Banking solutions for the aam aadmi: Business Line 21st August 2015

Payment banks can act as a vehicle for inclusive banking; but there are regulatory and technological concerns

The issuance of an in-principle approval to 11 applicants to start payments banks is a major landmark in the history of banking in India. For the first time we will have a new form of bank with unique features. The payments banks would only be taking in demand deposits up to ₹1 lakh from a customer, which clearly indicates the intention of reaching out to the lower income groups.

Further, 75 per cent of the funds have to be deployed in government paper up to 1 year maturity and the balance in deposits with commercial banks.

The model per se is quite straight forward and clean as the bank pays maybe 4 per cent on every ₹100 collected and could earn a return of up to 6.5-7 per cent depending on the deployment.

A spread of 3 per cent looks very attractive for any promoter of these banks. There is no credit risk or problems with capital adequacy or NPAs and hence is a perfect inclusive banking model.

A curious mix

There are different kinds of entities which have obtained approval, which is interesting. A depository, postal department, telecom companies, IT based firms and others provide a right blend to the players in this market. This is the first time that we have such a model being implemented and hence the outcome cannot be conjectured. But there are several possibilities.

The first is that for this model to work well every bank has to have several branches or contact points so as to cover a larger geography and population. As the routes chosen are not known, a kiosk selling telecom cards could be an example or a fully internet or mobile based model could also be used.

But every applicant will have to have a scalable model that can start functioning across the country to create business. Given that the targets will be the lower income groups, to obtain a sizeable quantum of funds, the numbers to be included have to be high. Prima facie it looks like that most of these entities do have a large number of touch points of a different nature ranging from a mobile application to a brick and mortar branch.

Second, when it comes to the postal department, there have to be changes in laws to enable a post office to do banking. While this could be a formality that can be overcome by creating a fresh entity, the interesting part of the story begins when the payments banking operations are commenced.

Post Offices are the agency which already collects small savings which also includes savings accounts. As of November 2014, outstanding savings bank accounts with post offices were Rs. 45,000 crore which conventionally would have been transferred to the state governments. There was no earning for the post office as it was a pass through vehicle being a government department.

But now with the postal bank having the potential to earn an income, how will the old savings accounts and the new ones be differentiated? This has to be worked out with the government. If they get the existing deposits, then they need to have a treasury to invest the same, and such skills have to be acquired as it do not reside with them.

Overlap and more

Third, there is a case of cannibalisation of either payments banks by commercial banks and post offices or the other way round. The successful Jan Dhan Scheme implemented by commercial banks has garnered as many as 175 million accounts with an average balance of just ₹1,200, with 45 per cent being zero balance.

These accounts are being used largely for various cash transfers and hence a large part of these balances. In this case how do the new banks convince people to open such accounts and maintain a positive balance?

Commercial banks have been able to absorb this cost as they are already large.

A large workforce will be required to talk to potential account holders, and this is where the models used by these new PBs will matter. Will those people selling telecom recharge cards for telecom companies double up as bank agents, and more importantly will the regulation permit the same?

Fourth, the use of technology is vital. These applicants will presumably have different approaches. The postal bank holds the biggest advantage of already having around 1.5 lakh offices. An NBFC will similarly have such branches. But they would need to connect all the offices and set up a treasury to deploy these funds. Others will have to start afresh.

Fifth, there are regulatory issues which presumably have already been addressed by the RBI. For instance can telecom selling agents become staff for collecting deposits? We cannot have unqualified staff dealing with customers as there should be protection against mis-selling.

Therefore, the RBI would have to set up a new cell to monitor these banks — which will be a logistical issue given the geographical spread.

The concept of new payments bank is compelling as it opens another route for inclusive banking. While time will tell how successful this model will be in incremental terms, the RBI on its part has given permission to probably the best players who are capable of making this a reality.

Operation Indradhanush for PSBs: Financial Express August 21, 2015

The Indradhanush (rainbow) design for rejuvenating public sector banks (PSBs) is quite wholesome, addressing the issues that confront them. Does it offer something new or is the new design a revised version of the old? This is the question posed by critics as the problems have been known for long, as have been the solutions. The test really is in tracking how these ideas progress over time.
Indians, as a rule, love to play with words, and just like we had the ‘100 small steps’, we have the first 7 letters of the English alphabet being used as the brush to sketch a rainbow which poses and addresses simultaneously the problems confronting the banking system.
Indradhanush starts with ‘appointments’, which have been pending—many PSBs have been functioning without heads for months now, with three positions being confirmed only on August 14. The post of PSB chairman has been separated from MD&CEO—it would be interesting to see if this alters the way banks work. The former is a non-executive position at head of the board while the latter is that of the executive head.
The novelty is in keeping the posts open for private sector executives, though there is little evidence that a public sector banker is less capable than her private counterpart. There have been cases of failure on both sides in the past. Two of the recently-appointed heads are from the private sector. Such change, however, could affect the staff’s morale as they might see a glass-ceiling at the top.
On the other hand, getting a private sector person to head a public sector unit is a challenge as PSBs have well-defined ‘standard operating practices’ under which arbitrary decisions cannot be taken by the CEO as there is limited flexibility. Hence, while the new head can add a breath of fresh air, dealing with boards, senior executives, unions, non-officer staff, compensation, etc. would mean an entirely different environment to work in.
The Bank Board Bureau is a new name for the ‘appointments board’ and will have a different structure. But with the government dominating the process of appointing members, this may not be very different from the existing set up.
One may not, however, not grudge the government this power because it is just like how owner-driven companies appoint their own boards and management. The issue of capitalisation of banks has been handled well and can be construed to be an ongoing process as previous budgets have been allocating funds for such capitalisation. A change from the stance taken last year is that all banks will be provided capital and that the six big ones would get priority as they would be funding large projects. An interesting aspect of this programme is that there will be substantial disinvestment, up to 52%, in the next few years to garner around R80,000 crore— the aggregate recapitalisation requirement is of
Rs 1.8 lakh crore, of which only Rs 70,000 crore will come from the government.
On the issue of distressed assets, various measures have been taken, with the ministries concerned trying to address the issue of stalled projects, especially where coal, power, land, permits, etc, have held up investment. RBI has taken steps to address NPAs, and hence this aspect of Indradhanush is a reiteration of the same. RBI has already spoken of moving large loans to the debt market to de-stress banks, and this should be pursued to strengthen the financial system.
The concept of empowerment is somewhat new, assuring banks that the government will not interfere in the commercial decisions taken by them. One may hope that, from now on, banks will have freedom in fixing interest rates as well, based on their own commercial judgement. The second part is in recruitment where they will be allowed to take in lateral recruits. This may not really be new as they have been doing so on ‘contract’ basis. This can be viewed as an extension of what RBI has done under the new Governor where there has been recruitment at lateral level on a permanent basis. However, it would be interesting to see how pay is structured, given the foreseeable resistance from the unions and the need to maintain equilibrium with existing staff. The present category of consultants has been received well by the unions, which is heartening. But it could become a challenge if existing senior officers take umbrage on grounds of fairness. Therefore, this has to be done gradually, taking the existing structure along.
The framework for performance is not really new, but it does reveal the parameters to be considered. The problem is that banks may work exclusively towards achieving these goals as this will be linked to ESOPs for the top management. Ideally, this should not be the approach because then the targets become the sole end and banks will use all possible means to achieve these. Besides, such incentives must also be provided down the line, to all employees who contribute to this effort.
In terms of the parameters used, we should look at incremental ratios as large banks will have both an advantage and disadvantage. The advantage is that large banks can expand the denominator to get a better ratio for NPAs while the disadvantage is that the profitability ratios will be harder to improve given their size. It is hoped that the evaluation looks at incremental business rather than aggregate.
The last part of Indradhanush, concerning governance, will depend on how banks are allowed to function and the persons who influence decision-making. This would follow from the segments discussed earlier in this column.
The rainbow metaphor puts together succinctly the issues confronting banks, just like we had the CAMELS approach earlier. But the colours are not new and have been ‘works in progress’ for the last five years and probably will remain so for some more time before they cast their imprints on the system. The appointments, empowerment, bank board bureau, governance and performance fallout have to be monitored closely to gauge the difference made to bank functioning. It may be hoped that the same recipe will taste better as concerted action is taken to make a difference in the way in which PSBs function.

The uncertain gains from GST: Financial Express 17th August 2015

The next big reform on the agenda is GST. The single tax has been projected as changing the way in which business is done. And along with the measures taken by the government in easing the business climate, it should make things much easier for India Inc. There are various studies to show how GST will bring in several benefits. The contentious issue today, holding back its acceptance, is the potential loss for some producing states, which need to be compensated when a single rate is applied. It is hoped that, over time, the sharing formula will be arrived at and accepted by all the constituents.
There are, however, some issues relating to GST that merit discussion. The first is that when we have a single tax rate on goods and services which are fixed at, say, 18% or 22% or 27%, someone has to pay for it and it is not possible for all to be gainers from such a tax. The government is talking of a revenue-neutral tax, which is hard to arrive at, given the complexity of the system. If it can be done, then it would be a Pareto optimal solution where no one will be worse off and someone better off.
Second, the inflationary impact cannot be escaped. Today, there are a series of taxes, with a lot many being under VAT, which means that the nominal rate would be applied on the value-added component at each stage. The system is complex and it is hard to add the nominal rates of central excise, central sales, state excise, sales, octroi, customs, countervailing duty, etc, to arrive at the GST rate. Assuming that tax authorities do find such a rate, on an average basis, there will be several goods and services that will be taxed a higher rate, which, in turn, will put pressure on prices. Services, for example, are taxed at 14% by the Centre and any rate that is higher will jack up the prices. For consumer goods, the final impact is uncertain as tax rates vary across states and there will be loser and gainer households. Also, with producing states being allowed to levy 1% special tax, intuitively there will be a price impact that has to ultimately be paid by the consumer.
There could be mitigating factors in terms of cost-savings by companies, which do not have to go to different windows to pay different taxes. The issue is whether they will lower their final prices if there is a net gain at a time when their profitability has been under pressure? Anecdotal experience shows that when taxes are lowered, the same is not fully transmitted to the MRP. Hence, if some goods are effectively taxed at a lower rate or there are savings due to efficiency, it is uncertain if final prices will come down. Therefore, the final impact on inflation will be a matter of conjecture, considering that services are not touched by the WPI and partly by the CPI. Currently, with global commodity prices down and manufactured goods inflation close to zero, the potential inflation impact looks minimal, but a growing economy always carries along a higher core inflation number which needs to be monitored more closely when GST sets in.
Third, the impact on GDP is uncertain. There are studies which show that India’s GDP will grow by 1.5-2%, based on different models. Logically, if we look at the output method of calculating GDP, then the question to be posed, whether or not we are producing fewer goods because of high indirect taxes? Have these taxes come in the way of production? The answer would generally be in the negative, which means that production decisions per se may not be influenced by taxes to be a limiting factor. The current system is inefficient for certain and pushes up cost of production and distribution, and hence there would be some front-loading on consumers. But as we have never had a situation where supply has not been able to keep pace with demand—as producers were not producing goods because of high taxes—it stands to reason that production per se will not really increase significantly with this tax, though efficiency would be enhanced. In fact, if we are talking of a revenue-neutral rate, then most certainly the tax incidence should not change and the question would then be if anyone held back production because of too many processes? Therefore, the direct impact on GDP could be limited.
GST would definitely be an efficiency-enhancer as companies will gain by spending less time and money in paying taxes. Their cost will come down for certain, as often trucks spend several hours at the check-posts waiting for clearances and paying taxes. A single point and rate of tax is ideal for anyone in business. Companies will definitely benefit from GST, which should get reflected in their profit lines.
That said, on balance the tax may not really lead to substantial increase in production except at the margin where a producer could not produce because of tax and process encumbrances. But compliance will definitely improve as several producers who hitherto were not paying taxes due to the painful processes would come forward. To this extent, there would be a one-time increase in GDP as their output gets recorded, provided there were no imputations being made for the same by the CSO presently.
Further, while there is impatience in having GST being in operation from April 2016 onwards, a challenge could be in the IT space as to how we manage to integrate the systems to ensure that the tax can be levied. Currently, every state and UT has its own means of collecting the tax and the systems have to be merged, which is a logistical issue. Also, the redundancy of staff would be an issue to be tackled, as there are such departments in every state, given that commodity taxes are the main source of revenue for all state governments.
When analysing the impact of GST, we need to separate efficiency issues from the economic ones, as the latter are more complex with the impact being nebulous. There is no doubt that we need to have a GST and get out of the labyrinth of taxes that exist today at different levels. However, the impact on GDP and inflation is still uncertain. While prima facie it is hoped that prices will come down and GDP may go up, such a win-win situation may not be easily forthcoming.

Managing for Success book review: Sinful times: Financial Express 9th August 2015

Managing for Success: Spotting Danger Signals and Fixing Problems Before They Happen
Morgen Witzel
Bloomsbury
Pp 246
Rs 379
When we talk of the seven deadly sins, the reference is to the Catholic theologian’s version. But the same can be used to explain why companies fail, and this is where Morgen Witzel makes a difference in his book, Managing for Success. His approach to telling us how companies could be successful is by avoiding these pitfalls. He uses examples of several companies such as Ford, Swissair, GM, Lehman Brothers, Time Warner, etc, which show some characteristics akin to the seven sins. When all or most of them combine, the organisation goes down.
While we generally tend to blame individuals for companies going down, Witzel argues that it is the general level of incompetence that builds in companies that pushes them to low levels. While leaders influence the culture of an organisation, it also works the other way round, where toxic cultures constrain and subvert leaders, thus restricting their actions. We in India can identify with the public sector, where the culture influences the leader, who, in turn, may find it impossible to change things around.
The author links the seven deadly sins with incompetent organisations in a very cogent and entertaining manner.
The first is arrogance, when companies think they can do everything they want to. More interestingly, arrogance of good intentions is critical where we believe that the means justify the end. He calls this the ‘Titanic syndrome’, when this feeling of indestructibility builds up, leading to the sinking of the ship.
The second sin is of ignorance. Often people are promoted to positions for which they have no competence or knowledge. Leaders describe all failures as ‘black swans’ to cover up their incompetence. An example was well-known company Zara. It came up with a T-shirt for kids with a design resembling uniforms worn during the holocaust, which was withdrawn. They withdrew the design, but did not know what the hullabaloo was all about.
Clearly, it was the wrong persons at the top of the company.
The third is fear of uncertainty, the unknown and personal timidity. Here managers look to analyse all the unknown possibilities and get bogged down to the extent that they do not move because of this fear leading to planning paralysis. The fourth is greed for growth, profit, market share and victory. Continuous pursuit of increasing shareholder value makes one become too greedy and these companies end up milking customers, squeezing suppliers and paying low wages to employees.
Fifth is lust, and while physical desire did bring down several leaders, it manifests in other ways. The lust for power resides in most CEOs. The lust to expand in all fields leads to uncalled for diversification in a big way. The sixth sin is of linear thinking where he brings in the Descartes curse, where the philosopher argued that human behaviour can be explained by step-by-step causation. The last is what he calls a zombie company where nobody cares about the company and there is a clear lack of purpose.
His responses to the deadly corporate sins are straight forward. Retain humility all the time. Others matter more than you. Create a knowledge culture which is shared. Have courage and taking some risk is part of the business and inevitable, and so on.
This is an enjoyable book where readers can empathise with several situations. But, more importantly, one should recognise if one suffers from these ‘sins’. This is the ultimate crux.

Defining an ideal interest rate regime: Financial Express August 6th 2015

What should be the ideal policy interest rate, or in our case repo rate? We keep saying it should be lower when we speak from the investor’s perspective, and argue for higher rates when we represent the savings community. A useful barometer is CPI inflation number as we have decided to adjust the repo rate according to this. It is helpful as we know what should be the anchor, which was uncertain earlier as economists tended to play safe with the cliched tradeoff between growth and inflation.
With the direction being clear, what should be the ideal policy rate which is linked with inflation? The real rate of interest can be calculated as being the difference between the policy rate and repo rate. Hence, can this ideal be defined? RBI is speaking of a rate between 1.5% and 2%. While policy-makers target inflation, the real interest rate is not overtly the objective of RBI. To get a fix of this number, we can look at what the global trend is in the difference between the policy rate and inflation. As expected, there is no clear picture and there are countries with high and low real rates, as table 1 shows.
The table highlights real interest rates for countries with highest and lowest levels as of a specific date—inflation numbers would change for all the countries and hence this is only illustrative. The real rate for India, at 1.85%, looks like being at the median for countries with higher levels. The right panel gives the countries with lowest real rates after excluding countries with negative inflation. It is hard to put one’s finger on the ideal rate.
Another way is to carry out a regression on data for a cross-section of 42 countries to investigate the relationship between repo rate and inflation rates. Extreme values of inflation have been excluded as they distort the results. This is a useful way to conjecture as to what should be the ideal repo rate for a given inflation rate based on a global statistical relationship. The results are very powerful as the equation explains 78% of the repo rate across the countries (called coefficient of determination). The coefficient for inflation rate is 1.162 with an intercept of 0.41. Broadly speaking, it says that an inflation rate would have a multiple effect on repo rate by 1.162 times, to which we add the intercept term. Using these results, the ideal repo rate comes to 6.69%, which can be rounded off to 6.75% as central banks normally change rates in multiples of 25 bps.
This result suggests that if inflation remains at 5.4%, which is the case now, the policy rate should be 6.75% based on the defined norm. The implication is that there is scope for reduction of 50 bps in repo rate to bring it to global levels, provided inflation remains at this level. But if we extrapolate RBI governor’s assumed target of inflation of 6% for January into this model, then it will suggest a repo rate of 7.4%, which can be rounded off to 7.5%. The limitation of this exercise is that the regression has been performed on single data point on a particular date. If the same can be done for a period of a quarter or year for both inflation and policy rate, a clearer picture would emerge for fine-tuning the exercise.
Another issue is the spread between the policy rate and the 10-years G-Sec. The latter is globally accepted as being the benchmark for all market rates and hence is indicative of the level of all interest rates in the market. The premium for a set of countries at the higher and lower ends has been presented in table 2. Countries which carry negative premium or discount to policy rates have been excluded.
The differential between repo rate and the G-Sec rate appears to be on the lower side for India, which is not surprising because, based on time value of money, the 10-year yield should be significantly higher than the repo rate. Further, a regression analysis has been carried out in an analogous manner based on cross-sectional data for 42 countries. The coefficient of determination is lower at 68%, but the coefficient of G-Sec rate at 0.89 is significant with an intercept of 1.60. Substituting the repo rate of 7.25%, the idealised 10-year G-Sec rate should be 8.03%, around 20 bps higher than current market rate. The current yield of 7.8% would be consistent with a repo rate of 7%, while it would be 7.6% for a policy rate of 6.75%.

The conclusion is, first, the repo rate is a bit on the higher side for inflation at the current levels. However, as monetary policy should be forward-looking, the expected inflation of 6% can warrant an increase in interest rates. RBI has probably pitched between the two as while inflation is stable today, there are chances of increasing in future. Hence the stance of status quo appears to be in order.
Second, the G-Sec yields are probably still on the lower side given the repo rate. But if the market is efficient and is moving on the basis of expected repo rate changes, then maybe it is at the right level. However, as stated in the beginning, this exercise is based on single data points and an average across a time period would probably make the picture sharper.
This, in fact, can be a template worth experimenting with to arrive at ideal policy rates.

How to Go Big, Create Wealth and Impact the World book review: To the power of three: Financial Express August 2nd 2015

Bold: How to Go Big, Create Wealth and Impact the World
Peter H Diamandis & Steven Kotler
Simon & Schuster
Pp 317
R599
IF WE create a triple sundae with the layers being exponential technologies, some unique and innovative thinking and crowd-powered tools, we can convert the world’s biggest problems into impactful opportunities. This is what the book Bold is all about. Authors Peter H Diamandis and Steven Kotler take us through these three components for creating wealth and impacting the world.
Bold is a guidebook telling entrepreneurs how to harness technology to start their enterprise. In the good olden days, it was widely believed that only large, well-known companies could make a difference in the business space, as they had the size and financial strength to do so. But this is passé now. With the use of technology, one can cross this perceived barrier faster than ever before. This is so because technology, as per the authors, is exponential in impact.
Hence, if one has a new idea and wants to pursue it, technology can be used meaningfully to make the super leap and create a successful enterprise.
But for this to happen, we need to also have the right kind of mindset. We need to have, what the authors call, a ‘mental toolkit’ to be innovators and chase our dream to make it big. Here, the stories of successful entrepreneurs like Richard Branson, Larry Page, Elon Musk and Jeff Bezos are provided as examples of people who thought differently and created not just flourishing enterprises, but also wealth in terms of knowledge and money for the world.
The third component is the widespread use of crowdsourcing for creating these enterprises. Today, in the age of the Internet, the entire world is inter-connected. So crowdsourcing can be used for pooling ideas and funds to make any venture happen. This also hastens the speed of creating an enterprise. Raising capital, in particular, has always been a challenge for anyone contemplating starting an enterprise and crowdfunding fills this lacunae well enough.
The entire discourse in the book is about combining these three facets—which have to work in cohesion to make an enterprise succeed—of building wealth. The favourite story of all such strategy writers is of Kodak’s. The company dominated the world of photography, but failed, as technology changed exponentially and it was not willing to recognise that and adapt. The power of technology is explained by the authors through the concept of ‘exponential’, which involves 6Ds. The first is digitisation, where everything can be digitised and, more importantly, spread at the speed of light. The second is deception, where we do not really realise this exponential speed, and by the time we do, it could be very late. The third is disruption, where a new technology replaces an existing one—the film roll, for example, is no longer required today in a digitised world. The fourth is demonetisation, where creative business models have to be undertaken to make money. A common example here is that of Google, which everyone can use without paying. The fifth is dematerialisation, where a product disappears—much like the camera today, as all smartphones today come equipped with one. The last is democratisation, where universal access to a product is provided, as costs are lowered to the minimum.
Given these kind of changes taking place in the technology space, we now need a different mental framework and approach. Here, the authors base their hypothesis on several examples of companies and people who have excelled by being bold in venturing into new areas. Some takeaways that are provided by the authors are in the form of some basic principles: if anything can go wrong, fix it. When given a choice, take both. If you cannot win, change the rules.
When in doubt, think. The best way to predict the future is to create it yourself. These can be the source of inspiration for anyone who is entering such a field.
Some of the tenets followed by Amazon, for instance, are quite interesting. The authors pull out a communication sent by the company to its shareholders that encapsulates what the authors refer to as a ‘broad mindset’. It goes like this: “We will continue to make investment in light of long term market leadership consideration rather than short term profitability. Second, we will make bold rather than timid investments when we see sufficient probability of gaining market leadership. Third, we will share our strategic thoughts with shareholders when we make bold decisions so that you can evaluate whether or not you are making the right strategic decisions. Last, we will balance our focus on growth, with emphasis on long-term profitability and capital management.”
Finally, the authors elucidate the approach to crowdsourcing. This is more of a manual on steps to be undertaken so that the entire strategic plan is well-knit.
The concept of being ‘bold’ hence is achieving a combination of physical tools (the technology aspect), the mental framework (summarised by the psychological strategies pursued) and exponential crowd tools (which provide additional resources such as talent, money, etc, which help cross the final frontier).
On the whole, Bold is an interesting book on innovation and strategy. It focuses on the mindset of a company and underlines the advantages of technology and crowdsourcing to build enterprises. It will be inspirational for new entrepreneurs in particular who are looking to do something different.
This is also a warning for companies—they need to be watchful of the changes taking place and not assume that status quo will prevail. And this holds for not just the manufacturing sector, but services as well—in fact, in India, the inroads made by e-commerce serve as a glaring example. By simplifying and reducing the philosophy to three principles, this book is refreshingly different from several other treatises on creating and running successful businesses.

Relying too much on interest rate cuts: Buisness LIne 31st July 2015

Monetary policy is no magic wand that will deliver growth. Our demand-constrained economy needs a fiscal stimulus

Today, world over economic policy is geared towards resuscitating economies through monetary policy. All central banks have been entrusted with the task of lowering interest rates and adopting unconventional policies like quantitative easing to revive growth.

Yet the progress has been uncertain and most of them are still struggling to come to grips with the meltdown that took place after the Lehman crisis.

In India discussions invariably come back to the RBI. There is a demand to keep lowering interest rates. Just how important is monetary policy? More importantly, can it be a singular tool for bringing about growth under ceteris paribus conditions?

If we go back a few years and trace the actions of the Fed and ECB, the picture we get is a case of the famous ‘liquidity trap’ which the economist John Maynard Keynes had spoken of. He had argued that this is a situation where the demand for money becomes flat; in other words, when interest rates are lowered to close to zero demand remains flat.

Easing all the way

Central banks have reacted with a higher flow of liquidity in the form of quantitative easing programmes. Since banks were less willing to lend to one another as they were not sure of their credit worthiness, the only way to break the impasse was for the central bank to buy back paper (government paper or asset backed paper) to provide liquidity.

The QE programme of the Fed has injected almost $ 3.5 trillion over a period of 5 plus years while the ECB will be injecting almost € 1.1 trillion by September 2016.

However, this has not quite restored equilibrium. US is just about trying to get back on its feet while the euro area is still in a state of flux with the Greece crisis casting a shadow on the future of a single currency.

In fact, a large part of these funds have moved over to the debt and stock markets emerging economies through ‘carry trade’. The unintended consequence was volatility in the exchange rates as a response to any purported move by the Federal Reserve.

Even today we keep tracking the Fed intention to alter interest rates as it affects flow of funds which actually were never meant for the emerging markets!

Let us look our own situation. The economy is displaying some signs of growth. However, investment is still lacklustre with the gross fixed capital formation rate declining in the last 3 years.

The RBI has been constantly told to lower rates and when it was done in 2012-13, it did not work. In 2015, rates have been lowered by 75 bps so far, and we are still waiting to see the impact.

The demand question

The first thought here is that while theoretically lower rates affect investment, it is not a sufficient condition. We need to have demand for physical goods.

RBI data shows that the average capacity utilisation rate is in the region of 70-72 per cent. Consumer goods growth has been negative in the last two years and barely positive in the preceding two years. Investment is unlikely to be considered by companies under such circumstances.

Further, potential investors will wait for rates to come down before going in for infra projects as no one wants to get stuck with a higher rate (even though the 5 by 25 scheme will offer a change once the first term comes to an end).

Second, when the RBI lowers the interest rate, banks do not respond with alacrity. Assuming that 1 per cent of net demand and time liabilities flows through repos (overnight and term), even if ₹80,000 crore is borrowed on an annual basis, a change in interest rates by 100 bps affects the cost by ₹800 crore in an interest expense of above ₹600,000 crore which is less than 0.1 per cent of the total.

Therefore the RBI change of rate is more of guidance which banks follow and may not be linked to cost of funds as such, with interest on deposits constituting around 90 per cent of the overall cost.

Further, banks need to look at their asset-liability match before taking a call on rates, which makes transmission tardy and could take six months.

Third, with a bi-monthly review, there is always an expectation of what the RBI will do, which gets factored in the market. Hence when the policy action actually takes place, the impact may be more muted.

It does matter

Curiously, whenever the RBI lowers the SLR, it still does not matter much except at the margin where banks which are on the periphery gain some liquidity. The system otherwise holds on to excess SLR paper to the extent of 5-6 per cent of NDTL. So, does monetary policy matter?

The answer is that it does, but cannot on its own work its way through, as the tools that are available cannot spur demand, or rather, generate demand. Nobody borrows money unless there is growing demand.

For this to happen we require a Keynesian solution of spending which can be done only by the government, as it is the only entity that can borrow at a low cost. One may remember that post Lehman crisis the government had gone in for a fiscal stimulus which worked well with a monetary stimulus. This can be a faster way to growth — though this route has provoked the charge of causing inflation.

In economics we do tend to view things with a narrow periscope given our ideological leanings towards Keynesianism or Monetarism or Rational Expectations. Often a combo approach is probably more suitable where monetary policy keeps an eye on inflation while a Keynesian push creates demand in case we have to expedite the pace of recovery. With fiscal discipline being adhered to in a rigid manner, relying only on interest rate to spur growth would take a longer time to work its way through.

This has also been witnessed in the West where there are concerns over fiscal ratios in US, UK, Japan, and some of the euro countries.

We may have to think differently from relying solely on the repo rate or a signalling ratio rate (SLR or CLR) to change things around.

The proposed Indian Financial Code: Venturing into an unknown territory: Financial Express 30th July 2015

The proposed Indian Financial Code (IFC) cannot be criticised for being wrong as there are various templates for managing financial systems across the world and this is one of them. Central banks across countries have different roles and there is no stylised list available for use. The way our system evolved, the central bank became all-encompassing, which made it convenient to coordinate financial decisions as it developed expertise in all areas for this purpose. That said, it is also a truism that implementing this code would mean fewer powers for RBI, which will be more involved with managing the banking system and less empowered to frame independent policies as there are other overseeing agencies in charge.
The six financial agencies spoken of by the IFC—Financial Authority, RBI, PDMA, FSDC, Financial Redress Agency and Resolution Corporation—would all be taking on the responsibility of managing domains that were hitherto under RBI. An interesting future development would be whether or not these six agencies would be monitored by the ministry of finance or would be independent given that they would be run by persons appointed by the ministry. Now, whether it is better or not than the existing system can only be evaluated with time. Interestingly, the IFC talks of a chairperson of RBI, and it is unclear whether it refers to a new person being designated or the RBI governor being called the chairperson in the new trimmed down structure.
The existence of the Financial Authority which oversees all non-banks and payments systems could mean that other segments of the market such as securities, commodities, NBFCs, MFIs, insurance, etc, could be classified as coming under this purview. There needs to be clarity on these structures as there other regulators in the picture.
The Redress and Resolution agencies are definitely needed to protect consumers and there can be some merit in having an independent entity which controls this function. Often it is felt that the consumer gets an unfair treatment when dealing with banks—like the number of ATM withdrawals or cheque books being charged—and hence an independent agency to address these grievances could be a better option. Again, while talking of protecting consumer interest, clarity is needed on whether these agencies cover issues in banking only or also securities, insurance and pensions. As a corollary, the role of Appellate Tribunals and Ombudsman has to be reviewed.
The more contentious issues pertain to the way RBI will conduct monetary policy, and the creation of the PDMA and FSDC which again replace RBI in specific functions. This is so because there is a strong link between the three. The monetary policy committee is to have three persons from RBI and four appointed by the government, which makes it in general a non-RBI majority. Now one is not sure as to whether the four government appointments would be officials or nominated outside experts. The former will automatically mean that the government will have the last word with interest rates. The latter could be seen as independent but would run into the same problem of directors who are appointed on company boards who do not actually function as independent directors. The RBI chairperson will not have a veto or overriding, say, in the decision and can have a decisive vote only in case of a tie.
The IFC further says that RBI will be finally answerable to the government if inflation is not controlled. This will make it challenging for RBI. First, the institution does not have a final say in the conduct of policy. Second, it has only one lever to deal with, i.e. interest rate. Third, it is targeting an inflation rate as measured by the CPI, over which it has no control as most components of the CPI are outside the purview of interest rates. Therefore, RBI will have a tough time managing these forces.
Now if we look at the PDMA, the mandate is clearly to keep cost down for the government and also make the market more liquid. These are the functions of RBI today. The PDMA would typically like to push interest rates down; and the operations of RBI in the secondary market through OMOs could be hampered by the pressures put by the PDMA. RBI could become a secondary player in the market.
Finally, the FSDC is to evaluate the risk in the system and manage the same. By implication, the Financial Stability Report that is brought out by RBI will now be authored by the FSDC. This aspect of the functioning of RBI was closely related to regulating banks and ensuring the soundness of the system. The IFC now transfers this responsibility to another agency.
Putting all these pieces together, RBI will be left with a smaller share of responsibility in terms of managing the monetary and banking systems. At the same time, it has to take the onus for explaining why things are going wrong without having the equipment to rectify them in the system. The problem really is that each of these agencies could have a different view, which though justified, has to be put together with one face. Currently, being the central bank with extensive powers, RBI is able to put them together and resolve the issues. With different agencies, we will still require a coordinator, especially so as there can be opposite views given the self-interest of each regulator.
A curious observation is that we already have a plethora of regulators in the financial space, such as RBI, SEBI, FMC (now under SEBI), IRDA, PFRDA, NABARD, SEBI (MUDRA?). We needed far more coordination between these regulators as all had to see the picture from a broader view. Now with six financial agencies, with criss-crossing functions, getting to meet and talk on a common plane for a coordinated solution will be a challenge.
Is this a right thing? A hard question to answer, as RBI has shown consistently over the last two decades that it has managed the system in an exemplary manner and taken the level of supervision and regulation to the highest levels. In fact, not once has the monetary authority been faulted for an incorrect action. RBI has tackled problems with dexterity and kept our system sound even when there were global crises. If the same is displayed equally by all the new agencies, things will work well.
Now, RBI will face the toughest challenge of being a goalkeeper defending both ends.

Nifty movements don’t indicate India Inc’s health: Economic Times 29th July 2015

The Chinese meltdown has taken along all the stock markets, indicating the power of globalisation. But a more pertinent issue is what do stock indices indicate in general? Do they tell you how the economy is performing or how it expects the corporate sector to perform in future? Or is it plain whimsical but very important as it involves a lot of money considering we have 14 hours of electronic media attention glued to these indices and all economic action is interpreted in the context of stock markets?
To know more let us look at the Nifty, which is taken to be the benchmark that reflects everything about Corporate India. It is widely believed that everything follows the Nifty and the correlation with all other stocks is very high.
The table looks at how Nifty has moved along with two financial parameters over the past five years. The Nifty growth rate has slowed down in the first two years, declined in FY12 and risen quite sharply in the years described as times when there was a policy paralysis, with a new high being witnessed in FY15.
The growth curve was U-shaped — declining and then rising. Now if this were juxtaposed with how these 50 companies were performing, two indicators can be used. In terms of corporate performance, it is the net profit margin (NPM) which is important and here the trend has been completely downwards with a total loss of 240 bps over five years. Quite clearly, this did not affect the Nifty, where the market initially followed this trend but then later disregarded the same.
In terms of EPS, a confused picture emerges. Ups and downs do not necessarily correspond with market movements. At times experts interpret the market in terms of ‘expected earnings’ moving up or down. Hence if markets expect earnings to rise, then it gets embedded in the price today. Using this data as an expost explanation, we cannot derive this conclusion unless the market has been miscalculating these projected earnings repeatedly.
For non-Nifty companies, the picture is even more glaring. EPS has been falling sharply to 2.69 in 2014-15 from 7.12 in 2009-10, which means the performance from the market’s view is dismal. Correspondingly, the NPM declined by 430 bps as these companies were under pressure on the price and cost fronts.
What does all this add up to? First, the Nifty is representative of the best companies in the country, which in a way shows resilience in the most challenging times. Second, Nifty movements are not really linked with the performance of these companies. The fact that when earnings are lower does not stop the index from increasing indicates the presence of irrational spirits or higher interest by investors that may not be linked to fundamentals.
More importantly, we ascribe a lot of importance to the stock market as being reflective of the corporate sector. Benchmark indices are specific to a set of the best stocks and do not reflect the trends in Corporate India. The rest of the companies have been on the downhill, as also reflected in the rising NPAs and restructured assets.
The takeaway is that the Nifty movements and companies cannot be interpreted as a reflection of the state of the overall corporate sector. The Nifty accounts for around 60 per cent of overall market capitalisation and if we add another 50 companies nearly 75 per cent would be covered.
While all stocks would tend to move in a similar direction based on an external shock, their movements may not be in consonance with fundamentals of the companies. So, to go back to the question posed in the beginning, the market is all about whims involving big money and it is hard to trace a method in the madness.

‘Inequality: What Can Be Done’ book review- The balancing act: Financial Express July 26th 2015

Inequality: What Can Be Done?
Anthony B Atkinson
Harvard University Press
Pp 384
Rs 1,250
THE SUBJECT of inequality has come back on the discussion table after Thomas Piketty raised this issue in his seminal work on capitalism (Capital in the Twenty-First Century), which, though questioned it in terms of interpretation, has nevertheless made us rethink the subject. Closer home, before the government headed by Narendra Modi came to power, there was an acerbic debate on whether reforms in the country have delivered for the poor.
To fight inequality, Amartya Sen favoured direct intervention, while his counterparts Jagdish Bhagwati and Arvind Panagariya preferred the growth-oriented, trickle-down path. Against this background, Anthony B Atkinson, in his book, Inequality: What Can Be Done?, carries forward this discussion with 15 solutions.
Most solutions given are not really new, but when put together, offer a comprehensive package for countries like India, where inequality pervades to a large extent. In fact, we have implemented quite a few of these schemes, which, ironically, have often been attacked quite viciously by mainline economists and analysts so much so that the government has not scaled up these operations. Or they have run against that cliff called fiscal deficit, which prevents the government from doling out the benefits. Atkinson has also put forward arguments backed by data to show that the objections raised against these programmes may not necessarily hold. Let us see how the story line goes.
He begins with the argument—like Piketty had shown—that after World War II, the level of inequality had come down. But since the Eighties, it has increased, especially in the western developed countries. Based on the proliferation of this phenomenon, Atkinson has forwarded 15 solutions to reduce inequality, with the onus on the government to take action. He rightly argues that technological change should increase the employability of workers, as technology is normally labour-replacing. For this, we need to create new skill sets, which can be in tune with technology. But the challenge is to reskill the labour force. This has become an issue with most professions, where existing staff is not upgraded and instead replaced with new staff with ‘elite’ skills, the best example being the IT sector.
Second, the author speaks of having a competition policy that brings about a balance of power across business segments. The Indian experience shows that it does not always work and there is concentration in most sectors, with entry barriers erected by larger players.
On employment, Atkinson talks of both providing jobs to the needy, as well as setting a minimum wage. The former looks a lot like our own MGNREGA programme, which has been criticised for doling out free money. The suggestion of a higher minimum wage rate is what the present Conservative government in Britain is looking at too, so that the burden on the government comes down. But this leads to other problems for factories that may not have the wherewithal to pay the wage, with the result that companies outsource or use informal labour to escape these clauses. Hence, while it is progressive in view, it could have several escape routes for employers.
Atkinson also talks of governments offering a savings bond with minimum real return with a maximum holding per holder. Here again, we can look at our own small government savings schemes that give this return to holders. But in all our discourses, there is criticism of these schemes, as bankers lament that the high rates come in the way of their lowering deposit rates. Therefore, at the practical level, acceptance of such schemes will be resisted. To this, Atkinson adds minimum inheritance or capital endowment for all adults.
Atkinson also talks of a progressive tax system with a top marginal rate of 65% that looks unlikely to be implemented, as most countries are trying to lower the highest marginal tax rate. The suggestion is also for a similar increase in tax on inheritance and gifts—something that’s been done away by most governments. In fact, Atkinson also talks of a special tax on wealth, like what we levied recently on the super-rich.
On the expenditure side, Atkinson argues for child benefits transfers in the form of cash that get taxed by the government. This could work in developed countries, but would be hard to implement in India, where the government has few resources. Social insurance is another add-on proposed by Atkinson, and the recent steps taken by our own government to provide insurance to all are exactly in this area. Finally, he talks of rich countries passing 1% of GDP to the poor. This can only be voluntary and a progressive step, but the challenge is really to ensure that it is spent on the right purpose, as recipient regimes could be self-serving.
To balance the discussion of his suggestions, Atkinson also raises three objections to his bouquet of solutions. The first is whether it will come in the way of efficiency if the rich pay more and the largesse increases from the government. He proves with data that this has not happened, as experience shows that when some of these measures were adopted, resulting in the Gini coefficient improving, it was not at the expense of growth.
The second issue pertains to whether this can be afforded by the government. Here, he shows how the higher expenses for the poor are actually self-financing, as once they become more viable economically, they will contribute to growth and government revenue. Third is the challenge of globalisation and whether it would come in the way of invoking such programmes, as countries cannot remain behind today vis-a-vis others. Here, he says this is more of a political decision than an economic one. This could be a signal to how countries like India react to rating agencies and are hesitant to follow pro-poor policies for fear of criticism.
Atkinson has done a very good job by making suggestions that are actually being professed, albeit hesitantly, by governments. By taking head-on the basic apprehensions of doing so, he shows that if we do not employ these solutions, we are probably making excuses and do not want to shake the present equilibrium due to vested interests.
For one who agrees with Piketty, this book will get a big nod, and for those who are not sure, it should probably remove some doubt. Further, if we look at the steps taken by our own government over the years, it appears that we are moving in the right direction, and this should be commended.

Align PDS and stocking with offtake: Financial Express 24th July 2015

The NSS study on PDS and consumption for 2011-12 is quite interesting in terms of interpretation. It assumes importance given the fact that the Food Security Bill created a stir over what was nothing more than a restatement of the PDS as well as the present discussion on the cash transfers in lieu of foodgrains. As the study covers above 100,000 households spread across all geographies in the country—in both the rural and urban segments—it is fairly representative of what happens in the consumption segment.
The first takeaway is that only 14% of the rural households and 33% of urban households do not have a PDS-related card. The states clocking in relatively higher levels of ‘no cards’ in rural areas were Jharkhand (42%), Odisha (30%), Assam, UP and MP (19% each).  Jharkhand and Odisha had the highest numbers in urban areas too with 75% and 66% followed by Bihar (48%) and Karnataka (46%).
When viewed at the aggregate level, this does come as a significant achievement from the point of view of the government where cards have been provided to most households in rural areas – (this includes Antyodaya, BPL and others). The proportion of ‘no card’ is higher for urban areas due to the transient nature of the population as well as some choosing not to apply for such cards, especially when they are out of the system and have other forms of identification. In fact, given the Indian penchant for reinventing the wheel one could argue that the Aadhaar is just a duplication of systems that are already in place.
Second, the survey also talks of what part of the consumption of the households come from the PDS. This has been done for both the rural and urban areas and the results are quite revealing.
The first thought can be that there could be high level of leakages. However, the PDS consumption is high for kerosene, a relatively rare commodity and one where there should be incentive to ‘cheat’ given the difference in value between market and PDS kerosene could reach Rs 40 a litre).  Therefore, the leakage theory will hold only in some cases. More likely, the households prefer to consume from the open market because of the quality factor.
Even though rice and wheat are available at low rates in the PDS with the issue prices remaining unchanged (range from Rs 2-7 depending on state and category of card holder), a fairly average quality is also not something that the people would desire. The survey also shows that even within the lowest 5% bracket of population in terms of consumption expenditure, the share of PDS for rice for instance is just 40%.

Hence, while the Food Security Act talks of providing 25 kgs of grain to a family, households may not prefer to take the full amount and to that extent all the calculations that have been made by economists to show how the coffers of the government would be affected . The message is that if we are serious about providing foodgrains to the population, we may have to offer better quality of food, as people are conscious of the same.
The kerosene number is heartening especially in the rural areas as it shows that the system works quite well. The lower number of urban consumers, of 58%, could be attributed to two reasons. The first is that in towns and cities, households have access to alternatives like LPG and piped gas, which are more economical and convenient to use. Second, there also tends to be diversion from the fair price shops to the petrol stations for adulterating petrol and diesel, which could be making less available at these outlets.
As far as sugar is concerned, the quantity provided is relatively low, varying from 0.5-1.5 kg/a family which is insufficient (different states have different criteria). Hence, recourse to the market would be higher.
Third, in terms of penetration of the PDS the survey also talks of the proportion of households which reported accessing the PDS system. Here, the numbers are high in both rural and urban areas.
The accompanying table indicates that there is a higher proportion of households accessing rice and wheat from the PDS, but ultimately relying less on the system for consumption. The access to kerosene in rural areas is again encouraging as three quarters of the population have access to the fair price shops for the same.
The interesting part of this story is that for rice, all the four south Indian states of AP, Karnataka, Kerala
and Tamil Nadu have higher reporting which could be attributed to the efforts taken by the respective state governments. For wheat Maharashtra, MP and Gujarat scored better with higher reporting of accessing PDS.
Last, the survey also looks at the rural population and examines the contribution of home stock consumption for various commodities. For cereals, the share of home stock consumption is 29.4% and for pulses it was 10.3%. These numbers indicate that a substantial set of households are actually cultivating these crops, and by virtue of such high consumption would also be selling less in the market, leading to lower marketable surplus. In case of milk, it is as high as 57%.
Intuitively, it can be seen that when the marketable surplus comes down for cereals like rice and wheat, the government should also rethink the PDS allocations given that households are consuming more from the open market. By having higher procurement and stocking the same, there would be less left for the private market resulting in pressure on prices.
Based on this data the conclusions that may be drawn are that , first, the PDS system is fairly comprehensive in terms of access and distribution of cards, and second, more households access the PDS for kerosene than grains.
Third, the market still dominates their consumption pattern with the PDS addressing less than third of the requirement. Fourth, we need to align the PDS and stocking system with the actual offtake as given low level of marketable surplus the government may be hoarding rice and wheat leading to pressures in the market.

The many shades of deprivation: Buisness Line 14th July 2015

The extent of the problem comes as a shocker, but granular knowledge also lends itself to better policy intervention

The Socio-Economic and Caste Census 2011 is an important compilation from the point of view of future policy action. For the first time there has been a detailed survey on rural India where households have been interviewed and classified under different categories. Such a classification can be used effectively for devising schemes for improving the life of the people.

However, there is a view that since the census is based on a survey, there could have been a tendency for understating the wellbeing of a household with the lurking fear that they could get excluded from certain benefits if a true revelation is made. But even so, the data can be used meaningfully for targeted programmes of the government.

Corporate lessons

The first important takeaway is that 73.4 per cent of households are rural-based; this is a large number. This fact also gels well with the view often held that rural consumption is one of the driving forces of the economy given the large size of the population. Hence, while focusing on smart cities is an idea that should be implemented in parallel, the thrust of the development process has to be rural-based as this is where most people reside.

It has often been argued that in the last three years, consumer spending especially on durable goods has come down mainly due to less post-harvest-cum-festival spending by rural households. This also provides a clue to corporate India that a large market does exist for their products in this region, but given the lower levels of income and high levels of deprivation, they would need to customise their production processes.

Second, going by the census, 10.69 crore households out of 17.91 crore households may be considered for deprivation. The criteria look at seven parameters such as single-room house, no adult member, no literate member, SC/ST, landless households and so on. Looking at households which fall in at least one of these buckets, 48.5 per cent of the households in rural India are under deprivation.

This number is quite shocking as normally we keep viewing poverty numbers and debate on the income or consumption criteria where different cutoffs are used. But by linking poverty with consumption/calorie criteria, we narrow the scope of deprivation. The deprivation methodology drawn up here looks like a more reasonable definition as it looks at multiple criteria which most of us take for granted once we reach a certain income level.

In fact, as the households have been identified, the Centre and States can take up these seven issues and address them through directed programmes. This would mean having housing schemes for those who have a single-room kuccha house, permanent employment for those who do not own land, education access for families with no literate member, special employment for women who run their households in the absence of an adult male , and so on. Therefore, social development programmes in rural India can be better targeted to lower the level of deprivation.

Beyond land-holders

Third, the classification of households on the basis of income is quite revealing. There are 9.16 crore landless labourer households which constitute 51.1 per cent of rural households. Land reforms keep talking of fair compensation to the owners of the land along with other issues relating to social audit and purpose of land use.

But if half the rural households are dependent on employment on other people’s land, any such transaction has to also address the concerns of this population which is large and cannot be ignored. Converting farm land into a highway is good for development, but the displacement of such casual labour which is not covered under the land compensation dispensation will have serious social implications. Fourth, around 30 per cent of the households are cultivators and involves around 5.4 crore families. This would be the section vulnerable to the monsoons and require special attention in terms of provision of farm inputs including irrigation and knowledge about crop prices, access to markets, etc.

Any attention given to enhancing productivity in agriculture would have to focus on these families. It has been seen anecdotally that the involvement of corporates in farming has helped to enhance their standard of living with end-to-end solutions being offered.

Finally, the fact that just 14 per cent of rural households are employed either with the government or the private sector is a reflection of the level of education. It also points to limited growth opportunity for future generations.

The SECC Census is a wake-up call for us to think harder on how to improve the standard of living of the poor in rural areas. In fact, to keep the capitalist machines moving it is essential that standards in rural India also improve.

Limiting expectations on govt investment: Financial Express 13th July 2015

A universal chant appears to be that the government will play a critical role in rejuvenating the economy this year.
With private sector investment not taking off at the desired pace, it is logically concluded that the government is best placed to kick-start the investment process by spending more. After all, the government is the only entity that can borrow at the lowest possible cost, which is today around 7.8-8%, depending on the tenure. The logic goes that, once the government spends, there is a virtuous backward linkage with the rest of the economy as demand is created for, say, cement, iron, steel, machinery and so on. This will lead to better capacity utilisation in the private sector, leading to higher investment to keep pace with demand.
The story line is obviously neat and cannot be contested. But there are two thoughts that need to be considered. The first is the government is constrained in a way by FRBM norms, and when we stick to a fiscal deficit ratio of 3.9% of GDP, there is generally speaking no compromise on this number. Thus, to have a Keynesian expansion of a larger order is ruled out and whatever can be done has to be within the confines of budgetary numbers. The second is a logical extension of the first—what kind of numbers are we talking of?
The size of the Indian economy is around R125 lakh crore at current market prices. What kind of push is really required from the point of view of the central government to influence this number? Here there are two aspects. The first is the absolute number of capital expenditure that is being incurred by the government and the second is the compulsions imposed by the government in enabling such expenditure. The accompanying table provides data on total expenditure, plan and non-plan capital expenditure in the last five years.
What stands out from the table is that the share of capital expenditure in total budget expenditure is just between 11-13% and works out to around 1.5% of overall GDP at current market prices. This amount is quite small to have a significant impact on the overall level of capital formation. Second, this amount has been increasing in numerical terms from R1.59 lakh crore in FY12 to R1.92 lakh crore in FY15. Third, the share of plan capex is now slightly higher than that of non-plan capex. The chief component of non-plan capex is defence which adds to capital formation by expense on equipment. However, a large part could be through imports, in which case it would not add to productive capacity within the country. Almost 90% of non-plan expenditure of the government is on defence, which hence has less impact on backward linkages. Fourth, plan capex has finally tended to be lower than budgeted, which means that it is compromised in case there are fiscal challenges towards the end of the year. The shortfall has been in the range of 11-17% in the last three years, when there were fiscal pressures too. Finally, in the last three years, the overall size of the budget was lower as per revised or actual estimates relative to what was budgeted. The lower level of expenditure of between 5-6% was mainly on account of revenue not increasing as the economy had not shown the buoyancy required to meet the targets.
Another feature which does not come out from the table is that, overall, the non-plan expenditure of the government has gone along with what was budgeted as most of the components like subsidies, interest payment and defence cannot really be lowered, being virtually committed expenditures. As a corollary, the government has actually cut down on plan expenditure and the extent has been almost identical to the difference between the budgeted and actual/revised size of the budget. In FY14 and FY15, the drop in plan expenditure accounted for 95% of the overall reduction in expenditure, while in FY13 it was 135% with non-plan expenditure overshooting.
The takeaways are, one, that any reduction in expenditure which has to be invoked by the government has to be from plan expenditure—the discretionary part of the budget. With 75% being non-plan expenditure, the focus of adjustment falls directly on plan expenditure. Here the choice is between capital and revenue, and while several economic and social schemes tend to be cut back, the capex has the advantage of being lumpy and easier to administer. In FY15, for instance, the cutback in plan capex accounted for around 20% of overall cut in plan expenditure.
Two, while capex under plan expenditure has been assumed to increase by Rs 34,000 crore in FY16 over FY15, it would be significant from the point of view of the budget as it accounts for almost 35% of the increase in overall budgetary expenditure. But this amount is still quite small relative to the size of the economy. Even in terms of incremental GDP to be witnessed in FY16 of Rs 14.55 lakh crore as per the budget document, this incremental expenditure would be just 2.3%, which is not very high.
Therefore, we need to be guarded in terms of our expectations of what can be done by the central government from within its budgetary allocations and constraints imposed by pursuing the path of FRBM. Past experience does indicate that if there has to be a compromise made, it could be at the expense of capex. Even if the target is met, the number may not be too large in itself to change the state of the economy in a discernible way. The private sector has to take the initiative and we cannot expect maximum effect from the limited push in the budget, and must be abstemious in our expectations.

Handbook for Independent Directors book review: Guardian angels: Financial Express 5th July 2015

Handbook for Independent Directors: Upholding the Moral Compass
Kaushik Dutta
LexisNexis
Pp 202
Rs 795
Madan Sabnavis
ONE OF the most important positions within the board of directors in any company is that of an independent director. The independent director has come to be a symbol of a ‘guardian of shared values’ for a company, which is essential to resolve the classic conflict that exists between the owners and management. Curiously, this is also an acceptance of the reality that the executive directors on a board may not always be able to discharge their duties in a dispassionate manner. While the board is supposed to address such conflicts, there has always been discussion, given the preponderance of the promoters on the board, on whether independent behaviour is actually manifested in the way boards function today.
Kaushik Dutta, in his book on independent directors, provides guidelines on what is expected from an independent director. The book covers everything, right from the concept of an ‘independent director’ to his responsibilities and expected conduct. To build this guidebook, Dutta gives a number of examples of how independent directors have made a difference to the functioning of boards. The book is further embellished by views expressed by persons of eminence who have served on various boards.
The concept of independent directors stems from the need to address public interest within the framework of corporate governance. Surprisingly, this idea was first mooted by Adam Smith, the father of capitalism, when he pointed out the apparent conflict between managers who ran the company and the interests of the owners: owners did not take part in running the company and managers were only in for the short term. But today, the issue has taken on another dimension, as there are majority and minority shareholders involved, and the latter may be kept out of the ambit, with the former influencing the management in a decisive way. It is, therefore, necessary to distinguish between general shareholders and minority shareholders, an issue that has been the concern of Sebi
all along.
The author also gives us the characteristics of an ideal independent director. Besides the experience and integrity criterion, they have to be bold and forthcoming, and should have the stature and courage to raise issues and have discussions.
Another area where the independent director has a role to play is in the area of insider trading. This has become irksome of late, though not very prevalent. They have to ensure that there are controls in place to ensure the highest values are adhered to by the company and management.
Also, in light of the Satyam fiasco, the author brings in the issue of culpability of the independent director and the fear of taking on this position, as their liability could be extensive in case of fraud. Interestingly, in this specific case, Dutta raises the issue of whether the four independent directors were right in resigning when the fraud was admitted. One view is that they should have carried on and ensured that things were corrected instead of running away, which looked opportunistic in retrospect and sort of vitiated the role of independent directors. The Companies Act of 2013, however, does clarify that the liability of the independent director is linked with his or her being an accomplice in a misdeed, and what is done in good faith after due diligence would not be held against them.
Dutta devotes another section to the board committees and the role of independent directors in these. In this regard, corporate social responsibility has become important today, given that companies have to allocate a certain amount of money for this purpose and follow up to ensure that all is in order.
Dutta also comments on the tenure of independent directors. While it is often argued that they should not have long terms, as their interests get embedded, a shorter tenure may also lead to absence of interest.
However, the most important area where one would expect affirmative action from an independent director is in the role of a whistleblower. This is where they have to be on constant watch and take cognisance of any deviations, complaints or any other activity or practice that may be inimical to the interests of the stakeholders, which include not just shareholders, but also suppliers, customers and employees.
Often, the position of an independent director is treated as a good post-retirement occupation with little responsibility and an effective way to stay in ‘business circulation’. However, lately, there has been some fear of taking on such positions—in several cases, independent directors have been held criminally liable for offences perpetrated—and those who do take these positions, prefer to remain silent and toe the line.
Dutta in this book convinces the reader that the main objective of an independent director is to speak out because only then will this position make a difference for all the stakeholders. Above all, they need not fear retribution when things go wrong, provided the duties were discharged in good faith.
Of late, there is also growing demand for having a fixed proportion of independent directors on the boards—today, this also includes women directors.
Handbook for Independent Directors is very timely and instructive for all independent directors, as it actually provides a textbook for them. It would be even more useful for first-time directors.

Ideas cafe: Is tax rebate for plastic money a good idea? Financial Express 2nd JUly 2015

The stated objective of the draft report on electronic transactions is to reduce cash usage, lower the level of counterfeit notes and enable convenience. Migrating cash payments to the electronic form is a good idea as it brings in convenience if one is able to carry out transactions without using currency. Another objective is to curtail tax avoidance or rein in black money. There is also the fear of mis-selling cards to people, especially the low-income groups levels.
Individuals will benefit from the use of cards if all costs—hidden and overt—are waived off. This starts from the banks, which today force account holders to pay for a debit card every year. Similarly, electronic transfers through net banking invite a bank charge, which has to be waived off to be attractive. Banks are always on the lookout for charging customers for everything and often the SMS service is billed even when not requested for. This, combined with the removal of charges by merchants, will open the door for seamlessly using non-cash modes for transactions. In fact, the boom in e-commerce is predicated on the use of non-cash for payments.
Banks have been competing with one another for issuing credit cards. It is not uncommon to have a bank agent make one sign up for a card in a supermarket. The joining fee and first-year charges are waived off and the customer often is not aware that there would be a running charge second year onwards, which could range from R750-2,000 per annum depending on the bank and the kind of card. This can promote mis-selling to an extent with the agent enticing the prospective customer with a free credit card.
The issue here is that the use of credit cards, when not backed by a direct debit, runs the risk of paying a very high interest rate on the outstanding amount. In fact, banks quite smartly ask for payment for only a proportion of the amount on the due date and charge this rate to the customer. It does not register that the card rate works out close to 30% per annum!
Thus, we need to tread carefully on this kind of migration and ensure transparency so that customers are aware of the pitfalls. Banks too would have to get their returns through merchants, interest charges and fees, and hence cannot lose in net terms to get on board this scheme. The charges for using ATMs have been increased with lower number of free usages. Against this background, are they willing to forego any income here?
On the level of avoidance of taxation, the move to force transactions beyond a limit, i.e. R1 lakh, to the electronic form may not work. Today, cash transactions in large quantities are in real estate, jewellery, forex and ‘dabba trading’. In real estate, there are fixed proportions that are paid in cash and the levels vary across locations. This being the case, as long as our tax or stamp duty rates are high, there will be an incentive to understate the value of transaction. For jewellery too, often buyers do not want to leave an audit trail, and as the market is largely unorganised, most transactions are in cash where one can also dodge paying the requisite taxes. A lot of forex is purchased in cash to avoid paying tax, and unless we rationalise this structure of taxes, the relative cost-benefit analysis is skewed against identification. ‘Dabba trade’, which is still prevalent in the markets especially commodities or even the equity derivatives, is unorganised but is run on fixed rules and on cash basis to dodge the taxman and exchange regulation.
The crux is that cash payments would never be the preferred option in most cases, provided the tax system was reasonable. The present scheme of thinking is in the right direction, but we need to address the issue of mis-selling, lower cost of transaction and provide more access points.
While the move to enhance convenience is well-taken, we need to ensure that there are checks along the way as we move to a new system; someone—merchant, bank or customer—has to pay for it. If this cannot be identified, then we could be missing something. It is a zero-sum game and someone has to give in.

Will new gold bond unbind us from physical gold?: Financial Express 24th June 2015

The new gold bond scheme to be launched is laudable as it is an attempt to wean away the public from investing in gold to other avenues. Intuitively, if households save their money in bonds rather than gold, then our import bill will benefit, which will keep our external balance in check.
The proposed gold bond scheme backed by the government will link the price of the bond with that of gold and offer an interest rate of 2% or more. When the bond is redeemed after, say, 5 or 7 years, the investor gets the current market value which is the rupee price of gold as of date. No one can invest more than 500 gm, which, say, at the price of R27,000 per 10 gm, will work out to R13.5 lakh approximately. The government, on its part, will issue bonds of the value of 50 tonnes to begin with, which would be R13,500 crore depending on the price of gold.
On the face of it, the scheme is good. The question is, whether or not it will work? The scheme does not require a person to surrender gold and exchange the same for a bond which earns this interest rate. Therefore, holding of gold and the bond are mutually exclusive. A person buying the bond could also be someone who would not be investing in gold and could enter the market for the first time. The bond will make sense for a person who likes a simple product. If we believe that, in 5 years, the price of gold will go up in the international market and that the rupee has to depreciate, then for a person with no interest in physical gold but in investment, this can be a good option. The rupee normally falls by 5% per annum and hence getting such appreciation makes sense. The hitch is, when one buys and sells gold, one can escape the tax net as all such transactions are through jewellers where there is no trail. Here one has to perforce pay capital gains tax.
The broader issue for the investing public is, whether or not this will make sense? Today, gold ETFs have not quite picked up. The futures market is buoyant but caters to an investor community which is agnostic towards any product as long as there is volatility, as they have no desire of holding the product. If knowledge of commodity was equal across all spectrums, they would be prepared to trade in guar seed as much as gold. No physical transfers take place. This being the case, investors may be a bit distant from a product which requires going to a bank or a post office to purchase them, leaving an audit trail.
Now, can such a bond migrate a holder of gold to the bond by bringing in substitution? In India, if 300 tonnes gets imported every year, it is more for holding on to the metal for sake of pride or tradition. There is a belief that such an ownership enhances one’s importance in the social order. If we get these people to break away from this statute, the scheme will be successful. Therefore, the government has to hold awareness programmes to convince the folks that this product is akin to holding gold with advantages of security. Leaving it to post offices or banks to market is not possible as the former are generally not interested and banks have their own products to market. Therefore, unless this can be done, there will be little migration.
Further, the bond will be listed and cannot be redeemed before the date at the bank. Asking him to go to a commodity exchange to trade is expecting too much, as this involves further cost and inconvenience. Hence, it remains to be seen if such a scheme really takes off or gets in investors who are not the ‘gold buyers’.
The government being the issuer will bear the cost of hedging. This is interesting because the transaction would be between the buyer and the government, with the government paying the final cost which will almost definitely be higher. If the price of the bond is lower, then most definitely the household will feel that it has been cheated, which never happens when physical gold is dealt with as, practically speaking, such gold never has a maturity date. Therefore, to keep the scheme attractive, the government has to hope that the price of gold does not come down. But for prudence, the government should be hedging the same on the NCDEX, which is the exchange whose quotes are being used; and probably the exchange risk too. If the amount to be hedged is R13,500 crore per year, with a possibility of 5% rupee depreciation, 2% interest and another 4-5% gold appreciation cost, the hit could be high. Otherwise, the cost, at around 10%, would be higher than the normal cost of 7.5-8%.
Another issue is exclusion. Would this be a scheme only for households or can institutions also come in. While institutions like mutual funds would find a limit of 50 gm too small, companies may like to invest in such bonds. Households, too, may be hesitant to reveal themselves as potential gold-holders for identification. As there is no transfer of gold, temples will be out of this scheme. Last, the government will have a problem marketing them as they will be clashing with their own tax-free bonds which will be out this year—these carry good returns with tax benefits. Therefore, such bonds may be a slow starter.
The government has taken the trouble of looking at various options to control gold consumption. A tax on gold is definitely more efficient and the ideal way to lower demand to an extent. Expecting households or trusts to part with gold for ‘saner’ deposits has not worked in the past to actually lower demand. The gold bond is a monetary transaction which involves no holding of gold by either the government or the buyer. If it meets with success, we can stretch to creating products that take gold from the holder of the metal. Otherwise, we can say that we have at least tried.

Wake-up call for banks: Companies may migrate to markets for short-term credit needs: Economic Times 24th June 2015

An interesting observation by RBI governor when presenting the credit policy was that while banks were quite slow to lower their lending rates when the repo rate dropped, the commercial paper (CP) and certificate of deposit (CD) markets had reacted with alacrity. This also holds for government securities or G-sec yields as they are market-determined. There could be moderation, however, depending on liquidity conditions.

To get an insight into this reaction from markets, the changes in interest rates can be measured over time across segments. Broadly speaking, since June 2010, when the concept of base rate came in, there have been four interest rate regimes. The first was between June 2010 and October 2011, when the repo rate was increased by 325 bps (basis points — one bps is 0.01%).
This was followed by a softer era of declining rates between April 2012 and May 2013, when the repo rate was lowered by 125 bps.
Subsequently, the RBI started raising rates once more from September 2013 onwards till January 2014 by 75 bps before plateauing for the next 12 months or so. Since January 2015, rates were dropped three times, of which two were before this policy announcement.
The chart shows how various rates have moved under these regimes and the direct response of banks comes through changes in the deposit and base rates. Here it is assumed that the response comes one month after the repo rate changes as there are processes to follow before they are revised.
To maintain comparability, the same is done across other markets such as 10 years’ G-sec, 91 days T-bill, CP and CD.
The responsiveness of market-oriented instruments has been the quickest to changes in the regulatory rate. The third regime presents a distorted picture in terms of direction of movement mainly due to the 2013 being unusual due to the global currency crisis, which had the RBI intervening repeatedly. This had increased the rate till August when the yields peaked, thus distorting the calculation.
If this regime is excluded, then it does show that the CP market has been more favourable for corporates where the buyers are both banks and other institutions like mutual funds? The same holds true for the other market-driven instruments and hence, the efficacy of policy will be stronger in these segments.
Also, curiously, banks are faster to increase lending rates as compared to deposit rates and slower when lowering lending rates relative to deposit rates, which helps them to protect and increase their spreads as either way the differential is maintained.
The implications are clear. If banks are going to be less inclined to lower rates, companies would prefer to unbundle their requirements for short-term funds from the aggregate and access the CP market. As commercial paper has to be rated by credit rating agencies, the investor too would be better off in terms of quality of borrower, which combined with a lower interest rate that excludes the cost of intermediation, would be a win-win for all parties.
In FY15, for instance, there has been an upsurge in the issuances of CP with a total of Rs 11.5 lakh crore being issued as against Rs 7.3 lakh crore FY14 and Rs 7.65 lakh crore in FY13.
Outstanding CPs (as of March 2015) as a proportion of outstanding bank credit was 30% compared with 18-20% in the preceding four years. There appears to have been some migration in FY15 to this market.
The CP market provides access to entities other than banks to potential borrowers and as financial systems evolve, companies will prefer this route. The comfort level with banks has been a reason for companies to go in for bank credit.
But if banks remain intransigent when lowering interest rates, there could be an unbundling of requirements, where term loans would be a banker’s domain while short-term requirements would be met progressively through the market.
The former too could change once the corporate debt market gains momentum. In FY15, the average differential between the average CP rate and base rate was just 25 bps, and has been coming down. In FY12 and FY13, this differential was around 88 bps and 40 bps in FY14.
This could be a warning signal to banks as the better-rated companies could just start this migratory process to begin with.

The MSP conundrum: Financial Express 19th June 2015

MSP conundrum

The issue of minimum support prices (MSPs) has become controversial today because of two reasons. First, the increase has gotten moderated of late, which has become a concern from the point of view of farmers. Second, the MSP has been linked to inflation, and as a corollary, it is being argued that one of the reasons for persistent high food inflation is the constant increases in MSPs which are not related to market forces.
The MSP debate is multifaceted. First, the MSP is announced for all crops—23 of them across the kharif and rabi seasons. But actual procurement takes place in only rice and wheat. If this were so, why should the ministry announce prices for all crops? Second, by announcing such prices based on providing market indications on what price the farmer can expect, the link with market forces is severed. Therefore, even in years when output is high, prices never come down or stabilise, but keep increasing. Third, the MSP has become a tool for political expediency as it helps to reach out to the farmer vote bank. The higher MSPs have created an inflationary spiral as higher inflation automatically gets embedded when calculating the next year’s MSP. More importantly, this has become a sensitive issue as it has become a debate between supposed “pro-farmer” (those who espouse higher MSPs) and “anti-farmer” groups.
The government has announced higher MSPs for the kharif crops with R50 increase for rice and a bonus on pulses. The increase for the 2015 kharif season varies from 0.75% to 6.3%, with pulses being favoured with the inclusion of a bonus. The whole idea is to provide a fair compensation and income to the farmers as well as provide them with cropping options by announcing the prices. For the latter, it may be a bit late as a lot of sowing decisions would have taken place already. The question is whether this will be inflationary or not given that higher food inflation has the potential to come in the way of future monetary policy action.

The accompanying table provides information on compound growth rate in output, MSP and WPI inflation for various farm products that enter our food basket. The period is between FY05, which is the base year for the WPI index, and FY15. While output has kept fluctuating over the years, it has been noticed that whenever prices rise as output falls, they do not revert to the base price when the output increases, and hence prices always get compounded. The same holds for MSP which can remain static but never decrease. The WPI has been chosen as it is the closest price that the farmer receives; and as these quotes are from the mandis, a major part of the intermediary cost between the wholesaler and retailer is kept out of the calculation.
The commodities have been put in three buckets. The first one consists of crops which have witnessed an increase of above 1.5% per year in production for the decade. The 1.5% number is significant as it is also the population growth rate. Typically, a thumb rule can be that growth in production should keep pace with the population growth. NSS data on consumption does show that till FY12, households actually spent less on food and more on non-food items. This being the case, the population growth rate can be a reasonable cut-off indicator. Within this group, with the exception of chana, where prices increased by 5.7%, there have been average annual increases of above 6% while the MSP increase has varied from 7.3% to 12.6%. Quite clearly, the increase in prices cannot be attributed to supply shocks—which could be there for single years, but not for the larger part of a decade. Given that the MSP increase is higher than WPI with a standard deviation of 2.0, the link between the two is quite high. Soyabean, moong, urad, rice and wheat have witnessed high growth rates in prices. For wheat and rice, the fact that the FCI procures a third of the output has meant that higher procurement leads to shortages in the private market, thus pushing prices up further (above MSP).
The second group consists of commodities where growth has been positive but less than the growth in population. Here, it is possible that demand issues have driven prices higher. Here, the standard deviation of WPI from MSP is higher at 3.2. Tur is a clear case of imports being used to complement domestic supply. Here, the link between MSP and inflation would be hazy as supply issues also have to be addressed.
The last group consists of products where production levels have come down, where the higher MSP and continued fall in output has affected prices. Here, the standard deviation is 2.6. In fact, in this category one can argue that higher MSPs have not even led to farmers growing more of the crop as the cost could be a factor along with other agro-climatic factors. Therefore, the purpose of incentivising farmers to grow specific crops has also not worked out for these products.
The linkage between MSP and inflation certainly exists in the first category of commodities. There can be no value-judgements passed since, if the farmer is really getting the benefit, then this is a useful way to improve her income. However, to ensure that it does not play with the inflation dynamics, it would be preferable to move to a system of cash transfers to farmers for crops where there is no procurement and then let the market forces of demand and supply address the issue of price discovery. This will be pragmatic being balanced and driven by objective factors and free from emotion.