Advantage small banks: Financial Express: 23rd September 2015

Small banks are the last bricks in the wall of financial inclusion that has been cemented by the Reserve Bank of India (RBI) and comes close on the permission to entities to set up payments banks. Small banks are a concept where the entity is allowed to collect deposits and use the funds for specific purposes with a focus on priority sector lending.
RBI has maintained a minimum paid-up capital of Rs 100 crore. Surprisingly, as of March 2014, there were 10 banks in the public and private sector that had capital of less than this level, which includes four associate banks of SBI, Lakshmi Vilas Bank, Nainital Bank, City Union Bank, J&K Bank, Catholic Syrian and Tamilnad Mercantile Bank. Hence, in terms of size, these small banks could compare well with the existing banks.
Further, assuming that the small bank starts with a capital of Rs 100 crore, the equivalent amount for an existing bank in FY14 would be Karur Vysya Bank, which had a balance sheet size of around Rs 51,000 crore, of which total advances were Rs 34,000 crore. Intuitively, one can visualise the potential scale that can be built on this size of capital over a period of time.
The basic concept involves a certain matrix in terms of lending. In fact, 75% of adjusted bank credit has to be for the priority sector that includes small farmers, micro units, etc. Further, there is a clause which says that 50% of total loans should be going to borrowers where credit is up to Rs 25 lakh. In addition, the prudential norms of CRR and SLR have to be met. Hence, for every Rs 100 of deposits collected, Rs 25.5 would be set aside for pre-emptions. Of the Rs 74.5 left, Rs 56 has to be to the priority sector (assuming adjusted bank credit is the base). Further, Rs 37.25 of total loans has to be less than Rs 25 lakh.
A look at the structure of credit in the banking system, as of 2014, shows that loans of size of up to Rs 25 lakh totalled Rs 16.71 lakh crore, out of a sum of Rs 62.8 lakh crore, with a share of slightly more than 25%. However, in terms of number of accounts, there were 137.1 million accounts with loans of each less than Rs 25 lakh, out of a total of 138.7 million accounts—share of 99%. Quite clearly, there is a large market in terms of number of accounts that can be targeted by these new banks. Intuitively, these banks can focus also on rural home loans to retail segment that would qualify under these stipulations.
The concept is again novel and with 10 applications being given an in-principle nod, there would be another ring of players in the market. The approvals are to eight microfinance institutions (MFIs), and one Local Area Bank (LAB) and Non-Banking Financial Company (NBFC). They are well distributed across the country with only two entities based in Chennai. They would be allowed to operate across the country with no restrictions. This appears to be a good enough experiment which is being tested before other players are allowed to join the fray.
The interesting thing about these small banks is that all of them are already in the financial business and hence do not have to start afresh. There are CRR and SLR norms to adhere to, which becomes important to ring-fence them from the risk associated with priority sector lending. However, the issue really is that priority sector loans tend to become vulnerable to becoming non-performing assets (NPAs) with the propensity being higher for them. In the past, the NPA ratio for priority sector loans has ranged from 4-5% while that of non-priority sector has been around 3%, with the number increasing to 4% in 2014 due to the problems in the infrastructure space.
The challenge would be to control NPAs here, as an unfavourable monsoon would have an impact on farm loans. Similarly, any slowdown in the industrial sector is first felt on the small and medium-sized enterprises (SMEs), which have payments problems. Therefore, on both scores, they would be at a disadvantage compared with the commercial banking system. Banks are able to diversify their portfolio by lending to all sectors which includes retail, services and manufacturing, while these banks would be left with dealing with the smaller ones only. Besides, given that these accounts would be small and well dispersed, the cost of monitoring would also be higher for them.
To the advantage of the licensees, their experience on this front would help them overcome this challenge as they already have relationships with customers in this area and only have to scale up. The rules allow them to open branches across geographies, though they have to be in unbanked areas. While this is an opportunity, the accompanying risk of focusing on the hitherto unbanked section would be a challenge. On the positive side, they would be able to garner deposits from the public, which will help the system to bring in more deposit holders as well as provide funding to these banks.
Two questions that come up are the following. The first is whether these banks will be able to add a ‘delta’ to the overall level of lending? This is pertinent here because these organisations already exist and are involved in lending. This portfolio, which hitherto was not part of the system, would get added to the bank credit level. But for the system as a whole, the incremental growth would be important.
The second question is whether these banks would also be treated like commercial banks in terms of having access to the money market and the RBI repo window. With them being subjected to the CRR and SLR stipulations, they should be part of the banking system and also be allowed to do treasury operations to manage their balance sheets.
While the concept of both payments banks and small banks will be tested over time, the small banks, being already in the business of lending, would have a distinct certainty in their operations. However, the fact that they will now be regulated and have to lend to the more vulnerable sections will ensure that they have to constantly be on guard when balancing their loan portfolios.

Capitalism at crossroads: Book review Financial Express September 20, 2015

Capitalism’s Toxic Assumptions: Redefining Next Generation Economics  
Eve Poole
Bloomsbury
Pp 187
Rs 499




AFTER THE financial crisis, there has been a tendency to highlight capitalist greed. A part of the critique has to do with the unethical nature of the system, which helps the rich get richer at the expense of society. But have we ever stopped to consider whether the capitalist system per se is faulty or whether the way it has evolved has made it less than perfect?
This is important because it’s largely believed that the market mechanism is the most efficient one and does not show partiality. This is where Eve Poole brings in her contribution by questioning the basic assumptions of capitalism in her book Capitalism’s Toxic Assumptions. We have all learnt that there are some fundamental principles of capitalism based on assumptions such as the ubiquitous invisible hand, market pricing, self-interest and so on. And in economics, as long as we have assumptions, the logical fallouts cannot be questioned. This, as per the author, is where we are completely wrong.
Poole argues that there are seven tenets on the foundations of which capitalism stands. However, these assumptions actually do not hold and are flawed. The first idea is competition. We are taught that in this system there is perfect competition. Here, Poole puts forward two arguments. One is from the point of view of math, where the assumption of large number of sellers and buyers competing independently to produce an optimal solution never exists. Game theory dominates the way business is conducted in real life and strategic behaviour moves on the basis of cooperation rather than competition. If we view the airlines loyalty scheme, the OPEC cartel, clearing houses and systems in markets, etc, the approach is one of collaboration.
The other argument put forward here is, interestingly, a biological observation, which involves greater participation of women in the system, which, in turn, guides the way business is done. Men typically respond through the ‘fight or flight mode’, which is competitive, but women follow the policy to ‘tend and befriend’, which is a collaborative approach. The greater participation of women has changed or modified the overall approach to compete. Poole’s corollary argument is that if this female mode of response had pervaded boardrooms during the financial crisis, it would have been resolved faster. This line of thought definitely sounds novel and is worth pursuing.
The second assumption relates to the existence of an invisible hand. This presumption, as per the author, though convenient for everyone, does not exist in the manner in which it was conceived by Adam Smith. The dominant players justify their unequal power by saying it’s the result of the invisible hand, even though they manipulate the markets to stay on top. The government accepts the invisible hand theory, so that it does not have to do much. The actual working of the market shows that it is never fair, is heavily loaded towards the rich and never delivers the theoretical benevolent outcomes. An example given is how the ‘invisible hand’ is loaded against developing countries—they have to open their markets to the West, but the western markets remain closed, with huge farm subsidies given to domestic markets to eschew free movement of goods.
The third assumption relates to utility or the premise that we work on the basis of self-interest. In practical life, however, we are not rational and don’t choose an optimal solution. Further, as we cannot read the future, we end up making the wrong choices, which models cannot capture. So the assumption that we are rational is an exception rather than a rule. The fact that we can be wooed by advertising to purchase goods defies rational behaviour. Another rudimentary example of how we end up not behaving rationally relates to how doctors are influenced by pharma companies when prescribing medication.
The fourth assumption of capitalism of the Smithsonian variety talks of the agency problem, where the management has to align itself with the interest of shareholders to take care of the principal-agent relationship. While we have a board of directors to guard the shareholders, they have no real interest. Does the board really guard the interest of the owners is a question that’s being asked today. The McGregor theory of motivation has been used by the author to explain why it’s necessary to turn Theory X workers (who have to be coerced to work and need supervision) into Theory Y workers (who are self-driven and address the issue of principal-agent). Giving stock options helps to align the management with owners, but drives a wedge with those in the lower-income echelons.
Next, capitalism assumes that market pricing is just. Do demand and supply always match? And second, is price always based on cost plus margin? Dan Ariely had shown that demand is driven by supply—as his experiment with shampoo showed that the ‘shampoo-rinse-and-repeat’ formula actually doubled demand—which then justifies a higher price. Further, the fact that the cost of tea varies in various locations such as cafes, hotels, etc, explains why the pricing is not perfect. Again, for goods where money is the basis of valuation, prices are no longer linked to costs. Here, examples of designer labels are given, where externalities, which are the order of the day, hold. Therefore, this assumption of price being determined by an invisible hand through market forces of demand and supply rarely holds.
The sixth assumption is the supremacy of the shareholder. This is whimsical and never really holds in practice, though all statements refer to working for the shareholder. This assumption has ended up fuelling an exponential rise in boardroom pay and encouraged a narrow view of corporate performance. These shareholders are actually elusive and cannot be identified. And often, all appeals made are actually for the well-being of the management. This has led to short-termism and a narrow definition of responsibilities.
Last, the assumption of the legitimacy of the limited liability model has been questioned by Poole. This makes shareholders bother more about gains than losses because their risk is limited. This makes them encourage aggressive risk strategies supported by incentive packages to maximise their returns. This means that both shareholders and senior management are aligned with share price maximisation with all accompanying dangers of the ‘get-rich’ strategy.
Poole is definitely not against capitalism, but only goes about proving that the classic system, as envisaged by Smith, does not exist. It has deteriorated to one, where the management works around the system, while the demand-supply mechanics are distorted, thus bringing about sub-optimal solutions—the breeding grounds for crises. This balanced view from another side certainly adds a fresh dimension to economic thinking on capitalism.
 

Enhancing doing business in states: The race begins now: Financial Express September 17, 2015

The report on an assessment of the implementation of business reforms by various states—brought out by DIPP along with World Bank, CII and KPMG—is interesting as it is probably the first of its kind. While analysing the extent to which states have achieved success when targeting 98 action plans, we get a fair idea of how states stand on a common scale. This is a starting point and, going forward, if this exercise is done on an annual basis, we will get a clear idea of the progress made intertemporally. Given the stark differences across states, there would be an incentive for those lower down the echelon to improve on the pace of business reforms, enabling faster growth.
India’s overall rank of doing business is low, at 142, in a list of 189 countries, and in only two parameters—on credit access and investor protection—we come in the first 100. The implication here is that we do well when it comes to regulation—where credit goes to RBI and Sebi—but falter when it comes to processes where there is human interface. Besides, most laws that have to be adhered to are localised and fall under the domain of the state or the specific town or city where activity is undertaken. Hence, a state analysis is more compelling to pinpoint the areas that need improvement, as often these stress areas are not under the purview of the Centre.
Potential investors look at the comparative environment provided by states before taking decisions. It matters more when the decision to invest is not based on the availability of something specific to a state—like minerals—when there are fewer options.


The results of this study are revealing. First, no state has complied with above 75% implementation of the 98-point action plan and hence there are no ‘leaders’ as per the report. The other three categories classified in terms of implementation performance are ‘aspiring leaders’ (50-75%), ‘acceleration required’ (35-50%) and ‘jump-start needed’ (0-25%). The bands have been kept quite wide, and the aspiring leaders are Gujarat, Andhra Pradesh, Jharkhand, Chhattisgarh, Madhya Pradesh, Rajasthan and Odisha. Some of these names do come as a surprise as they are not associated with high growth. The opportunities for mining, for example, in states like Jharkhand, Odisha and MP could be accelerating factors for the states.
On the other side, states like Maharashtra, Karnataka, Tamil Nadu, West Bengal, Delhi and Punjab, which come across as the more advanced states, are in the ‘acceleration required’ category. There are 10 states that need a jump-start, and eight of the set of 16 states have a rate of less than 10% with six of them being states of the Northeast. While these states have traditionally been neglected, the state governments should start becoming more involved in the growth process and create an enabling environment.
The study points out that there is little relationship between high level of implementation and per capita income or investment, though the trend line moves downwards for the former and upwards for the latter.
The table gives the share of states in the total number of Industrial Entrepreneurs Memorandum (IEMs) filed from 2010 to July 2015 in terms of number and value. It shows that six of the seven states in the ‘aspiring leaders’ category are in the top 10 states witnessing filing of IEMs. States like Maharashtra, Tamil Nadu and West Bengal are the others on this list, which has a lot of interest from industry notwithstanding the limited set of reforms that have been implemented.
Some conclusions can be drawn. One, while doing business may be difficult, it may not be a deterrent, provided there is opportunity. Highly industrialising states will still get higher doses of investment, notwithstanding the challenges.
Two, as a corollary, it can be said that if there is improvement in implementation of business reforms, there would be probably more investment flowing in these states. Therefore, these governments cannot sit back and have to work on improving these scores. Three, the relatively new states of Jharkhand and Chhattisgarh have done better, probably due to the mineral wealth and interest of investors. But Uttarakhand lags and falls in the ‘jump-start needed’ category. Normally, new states starting afresh would be better positioned and enthusiastic to make investment easier. Clearly, this has not happened here. In fact, even Telangana is in the acceleration required category, and hopefully will see a major change when the review is done the next time.
The report indicates the area where there has been maximum progress in terms of states implementing reforms is taxation—VAT, CST. This involves doing away with manual intervention with e-filing. The hint here is that, as the country introduces GST, there will be a lot of convenience for companies which will make doing business that much easier.
On the other side, wherever manual intervention is involved, reforms are harder to come by. Here the report talks of inspection in areas like labour, wages, bonus, shops and establishment, etc, where a lot needs to be done. Similarly, the idea of electronic courts at the district level has been covered relating to e-summons and e-filing of cases. Also, in the area of enforcement of contracts, conditions are pitifully slow across the country and would be a deterrent to investors.
Cross-comparison of states in terms of achieving these 98 action points is classified under eight categories. The table lists top five states on the scale in each of these areas along with the national average and highest score achieved by the leading state.
There is concentration in the performance of states, and it is members of the same group that dominate these lists.
When juxtaposed with regional disparities that exist across countries, it is a wakeup call for those governments where investment does not take place, so special effort has to be put in case these states have to advance. Those which are doing well but are low on implementation have to take corrective action, as there would be migration of investment to other states that are more hospitable to the same.

No Ordinary Disruption: The sign of four: Financial Express September 13, 2015

No Ordinary Disruption: The Four Global Forces Breaking All the Trends
Richard Dobbs,
James Manyika & Jonathan Woetzel
Public Affairs
Pp 277
Rs 799
TWO SUBJECTS that still get more authors than the financial crisis are ‘change’ and ‘leadership’. Both lead to several suggestions on how companies should plan the future and strategise for a better tomorrow. The book, No Ordinary Disruption, is written by three McKinsey Global Institute directors and, hence, was expected to provide several insights on what is happening in the world around us. The book does not disappoint and while it may not say anything different from what various management experts have been saying, it reiterates quite cogently the current waves that are sweeping us, which should help companies gear up for the challenge.
Let us see how the authors go about putting these ideas together. They point out that there are four major disruptions taking place in the world today, which have positive implications, but also have the ability to shock. The word ‘disruption’ is used from the point of view of major changes taking place rather than being barriers to growth. At the same time, not responding to these changes could make these phenomena impediments.
The first is that the fulcrum of economic and business activity is shifting away from developed countries to emerging markets—China leads the way here, with other emerging markets like India, Brazil, etc. The authors point out, quite interestingly, that the new power centres are no longer countries or regions, but new cities that have been growing. And these will dominate the global scene in the years ahead. This rapid pace of urbanisation, which is inherent in the transformation process, is the game-changer and will keep generating demand for various products at a progressive rate, providing new opportunities for everybody.
The second is technological change, which goes beyond what happened during the industrial revolution in the 19th century. Few would have expected the hydraulic fracturing and shale energy discoveries disrupting the oil economy, which we can see today—oil prices have crashed with this new oil coming in. Robotics is another field that is fast catching up, with autonomous vehicles without human drivers set to be the next big thing. The takeaway is that companies must keep thinking of ways to rejuvenate their business by leveraging technology.
Third, the demographic changes taking place are quite distinct, with a rapidly ageing population in the West. This trend is normally interpreted as being a burden for governments, wherein they have to provide social security benefits. Alternatively, it is looked upon as a blessing when dealing with the trait of demographic dividend for countries like India. But from a business perspective, two features stand out. The requirements and demands of the ageing group of people are quite different from the lower age groups, and the way forward is that companies should gear their product processes towards this population. The other is a mirror reflection of this phenomenon: the working population has been affected with the replacement demand not being met due to the non-availability of skill sets. This will be a challenge going ahead. A common development in all countries is that people who started working, say, 20-30 years back, have been through a phase, where their skill set became redundant, forcing them to reorient their professional course. This will continue.
The fourth disruption is greater connection through globalisation, which has brought people and countries closer. The two major areas, which have enabled free flow of goods across countries have traditionally been trade and finance. Growth in trade in goods and services has been hastened across the world with new agreements, bringing about considerable integration between countries. Finance has become universal with the proliferation of markets, resulting in easy access. The financial crisis in the US clearly showed how integrated the global financial system was, encompassing several countries. The authors conclude that smart planning, willingness to change and openness to new ways of conducting business will be attributes in harnessing the power of global flows.
However, the suggestions made for corporates are more practical. The authors say corporates need to think of new opportunities in terms of cities and urban clusters. Products have to be customised to meet local tastes and they need to build lower-cost supply chains and innovative models to become competitive. One has to design and control multi-channel routes to the market, and rethink brand and marketing strategies. Organisation structures and talent strategies have to be returned to this new setting. Here, the authors give examples of how some companies have been adaptive: Frito-Lay has captured 40% of the branded snacks market in India. Instead of tailor-making their products to local requirements, they created Kurkure, inspired by traditional street-side food. Tingyi in China became the leading food and beverage vendor by redesigning instant noodles just like Wrigley’s in the gum market.
Besides these four changes or disruptions, the authors also examine three other significant challenges for countries. The first is resource management. Here, the challenge is not just in the use of resources, but also in discovering new ways of doing things. A proactive stance needs to be taken, the authors say. For this, they put forward themes like recycling, efficiency and conservation. These lead to competitive advantage when resource prices become volatile, as efficiency efforts become the distinguishing factor.
Second, the authors highlight the uncertain nature of the cost of capital. The Federal Reserve’s moves to lower rates (or go in for quantitative easing), withdraw easing programmes and increase interest rates can impact the cost of capital across the world. Various actions have been suggested by the authors—which, on second thoughts, are no-brainers. The first is to improve the productivity of capital followed by exploration of new sources, where sovereign wealth funds find special mention. Next, risk has to be addressed through appropriate mitigating measures, as new commercial opportunities are exploited.
Finally, governments have an important role to play in terms of creating the right policy framework. This will evidently vary across nations and will be the differentiating factor for the future performance of companies.
The authors put forward the McKinsey view of how things are looking and are likely to proceed with a fair degree of competence. While their suggestions may not be entirely new, the fact that the authors are practitioners from McKinsey, which has great experience in reshaping companies and countries, leads us to believe that the suggestions can be taken as a refresher course for CEOs.

Can anything beat the allure of gold: Buisness LIne September 11, 2015

The gold monetisation schemes are laudable, but they are up against Indians’ craving for the yellow metal

At present, the demand for gold is down and the current account deficit very comfortable. But we can never be sure how Indians will behave when it comes to gold. It is for this reason that the government has been working on devising alternative instruments that would deliver the same benefits to holders and potential buyers of the metal. This could further reduce the physical import of gold.

The gold bond and monetisation schemes are progressive steps taken by the government in this regard. Both assume that the potential client is not strongly inclined to have physical gold in possession and that by providing similar rewards, this inclination will only decrease.

Good for government

The Gold Bond Scheme is an excellent one from the point of view of the government. Here, households buy a bond that is linked to the weight of gold in rupee terms. The bond is for 5 to 7 years, which means there is a good investment tenor for the same. The government may pay a nominal interest rate, say 1 per cent, and take over the price risk as it has chosen not to hedge the same. The amount is put in a fund, which can be used to cover the increase in price in future.

The way this gold reserve fund operates is important. If the money lies idle, it will be useful in taking liquidity out of the system when these bonds are purchased. If the fund invests in other assets, then there could be a return for the government.

In fact, such funds could be lent to the State governments with the interest cost being used to cover the price risk. The amount is to be a part of the fiscal deficit, which does not matter as it would only be an accounting entry with no money being spent if kept in the locker, with the nominal interest rate paid being the only cost.

Why buy?

Why should an investor buy this bond? A conventional investor who values gold would not like such an option, as it is better to have physical gold in the locker where it would not earn any money, but there would be a guarantee that it exists. Besides, buying a bond involves adhering to all the KYC norms, and hence if gold is to be used to escape the taxman, this is not a very attractive option. But if capital gains are indexed or exempted, then it could be a jolly good option.

There would not be too many long-term investors here who would like to keep a gold bond for 5 years. Those dealing in the short term would be using the commodity derivatives market and trade on, say, NCDEX where one can take a call on short term movements. Locking in for 5 years may hence, not be very appealing, especially as there is no option of redemption in gold.

But assuming that some people do opt for a lock-in, there would be two options for them. One is that they keep rolling over the bond. This is of advantage for the government and works well where there are taxes to be collected on such appreciation. But if everybody wants to redeem the same, then the outflow from the government would be to that extent. However, by making it a pure monetary transaction, the physical demand for gold would be eschewed.

Hence, this is an excellent scheme for the government, though the investor would come from a very niche segment that sees value here. If it works, it would add to the entire basket of financial instruments available today for savers.

The second scheme

The gold monetisation scheme is trickier. Here the individual deposits physical gold with the government (through the agents) and can ask for the gold back at the time of redemption in case it is short term of up to 3 years. For medium and long term, it is to be only in cash, which can make it equivalent to the gold bond and hence would be interchangeable in concept. There would be few people who would like to give up their gold for cash and also make themselves known to the taxman! While the cost here is higher for the government as it has to reimburse for the conversion, assaying and storage charges, the main problem would arise when there is demand for physical gold. As long as the deposit is renewed, it serves the government well. But if there is large scale redemption, then there would be the need to import gold from the market. This can be avoided, provided there are fresh deposits coming in every year, just like bank deposits. But any specific positive or negative event can cause an adverse movement and demand for gold. Given that part of the gold would have been lent to the jewellers, there could be a mismatch between the supplies and demand.

The government has done a commendable job in trying to mimic the purchase of physical gold with these two new schemes. But one is never sure how individuals will behave especially when it comes to physical gold. The gold futures contract or even the spot contract which are offered on commodity exchanges (where one can demand gold anytime when traded on an exchange at the time of expiration) has not quite lowered the physical appetite for gold. The fact that the KYC norms cannot be dodged can be a major deterrent for the investor as most of the gold transactions escape the organised network.

It would be the investor community which is not savvy enough to go to the exchanges that will find these instruments attractive. The monetisation scheme is quite restrictive as it expects people to give up gold and not ask for it if held beyond 3 years. This can be a weak point to start with.

Worries only on policy front : Asian Age: August 30 2015

Indian investors watch stock prices fall in BSE

Based on the experiences from the past, global economic developments were always going to be important in shaping the future of policy formulation in the country. The guess of late was however restricted more to the Federal Reserve and its stance on interest rates. However, the dynamics have changed in the last couple of weeks on two fronts. The first is the devaluation of the Yuan by China which came unexpectedly, followed by the shakeout in the stock market which has had reverberations across all global markets. Both of them indicate an expected palpable slowdown in the Chinese economy. What does this mean for us?

The most important factor that would guide the future is the permanency of what is happening around us. Will the Yuan depreciate further or will it stabilise? Will the Chinese economy continue moving downwards or will growth stabilise soon? There are evidently no easy answers here as the stock market crash came just after the devaluation. In fact China has followed it up by cutting interest rates too which means that the government does recognize that the economy is slipping and that it would work on all fronts to restore growth through export advantage and domestic demand.

To answer the questions put forth earlier, the currency decline could be considered to be more transient as the Yuan has been around 6.40 to a dollar which was the expected target rate to begin with. However the lower growth puzzle for the country will be deeper and it will take time to reverse the same. It may be expected that the 7 plus growth rate would take between one and two years to achieve on a sustained basis.

A Chinese slowdown is negative for all countries which have strong trade relations with the nation as imports will slow down thus affecting exports of countries especially in Latin America and East Asia which are dependent on this market. At the same time low growth in China will affect its own imports and demand for commodities and the cycle will remain in the downward direction for another year for sure. China is the largest consumer of metals and the declining prices have affected the profitability of all companies across the worlds which have confronted declining incomes. India has not been immune to this phenomenon.

Putting these facts together, the feeling one gets is that the Chinese slowdown will retard growth in the world economy especially in export oriented countries and given that other regions are tied to growth in this geography or have their own problems like the Euro region, all eyes will be on the US to be the engine to growth and hence the Fed to take a call on interest rates. The picture today is positive though there are few signs to show any kind of acceleration is in place.

India is relatively a more domestic oriented economy where growth emanates from within the country and exports are more of a secondary support. However, the economy will not be insulated as it will get affected in two ways. The first is the exchange rate route where the rupee has also been falling continuously to new lows. The second is the interest rate action of the Fed will also have a bearing on RBI’s decision on interest rates.

The rupee depreciation this time is different from the 2013 episode as the earlier one was based on the combination of an external shock and weak fundamentals. This time, the balance of payments looks robust and the only shock is external. Ironically there are limited policy options for the RBI which will have to think of direct intervention to bring about any correction. The fact that we have reserves of $ 355 billion is a comfort here. Therefore a lot will depend on the stance taken by the central bank and its level of comfort. More importantly the RBI will be observing if the current round of depreciation in the rupee is temporary or of a permanent nature. Also given that there has been a call by the market to allow the rupee to depreciate before this event took place, the central bank may probably be comfortable with the present turn of events.

But from the monetary policy standpoint, the rupee depreciation and volatility may not be too satisfactory. It has been agreed that the RBI will target inflation, but a weak rupee will have a tendency to increase imported inflation which will become a monetary concern. Presently inflation is low and the concern is only the kharif crop. With the rupee falling by almost 5% in the last month, there will be some upward pressure on prices. At another level, with the rupee being where it is, the RBI may have a strong reason not to touch interest rates at this point because the window for FPI in debt should be kept open at a time when the trade balance is already shaky and the rupee weakening.

In fact there is a strong reason for the Fed to defer its rate hike as it would be keen to ensure that US does not lose its export competitive edge by letting the Yuan fall. With inflation being marginally positive and its own target at 2 per cent, the US is far from an inflationary situation to warrant a rate hike. This can be another factor supporting a deferment of rate cut by the RBI.

To conclude it can be said that the Chinese devaluation and stock market crash has had repercussions on these two markets all over the world. India has not escaped this contagion as these two markets are well interconnected globally given the preponderance of foreign investors in the stock markets and the rupee being linked to the dollar. Therefore, adjustments by the central bank are inescapable. The comfort however lies in the fact that the economy is growing positively and is more dependent on domestic demand. In fact growth in exports is in the negative territory and yet, GDP growth looks quite positive. Hence while we would be concerned on these developments from the policy standpoint, we can feel somewhat reassured on growth and employment to a large extent.

Crumbling Red Empire: Asian Age 16th August 2015

Plagued by slowing economy, rising wages, falling exports, china has devalued its currency to resurrect its growth. but it ended up sending shock-waves across the world.

The devaluation of the yuan is a conscious attempt made by the People’s Bank of China — as the central bank in that country is called — to revive the Chinese economy which appears to moving downwards in terms of rate of growth. While the ostensible reason given is that the currency is being aligned to the market, the general belief is that this correction is being made to boost its exports, which are very important for China as it accounts for around 25 per cent of GDP.

As the rate would be fixed to the previous day’s close, the value may be expected to continue in the downwards direction. This move is a fairly aggressive as China is one country which has been building its forex reserves over the years leading to a strong case for appreciation of the yuan. It has however held on to an undervalued currency to support growth in exports. Hence, this devaluation has chan-ged the currency equations in the global market as it impacts all countries. While there is a view that currency depreciation was being driven by the fact that other currencies have depreciated through conscious easing programmes of the central banks, this action is quite singular as it has not been brought about by market forces but driven by the central bank.

Such an action has already caused currencies across the world to decline as markets everywhere are out to protect their own currencies. The main target would be the US where a recovering economy is witnessing a stron-ger dollar, which is not what is desirable at a time when the economy is sho-wing growth tendencies.

This trend is quite pernicious as it may trigger a currency war especially for exports dependent economies where ‘not following the herd’ would mean slowdown in exports and hence growth. This would not be a major problem for the exporting nations when overall growth in world trade is high. But today with global trade still at a low level, the overall size of the pie is not growing to accommodate all such depreciation and hence there will be incentive to depreciate at a faster rate.

The rupee has already fallen by more than a rupee against US dollar in the trading sessions subsequent to this devaluation as the market is guessing the right rate given that the yuan is now expected to move towards 6.6-6.7 to a dollar in the next few days.

The challenges are on several fronts. First, with imports from China getting cheaper there will be a threat to companies in sectors such as steel, textiles, auto components etc. This can only be countered by higher duties and rupee depreciation will not help.

Second, exporters will be hoping for a sharper rupee depreciation as the price advantage in the global market can be retained only if the rupee can match the yuan fall.

Third, companies with forex exposures will find themselves vulnerable if the depreciation carries on or stabilises in the ran-ge of `65/$ which appe-ars to be the new benchmark.

So far the RBI has ensu-red that the rupee rem-ains within a band by intervening in the market. External capital flows also helped to stabilise the balance of payments even when other emerging market currencies depreciated faster on account of the expected hike in Fed rate. Therefore the risk of unhedged exposures surfaces again. Four, there can now be a strong reason for RBI to hasten the process of lowering rates as typically we would like to see a weaker rupee which was being countered to an extent by the FII flows into the debt segment. Lastly, RBI will be back into business of controlling the fall in the rupee as the so-called correct value of the rupee has to be conjectured and then attained. The yuan fall has hence added a new dimension to global volatility which hitherto was centred on the actions of the Federal Reserve. This shock is even more severe as it affects trade flows that adds or subtracts to GDP growth and not just the balance of payments as was the case when investment flows were affected

 

Commercial considerations must guide bank decisions: Economic Times 9th September 2015

The base rate issue has come to the fore again in the context of the tardy transmission mechanism from the repo rate. The problem really is that repo transactions constitute not more than 1% of lending activity by the Reserve Bank of India through the LAF, which is a maximum of Rs 95,000 crore. A 1% change in repo rate affects banks by just Rs 950 crore on an annual basis, which is very small relative to total interest income of banks of around Rs 8.5 lakh crore (in FY14). Therefore, prima facie, the rate change on its own cannot really alter the dynamics of the base rate.

What should the ideal base rate be? Looking broadly at the functioning of banks, the average rate that can be charged would be a sum of five components. These are the cost of funds (deposits and borrowing), return on capital, intermediation cost, cover for asset quality and compensation for negative carry on pre-emption. One way to build this number is to theoretically impute values for the banking system.
These numbers would vary across banks depending on their balance sheets and the point of reckoning of the same. Based on the 2013-14 balance sheets of all banks (RBI data), on an average out of every Rs 100 of liabilities, Rs 88 emanates from borrowings, Rs 7.5 from capital (reserves and equity) and Rs 4.5 as other liabilities.
The outline provided here is a template that could be considered by logically looking at the cost of banking operations. There is nothing sacrosanct about these numbers and the assumptions can be changed to get a different result. The repo cost would be a very small component of the 5.25% cost of funds in the table. The table uses data for 2013-14 and 2014-15 to calculate an idealised base rate, which comes to 10.83% under certain assumptions.
The RBI has brought out fresh draft guidelines on what should go into the base rate, which looks at the issue from the point of view of marginal cost. This is based on the premise that when looking at the base rate, the average would not hold as rates change only for incremental components. For example, while non-term loans should be at new rates, only incremental deposits can be adjusted with the new rates as the older deposits would have been contracted at the older rates. Similarly all new borrowings of banks would be subjected to the new rates which should ideally get reflected in the new base rate.
The extent to which the base rate gets affected will depend on how the various components move. The cost of funds would definitely change while the other four components will tend to remain unaffected though the negative carry on the CRR would be affected provided the government securities yields do change — which has not been witnessed in the past year or so.
Now Rs 88 in the balance sheet is through deposits and borrowings. Of this Rs 78 comes from deposits and Rs 10 from borrowings. Further, out of these borrowings, around half is from external sources which is not affected by domestic rate changes. Assuming CASA of 35%, Rs 51 would be time deposits. Hence, the sum of Rs 51 and Rs 5, that is, Rs 56 would be subjected to the new rates when the RBI changes the repo rate.
Now assuming growth of 15% in these two components, Rs 8.4 would be subjected to the new rate, and hence a 25 bps cut in interest rates, if fully reflected in the new deposit rates as well as borrowing, will change the base rate by 0.02%, which is quite insignificant.
This is probably the reason why banks are not able to really lower the base rate to the same extent even when driven by a formula. The crux will be the reduction in deposit rates, and if the same is delayed or is not equivalent to the extent of repo rate change, then the base rate will remain sticky.
At an ideological level, three questions arise. The first is whether the concept of a base rate is right. While announcing a benchmark is required for transparency, having a rate by statute based on an objective well-defined formula does come in the way of the independence of the system to choose their rates.
Second, while the RBI does expect base rates to follow suit, banks can still charge the same rate or higher rate to the customer based on risk perception. Third, in a deregulated set up, can any authority compel banks to lower rates? If the ideal system is one where there is independence in monetary policy formulation, arguably the same must also hold for decisions taken by banks, which should be guided by commercial considerations. Interest rate changes will take place under the force of circumstance when companies move to the CP or bond market.
 

The Public Wealth of Nations book review: Book Review Financial Express Sept 6, 2015

The Public Wealth of Nations book review: A way & some will

The Public Wealth of Nations: How Management of Public Assets Can Boost or Bust Economic Growth
Dag Detter & Stefan Fölster
Palgrave Macmillan
Pp 230
$40
WE NORMALLY talk a lot about the extent of government debt and the concerns that go along with it. In these discussions, an argument that comes up often is why not also evaluate government assets or public wealth of a nation? This is the starting point of Dag Detter and Stefan Fölster’s book, The Public Wealth of Nations, in which they highlight the importance of the assets of the country that can be effectively used by the government to generate income, reduce debt and improve efficiency. This combined wealth of all governments in the world has been estimated to be the equivalent of world GDP, at around $75 trillion.
Now, when we talk of government wealth, it is fairly diverse in concept, ranging from state-owned enterprises (SOEs) to departmental assets covering property associated with, say, railways or roadways and other physical assets such as buildings. In commercial terms, the authors are talking of monetising government assets by putting them to better use. In countries like France, Germany, the UK and Japan, the sum of the government’s financial and non-financial assets exceeds their debt. Now, this idea will strike a bell for us in India, where the government has also been mooting the idea of use of railway land and other property to generate revenue.
The treatise in the book is basically two-fold. The primary focus is on SOEs in various countries and the methods used by governments to make them more efficient. The other is a discussion on real estate-related assets of the government that can be used more effectively. Along the way, the authors bring to fore the point that for all these enterprises to succeed, we need to have less government interference, which can be achieved by ring-fencing them from politicians. The problem with government intervention is corruption, crony capitalism and serious conflict of interest.
A heartening revelation that will provide a lot of comfort for us in India is that the problems facing SOEs in other territories are not very different from that in our country, as SOEs are structured and operated on similar lines everywhere. The major challenge is government interference, where both majority and coalition governments use these enterprises to dispense favours. Hence while the authors keep harping on the point that there should be no government interference in the operations of SOEs, they do admit that countries have a tough time implementing this. In this context, the authors also emphasise the requirement of an independent central bank for better governance. This should again strike a chord in our context, where there is an ongoing debate about the RBI’s independence in the light of the proposed monetary policy committee to decide on interest rates.
The authors suggest the concept of a National Wealth Fund (NWF), which takes ownership of all SOEs and then runs them like a private-sector entity. This concept of a ‘holding company’ for public-sector units is also not new for India, where we have been talking of it for all public-sector banks. Now, the authors argue that if we do have such NWFs that are free from interference from the government, we would get superior solutions.
In fact, they speak of either ‘fragmented’ ownership or ‘consolidated’ ownership, where these funds manage all SOEs under different levels of the government, as almost all countries have federal structures starting from the central government to state or provincial ones and moving to local set-ups. Such a large company that is professionally run would have an advantage in raising both debt and equity.
With a larger balancesheet, raising funds for infrastructure purpose becomes easy for the NWF even in global markets, which will be difficult for individual companies that are not well-run. Also, for any kind of disinvestment, selling through an NWF becomes easier than for individual companies.
Quite interestingly, in the area of disinvestment, the authors do point out that all countries go through the same pain of apprehension when deciding on the pricing of such sales. As late as 2013, the UK government came under fire for the privatisation of Royal Mail, when the share price rose by 38% on the day of listing. It was lambasted by critics, who claimed that tax payers lost 1 billion pounds on account of poor pricing. This seems to be a major fear for bureaucrats in India as well when taking a decision on when to disinvest shares in a company. Having an NWF carry out the same sale would carry more credibility, as there would be professional decisions taken.
Detter and Fölster argue that the objective of these NWFs is to create value, inculcate professionalism and pursue the highest standards of governance. While this is okay on paper, we do see that SOEs have been used by politicians everywhere as per their wishes. This is one reason why they tend to fail, but never collapse, as they keep getting support from governments. This is a question that only individual countries can answer. In India, too, we often see that all SOE appointments are made by the government and even if a holding company is created, a similar pattern may follow.
Hence, while the authors’ governance principles relating to independent survival, professional decision-making and day-to-day execution are sound, these are the very same domains that governments like to capture, as these empower them. We all lament that in India, public-sector banks are not free from interference from politics and several unsound commercial decisions are taken on this score. Hence, there is no guarantee that such models will work everywhere unless the government has the willpower. The authors give examples of the NWF, Temasek, in Singapore, which has operated on these principles and even gone out of Singapore, with significant presence in other countries, too, today. There are other examples as well of such structures working in countries such as Finland, Scotland, Peru, Spain, Abu Dhabi, etc.
Besides SOEs, which is the core of this book, the authors also explore the leveraging of real estate owned by the government through the NWF, which, however, has not been very common, as land records are not in place.  They focus on three kinds of assets—administrative buildings, department assets (defence land, airports or ports) and property owned by various departments, including forests and farmland not being used, etc. Intuitively, such assets can be leased out or sold for revenue. Alternatively, administrative offices could shift base to cheaper areas and the prime land could be used for generating revenue.
The Public Wealth of Nations is quite interesting, as it outlines several possibilities of making government assets work. But the fundamental clue to this model working is the absence of government—read as political interference—which in several countries is hard to come by. But as there have been several success stories, though confined mainly to  developed countries, there is hope that this could be accomplished in other nations, too. But the initiative has to come from the government.

Making payments banks work through large customer volumes, controlling costs: Financial Express Sept 5, 2015

India will witness the introduction of payments banks (PBs)—an experiment with little precedence from elsewhere—in the coming year. We have had regional rural banks and cooperative banks in the country, but their focus has been more on lending than deposits. The idea behind PBs, from the point of view of the RBI, is to extend financial inclusion by using novel delivery channels. Hence, the 11 parties that have gotten an in-principle nod include telecom companies, NBFCs, the department of posts, a banking-correspondent player, depository, and some large corporates. Each of these must have thought through the plot while filing the application. The existence of entrepreneurs with diverse backgrounds could ultimately be a test for which model works best, beyond conventional banking.
Two factors have to be kept in mind. First, there is a large banking system already in place, with 65% of a total of 127,000 branches located in rural and semi-urban areas (as of March 2015). Second, the Jan Dhan Yojana has led to the opening of 180 million new accounts through banking channels. Hence, any growth, on top of these structures, will have to be accelerated and must be as rooted in the lowest level as the top.
Let us visualise the likely scenario. PBs have to target large numbers to build their business. As they cannot take deposits beyond R1 lakh per account, they have to look for a large number of mid-size deposits to reap economies of scale. But households, which may wish to make such deposits, would probably already be holding bank accounts.
Therefore, PBs have to look for new small account holders. The telecom companies may scale up their existing e-wallets, popular with the urban population in particular, but there will now be a cost involved as these accounts have to get converted to savings accounts with interest payout.
As much as 80% of all bank accounts—977 million of 1,226 million, as of March 2014—are savings accounts. The average balance held in savings accounts across different population groups is as follows: rural R11,082, semi-urban R17,263, urban R30,946 and metropolitan R41,274.
Rural and semi-urban households account for 36% and 29%, i.e., 65% of all savings accounts held with banks. Urban and metropolitan depositors comprise around 17% each. For PBs, while tapping into the latter looks attractive, the cost would be high because while there is fairly widespread use of e-wallets—companies actually charge a fee on these at the moment, but they will, from hereon, have to pay an interest on the amounts held in these. The remaining depositors would probably already be in a banking relationship. Therefore, even though targeting this segment is good economics, PBs have to offer other value-added service to bring them into their fold.
Targeting the rural segment of the customer base seems the logical option, given it is a highly under-penetrated market. But, here the ticket-size will be much smaller than urban/metropolirtan areas. Also, while banks are able to average a balance of R11,082 per account (as of March 2014) in rural areas, the new accounts may not be able to scale up to similar levels. The total amount of deposits collected in the 180 million Jan Dhan accounts was around R23,000 crore. Of these accounts, 45% held zero balance. Therefore, the average balance (discounting the nil balance accounts) was around R2,300 per account, rounded off to, say, R2,500. To reach even these levels, PBs have to garner a large number of accounts.
Now, let us look at the PB model. PBs can only take in demand deposits: that  means they can hold either current or savings accounts. Households largely prefer the latter because of interest rates, which means getting the depositors involves a cost for PBs. They have to offer a minimum of 4% interest, given existing bank rates for savings accounts. PBs can deploy these funds only in Treasury bills or G-Secs of less than 1 year and put another 25% in other banks for managing cash. There is no risk of default nor are there any capital adequacy issues. Their earnings would be at least 7% on their investments. The spread of 3% looks very attractive, comparable if not better than that earned by banks today in their ordinary business.
The crux for PBs would be to keep costs down. The fixed cost would vary depending on the models chosen by the banks. The operating costs would be on IT, staff, administrative and selling costs, etc. Eyeing an average balance of R2,500 per account, 1 million accounts would yield a corpus of R250 crore, giving a spread return of R7.5 crore. Multiplying the account numbers by 10 would escalate the same to R75 crore and so on. Costs have to be reined in here.
The intermediation cost, as a percentage of total assets, for banks is 1.8-2.5% today, depending on size, age and ownership of banks. Therefore, for PBs, the focus has to be on lowering these costs, which will presumably happen as they will be using existing infrastructure which can be scaled up to maintain low-cost models. The aim should be to get a net return of 0.5-1% on assets (which will broadly be equal to the deposits garnered).
If PBs can rake in a higher average balance, say R5,000, then the model would work better with a corpus of R500 crore for 1 million accounts. This looks more likely if they are able to cause metropolitan and urban bank account holders to migrate to their channels, where other value-added links such as the e-wallet are on offer. But such migration would not add to overall deposits and would mean a loss of business for banks.
The strategy has to be two-fold: to create the necessary volumes and to control costs. Given that the average return on assets for the banking system is 1% (0.8-1.8%, depending on whether the bank is a PSB or a new private bank) and return on net-worth being around 15%, PBs achieving these levels calls for major scaling up.
The challenge is that most PBs will have to compete with each other in the same geographies, with everyone focused on a diversified base across the four customer segments. The next set of entrants would probably be closely watching these developments.

Time to rebuild the foreign investment platform: fINANCIAL eXPRESS: aUGUST 31, 2015

A fickle rupee and an increasing trade imbalance may not provoke an indifferent sentiment always. While the forex reserves have reached $355 billion, which is higher than the March level by almost $13 billion, a lot still depends on how our capital flows behave. While it is argued that we could be having a current account surplus any time with invisible flows being very positive, attention must turn to foreign investment, FDI and FPI, as it is normally assumed that we could get around $30-40 billion from each of these sources. At the same time, there is some reassurance that with the doing business environment improving significantly in the last year or so, there is hope that more funds would come in. The Make-in-India campaign is indirectly an invitation to investors to come and invest in the country. What exactly is the picture at the ground level?
On the whole, it is a mixed bag with several extraneous factors also working towards these flows. The Fed’s tapering programme followed by the expectations of a rate hike any time now has put these flows on the discussion table for both FDI and FII. While the former is normally associated with long-term commitment to any country, a pertinent question is whether or not these funds will get back to their homeland as the US economy recovers?
So far, FDI flows have been encouraging. In the first three months of the fiscal, there has been an increase from $7.2 billion in FY15 to $9.5 billion, though admittedly there is not much seasonal pattern here and these flows are dependent more on the current environment. In terms of the calendar year, the increase is from $15 billion to $19.4 billion. Assuming the same trend to be maintained, we could be expecting around $38-40 billion for the year, which is much on target.
Two issues which always come up when we talk of FDI in the current context pertain to taxation and our own mindset. Successive governments have been blowing hot and cold on tax laws, with the retrospective tax shadow always being an issue to watch out for. Any investor would like to have clarity on these issues as it is the basis of deploying capital. In the past it has been observed that investors do take into account the known impediments, like the difficulty in doing business in any country, as a known cost, but still do not hesitate to invest. But no one likes surprises.
The other is the recent Maggi controversy where there is already a sense in some foreign investors that there could be differential laws for foreign companies operating in India. With several countries clearing the same product, there is an impression that the due processes may not have been observed before the ban. Hence, while we strive to spread the message of Make-in-India, we need to be clear about such issues which could be irritants at the margin, but if left unchecked could colligate to become a deterrent for such investment.
The FPI scene also raises some policy issues for us. The debt inflows so far this fiscal till August 21 have been in the negative territory. The problem is structural. FPIs have a limit of $81 billion, of which $30 billion is in G-Secs and the balance $51 billion in corporate debt. Data presented by NSDL for August 24 shows that the two components of FPI in ‘G-Sec auctions’ and ‘G-Secs on tap’ have been fully exhausted. This means if we want to get more FPIs here, the limits need to be increased. The balance $23-25 billion are in corporate debt where there is a large balance, but also absence of interest.
The reason is simple. Until such time that the corporate debt market becomes liquid, it would be relatively unattractive for FPIs to invest here, as the exit route is very narrow. Considering that these funds are here to make money, the corporate bond market does not offer the same flexibility as does the G-Sec market. Therefore, we need to take a call here and probably shift some of these limits to the G-Sec segment. Are we prepared for that?
This scene also can be interpreted to mean that unless G-Sec limits are enhanced, India may not be at the receiving end in case the Fed increases interest rates at least on the debt side, as there is virtually no scope for higher investment under the current dispensation. Also, given that investors have fixed allocation for debt and equity, the switch to equity may not be forthcoming.
The equity picture also does not look too rosy. The first four months of the calendar year saw an upsurge in FPI equity flows of $7.7 billion. But since May, the flows have turned negative in three of the four months (till August 21), with net investment cumulating to negative $1.2 billion. Therefore, notwithstanding the Sensex swinging in a range of 27,000-28,000 during this period, FPIs have been net sellers in the market. The absence of clarity on the MAT retrospective that was spoken of by the government could have had some impact on these flows.
It is true that when currency markets are in a spin, there would be little order in all the flows as they search to cut losses in various markets which have repercussions on others. But in this wave of a run on currencies, the prudent thing would be to strengthen policies that inspire more foreign investment through both the routes so that we prepare the firm ground for these investors to come in when conditions stabilise.
It is clear that lower commodity prices due to weak growth proclivities in major markets helps us cut down our import bill, but also gets reflected in declining exports. The weak currency argument for augmenting exports works in a limited way, as they are driven more by demand-side forces. In such an environment, getting more foreign investment would work well for the balance of payments.
This becomes more important today, as we must remember that the 2013 crisis was tackled by getting in more NRI funds of above $30 billion. But all debt, which has crossed $475 billion in March, has to be serviced and probably returned to NRI deposit holders. Investment appears more attractive and hence the current crisis should lead to a fresh look taken on both FDI and FII flows