified as even if rates are lowered to, say, zero, people cannot borrow to demand food or fuel products and hence should not affect these two components of inflation. Therefore, RBI may have something else at the back of its mind when talking of interest rates. The clue is really real interest rates. With WPI inflation at 7.3% and CPI inflation at, say, 10%, the real cost of funds is in the negative zone with the repo rate being 8%. If one goes back to the Chakravarty Committee of RBI in 1986, it had recommended a real return of 2% to the deposit holder ideally. Using this logic, deposits should give a nominal return of 9-10% going by WPI and 12% by CPI. Otherwise, they are actually not being compensated at all for inflation or are suffering from money illusion. One can hence surmise that when RBI says it should not be looking at just core inflation, which is 5% today, but overall inflation, the thought at the back of the mind must be the entire structure of real interest rates in the economy, and the reference is not confined just to the effectiveness of monetary policy. By not keeping rates high today to adjust for inflation, the cost of funds gets distorted and borrowers gain while savers lose. The lending rate in real terms could be close to negative if the base rate is juxtaposed with, say, the CPI rate, which distorts the money market. Therefore, it may be argued that this rationale must be floating somewhere at the back because RBI would otherwise not have any other justification in terms of transmission of monetary policy measures to the economic system for its current stance.

GRAND PURSUIT: Book Review Business World 23rd July 2012

FinanceBanking Markets Personal Finance Fund Manager Speak OpinionColumnists BW Opinion Global Commentary PersonalitiesInterviews Profiles Editor's Letter Science & techHealth Medicines Tech Talk After hoursArt Fitness Gadgets Lifestyle Travel MagazineCurrent Issue Archives Subscribe BW BooksReviews Books & Guides Extracts Columns Reading Room Personalities Alerts Author's Corner Grand Pursuit: Great 20th Century Economic Thinkers And What They Discovered About The Way The World Works By Sylvia Nasar In her new book, Sylvia Nasar discusses the lives of economists —from Thomas Malthus to Amartya Sen —and how their ideologies were influenced by the environment they lived in A book on the life of economists would be considered boring by most readers, and even economists. But not Grand Pursuit by Sylvia Nasar. It discusses the lives of economists and how their ideologies were influenced by the environment they lived in. The narrative is interesting, starting with Thomas Malthus and Charles Dickens (yes, the novelist) and going right up to Paul Samuelson and Amartya Sen. The list is selective, which is understandable as it is hard to include all. Alfred Marshall termed economics the engine of analysis, while John Maynard Keynes called it the apparatus of the mind. Just how the discipline evolved is Nasar’s focus. The book has Friedrich Engels, a well-to-do gentleman, who led a double life mixing with capitalists during the day, while building his theory of a revolution in England. He also ghost wrote for his partner, Karl Marx, a lazy man who liked to drink and argue. They came from capitalist and bourgeois backgrounds and worked towards overthrowing the bourgeoisie. Interestingly, Keynes had unkind words for Das Capital. He felt it was an obsolete textbook “scientifically erroneous without interest or application for the modern world”. Malthus, who wrote on population and food, traced all our ills to sex as it brought about the undesired population explosion. Marshall was the first to introduce mathematics to the dismal science, which we all know; what we didn’t was his romance and marriage to his student Mary Paley. He liked the American society as it offered equal rights to women and there was little class distinction. He marvelled at the US dominance, which he captured by its omnipresence: an average citizen wakes up to an American clock and uses American sheets and soaps… travels by a tram made in New York, and goes up a Yankee elevator, etc. Like Marx, Marshall liked to blend history with economics. But economics was the preserve of the British until Irving Fisher came along and was taken seriously in Cambridge and accepted by Marshall and Leon Walras as a genius. He brought in concepts of physics and mathematics and was impressed by the securities market, though he failed at it finally. The author introduces us to a flamboyant Joseph Schumpeter whose theories work even today. He spoke of the use of innovation, and enunciated the theory of creative destruction, which was integral to capitalism. He was among the first to talk of economics in a dynamic sense where countries evolved and progressed through innovation and got destroyed to be rebuilt. Ironically, while he headed an investment bank, Biedermann, it went bust in 1924, taking with it his reputation as also his weakness for women. But among all these giants, Keynes commands maximum references today. He had worked on India while in the colonial office as he could not make it to the Treasury. A stock broking wiz, he helped the nation borrow from the US and was instrumental in drawing up a plan for reparations for Germany after the World War I. Keynes also loved to gamble and went long on the dollar and lost during the 1930s. At the time of the depression, he ran the King’s College endowment fund, which went bust, but he clicked with US President Franklin Roosevelt (1882-1945) and got in his idea of fiscal stimulus in 1934 to get out of the depression. The rest of the book talks about others of the Cambridge school such as Joan Robinson, Richard Kahn and Piero Sraffa. Robinson felt Keynes was a bully, and Hayek opposed and believed that low interest rates misallocated capital. Milton Friedman started surprisingly as a follower of Keynes, but took an opposite stance later. Robinson took Keynesianism to the second world, while Sen focused on welfare and poverty. The book is an easy read. Nasar has done a good job by getting into the character of the economists. And that makes the book unique and, more importantly, unputdownable.

Getting the polled rates right: Financial Express 14th July 2012

After the Libor scam, the way Mibor is calculated needs to be changed. A system that uses actual traded numbers is best The recent controversy on the rigging of the London Interbank Offered Rate (Libor) is interesting as it invites debate on the best practices to pursue given the assumption that human frailty gives in to temptation to game the system. The Barclays story is quite straight. The Libor rate is determined by a poll where a fixed set of companies provide their rates, at which they have traded or feel is the right one. There is a trimming of these rates where the outliers are removed and the final number is averaged. Evidently, as the numbers given by any organisation polled is not based on actual trade data but a guess, there are ways of stating prices in conjunction with others or on their own if they have clout to keep the rate at a certain level. The rate may not matter if it is just an academic one, but when trillions of dollars of transactions, especially in derivatives across the globe are linked to this rate, then it is a serious issue. Mibor in India is a money market rate polled by Reuters and NSE, and while it is similar in terms of use, the volumes transacted may not be that large. And considering that the polled institutions are dominated by public sector banks, the risk of gaming could be lower. How is one to view this system of polling rates or determination of any spot price? Ideally, one should be using actual rates at which any product is traded, which is possible if the market is regulated. But the issue is of having these rates reported at the right time. If it is online trading it can be tracked, but OTC transactions would be out of the ambit unless it is made mandatory to report the transactions immediately. For this we need a regulator, and while RBI can impose on money market transactions, there is no such entity for global transactions. Hence, at the global level this would be impossible. Also, if one wanted to game the system, then the volumes could be changed so as to reflect a desired weight at the time of polling, say 9am or 10am, while the rest would be conducted after these hours. In stock markets, in the cash segment, transactions are online and the price is hence a revealed traded price. Price bands ensure that prices cannot be overstated or understated at any time and there are surveillance systems to ensure that the market is orderly. This is possible because it happens on an exchange which is organised and is hence the best platform for trading and settlement. But the same does not hold for the forex or money market as the OTC segment dominates. In the derivative segment, the spot price is already determined in the cash market, and the futures prices move in accordance with the spot price with bands being fixed. To ensure that the prices are not rigged by large players, position limits are placed so that no one can corner the market and drive the prices. Asking players to bring in more margin capital ensures that price movements are orderly. But, if the analogy is carried to the commodity market, there are no unique spot prices given its fragmented nature, and hence these are polled by the exchanges. This brings it back to the integrity of the polled participants. Commodity exchanges like NCDEX outsource this exercise to agencies like CMIE and NCMSL, which conduct these polls by jumbling the participants. So, from a universe of say 100 participants, a different set is polled everyday to ensure there are fewer chances of rigging the prices. This is more acute here because several commodities are not traded in the spot markets and hence do not have a ready price. But with futures trading taking place, the spot price becomes one which is guessed by participants from a wide cross section of the community. Simultaneously, there are checks carried out by the exchange in the cash market to ensure that the prices are in line with the reality. Now, Mibor is polled by Reuters in the morning based on conjectures and again in the evening based on traded numbers as reported by the participants. The two normally tend to converge. NSE does it in the morning and uses a more scientific process of boot strapping which goes beyond plain haircuts of the top and bottom quotes. In simple language, a multitude of samples are drawn and their averages and standard deviations are calculated through an iterative process and the one with the lowest standard deviation becomes the quote for the day. This is also replicated by NCDEX in the commodity market. So clearly, a plain vanilla average removing the outliers is inferior to a bootstrapped method that delivers more accurate results. Second, the samples used should be large and change regularly. If the polled participant is not sure if its quote is being used in the sampling, then the incentive to cheat is lowered. Therefore, ideally the entire universe of banks and PDs should be polled and the bootstrapping method used on a section of them. It could suffer from the exclusion syndrome for if a major bank is excluded which dominates the market, then the number may not be representative of the reality. But this will ensure the integrity of the system. Third, we should try and migrate to a system that uses actual traded numbers, which is the best option. A change definitely is required as the present system for polled rates for any product which is not regulated or traded on an exchange is susceptible to both judgment and fudge.

FINANCIAL REFORM IN POST-REFORM INDIA: Book review Business World 9th July 2012

Financial Access In Post-Reform India By T.A. Bhavani & N.R. Bhanumurthy Oxford University Press India Financial Inclusion is one of the most popular subjects for economists to write on given that successive governments have spoken about access to finance being the major lacunae in India’s development model. However, with a lot of literature on the subject, the challenge is really to bring in something fresh. T.A. Bhavani and N.R. Bhanumurthy have done so and done so well. They provide a different perspective to measure inclusion and its progress since reforms. The book is aimed at policy-makers, bankers and academics, and the study shows that there has been significant advancement in the evolution of the financial system in terms of structures, systems, products and depth. The authors have their reservations, too, and make a global comparison to begin with. They chose the UK, China and Brazil. The British banking system, though, is more advanced than any of the other countries, and in relative terms, India’s system is the smallest of the four. This also means, its financial access is not that deep in a global context. More importantly, financial access is lower in India than in Brazil. The authors do not look at data after 2002, which is understandable given its availability. But one can assume that there should have been substantial improvements over the past 10 years. They show that around two-thirds of households did not have bank accounts. During 1992-2002, there appeared to be greater reliance on moneylenders as formal systems declined. The proportion of productive investments of households financed through informal systems was high in, say, agriculture and unorganised manufacturing. By 2004-05, the next time when a review was done, farming and services still lagged, while industries did well. Clearly, banks had a bias. The sectors or regions that tend to get excluded suffer from higher production and behavioural risk. While the former is linked to their profession, the latter is more due to lack of information availability — a challenge even today. Getting hold of reliable data and processing it increases transaction costs. The logical corollary is that we need to reduce this risk, and hence cost, to enable better flow of credit. This is where our policy-makers have faltered, note the authors. We do not have too many schemes where the risk is absorbed by the government. Further, borrowers complain not just of the cost, but also timely availability of capital, which, at times, is more critical when investment is reckoned. Also, banks generally achieve their priority sector targets but not the sub-targets, and often insist on farmland as collateral. The authors’ solutions are to enable decision-making at the village level where information is being stored. Also by linking loans to savings accounts could create a buffer. A more innovative solution is to have priority-sector lending certificates that can be traded, which may make some banks specialise in the unorganised segment.

Is India moving towards a stagflation-like situation? Business Standard, 4th July 2012

“Those using the ‘S’ word are equating the current economic matrix to a ‘bust’ situation, when the situation is more analogous to the downward slope of a normal business cycle” German philosopher Friedrich Nietzsche had said: There are no facts, only interpretations. This seems to apply to the situation today when there is talk of India’s economy being in a phase of stagflation. With the level of dissatisfaction in the economic barometer rising, it is tempting to make sweeping statements since it is in vogue to say negative things about the economy. First, what is stagflation? Keynesian theory spoke of recessions as phases of prolonged unemployment and negative growth with price deflation. These could be countered with expansionary fiscal policies, and inflation took place after full capacity was achieved. This was explained by the trade-off between unemployment and inflation through the Philips Curve. As unemployment decreased, there was more spending, which was inflationary in nature. Monetarists like Phelps and Friedman spoke of a situation in which this trade-off went backwards as wages rose with inflationary expectations, leading to wage-inflation and higher unemployment. In the seventies, when the first oil-price shock rocked the global economy causing unemployment, expansionary policies only fuelled inflation since it added to cost-push inflation. The problem was that countries expanded at a time when supplies were down not because of demand, but because of higher cost of oil. This is stagflation — recession and high inflation. Can we term the situation in India as one in which there’s a combination of recession and inflation? The answer is a clear “no” because what we are seeing is a slowdown in GDP growth. Usually, two successive quarterly negative growth rates in industry are regarded as a sign of recession. Our growth in industry has been low but positive; and, though, the GDP growth rate has been declining over the four quarters of the last financial year and hit a low of 5.3 per cent in the January-March quarter, there is no negative growth. Moreover, recessions are characterised by large-scale job losses, which is definitely not visible in our context except in certain multinational corporations in the services sector. Also, there is little evidence to show that wages have increased in the organised sector to lead to layoffs. With India still having the second-highest growth rate in a year in which developed and emerging markets have registered low growth, the word “recession” seems inappropriate. What about inflation? Wholesale price index, or WPI, inflation has been high but curiously came down, on average, from 9.9 per cent to 8.8 per cent in FY12. Clearly, this cannot be seen as inflation going out of control. In fact, in FY10, when growth slowed to 6.7 per cent, inflation was also at 8.0 per cent and this did not provoke the “S” word. More importantly, we are seeing high inflation in the food and fuel segments because of our farm policies and global conditions; and not because of supply constraints in the manufacturing sector. How about policies? Stagflation has, historically, been caused by expansionary policies that exacerbate supply shortfalls. But, the grievance has been that the Reserve Bank of India has been choking growth by raising interest rates and that the government has withdrawn the stimulus. If this were so, there is again a strong case for not terming the situation close to stagflation. Hence, the basic issue is the interpretation of data. In 2012, the World Bank talks of the euro area moving into a recession with negative GDP growth. China is to slip from 9.2 per cent to 8.2 per cent, while India is to move up from 6.5 per cent to 6.9 per cent. Those using the “S” word are equating the current economic matrix to a “bust” situation, when the situation is more analogous to the downward slope of a normal business cycle, which is not uncommon in the current global context. There is, thus, not much of a case for using the word stagflation here.

RBI questions, but provides no answers: Financial Express, 3rd July 2012

RBI’s Financial Stability Report is another commentary on the state of the economy which goes beyond the statements and speeches made by various government and RBI officials. While the report is evidently focusing on the stability of the financial sector, it necessarily takes us through the macroeconomic scenario and then juxtaposes the state of the financial sector along with the macro picture. In the process, it brings out additional concerns that are latent in the system, which go beyond the regular pessimistic views on GDP growth and inflation. These reports are a new addition to the economic literature and are in line with what other central banks do in other countries and the IMF at a global level. The report actually does not say anything that we were not aware of, but by putting these otherwise random thoughts on paper and highlighting the possible repercussions, RBI actually does ask us to stop and think about the way ahead. Two areas stand out. The major takeaway on the economic front is an overt acceptance that things are not right today and that the downside risks are far too many. GDP growth is precariously placed, as are industrial growth and investment. Should one take it that there could be a downward revision in RBI’s estimates of GDP for the year from 7%? Here, RBI has not really provided numbers. Again, it talks of inflation being a concern and the belief that it will remain elevated. Does this mean that there is a signal again that RBI will not be in a hurry to lower interest rates? One is not too sure here about whether it is a strong thought to be chewed on or whether it will be the underlying conviction when the July policy is announced. There is an acceptance that the opinion of credit rating agencies on India’s sovereign rating does matter and the impact is negative. Also, the dollar will be volatile. Are we to take it that RBI will have little to do on this front once all the policy options are exhausted? At another stage, it is quite harsh on the fiscal side and quite realistically casts a doubt on whether the fiscal deficit target will be attained, given all the current pressures around. This sounds contrary to what the ministry of finance has averred, that the deficit will not be exceeded. Therefore, at the macro level, one gets a feeling that RBI is saying things that are different from the government, where the stance is that while problems are there, we are not going to do too badly. The other area where RBI has been vocal is the financial system. Here, it does blow hot and cold on the state of the system. It does say that the banking system is very well capitalised and there is no worry, though going ahead, raising capital will be a challenge and it will entail a cost. It is more definite and unequivocal on the quality of assets part, where it has voiced concerns on the rising NPAs and the quantum of restructured assets, which will come back to haunt us later. Interestingly, the highest level of NPAs is in the agriculture and SME segment within priority sector and textiles, which account for almost 40% of total NPAs. Does this mean that we can expect the NPA ratios to increase substantially in the future? RBI has been critical of the interconnectedness of banks and the fact that there is a systemic risk posed to other segments of the financial system. This is serious because, first, the asset liability mismatches caused with the assets being financed by borrowings, from others sectors such as insurance and mutual funds when coupled with the declining quality of assets poses a serious risk for the other segments too. It has pointed out that banks have relied excessively on short-term borrowings from mutual funds leading to potential liquidity and rollover effects. Here, clearly, there is need to have some set guidelines on how the banks should manage their balance sheets. Today, with the repo window becoming a permanent one, there is a tendency for such funding to be taken for granted, which sort of converts it to a major source of funding. Second, any slippage in terms of quality of large banks can have a ratchet effect on others too. Their own analysis shows that a contagion can lead to a maximum loss of over 16% of capital with the largest ones being vulnerable to such risks. But how is one to read the entire report? A financial stability report is to outline the risks involved in the system as well as economy, which it does adequately. But are we to be worried about it? Worried, probably no, but concerned, yes. This holds for the financial system because there are some very disturbing signs on the quality of assets as well as interconnectedness of banks. The ones pertaining to the economy are clearly well known and hence do not really come as a shock. But RBI does not offer any solution for either the economy or the financial system. Therefore, the report tends to read like a note of caution on all aspects, highlighting the risks and the worst-case scenarios for various aspects. Therefore, it reads more like the ‘weaknesses’ and ‘threats’ part of the SWOT analysis, leaving out the strengths and opportunities.