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.
 

The truth about futures trading: DNA 21st September 2012

drought is an issue which tends to lead to speculation on the future of futures trading in farm commodities. This is so as a drought is associated with crop failure and high prices. In the light of the present inflation scenario where prices are already high notwithstanding two good harvests in 2010-11 and 2011-12 this fear is palpable.
Some of the coalition partners in the government have already raised objection to the introduction of the FCRA bill in the parliament which really means that the expected reforms in this segment empowering the FMC and introduction of new products such as options and indices may be forgotten. We have already seen a ban on futures trading in contracts like guar, which is a commercial and not consumption product. But before any rash decision is taken we need to keep in mind certain facts.
First, futures trading and prices are only a reflection of reality. If there is a shortfall in production, prices will increase and this market tells us in advance that there will be a shortfall, and hence, these signals should be used to take pre-emptive policy action. In 2007 the futures market indicated a shortfall but we went and banned wheat futures, even though the open interest to output ratio was less than 2 percent. (Open interest for the running near month contract is the potential delivery that can take place and theoretically influence prices). Prices did not come down, and after a period of self denial we ended up importing wheat at progressively higher prices. Further in 2009 the same was witnessed in sugar when futures trading was blamed and banned. But prices increased even more so after the ban and we had to import more sugar. The lesson is that we should take heed of the prices and use it for policy rather than ban futures trading in the product.
Second, official studies have shown, by way of the Abhijit Committee Report, that there is no causal link between futures prices and spot prices. This said, we should not fall prey to populism on pulpits and destroy a very valuable tool for farmers and policy makers.
Third, the increase in prices witnessed in products not traded on futures platforms has been much higher as is the case of tur (10%), masoor (23.4%), bajra (15.7%), ragi (19.4%), eggs. Meat etc (16.0%) etc where supply shortages relative to demand has led to this phenomenon. Therefore, we need to not fall into the trap of being myopic and look only at the basket of commodities that are traded in the futures markets.
Fourth, futures trading should be viewed from the point of view of open interest and not volumes traded as it is the former that influences prices potentially while volumes traded only adds liquidity. Intuitively a trader can influence prices by actually physical delivery which is controlled by the open interest. With strong position limits being placed by the FMC along with the exchanges, and strong surveillance systems which have not revealed oligopolistic trading, which is revealed by the large number of participants in trade, there are no signs of manipulative trading. This means that the market is orderly.
Fifth, by banning futures trading in guar, the administration has actually hit the guar farmers. While the product is quite insignificant in terms of the total quantity produced and would not have received any attention, the ban has actually pushed us back as it is an exportable commodity and the US market has been shaken. There is now serious talk of growing more guar in countries like China and parts of Africa as the price of guar gum, the final product that goes into chemical formulations and machinery, is scarce.
If this happens, India would lose it’ monopoly position and the farmers would tend to be adversely affected. Curiously, even after the ban of futures trading, prices increased by as much as 31.2% for two months following the ban in March.
The basket of products that is now available for future trading has gotten compressed, with chana, mustard, spices, soybean and soy oil being the only significant products that are traded. Wheat and sugar, though reintroduced have never really caught on with the market players who are wary of bans. This is so because every time there is a ban, and contracts have to be closed, there are losses made by one section as decisions are taken with a time frame in mind.
The hope is that we behave in a rational manner when the impact of the drought sets in and we do not go around banning products - presently there are few liquid kharif products that are left to be banned. In fact, we should encourage such trades so that we get better signals and use them for taking policy decisions. The RBI did not go around banning players from trading in forex when the rupee fell nor do we stop stock market trading merely because share prices are falling, because the economy is not doing well.
We should not have a different standard for commodities merely because it is an effective political tool to score victories. As bans have never brought down prices since 2007 when this tool was used, there are really no gains from such action. Hopefully this message has been absorbed. Orderly markets are a reflection of the underlying and there is no point in smashing the mirror, if we do not like the image.

Reviving India’s animal spirits: Financial Express 15th September 2012

The epigram ‘India Shining’, which was coined years ago, appears to have been replaced with the epitaph ‘India Dimming’. Those with a cynical bent bring in the bathtub metaphor and liken the Indian growth path to one where we are moving from the state of ‘sliding’ to ‘stagnation’ into the ‘drain’, in case the status quo prevails. Besides, the world over, governments are doing something to resuscitate their economies while nothing much seems to be happening in our economy.Today, virtually every economic indicator is under pressure. GDP growth projections are only being scaled down. Industrial growth rate discussions are more academic in nature where, while we discuss whether 0.1% is better than a negative number, the inescapable fact is that there is stagnation. Inflation appears to be something about which no one has a clue because while RBI has taken the onus of addressing it, the other government arms are not so keen. MSPs have been raised and adjustments in fuel prices will be inflationary. Growth in credit is tardy because investment is not taking place in an environment of high interest rates and the primary capital market is lacklustre. The secondary market is surprisingly stable within a range, with foreign interest still holding on partly due to the fact that we still remain a better-placed market. But for how much longer, is the moot question.The fiscal deficit is going awry because low growth has upset revenue collections and our unwillingness to do something on subsidies means that expenditure continues to overshoot. Government spending per se can be Keynesian in nature if the money is spent. So, MGNREGA should be good to the extent that the money is spent on non-food items. Subsidies are not effective Keynesian tools because they only buffer us from price increases and do not add to purchasing power.The external account, too, is under pressure. The exports boom has petered down to a whimper; and with global economic conditions being where they are, a revival will be only slow. QE3 and OMT will mean more money that will push up commodity prices and hence our import bill. FDI has slowed down, which could be an aberration but the rupee has become sticky now with prospects of a further depreciation, which makes ECBs less attractive. The question is, what do we do considering that we actually may not have much control over several of these variables?In mathematical terms, we are trying to maximise the function subject to several constraints. It is quite clear that our current policies have not quite been able to deliver on any of our goals. One way out is to do things in a different way, for which we have to identify the variables that we can control. We should draw our trade-offs. One option is to focus on growth and improve sentiment while possibly living with higher inflation.This means, for instance, tackling the fiscal deficit. While there is controversy relating to raising the prices of the administered fuel products, a simple solution is to increase prices marginally in steps so that the burden is absorbed easily. We have always had the penchant for going in for high increases in prices sporadically, which does not go down well. A better way is to increase price of diesel by, say, a rupee on a monthly basis, which will be palatable.Second, all project expenditure that was planned in the budget should be implemented immediately now. There is around R1 lakh crore budgeted for the year, which should be spent immediately. The practice so far has been to keep this expenditure pending till the end and cut back in case the deficit goes out of control, which will again be the case. This will provide the stimulus to the extent that it has been budgeted and will also let the private sector know that the government is doing its bit.Third, the steps already taken on disinvestment are laudable because they have the potential to revive spirits and also help to lower pessimism on the attainment of the target of R30,000 crore. A clear list of companies to be divested along with timelines will reassure the markets. The same holds for sale of spectrum.Fourth, RBI should now try lowering the interest rates. While this may sound out of place at a time when real interest rates are already negative and inflation likely to only increase, it may be worth trying just to assess whether the animal spirits are revived. Industry has been complaining that high rates have held back investment. The ball should now be passed into their court by lowering rates by 100 bps in one shot, with the caveat that RBI will review them in case the results do not flow. This way, the onus will be on industry to take the lead.Fifth, some of the issues relating to supply of coal for power plants, FDI in airlines, new private banks, environment policies etc that do not have any major opposition should be implemented as soon as possible. While this would not have a direct impact on the economy, sentiments surely will improve. One good measure already taken is to just correct the twin blunders of GAAR and retrospective taxation. These have had a soothing effect.Quite clearly, once the government starts taking action, as it has just done, the right signals will be sent out. One can now expect some serious action on the fiscal side and policy implementation.

Retain but reward CRR: Financial Express 8th September 2012

Around R3.25 lakh crore is locked up with RBI as CRR, earning no return. Paying at least 3-3.5% interest would be fairAn interesting issue that has come up for discussion is the relevance of the cash reserve ratio (CRR). CRR is spoken of quite often just before RBI announces its monetary policy as it is a signal of the stance of the central bank on monetary easing. CRR today is 4.75% and there is a section of bankers who feel that this is a drag on the system as it constrains them.The argument goes like this. The Indian banking system gets R100 as deposits. Of this, R4.75 has to be kept aside as CRR and another R23 has to be invested in government paper. The bank is left with R72.25 to work with. Of this, again, 40% goes as priority sector lending, which leaves them with R43.35 to pursue discretionary banking activity. Is this fair enough?While the 40% priority sector credit allocation is inescapable, and given that the buzzword is inclusive growth, it is politically incorrect for bankers to be critical of this component even though the highest level of NPAs reside in this category. The SLR criticism becomes weak because banks are holding on to excess SLR (currently around 28.2%) anyway, meaning thereby that it is still relatively attractive. In FY11, the net return on investments over cost of funds was 206 bps and that on advances was 445 bps. But given the benefits on investing in government paper when reckoning capital adequacy and making provisions on the asset portfolio, investment in SLR securities makes a lot of sense. Therefore, CRR has now become an interesting bone of contention.CRR actually has two purposes. The first is that it is a safety valve of solvency for banks as they need to have a certain prudential level of cash to meet their requirements as well as contingencies. This again is not sacrosanct because some countries have this reserve requirement while others do not. But, intuitively, having it makes sense as it affords comfort to the central bank. What should this level be? Currently, the ratio of cash on hand and balances with RBI is 5.3% of Net Demand and Time Liabilities (NDTL), which means that banks can actually manage, with around 0.5% of NDTL, their cash requirements under normal conditions. This is a matter of discretion for the central bank and is often linked to the second purpose of CRR, i.e. monetary policy.RBI has several means of controlling the growth in credit and one of them is CRR. It is a quantitative measure which ideally is not efficient since it is not market-driven and means tinkering with the market forces. But CRR is very effective because it directly takes out or induces liquidity into the system, thus ensuring success of the monetary policy measure. The analogy can be drawn from the difference between a quota and tariff where a quota works immediately though it may not be efficient in the market sense. Therefore, RBI would love to keep this option open.The open market operation (OMO) is used more frequently by the Federal Reserve, but theoretically an OMO may be good for supplying liquidity but may be ineffective for drawing it out as banks can choose not to buy paper from RBI which is offered to them. Therefore, CRR is more effective than an OMO and, in fact, even more powerful than the repo rate, because while such rates are indicative of what RBI wants, the P&L of banks are affected only to the extent that they borrow or lend to RBI through the repo/reverse-repo windows. Therefore, often changes in the repo rate do not translate into changes in deposit and lending rates as the balance sheets are not directly affected significantly.This means that CRR has to be retained and is an effective tool for RBI. But the other part of the debate is whether banks should be paid interest on these balances as banks bear a cost on their deposits and borrowings, and any impounding of these balances is a setback. A back-of-the-envelope calculation shows that with deposits standing at R62.8 lakh crore, and NDTL at R68.38 lakh crore, around R3.25 lakh crore are locked up with RBI, earning no return. A 1% return would earn the system R3,250 crore and would increase as RBI offers a better rate. In FY11, net profits of banks were around R70,000 crore and 1% return would improve profits by around 4.5% and increase progressively as the return is enhanced by RBI. Banks would naturally see this positively as it improves their profit margin.A counter-argument could be that as banks do not pay anything on demand deposits, which account for around 9% of total deposits, there is actually no implicit loss for banks, though it is also true that money is fungible and matching source with use does not always happen.As can be seen, there are no right or wrong answers here. Retaining CRR is a prudent move to ensure solvency of the realm, especially in times of a crisis. But rewarding banks with a return may not be a bad idea as they are already handicapped with too much pre-emption. Another argument to support this reward can be that if the same amount were to be added as a mandatory second tier of SLR that has to be held to maturity and replenished, banks would still earn a return of around 7% on such paper besides allowing the government to borrow more money. Therefore, going back to paying at least 3-3.5% would be a fair deal.

Is the worst over for the economy? Business Standard 5th September 2012

The critical phase is the third and four quarters. Here, there is reason to be a little more sanguine. The monsoon has finally not turned out to be as bad as was expected and the overall kharif numbers may not be too unsatisfactory”
The latest GDP growth numbers – to the extent that they do not change soon – are mildly encouraging but are not strong enough to make us ecstatic. They are encouraging because after four successive declining quarterly growth rates, this mild increase comes as a breath of fresh air. The GDP internals reveal that growth is not really broad-based and that some of the sectors like construction or agriculture that did well this time may not repeat the performance over the next few quarters. The issue is whether or not growth has bottomed out and what this holds for the rest of the year.
There is reason to believe that growth will be in the upward direction from now onwards, though the sectoral contribution will vary. The second quarter is typically a phase in which nothing really significant occurs. There is only residual farm production that comes in since the kharif and rabi are third and fourth quarter phenomena. It is more horticulture, animal husbandry and so on that add to the numbers. Manufacturing chugs along. Construction activity slows once the monsoon sets in. The only major driving force is services, especially in the government sector that by virtue of a high fiscal deficit can provide a boost to the extent that it creates demand and does not just buffer costs as in the case of fuel subsidy. This is also the time when the National Rural Employment Guarantee Scheme is active.
The critical phase is the third and four quarters. Here, there is reason to be a little more sanguine. The monsoon has finally not turned out to be as bad as was expected and the overall kharif numbers may not be too unsatisfactory. Add to this the fact that the late monsoon helps rabi sowing, and we could see some steady farm sector performance. Manufacturing would benefit more from the presence of the base effect in these two quarters in which growth was low last year. This, combined with a pick-up in consumer spending will help a bit. But overall growth may not go beyond the three-per cent mark by the end of the year. Construction would revive once the government expedites projects in the infrastructure space.
The service sector will continue to be the mainstay and though the performance in Q1 was tardy with the trade and transport sector crawling, other components such as finance and administration have done better. With agriculture and manufacturing reviving, there will be a positive impetus to trade and transport that is based on production activity.
Can something upset this story? The absence of a policy thrust is an issue for overall growth, and may not come too soon. But these conditions were anyway not present to begin with and our growth was based on other factors. The absence of government spending is a possibility, given it cuts back on project expenditure to rein in the deficit. This can push us back considering that private investment is not forthcoming.
On the positive side, the Reserve Bank of India (RBI) could lower rates in the third and fourth quarters mainly owing to growth concerns as in April, though inflation will continue to be high in the food segment. No action from RBI can be a factor disrupting this story.
Therefore, there is reason to believe that growth will climb upwards, albeit very gradually, and will be around six per cent for the year. The fact that everything that can go wrong has already been buffered is in a way positive. Can there be a hard slippage in any of these quarters? This cannot be ruled out in the second quarter but considering that most of the productive activity comes in the third and fourth quarters, it should not be interpreted as a fallback unless things go horribly wrong and growth slips below the psychological five-per cent mark.
Though the bottoming-out theory will most probably hold, it does not mean we can gallop along at this rate without affirmative action on the policy front for too long. We can be lucky once more this year, with a lot of aid of the base effect, but we should not push our luck since moving to a higher growth trajectory cannot be achieved with status quo in the topography. There lies the rub.

Are CDRs = NPAs? Financial Express 4th September 2012

The issue of restructured assets has come to the forefront at a time when the banking system is also under pressure with rising NPAs. An issue raised is whether or not restructuring is a euphemism for an NPA that is not classified as one. Or even if restructured assets are properly ‘identified’ and follow a well-defined classification, are there implications for the banking system?Corporate debt restructuring (CDR) became a controversial issue in the aftermath of the financial crisis in the US. During the crisis, it was difficult to judge the viability of a firm, and banks were jittery about the extent to which they could stretch their forbearance. However, post crisis, such restructuring was possible and banks were more confident of taking such decisions. However, here too it was critical to have the right judgement because through adverse selection or any attempt to protect the balance sheet to placate the markets, the malaise could get even more deep-rooted.In our own case, the rules have been laid down for CDRs as far back as in 2001 by RBI where consortium lending was the rule. The idea of CDR was that when companies are hit by extraneous circumstances that affect their performance and hence their ability to service their loans, there are credit-debtor agreements that are drawn up to restructure the debt in terms of tenure, swaps, interest rate and so on. This provides space for continuance of the company’s activity and the bank does not treat the loan as an NPA. There is a structured process for invoking CDRs, which ensures that there is transparency, and which limits the prevalence of arbitrariness.The growth in restructured assets has been 74% in the last three years, which is higher than the growth in credit that was around 66%. While the ratio of debt restructured to outstanding credit is low, at 3.3% as on March 2012, the elasticity of growth in debt restructured in response to growth in credit is increasing, which is a concern. It declined from 1.2% in FY10 to 0.3% in FY11 and increased to 2.1% in FY12 and further to 3.6% in June 2012. Quite clearly, while the overall level of debt being restructured is not of very significant dimensions in absolute terms, the fact that it has increased sharply in the last 15 months should make us pause and reflect. Also, given that over half of the restructured debt is in sectors such as iron and steel, infrastructure, textiles, telecom and construction, where the present prospects would probably be linked with those of the economy, these numbers could increase.While NPAs and CDRs are distinct concepts, their simultaneous growth over the years is significant. The ratio of incremental gross NPAs to incremental credit was 6.1% in FY12 while that for CDRs was 5.9%. Therefore, during the year, the ratio of the combination was 12% of increase in credit, which is quite high. As the economic environment would continue to be tenuous in the coming months, given the slowdown in industry and the uncertainty of policy direction, there could just be the tendency for these assets to increase. The fact that interest rates may not come down too soon would add to this feeling that the overall level of restructured assets would only move up in future. In fact, studies show that the corporate sector is now moving into the negative territory in terms of growth in profit with interest cover too decreasing, indicating stress on debt service.The CDR concept has, however, raised some controversy. The first is the treatment of such assets, which is a tricky issue. Once an asset is restructured and is out of the ambit of being a non-performer, it would get classified as a performing asset. But, what if it fails subsequently? Is there any recourse for the banking system as such, which would have proceeded on the basis of lower NPAs?Second, there has been a tendency for larger companies to have access to such a facility while the smaller ones are at a disadvantage. Is there uniform application of the process or does it tend to get discretionary?Third, there is need for some introspection on the reason for the emergence of such cases. Is it purely due to external factors or is it also a part of incorrect judgement on the part of the lending institution? This is important to ensure that banks are also more cautious when lending money.Fourth, while performance of CDRs has been satisfactory so far, should such restructuring be encouraged? This is so because there is a view that there is a very thin line between restructuring a debt and the ever-greening of a loan. There is hence a moralistic issue here.Given that some sectors such a real estate, aviation, power, mining, etc, would tend to be volatile in terms of performance in the next couple of years, can there be an objective formula to qualify for a CDR? Some thoughts may be put down here. First, we need to have a transparent set of prerequisites for qualifying for restructuring. Next, once a CDR is invoked, there has to be an observation period during which banks should probably not treat the asset as being standard and it should be only after this cooling period that it actually goes back on track. Last, in case of failure, there must be a clear mention of the same in the books. Such principles would be useful for an objective evaluation of this process to ensure that CDR does not become simply a tool for delaying the inevitable.

RBI versus PMEAC: Financial Express 24th August 2012

Apart from differing on the GDP forecast, RBI counters PMEAC projection of meeting the fiscal deficit target
RBI’s Annual Report, released just six days after the PMEAC’s Economic Outlook, is hard-hitting and gloomy at the same time. RBI has placed on record the hard reality that we should now see clearly and has also indicated that we need a very big overhaul of the way in which we operate, but this, unfortunately, does not seem to be forthcoming. While we cannot get help from the global economy, there is a pressing need for a domestic response, in the absence of which we cannot really hope to move to a different level of growth.RBI is clear that growth cannot be over 6.5% since the basic forces that are needed to move the economy are missing. Investment is down and the reason is ‘policy stasis’. The report is quite blunt in saying that we need to have the Singapore model in place where all the ministries sit together and sort out issues. The power sector has been pushed back due to the problems with coal allocation. Roads cannot be built because there are issues of land and environment, and progress in telecom is similarly afflicted with inaction. Quite clearly, there is a call for a shakeout in policy from the government on all ends. In fact, it goes head on to say that there is ‘absence of sufficient policy response’ which is required for any improvement to take place.By going into the reasons for inflation, RBI has actually highlighted two factors: one is the real reasons and the second is that there is a very strong reason for doing what it has been doing so far to control inflation, i.e. retaining interest rates at a high level. The report is critical of the MSPs for raising prices of food and has also highlighted that there is a rural wage spiral (is it MGNREGA the report is referring to?) at play somewhere, adding to demand through higher wages in the country coupled by higher staff costs in corporate India. This means there is reason to believe that there are demand-pull forces operating somewhere that will put pressure on prices. This implies there is still a role for interest rates.Next, RBI takes on the issue of fiscal consolidation. It does not believe that the fiscal target will be met, unlike the PMEAC which has stuck to the 5.1% target for the year. The economic slowdown will affect revenue; and by its own calculation feels that by not taking action on fuel prices, the subsidy bill by itself could swell by 0.4% of GDP, meaning thereby a slippage of around R40,000 crore or the doubling of the budgeted amount. This is based on the twin developments of oil price moving up, which has already happened, and the hesitancy in increasing administered prices of fuel products, which would inflate the subsidy bill. This is serious stuff because it means that the deficit would be at least 5.5% of GDP, to which one must add the revenue slippages on tax as well as disinvestment and spectrum auctions. It has hinted at expenditure switching from cutting revenue expenditure to capital—a theoretical and not practical possibility, given today’s conditions.RBI is also less confident on the external front. The current account deficit, while benefiting marginally from the lower commodity prices, would be under pressure on services and there has to be considerable support from the capital account. Here, RBI warns of not using the debt route, which was popular earlier on account of the ECB cost that was attractive. This will lead to issues of debt sustainability and hence we have to look at FDI. Here again, there is a question raised on the policy front because under depressed global economic conditions, one cannot elevate these flows without affirmative action on policies.With an overall warning being given by RBI on all ends, what is one to make of it? The first is that growth will not be higher than 6.5% and there is a chance of a downward revision by RBI if things do not improve. The drought and its impact will be a reason for such downward revision.Second, there appears to be an exhortation from RBI to the government to mend the fences in terms of both fiscal consolidation and policy movement. It has very subtly mentioned that the government had promised to take steps in early August, which, if taken, can improve economic conditions. Would this be a cure for the present ailment? This is debatable because while policies would work in the medium run, they would only improve sentiment in the short run. Can the government really bring about the policy changes that we are talking of? Some of the issues can be dealt with and would probably be taken up with urgency, given that the FM has also spoken of moving the economy along. But, in the immediate run, this could probably only mean that we would be within this range of growth and not slip badly.Third, RBI has also quite clearly stated that there is limited space for monetary policy action, which can be taken to mean that we should not be expecting anything dramatic from RBI in terms of rate cuts, given the severity of inflation, where there is also excess spending taking place. It has also been silent on measures to improve corporate investment and focused more on improving infrastructure investment—another indication that India Inc should not expect significant rate cuts this year.

Optimism, thy name is PMEAC: Financial Express 18th August 2012

At a time when there is pessimism and despondency all over at the prevalence of the status quo in our economic lives, the PMEAC has made optimistic projections on the state of the economy, which are slightly better than those made by RBI even though it has stepped down from the assumptions we worked with in March. It is well that we do have an official stock-taking of the economy considering that presently besides RBI’s own downward revisions of GDP growth and upward revision in inflation for the year, there are only private estimates available on the state of the economy. And most of them present a near doomsday picture. However, there could be areas of disagreement with some of the numbers presented by the PMEAC since the underlying conditions that could theoretically lead to such growth appear to be missing.
The GDP growth assumption of 6.7% is based on three numbers working out. Farm output is to grow by 0.5% in drought conditions and could still be attained, provided the rabi crop turns out to be better, which has happened in the past. While this may still be acceptable, the optimism on industrial output will be hard to share. It is assumed that growth will be 4.5% for manufacturing while the industrial sector will grow more at 5.3%. Given a negative growth in the first quarter, it will require a substantial shift in the next three quarters to warrant this growth number. Corporate sales and profits have been showing a continuous decline over the last five quarters and do not really inspire such feelings. The PMEAC has argued that the base effect will prop up this number as growth was high in the first half of last year and low in the second half. While this will work in favour of growth, in the absence of demand conditions improving and investment taking place, it is unlikely to fructify to this extent.The services sector is assumed to grow by 8.9%, which would probably be the best-off case, as sustained growth in this sector requires growth to be buoyant in the other two sectors—agriculture and industry—which is not the case today. Shortfalls may be expected in growth in industry and services unless something really radical happens in terms of policy shift. Even then, given the time lags involved, growth cannot be instantaneous.The take on fiscal deficit appears to be unchanged, notwithstanding everything that is going amiss right now—slippage in revenue, higher subsidy bill, demand for higher drought relief, limited movement on disinvestment, unsure collections on spectrum sale, and possible higher borrowings this year. This is something that few will agree with. The assumption probably is that even though growth has slowed down by 0.9% based on what was assumed during the Budget time, inflation is higher by a percentage point, thus making up for the denominator. But this may not be too convincing because it is the numerator that will carry the slippages and cannot be eschewed under the present circumstances. In this eventuality, a higher fiscal deficit number will definitely result.The other area where the PMEAC takes a bold stance is on the external front. While the call of 3.6% current account deficit is possible, given that international price of oil has been coming down, the recent trends indicate that this could be tenuous and a turnaround in prices is possible any time. This would actually pressurise the external account. However, the projection of an increase in capital flows is something that could be disagreed with. While the euro crisis and the global slowdown have a secondary impact on our economy insofar as we are more of a domestic-driven economy, the flow of foreign funds is bound to be impacted.The assumption made here is that FDI will be higher at $24 billion while FII will still be high at $14.2 billion as against $17.2 billion. Now, the World Bank has spoken of a gross amount of $16 billion flowing as portfolio flows to emerging markets in calendar 2012. Therefore, the assumption here is India will be the hottest destination for such funds even though the issue of GAAR has been deferred and not really resolved. Another assumption made is that our ECB account will increase to $21 billion, thus making up for the current account deficit. In fact, the implication is that the balance of payment will be in a net surplus position, adding marginally $4 billion to our forex reserves. This by itself should mean that the rupee will have to strengthen by the end of the year, which may not find too many supporters.The Economic Outlook then goes on to make several suggestions as to what has to be done to revive the economy—all are well known. As it is an advisory council, the role is evidently to provide the framework, but obviously the implementation requires support at the political level. This does not mention that it has assumed that any of these developments would come about to justify the higher growth number on GDP, and hence reads more like a routine Survey of the economy which comes through the ministry of finance or RBI in their quarterly reviews. As it does not outline what will be done in the course of the year, as that is the prerogative of the respective ministries, the document must be viewed as a set of forecasts made this time by an official agency which by touching on all aspects of the economy is comprehensive as compared with other official forecasts which stop at predicting or targeting a few indicators.