Rs 500/Rs 1,000 Notes: Ban may not be able to stop creation of another black market in new notes: Financial Express 10th November 2016

Using demonetisation to attack black money is definitely a great idea; and the manner in which it has been executed by the government is praiseworthy. The opening of bank accounts through Jan-Dhan was a prelude to this exercise. This was followed up by the income disclosure scheme, which was a good success; and after this came this big step of simply banning the use of the R500 and R1000 currency notes. It has been done with clinical precision and with a great degree of secrecy.

However, when implementing this grand design care has to be taken to ensure that all the pieces are together, because if they are not, it would result in chaos. Let us see what has been done this time. High denomination notes have been immediately demonetised to be replaced by new R500 and R2000 notes. People can withdraw limited sums from their accounts while there are no limits for deposits—but the tax man will be watching. The attempt is to block black money and get rid of counterfeit currency. While this sounds reasonable, some issues need to be discussed.

When it is believed that high denomination notes leads to generation of a parallel economy or black money, introducing new ones with higher denomination will be met with suspicion by the public. There can always be a repetition of such an act in future, and no one would like to be left holding such notes. Further, terming R500 and R1000 notes as high value can be debated as a R500 note cannot really get one much from the market—a single can of edible oil for a family of four costs above this amount. Similarly, an R1000 note cannot pay for the milk bill for a month. Hence, the premise that these notes are high can be discussed further.

The second reason provided for this action is that there are counterfeit notes. But banning all notes because a small proportion is ‘fake’ may not be the right way out given that it involves the lives of 1.3 billion people. Also, there is no guarantee that the new notes will not be counterfeited again. In fact, it is hoped that the government has taken measures to ensure that such currency does not enter the stream as whenever new notes are introduced, the public could be fooled by counterfeit notes as it takes time to adjust before they can identify the right ones.

The other issue of demonetisation is the timing. There is compelling reason to do it immediately as this does not give time to anyone to dispose of these notes. The success of this scheme will hinge heavily on whether our systems are prepared to face this challenge, and this is where there could be some doubt. Our banks need to be geared up to making such provisions and in the past it has been observed that ATMs have tended to run out of money on long holiday weekends. With volumes increasing, the banks across the country need to ensure that all branches across the country are equipped for the same. Even prior to this move banks were never able to provide R100 notes to customers in sufficient quantities. Hopefully, this has been addressed appropriately otherwise it could lead to substantial unrest.

Households in particular will face the challenge of keeping money for emergencies. Normally, it is locked in R500 and R1000 notes which have to be deposited and then withdrawn as this need would not ebb though would be replaced by different notes of similar denominations. Hence, the next few months would be hectic as they strive to restore equilibrium.

The other part of the infrastructure which has not been put in place is a system of alternatives. For example globally plastic cards have been used for transactions for which every dealer has the swipe facility. This does not exist in the country which will create continuous disequilibrium in the demand-supply chain. Even government services like the Railways accept only cash at the counters. Further, the committee on black money had earlier suggested that all usage of cards would have to go without a charge which has not been implemented. Hence, cost of using non-cash has become more expensive. At any rate there have to be more facilities provided at every point of sale (PoS) to make the system work in future.

Is there a better way of doing the same? Probably not, because any extra time given for holding on to the existing currency would be self-defeating as black money would filter out of the system. However, if all bank branches and ATMs had been equipped with large amounts of currency from Day 0, it would have been reassuring. By putting limits on the withdrawals (which is mainly due to the logistics issue of quantities of currency involved) panic would set in till such time every household is able to reach equilibrium. Also, a longer time window for depositing such notes would have made it convenient as the December-end date appears too close given the systems that are in place today.

In terms of what has been intended there could be conjectures of how things could work out. While it will probably never be known how much such money has been blocked, it must be mentioned that often black money gets diverted into gold or property which will be hard to track. Also, often such money is converted into foreign currency and stored in different locations. It would probably be only at the fringe that large sums would be lying holed up.

Who then would be affected by this move? First, real estate prices could moderate with this move, but developers could just raise their prices by the tax amount in the medium run after forming a cartel—which cannot be ruled out. Rural households would have considerable amounts stashed away out of habit and may have some explaining to do to the tax authority. Most farm transactions are in currency notes and so is the storage if not invested in gold or jewelry. Political parties using cash for election purposes could be the other community affected, provided the notes are of high denomination. Last, there could be individuals who have been deep into corruption would find their funds blocked.

This attempt at curbing black money may not really be able to stop the creation of another such parallel economy with the new notes. But the harsh steps taken today could be a strong signal to such players that in future the government could just bring in similar measures. For sure households would remain uncertain of the future.

India’s rating & outlook: More objectivity required: Financial Express November 9, 2016

S&P’s decision to retain India’s rating as well as outlook is definitely disappointing. The reason is that it is not really clear as to what is it that is objectively being evaluated when assigning a sovereign rating. India stands precariously at BBB(-) which is on the precipice of being sub-investment. The need for open discussion is not just because it affects India, but also several emerging economies are in a similar situation.

Yet, it has been a market looked at very positively by foreign investors—both FDI and FII. FDI sees a lot of opportunity in various sectors and has been flowing in large numbers in the last couple of years. In 2015, India drew more FDI than any other country. FII funds look at money making opportunities and have entered both the debt and equity markets thus reinforcing their faith in the economy and prospects. Curiously, the same government debt that has been flagged by the rating agency as being a concern has seen the most enthusiastic response from foreign investors and the limits get exhausted almost immediately.

Quite clearly, those who are investing have a different view on the country and have never found it risky to invest in the country’s debt, which a rating is supposed to evaluate. Does it mean that such ratings are more of a commentary by an agency on the country in general and not a factor that is used for decision taking by those who are staking their money? There evidently seems to be a disconnection between what the rating is supposed to denote and the way in which it is perceived by investors. In fact, if one looks at the initial response of masala bonds, which is not being raised by the government but private parties, the response has been very impressive. What is one to make of it?

The answer is that it is hard to assimilate the fact that the fastest growing economy in the world has an unchanged rating for several years now; and when an established rating agency declares that there is unlikely to be a change in the rating in the next two years, it is difficult to accept the same. The major bone of contention is government debt; and almost all issues are orbiting around it. The curious part is that all Indian debt is denoted in rupees and hence, theoretically debt which is exclusively in domestic currency cannot default and the worst case situation is when it becomes inflationary. Therefore, to over-emphasise the fiscal deficit and the debt level could be questioned as being restrictive in scope.

In fact, the reforms on the fiscal side have been quite amazing and should have been a reason for change in rating or outlook. The power sector reforms at the state level have been largely successful, and hence has been a very good response to the concerns that have been expressed by global rating agencies on the state of the DISCOMs. The realigning of fuel prices and rationalising the same on the subsidy front by the central government are major steps taken which provide better flexibility to the fiscal numbers. Further, the GST is a just a few months away and will bring about efficiency on the revenue side. Hence, the fiscal situation can only be regarded as being very positive with no discernible risk factor.

It does appear that sovereign ratings run the risk of being very straight jacketed in approach where a single norm is used for evaluating various countries. Pure numbers like debt to GDP are much higher than India for almost all developed economies like USA (104%), Euro (91%), Germany (71%), UK (89%), France (96%), and Canada (91%). And all these countries with stagnant growth and high debt levels have a rating of anywhere between AA and AAA. While the justification given is that these are anchor currencies and hence have the prerogative, a difference in rating of 6-8 notches between India and the others becomes difficult to explain.

A curious pattern in the way in which the rating of India has been judged by various international rating agencies is that there is a list of concerns that have been put forward which include parameters such as growth (under the UPA government), fiscal deficit (when it crossed 5%), government debt, inflation (when it crossed 10% due to crop failures), reforms (including GST), current account deficit (when it went past 4-5% mark when oil prices spiraled), bank NPAs (bankruptcy code is now there), FDI (need to open up more to foreign investments) etc. Over the years, the government and RBI have addressed all these issues sequentially such that the country was more or less compliant with these issues. Yet, there is fairly cynical approach taken to evaluating the Indian sovereign rating, which actually begs the question as to what is it that any country should do to get a better rating? The WEF and World Bank think that in the last two years we have made significant progress on the business environment front which is however not noticed by the global rating agencies.

This is probably why there has been some talk within the developing nations that it is always a challenge to move up the rating scale as the approach to rating appears to be quite singular. Developing economies have certain deep rooted problems like poverty and inequality and have to strive towards inclusive growth. Governments cannot shirk their responsibility here and while they have been critically looked at when there are subsidies, the same yardstick is not used when western nations have large allocations for healthcare —which are similar in scope to what governments in emerging markets do.

It is also not surprising that there has been a call to have more international rating agencies to offer alternative views (provided they believe so) which has also led to the germination of the idea of BRICS Rating agency. In fact, a new credit rating agency, ARC Ratings (where CARE Ratings is a shareholder) views the Indian economy differently with ratings of BBB+ for foreign currency and A- for domestic currency ratings.

While we in India could be wary of the unchanged rating, at the broader level, there needs to be some discussion on bringing in some more objectivity in these ratings as countries could also then strive to move in the right direction. Using per capita income as the ultimate explanation may tend to blur the vision as populous countries will always tend to have a low number even if they are growing at a very high consistent rate. The debate must begin

Plastic money gains currency, but cash still remains the king: Economic Times, November 2nd 2016

One of the objectives of central banks is to move people away from holding cash to the plastic or virtual world where it becomes easy to monitor the source of transaction. To this extent, governments are first trying to link all high-value transactions with the identity of the person while banks are working towards migrating customers from the branches and ATMs. How far has this succeeded?

Three trends can be examined closely here. The first is the proportion of currency in money supply. This gives an idea of the amount of cash that the system holds for purposes of liquidity, transactions and precaution. The table shows that the share of cash has been stable between 13% and 14% in the last five years, which is the period when the banking system has given specific thrust to alternative forms of holding money.

Households prefer to hold a fixed proportion of cash for several reasons. First, the precautionary motive is dominant for emergencies, especially in non-metro cities. Second, cash is used for several land transactions as well as purchase of gold to avoid the identity being revealed. Third, there are a large number of small-value transactions in mom & pop stores as well as travel where cash has to be used. Therefore, cash is still very important and has not ebbed in importance.

The second trend pertains to the use of debit cards. Banks are issuing debit cards to all account holders and often charging for the same. They are used for purchases as well as for withdrawing money.

Between 2011-12 and 2015-16, the number of cards in circulation increased 2.4 times to around 660 million, which is impressive. However, the average number of transactions per card has come down from 19.44 to 13.97, which is quite revealing. The average value of transaction was Rs 2,914 in 2015-16 and had increased gradually from Rs 2,684 in 2011-12, with the value being in the range of Rs 2,900-3,000 in the intervening years.

Third, the number of credit cards in circulation increased from 17.64 million to 24.50 million during this period. This has largely been due to the issuance of cards free of cost and fees being waived off in the first year. In terms of usage, the average number of transactions is better than that of debit cards increasing from 18.15 to 32.31. This can be attributed to the relatively more affluent public using these cards to a greater extent. As the lower income group subscribers realise that the interest rate charged is 24-30%, with recurring fees being the icing, they tend to stop using them. Curiously, during this period, the outstanding credit on account of credit cards for banks has increased from Rs 2,345 crore to Rs 3,444 crore. Again, in terms of value of transaction, the numbers are better than that of debit cards at Rs 3,078 (Rs 3,054 in 2011-12).

Hence, data shows that while penetration of non-cash has increased considerably with efforts put in by banks and the government, the habit has not caught on commensurately. There is still preference for cash and some hesitancy in use of cards. Credit cards are often used as debit cards where payment is made on time. Debit cards, though useful and forced on consumers, are not accepted universally, in say, a bus or cab or kirana shop. Unless this happens, people, will continue to transact in cash. This infrastructure has to be built to provide access besides making the use of debit cards free of cost.

High-value cash transactions in gold or property are hard nuts to crack and contrary to the western view that demonetisation of larger values helps, it may not be suitable. Inflation is high in the country and the purchasing power of even Rs 1,000 note is low – cannot cover consumption of 1 litre of milk for a month. Theoretically, one can switch over to a new currency and then issue small value currency, thus starting afresh. But this is not feasible. Cash will continue to reign in the wallet.

View: It’s time to bring back the widely-traded chana futures: Economic Times 31st October 31, 2016

The standard operating practice when it comes to tackling a price rise on account of shortfall in supply for any commodity is to first deny that there is a problem. Second, the suspicion is passed on to the hoarders even if the product involved is perishable like onions. Third, high stock limits are imposed on holding of such commodities by wholesalers and retailers with the penalty stretching to imprisonment. 

When all else fails and there is futures trading in the product, a ban follows. 

Curiously, almost always, none of these measures have worked as a decline in supply can seldom be addressed by any physical measure except imports. And by interpreting a useful signal, which is what futures prices are, as the cause rather than awarning, and going ahead with a ban, the damage done to the market is irreversible. 

The ban on trading in chana futures is the latest episode in this futile exercise. 

This has happened in the past in case of tur and urad, which were banned in 2007, and never came back on board. Wheat was agood contract which was banned and reintroduced, but lost the bounce that was there. Sugar and soya oil have also faced this onslaught in 2008 but have managed to recover. 

The latest casualty is chana, which is a very good contract that had large number of participants and was hence widely traded. Trading was smooth with the exchange surveillance systems ensuring that there was no scope for control by any group of traders. The futures contract was banned in June 2016 but interestingly, three months down the line, the prices continue to soar. 

The price of chana had increased from an average of Rs 6,477 in June when the ban was imposed to Rs 8,791/quintal in October –– an increase of Rs 2,314 or 35%. The increase over March when futures trading was in play was Rs 1,395/quintal. 

Quite clearly, the price increase was higher after the ban than before the ban. It will also be illogical to say that the price increase was lower because futures trading was present as futures trading only reflects the market reality which is created by fundamentals and not by trading. This has been missed often when the conclusion linking the two is drawn. 

Chana, which is the highest grown pulse in the country, where demand increases sharply during the festival time has witnessed decrease in production over the past two years. In 2013-14, it was 9.53 million tonnes, which came down to 7.33 million tonnes in 2014-15 and further to 7.17 million tonnes in 2015-16. 

With lower production and disappearance of carry forward stocks, shortage of the product is palpable which has led to an increase in prices. The conclusion that can be drawn hence is that prices will mean-revert only if production improves or we are able import on a timely basis. We need to bring back chana futures. 

E-commerce: Festive season sales a success; here are the key takeaways: Financial Express 26th October 2016

We have entered the critical and exciting period of the festival season which is also the beginning of the harvest season. In monetary parlance, this is the start of the busy season when demand for credit typically picks up. The entire consumerism story, i.e., to reach the climax and provide a thrust to GDP-growth is based on the edifice that households will spend more after two years of subdued spending. In FY14 and FY15, consumer goods production grew at negative rates and increased by just 2.9% in FY16. The third quarter of this fiscal has been made symbolic of the expected great turnaround. October has started off on a very bright note, with three leading retail portals Amazon, Flipkart and Snapdealhaving their discount sales which have been roaring successes. What are we to make of it?

Let us look at some facts. Each sale has claimed to have generated as many as 15 million units of purchases and while competitors have disparaged others’ claims as being overstatements as they involve sales of the humble packets of spices, the fact remains that there have been several transactions all through this period, which started with Amazon’s sale, followed by the those of the other two. While the precise numbers will never be known, the market guesses that the total sales together could go towards the R15,000-crore mark in these pockets of 5-day sales. The focus has been on electronic and consumer goods, including mobile handsets and spread to garments, perfumes, leather products, etc. The discounts varied and went up to 70%, though the numbers available at these super-discounted prices were limited. The fine-print of ‘terms and conditions apply’ kicked in with only the first few to log-in being entitled to the same.

The first thought that strikes us is that such an upsurge in spending is a manifestation of the consumer-demand cycle starting off on the third gear, with various incentives being thrown in. This cannot be disputed as these volumes are really amazing and, if this is a trend, there could be further momentum once Christmas and New Year’s are factored in.

Second, it is not clear whether these sales were exogenous ones, where demand was created by these aggregators and not just cases of substitution from the conventional channels of bricks-and-mortar stores. There is an argument that given discounts offered were much higher than what any shop has offered, the sales could have been substitutions. But this argument will hold only to a limited extent. It would be more of a 80-20 distribution in favour of fresh demand as, typically, deep discounts generate a new consumer class. The low prices offered would have been a good incentive for households to go in for unplanned purchases.

Third, while sales on these websites have been reckoned from across the country, this demand cannot be directly linked with advance purchases in anticipation of higher income either on account of the kharif harvest or the Pay Commission calculations. There could have been some use of bank loans and credit cards for this purpose though information is not yet available for October—it could be more credit cards than loans, given the timelines involved. The other way of advance purchase could be dipping into savings, which looks unlikely given bank deposits growth has been sharp till end-September. Hence, it is possible to again conclude that these purchases were exogenous and added the delta to the spending cycle. With the fresh flow of farm and salary income coming in, one could expect demand to increase though a part could have been reckoned in advance.

Fourth, it is uncertain again about what quantum of these sales has come from inventories and fresh production. Normally, when there are end of season sales, they are based on the assumption that fresh stock would be coming in leading to inventories getting out-dated. Hence, there is incentive to sell at lower prices. But there is reason to believe that a large part would have been fresh stocks as the growth in production of consumer durable goods has been impressive, with growth being at above 6% till August.

Fifth, a pertinent question to ask is that if companies have been selling goods at discounts, then are the mark-ups very high in normal course? As mentioned earlier, not all the sales were at the highly discounted prices advertised and they were virtually ‘limited edition’ offers where the fastest fingers got access to such deals. Further, dealers have been disposing off old stock where the cost of holding them is high given the interest payment on loans. Therefore, such high sales may not necessarily mean that corporate profitability will be better. In fact, irrespective of whether they are fresh sales or a part of the process of inventory reduction, lower realisations are more likely to affect profit margins of this segment.

Sixth, will this be sustained? Consumer demand should continue to be buoyant even though the intensity will be lower. There would be some bit of satiation of demand in the next two months or so as there will be limited new entrants in the market. Such entry is more likely from the rural areas. However, if similar discount sales are announced, demand will increase as several consumers wait for such offers to place their orders.

Therefore, this episode of e-commerce success is encouraging as it has set in motion the initial momentum for consumer spending. But it does appear that consumers are more receptive to such discounts as almost-forced replacement-demand sets in when consumers buy new goods to replace old models which would not have been considered in the absence of discounts. This may be the new way forward where companies have to make such offers to claim a higher share of the consumer wallet.

Bank NPAs: Selling stake in PSBs now will lead to low market price, adverse valuation: Financial Express October 19, 2016

Recapitalisation of PSBs evokes mixed emotions, which range from strong defence on the grounds of it being the responsibility of the government to provide support to a high level of umbrage over governance issues. While there are valid arguments on both sides, the solutions appear to be very much limited. Either the government has to keep supporting banks with further doses of capital infusion from the budget or they should be willing to let go control, which is not easy as there are several issues relating to human resources that have to be addressed.

Selling government stake in any enterprise under the name of disinvestment has been generally done in a manner where government ownership remains while minority stake enters the market. Hence, the entity remains a public sector entity unless it is fully sold to a private party. Right now there is considerable opposition to sale of government stake of PSBs moving towards 51% and subsequently below this mark. Ideologically, reducing stake to 51% may sound compelling as there is money to be had by the government which in turn can be used for capital infusion.

However, once it is fully sold to a P-E investor or a foreign entity, there would be a change in ownership. The history of such sell-outs—which has been the case with private banks—is replete with stories of exit of senior staff, rationalisation of staff at mid-levels, closing of branches, and considerable pain for the workers. There could be some increase in salary but over three years’ time the acquiring bank has in place its own management and the existing personnel are sent off for gardening. This is the truth and, hence, it is not surprising that there will be a lot of opposition as the number moves towards 51%. There are as around 850,000 employees in these banks.

At the theoretical level does this idea sound good? Prima facie it does appear to be a way out, but like all disinvestment programmes it should be understood that there are limits to which one can sell and earn money to recapitalise banks. Once sold, the opportunity weakens. If one were to look at just numbers, the total market value of government holdings in PSBs has been moving downwards along with the market as well as the performance of these entities. In March 2012, the potential that could have been extracted was R3.07 lakh crore (if all government stake was sold), which has since come down sharply to R1.95 lakh crore in March 2016 and recovered to R2.47 lakh crore in September 2016.

But if the government sticks to the 51% threshold, then the maximum that could have been derived would be around R70,000 crore, which has come came down to around R50,000 crore in September 2016. Hence, the question to be posed is how much is the government willing to let go? An amount like R50,000 crore can at best provide solace for two years after which this option would no longer be available.

Second, the timing is important and in almost every disinvestment the puzzle is when to do it. There is always the fear that if it is sold today at price X, but the price moves to Y after six months the entire process will be questioned. This is one reason for high degree of procrastination and invariably the purchasers turn out to be other public sector entities with LIC being the investor of last resort. This may not really help the cause.

Third, we are looking at around R1.8 lakh crore as capital by 2019, of which R70,000 crore would come from the budgets. The balance is to come from internal accruals and disinvestment. Quite clearly the latter has limitations and, hence, the succour will come from internal accruals. Profits of these banks at the best of times have crossed R40,000 crore, of which the dividend payout ratio is in the range of 20-25% at the highest level, which if replicated can be used largely to recapitalise banks. But, in a way if say, 50% is the government’s share then the loss to the exchequer would be of the same amount in the ‘non-tax revenue’ component.

The conundrum with selling stake is not just the timing with the market, but also the state of the banks which is the last issue. With the NPA mess yet to be sorted out, profitability of banks is under a cloud which also implies that the market price will be low leading to adverse valuation. Hence, unless there is a major turnaround in these banks only then can one expect the valuation to increase, which is a prerequisite for any successful disinvestment programme. Paradoxically if banks do well, then the internal accruals would be high for plough back and support may not be required for the banks.

Quite clearly the focus has to be on cleaning up the balance sheets and improving the governance processes to ensure that the books are clean and robust to command good valuation. When this happens, it will be concomitant with better internal accruals which can be used for recapitalising banks. Until such a situation is reached, it will be necessary for the government to deploy more funds as this appears the only way to enable them to lend more in the market.

At present, there is a muted demand for credit and to the extent that it is not being met by banks, there is substitution taking place through the debt and CP markets. Further as interest rates in these markets are more elastic to policy rate changes, companies prefer this route. Quite clearly once the demand for credit picks up with higher investment being undertaken there would be pressure on these banks. Hence, the government will have to play a proactive role to ensure that these banks are well-capitalised to face this challenge. There appears to be no other way out presently.

Book review: Failed by Mark Welsbrot, how blindly following west could be harmful Financial Express 16th October 2016

The financial crisis, followed by the Euro imbroglio, has produced probably the largest number of books in recent times. Some tomes tell us how the crises came about and were addressed, while others have been critical of the capitalist system that engenders greed. The Federal Reserve, European Central Bank (ECB) and their chiefs have been the protagonists in all these expositions. Mark Weisbrot, the author of Failed, starts off from these crises to build his theory of how the so-called new-liberal policies, built around the Washington Consensus, have failed, and why we should think differently. In fact, he details how these policies have ossified economic growth paths of nations, while those that did break with their commandments have done better.

Look at the US and Euro regions. Both faced a crisis of immense magnitude. Yet, the US officially came out of the recession after 18 months in 2009, while Euro zone countries continue to struggle to get out of it. Here, the author points out the differences in approach from the policy perspective. In the US, the government was responsible towards the people and the politicians could not get away with so-called conservative, or rather ‘oppressive’, policies. Quantitative easing was a result of this thinking. As various measures of easing started almost immediately, the country was able to come out of the rut.

In case of the Euro region, this was not possible, as governments there had no control over the currency, as well as the interest rates. The concept of one central bank—the ECB, combined with the European Commission and the International Monetary Fund (IMF), formed the deadly trio—forced several structural reforms on countries facing a crisis like Greece, Italy, Spain, Portugal, Ireland, etc. This, as per Weisbrot, was inappropriate and pushed these countries further into recession, as their governments could not spend and had to cut down on social spending, including pensions.

This mistake was realised quite late in the day when Mario Draghi reassured people that the ECB would do everything to support the system—that is, provide money. Hence, the change in stance from ‘no printing’ to ‘printing of unlimited currency’ brought about a transformation. Interestingly, the absence of a political will, or rather political ability, to follow independent policies was responsible for the downfall of 20 governments during this period, which tells the entire story.

The author is very critical of the IMF and the role assigned to it as the gatekeeper or head of the creditors’ cartel all through its history and more so after the breakdown of the Bretton Woods agreements. Here, even India can vouch for the stiff conditions, which have been imposed in the past when drawing assistance from the IMF—the last dose of such bondage being, ironically, the introduction of economic reforms in 1991. This package includes opening up the economy, privatisation, letting in foreign investment, a strict monetary policy, constriction of the fiscal policy, etc. These had to be implemented by the countries sourcing finance, as not doing so kept them away from the entire cartel of lenders, including the US. However, by pursuing these policies, the countries fell into the trap of low growth.

The author points out that this new-liberal doctrine pushed low- and mid-income countries further down and the levels of poverty increased. Governments were not allowed to spend on social causes like education, health and sanitation, etc, as fiscal prudence had to be adhered to. Consequently, the implementation of these policy prescriptions led to increased suffering in these countries.

The Asian crisis was a clear case of how the situation became worse because of the IMF, a view echoed by economist Joseph Stiglitz in the past too. The author is all praise for Latin American countries, which broke away from these neo-liberal policies and pursued independent approaches to bolster their economies.

Failed is a strongly- and passionately-worded book on how blindly following the western doctrine could be harmful. Weisbrot admits that there have been exceptions—like China—which have gained from this, but a ‘one-size-fits-all’ approach is doomed to fail. The way he goes about demolishing the IMF and the Eurozone myth is very logical and particularly interesting. The rebellion started by Latin American countries like Argentina, Brazil, Bolivia and Ecuador has vindicated his theory that working independently to fight problems works best.

Failed should be read by all our policymakers, as we often fall into the trap of following a western doctrine especially when it comes to the Budget, where we are conscious of the western reaction to our fiscal deficit. The so-called structural changes and austerity measures have hurt the European economies and delayed their recovery. Following the Washington Consensus blindly and ignoring the issues of poverty, unemployment and absence of social services is not the right approach for a country like India.

There are lessons to be drawn from this book and it will go down well with both politicians and economists who frame policies—the former because they can be voted out of power (notice how the present government is taking pains to tell us that its priority is inclusive growth) and the latter because it moves them away from the textbook to reality.

Commodity options are here, but not many players likely Economic Times, October 13, 2016

The introduction of options in the commodity market, which has been a demand for over 12 years, is significant and could be the precursor to the widening the scope of participants to include institutions like banks and mutual funds. 

Simply speaking, an option gives the right but not the obligation to go through with the contract for a premium that is paid. Hence, if spot price is Rs 100 and the contract is sold forward at a price of say. Rs 105, in case on the settlement day the price is Rs 110, then the sale at Rs 105 need not take place. 

Prima facie, this resembles the MSP of the government, where the farmer has a choice of selling to the government if the price in the market is lower than the MSP; and hence sounds alluring even if there is a cost involved in the form of a premium. Options would be on the futures contract, which means farmers have to be players in the latter to take this advantage.

There are three issues here. First, farmers need to be made aware of how these contracts work which will mean that they have to understand futures. So far, there has been limited participation from this segment, which means that we cannot expect farmers to trade in options. 

It would be an instrument for only non-farming players. Second, for the options market to evolve, we need to have institutions trading in the market in a big way. Presently, participation is from the trading community as others are not permitted. Hence, we need to have banks, mutual funds, FIs as active participants. 

Third, how deep will this market be? It is argued that while options trading per se may not be too deep, having them will help in increasing volumes of trade in futures as there will be heightened trading activity. This is interesting and it would need to be seen how the market reacts to options once introduced and it is likely that bullion would be the first segment that will evince interest. 

This is important because globally, options trading have not been significant in commodities though it has been high in case of single stocks and indices. The table (left) shows that the ratio of options contracts traded to futures contracts in 2015 for all member exchanges of World Federation of Exchanges. 

The picture for commodities is not too exciting. While having options is necessary as part of the bouquet that is offered, we must not expect too much too soon. 

The silver lining for the consumption story: Business Standard 13th October 2016

The consumption cycle appears poised for a turnaround. Three elements have to come together to see concerted growth in this segment. These are timing, income and finance. Timing is important because there typically are seasonal variations in the spending cycles of households, which coincide with the harvest (October-November and April-May) for farm-related households, bonus/incentive payments in the organised sector (April-June) and festivals (September-December) for all households. Second, income is evidently required because householdsspend when income increases by more than food inflation, as normally non-food spending is based on what gets left over after spending on food. Third, when one spends on consumer durable goods or automobiles, access to finance is even more critical.

At present, all these three elements point in the same direction. A good harvest will ensure spending is on track and would be of the order of an incremental Rs 15,000-20,000 crore. Payouts from the pay commission's recommendations will add Rs 40,000-45,000 crore after adjusting for tax and savings. Hence, the income factor would also be working well, at a time when the festive season provides the right environment.

Bank finance is of importance and data on credit disbursement shows the personal loans segment is the best performing, with growth of 4.6 per cent in August over March. Of this, loans to the consumer durables segment, though small, have grown sharply at around Rs 20,000 crore. Automobile credit is around Rs 1.6 lakh crore and growing, while other personal loans that can range from education to current consumption are around Rs 3.1 lakh crore. Here, the driving factor is cost and availability of funds.

Of late, banks have preferred to target this segment mainly because delinquency rates are lower and returns competitive. This has provided a push to the consumer goods sector and, hence, the recent interest rate reduction by the Reserve Bank of India will have a lubricating effect on such consumption.

There are other factors at work to ensure that this scenario will turn out to be right. The first is that the consumer goods segment has been downbeat in the past three years with growth rates of -2.8 per cent, -3.4 per cent and three per cent, respectively. This low consumption base should create a possible demand upsurge in the coming months. Second, companies have excess inventories that have to be dispensed with. This holds for textiles/garments in particular, where fashions matter and holding on to stocks could be a liability. In a bid to sell these goods, there are signs of offers for customers that are positive for the consumption cycle. Last, the advent of e-commerce and competition have also led to a plethora of discounts being offered on almost all products, which is actually a cut on the profit margins by companies.

It does appear that we are at the cusp of a major recovery in the consumption story in India and the sectors that can look forward to better times are automobiles, garments, fast-moving consumer goods, white goods and electronics. The story so far this year has been more cheerful for these segments, relative to the rest of manufacturing. And, they can see acceleration in the next few months till the end of the year. While low demand conditions have affected growth prospects, consumerism can be the trigger for higher growth.

Nobel prize in economics: Getting the ‘contract’ right Financial Express 11th October 2016

In Jean Jacques Rousseau’s theory of social contract, individuals enter into an agreement with the rulers to empower them to take decisions on their behalf in exchange for certain rights. The 2016 Nobel Prize winners, Oliver Hart and Bengt Holmstrom, would extend their theory on contracts to term this relation between the people and government as the classic ‘principal-agent’ dilemma. At the time of the elections, there are certain terms of engagement agreed upon, and several others which are not. This is the best analogy that be provided for extrapolating their theory to our political scenario.

In our economic life, we can observe that there are always contracts between two parties, where both sides agree on what they will give and get in return. To ensure that there is compliance on both sides, there are systems in place to ensure that there is no violation of the terms.

The classic example that is quoted in contract theory is the principal-agent conundrum which characterises all publicly held companies. The shareholders own the company; and in turn appoint a management (represented by the CEO) through the board of directors that are nominated by them. The management is to act in the best interest of the shareholders and gets compensated in return. As they are incentivised to do the same, which is specified in their contracts, in terms of bonuses and stock options, there is a Pareto optimal situation created where everyone should be better off. If the shareholders are to do well, then the company must perform and if both happen, the management benefits monetarily.

At a more basic level, the employee is rewarded with a salary by the company though the question always is whether one can get more from the person than is specified in the contract. This is why a fixed salary concept is justified as it is not possible for one to evaluate the work done by an individual beyond what is specified at the time of signing the employment contract. Additional incentives have to be provided to derive more value from them by the company, as they would otherwise not be willing to go beyond the terms of the contract. An extension here spoken of by the theory relates to ‘team work’. Interestingly, where there are difficulties in identifying the main contributors as it is not possible to ‘observe’ members in a team, free-riding results, which can demotivate employees. Separate structures have to be drawn up for the same.

Another area addressed by Hart and Holmstrom relates to education. How do we evaluate teachers in a school? Should it be based on scores of the students in examinations or the quality of education imparted? Drawing up such contracts can create perverse incentive to work at achieving the target of getting better scores and ignoring the basic thrust of education and learning. In such a case having a fixed salary may be better though it could lead to loss of interest as one is sure of the paycheck at the end of the month.

The theory on contracts is, hence, very important as it comes into our lives every day where there are both written and unwritten contracts. Making it formal imposes an obligation that can be sorted out through the legal processes if the need arises. But as it involves human beings, there are interesting challenges involved when drawing up such contracts. In insurance for example, there is a formal contract between the insurance company and insured for compensation based on the happening of an event. If companies agree to pay a larger portion of the contract then there will be an incentive for the insured to be reckless if it is a motor insurance or choose a higher-end medical facility unnecessarily for health. Therefore, the contracts have to be drafted carefully to eschew this moral hazard.

The interesting part of such contracts, according to Hart and Holmstrom is that they can never cover all possibilities as there are several unknowns which have to be addressed. The shareholders can hold the management responsible for the sales or profit targets. But they cannot really determine action taken on a day to day basis. At times an acquisition could be necessitated and while shareholders have to be consulted for the same, taking equity stake can be done independently as part of business decision without consulting them. Therefore, the contract also has to be clear about who has the power to decide when there are such questions. Leaving it to the management is efficient as it can definitely not be going back to the shareholders each time. Demarcating these domains will enhance efficient operations.

Contracts are very important in the financial sector as every deal involves an agreement between two parties. A loan is an agreement between a bank and the borrower and a deposit is the agreement signed between the saver and bank. Both of them have the terms specified—what we call the fine print which tries to address all possibilities so that there is no room for interpretation. The same holds when one trades on exchanges in stocks or any other instruments.

An interesting extension to the theory of contracts is in the area of privatisation. When the ownership is public, what should be the goal of the manager? Generally the focus is on cost cutting rather than improvement in quality, which is a basic flaw in the model. Even at the government level, most departments are keen on tick-marking targets set like the number of schools established or hospitals inaugurated, but never address the issue of quality. Quite clearly, in all such contracts, the shareholder (i.e. the tax payers) must have a right to decide the content.

Some of the issues which are still nebulous can be found in the corporate world. The financial crisis was all about such contracts being broken where managers overpaid themselves and when the chips were down withdrew from the system. While jobs were lost, there could be no punitive action against them as they claimed they followed common business rules. This is a case where such contracts fail. Governments also fail in meeting their part of the deal with the electorate, and rarely lose power on this score. Hence, while the contract theory works where there is recourse, when large numbers are involved and there is limited recourse, this theory tends to melt.

Contract theory can also be extended to even more rudimentary situations such as marriage where partners must decide on what they expect from one another. The higher incidence of divorce in the west is a clear case of enforcement of such contracts. Similarly, shifting allegiance to products in the market due to expectations not being realised is a case of reactions to the terms of the contract with the company ‘not being realised’.

Hence, the extrapolation of this theory is enormous, as it covers almost all economic, social and political options; and would hence get more attention after the announcement of the Nobel Prize this year.

RBI repo rate cut: interest rates do not matter if growth is high: Financial Express 6th October 2016

here are some interesting features in the credit policy brought out by RBI on Tuesday. The first is that it continues to be a kind of bi-monthly review of the activities of RBI where it tells us what all has been done and what could be expected in the coming months. Second, the decision has been unanimous, which is significant as there are three academicians involved and everyone agreed that the rates should be lowered. Third, with the decision being taken by the MPC, it cannot be said that RBI was forced to lower rates by the ministry, which is often argued in some circles. Fourth, while the inflation goalpost of 4% has been maintained, RBI does not expect to move closer to this mark this year, and a 5% figure, by March 2017, is being spoken of. Fifth, the market will always find it hard to gauge the reaction of RBI while the inflation number moves along the corridor of 4-6% because, at times, the stance has remained unchanged while at other instances, like this one, the decision to lower the repo rate was taken. Lastly,

RBI has indicated that the targeted real-interest rate would be 125 bps as against 150 bps.
The repo rate impact is actually quite small as it needs just R2,500-3,000 crore to influence interest rates paid and charged by banks. Yet, it is the anchor for setting interest rates, and hence the issue of transmission has been alluded to by the Governor. The repo rate change enters the bank’s interest rate through the base rate calculation or the MCLR. The banks, however, would still be free to lend at any rate they wish depending on their risk perception, but can’t go below the base rate/MCLR.
How have banks acted so far? The accompanying graphic gives the movement in the repo rate, the average deposit rate of banks for a tenure of above one-year and the average base rate of banks (as presented by RBI).

The dynamics of interest rates changes is interesting. When RBI lowers rates and banks follow suit, lending rates would all tend to decline almost immediately, unless they are fixed rates for term loans. But deposit rates would get re-priced only on maturity as they are of a fixed-contract nature. Hence, deposit rates tend to move faster than the lending rate. Therefore, the present reduction in the repo rate may not lead immediately to a decline in the base rates of banks while deposit rates could come down.
An interesting calculation from the graphic is that the difference between the deposit and repo rate has never exceeded 75 bps and, hence, with the repo rate going down to 6.25%, the deposit rate would tend to gravitate towards the level of 7%, which will be at least 15 bps lower than it stands today. However, borrowers may feel better off as the difference between repo rate and the base rate has been less than 300 bps, though this differential was maintained at this level in FY16 and the first half of FY17. A correction of up to 25 bps may be expected with the repo rate, at 6.25%, and the base rate could move to 9.25%.

At the theoretical and ideological level, the issue which can be debated is whether a reduction in the base rate and thus all lending rates spur growth in credit. The graphic provides information on the growth in credit in various segments along with the so-called regimes of easy/tough rates as represented by the repo, which are mimicked by the base rates (though not in proportion).
Some interesting observations emerge here. Regimes of high interest rates did witness steady growth in credit, as seen in FY11, FY12 and FY14. In FY11, the repo rate had increased by 175 bps and yet there was growth of about 20% in credit. Further, by lowering rates, as was the case in the other three years, growth in credit had slowed down instead of increasing. In fact, growth in credit is better linked with GDP growth where interest rates do not matter if growth is high. In the last two years, growth has been stagnant, leading to lower growth in credit.

Also, low industrial growth has affected demand for credit and it can be seen that growth in credit to manufacturing trails that of overall credit. Services had witnessed higher increase in relative terms but this could be more due to the inclusion of NBFCs which have to borrow to do business. Retail credit growth has gone counter to that in the other sectors over the last 2 years and has been buoyant, indicating that not just demand has gone up, but banks have also shifted to this segment where delinquencies tend to be lower.

Hence, the cut in repo rate will lead to lower deposit rates—small savings rates have already been lowered. RBI believes that inflation will be around 5% and hence another rate-cut cannot be accommodated. Lending rates would tend to decrease this time as well, but it is a tough call on credit growth in response to this cut. It is a shoulder-shrug for manufacturing, but an affirmative nod for retail credit.

As a central bank, RBI has made the right move to provide a boost to lending which can help industry. But until industry sees vibrant demand and the exhaustion of excess capacity, chances are that we may have to wait for a longer while for the investment cycle to resume. This is something we have to accept.