Revisiting inflation targeting: Business Line 23rd August 2016

By casting a target in stone, monetary policy is effectively shutting out options to work as a growth stimulant

The debate on inflation targeting has come to the fore once again as Raghuram Rajan, in a statement, and D Subbarao, in his memoirs, have expressed compelling views on this issue. The point is relevant because the perceived conflict between the Reserve Bank of India and the finance ministry over the years has centred on it. The RBI has generally been hawkish about inflation while the government has been arguing for lower rates from the point of view of growth. How do we view this debate?

The curious thing about this so-called discord over inflation targeting is that to begin with, all parties agreed with this objective. An RBI committee recommended targeting CPI inflation even while there were counter-arguments on the appropriateness of this measure. Next, the RBI accepted these recommendations and proceeded to target the CPI. At the final stage the ministry signed an agreement with the RBI that the CPI number would be targeted at 4 per cent with a band of 2 per cent either way. This means that conceptually everyone has agreed to such targeting. The question now is how one perceives an inflation number of 5 per cent. If inflationary expectations are grim, it does not look good, and if external factors are congenial, the number looks low.

Is there a theoretical basis for targeting inflation? Yes, if one is a monetarist, which is what most central banks tend to be. If inflation is believed to be, as Friedman had put it, “almost always a monetary phenomenon”, central banks should target inflation. The ECB or the Federal Reserve always talk of an ideal number of 2 per cent and work around it.

What’s the basis?

The rationale is that minimum inflation is needed to encourage economic activity; but beyond a point, easy money creates excess demand forces which push up prices. This is the classic case of ‘demand pull inflation’ which monetary policy can curb by increasing interest rates or reserves, or going in for open market operations to handle liquidity.

But if one follows the Keynesian school, then monetary policy can also influence growth and hence there is room for talking of expansion. This is where the government comes in, when the argument is put forward that lower rates will push up growth. Given that the government is not willing to spend by the theoretical Keynesian prescription of fiscal stimulus, the onus is passed to the RBI to lower rates which will enable the private sector to invest more.

There is, however, an argument that excess demand comes in only when full employment is reached and hence as long as there is spare capacity monetary expansion should not be inflationary. Hence both monetarism and Keynesianism can coexist.

But what has been observed globally is that merely lowering rates or even enthusing liquidity by buyback of securities is not adequate to propel economies. When the problem is on the demand side, which is the case in India today, lowering rates has weak effects. People do not buy homes or companies invest when there is less money being earned by households or excess capacity residing in industry. The solution does not exist on Mint Road.

The RBI can only lower rates, but economic agents have to start borrowing more and banks should be willing to lend more given their asset quality challenges. By treating interest rates as the overriding factor driving the economy and focusing excessively on lowering the same, we could just be losing the plot.

Debatable

It is also a matter of debate whether CPI is the right index to target in the Indian context, as the components of this series are not linked with leverage. In the US, credit cards are used in every sphere of life starting from bus tickets to consumer goods. Hence, viewing the CPI and then targeting the same makes economic sense. But for India, where almost 90 per cent of the index is not based on borrowing, interest rate policy cannot influence this number. The CPI is basically a supply-side phenomenon where shocks in production can set us back considerably. Ideally, the WPI which comes closer to being a producers’ index should be targeted, and going by what has transpired in FY16, negative WPI inflation was not consistent with the conservative monetary policy action of the RBI.

The main takeaway is that monetary policy is one aspect of the framework which can work only to a limited extent, for two reasons. First, we are targeting an inflation rate over which the policy has less control. Second, even if rates are lowered, the decision to spend is a demand-side issue and hence has met with little success.

Two conundrums come up. First, if crude oil prices go up, given that the government has withdrawn the subsidy substantially, prices of fuel products are bound to increase; this will push up inflation. Can the RBI then be pressured to lower rates in a situation where the government has contributed to rising prices?

The second issue is that as there is a lot of focus on growth when it comes to monetary policy, should we abandon the inflation targeting model and start talking of targeting growth? Hence, instead of looking at 6 per cent inflation, the vision can be , say, 8 per cent GDP growth, and as long as we are below this mark, interest rates have to come down. If inflation is on the supply side driven by potatoes and tomatoes, such rates should then be non-inflationary.

A realistic view

At a more realistic level we can also consider fixing ideal rates of inflation and GDP growth, and gear policy to these numbers. This was the RBI’s way of expressing itself before it settled for inflation targeting; when the opening lines of a policy statement referred to growth with stability, without explicitly stating numbers. But casting the target of inflation in stone does constrain policy action as while the band of 2 per cent for inflation allows for flexibility, excluding growth numbers in the approach generates controversy.

Going ahead, it is the monetary policy committee that will work on the structure. It will be interesting to see how the last part of the agreement between the RBI and the finance ministry will be handled in case inflation goes beyond 6 per cent, especially if the tomato or onion crop turns negative. The committee will be answerable.

Urjit Patel as RBI Governor: Here’s a sneak peek into what’s in store: Financial Express 23rd August 2016

Suggesting an agenda for the new Governor of RBI is both improper and pompous given that the person chosen to head the central bank is an accomplished person from the system who knows what to do and does not require any advice.

This said the markets will be watching for signals from the new Governor as this has become a habit where there are certain expectations that are raised which create a modicum of volatility when not realised. The immediate checkpoint is the management of the forex outflow resulting from the redemption of FCNR (B) deposits which would be around $25 billion. In August 2013, when this swap facility was introduced, our forex reserves were around $276 billion, but are now higher by around $90 billion. Prima facie these outflows should not make a dent with limited volatility being witnessed in the interim period, just like what was witnessed when the Brexit vote was counted. The market however, will be keen to take a clue from the RBI stance on exchange rate.

There is always a compelling argument that a weaker rupee would be good for exports, and in case the rupee is allowed to move towards 68-69 to the dollar, it would be helpful for the cause. On the other hand if RBI ensures a smooth flow so that the rupee remains within the present band of upto 67, then the message will be that, even in the future, the central bank will work towards maintenance of stability in the exchange rate. RBI Governors somehow get typecast on their view of the rupee; this impacts future movements too.

The second issue that will keep everyone in the financial sector guessing is the conduct of monetary policy. There are already statements made that Urjit Patel is an inflation hawk—though one does not quite know what this can mean considering that there is an MPC (Monetary Policy Committee) in place which may constrain subjective judgments. The Urjit Patel Committee had conceptualised the creation of the MPC for setting goals on inflation where the CPI was chosen as the target indicator. Also, the band that was suggested has been ratified by both RBI and government, which really means that RBI would be targeting this rate irrespective of the personal bias of any Governor. Further, as the decision will be based on a consensual approach, the direction is clear. After all CPI inflation of 6% is an objective numbers and cannot be interpreted differently by anyone on the committee.

In a way, the thrust of monetary policy is a given, unless there is a new line of thinking which brings in the growth aspect through a sub-target. This way the twin objectives of growth and stability will be addressed. But this is unlikely to happen as the contours have been well-defined.

The interesting part of this episode will be in the direction of how the MPC functions and how the policy is presented. At present, RBI presents the policy and takes the final view on the content. With the MPC deciding now, the question would be whether it will be RBI or MPC occupying the dais and explaining the reason behind such action. Further, as RBI will be held responsible for the targets being met, how will it respond in case there are divergences for three quarters? Will further action be taken or would it be back to the MPC?

The third, and probably the most important, decision followed by action that would have to fructify pertains to the recapitalisation of PSBs. This is a ‘work-in-progress’, which has to be logically concluded and is the most difficult part of the exercise. The conundrum is that the public sector banks have high NPAs today and will not be touched by investors. Their asset books have to be cleaned fully before going to the market. Also, the government has to show willingness to give up its stake and bring it down to 51%. Disinvestment has always been a tricky exercise given the pricing problem which often leads to cross-purchase by public institutions of these stake-sales. Also it should be noted that for the kind of growth we are talking of, banks need a lot of capital and are woefully short of the same. As economic growth is still rather stagnant with investment not picking up, the system is able to adjust to the situation in a non-distortionary manner. But, once growth accelerates and investment demand increases, then the system may not be in a position to deliver. This has to be addressed in the next 1-2 years.

The fourth area will be the setting up of the public debt cell or PDMA. This has been on the agenda with several arguments in favour of either having such a specialised agency or continuing with RBI holding this responsibility. A resolution of the same would be likely during Urjit Patel’s tenure.

Liquidity management would be another aspect of RBI that could be debated, but considering that the central bank has opted already for moving away from LAF and relying more on OMOs, there is likely to be continuity here which is good for the market. As this has been decided in the earlier monetary policy review where Urjit Patel was also part of the consultations, it may be assumed that this would be business as usual.

One must understand that central banking is a fairly standardised business encompassing conduct of monetary policy, banking regulation and financial sector reforms to the extent that they are related to the banking sector (other regulators come in when insurance, stock markets or pension funds are concerned). The path is always well defined and while the central bank can address regulatory issues, which has been done in quite an exemplary way so far, when they get entwined with government policy (on disinvestment) the road becomes longer. With RBI and finance ministry setting the contours of monetary policy, there is less room for controversy to be stoked, which also brings in objectivity. It can also be assumed that initiatives on financial inclusion, new banks, market development, derivatives, etc would continue in the normal course of business.

Hence, just like there is continuity on Mint Street, the road map is the same with the central banks forcing these issues along the path so that resolution is quite seamless.

India’s Long Road: The Search for Prosperity by Vijay Joshi; Book review: Financial Express 21st August 2016

PROVIDING A view on the state of the Indian economy and conjecturing the future has become a habit these days. There have been several such books written, mostly on a eulogistic note. Everyone has a view that the Indian economy has a great future, and that we are in the right direction. In fact, the inaction of the UPA government in the last two years of its reign has been contrasted with the urgency shown by the NDA. We all like talking of India being a leader in future and various scenarios have been painted; and the present NDA government has been lauded for putting us in the ‘sweet’ spot.

Vijay Joshi’s India’s Long Road, which intuitively tells us about the author’s perception, follows a similar pattern when one reads the first 270 pages or so. The view is that India has potential to become a leader by 2040, provided some deep reforms are undertaken by the government. There is the usual chapter on ‘state failure’, not just in the economic story, but also in terms of administration and corruption. Subsidies have been thrashed and the policy to keep PSUs has been criticised with the usual gusto that goes with such essays.

Joshi also talks of low total factor productivity levels, typical of an economic theoretician, besides usual factors such as labour and capital. The skill of the labour force is important for future growth. Capital is another factor and the author argues that we need to get in more investment. The author also guns for inclusive growth and is critical of what has happened so far in this area, blaming state failure in finding a solution in giving free power, food, money and water, and never working seriously on improving the quality of education and health, the two essentials for any sustainable development model. This is because of misplaced priorities. Here, the author lambasts PSUs, which have become a major burden for the exchequer. Similarly, he highlights the fact that while we have reduced the number of families dependent on agriculture, we have not made it resilient or created an alternative that is long-lasting, leading to lopsided structures.

The book gets interesting when the author talks of what should be done. More importantly, he unbiasedly evaluates how the Modi government has performed. He talks here of seven areas where such reforms are required and presents a view on the performance of the government.

First is macro-economic stability, where he gives a good score to the Modi government. Inflation has come down and we appear to be on the right path. He, however, feels that the RBI should follow a ‘managed float of the rupee’ and not let it appreciate, as it affects exports. This can be debated by detractors—that a free rate is better than a controlled one as we can’t push up exports this way.

He is non-committal on the second area of investment climate. While a lot has been done to prop up investment in terms of doing business, he links it with the problem of NPAs and how it has come in the way of flow of funds. Here, the performance has been mixed. Third, he is critical of the progress made in the area of deep fiscal reforms. There have been benefits of low oil prices that have been leveraged well by the government. However, the subsidy levels have not been lowered, which is where Joshi has a quarrel. Fertiliser and food subsidies have not been lowered and while directing them better has been done to an extent, courage has not been shown in lowering the quantum. Similarly, he writes a bit on implicit subsidies like the loss-making PSUs.

The fourth reform is in the areas of markets, ownership and regulation. Here, he is harsh on the government on the PSU front and has rightly pointed out that progress is lagging in infrastructure, environment and agriculture. The same holds true for land and labour reforms.

Fifth, he is all praise for Modi and his government on the external side and what has been done for FDI. The way forward is further liberalisation. The sixth reform is in the area of social development. Here, he gives a mixed score. On the positive side, Aadhaar and cash transfers have been successful. But less efficient schemes like NREGA have not been lowered in scope. Also, a lot has to be done in education and health, which is a theme often alluded to in the book.

The last reform pertains to the state where corruption has to be addressed to make doing business easier. Here, Modi does well, unlike the UPA government. But Joshi is again cautious when talking of the much-touted schemes of ‘Clean India’ and ‘Make in India’. The former, he says, has been crafted poorly, with no major benefit accruing except tick-marking of targets. ‘Make in India’, to his mind, is not possible unless we have all these reforms in place.

A couple of interesting points made along the way that should be addressed are that the government has become less democratic and allowed fringe elements to dominate, which can push us back by years. Second, the government has failed to take the Opposition along despite a large majority, which has made undertaking reforms that much more difficult.

Joshi is a very well-known economist and his insights are welcoming. The first part is a good treatise on what is happening in the country and the problems that exist. The second is a fairly unbiased evaluation that should be looked at closely by policymakers, as his name does matter.

Being a central bank is good business: Financial Express August 19, 2016

an you guess which Indian entity earns the highest net profit in any year? The answer is the Reserve Bank of India (RBI). In fact, the central bank is the highest money spinner, and in FY16 (year-ending June) had earned close to R66,000 crore in net terms, which is ultimately transferred to the government.

This amount is about 30% of the net profit of Sensex companies and also higher than the profit earned by the two highest profit earners: Reliance and TCS. Clearly, central banking is good business.

It should be pointed out that, by statute, the surplus of RBI has to be transferred to the central government and enters the budget calculations under the heading ‘non-tax revenue’.

It is important from the budgeting angle because it supports the budget deficit substantially. This amount was around 12.5% of the fiscal deficit for FY16.

Further, if this support was not there, the government would have to borrow the same from the market under ceteris paribus conditions, which will hit it hard. The significance of this amount can be gauged from the impact on the fiscal deficit ratio for FY16, which would have increased from 3.9% to 4.4%. So, transfer of surplus from RBI to the government is very significant.

The amount has become more aggressive of late, and was just about R18,800 crore in FY10. It accelerated to R33,000 crore in FY13 and to about R66,000 crore in FY15 and FY16.

The interesting part of the finances of RBI is that the revenue is based entirely on how much involvement is there of the central bank in the financial and forex markets.

There is nothing unusual about such transfers. For example, the Bank of England transfers 100% of the surplus of the Issue Department and 50% of the Banking Department to the Treasury.

The Bank of Japan retains 5% of the surplus while the Riksbank (central bank of Sweden) distributes 80%. Hence, the concept is not dissimilar, though the ratios are different.

The system of movement of funds is quite singular. RBI, for instance, earns considerable money from holding on to government securities (G-Secs), on which the government pays interest.

These securities are held by RBI for conducting open market operations (OMO) for infusing money or drawing out liquidity into the system. In FY15, RBI earned about R440 crore as interest on securities held, which would also most likely be the amount this year.

Hence, every time RBI infuses liquidity through OMO purchases—which will be a regular habit once it moves away from LAF—the earnings of RBI will increase as its holdings of G-Secs cumulate.

Being the central bank, there is no cost attached to providing liquidity (reserve money) except for printing currency, if needed. This component of interest income is almost 60% of total income earned.

Further, there is a gain to be made by selling securities, which helps the cause as the profit from sale of securities was R140 crore in FY15. Hence, RBI is also a major player in the G-Sec market—though for regulatory and not trading reasons.

The process of circular movement of funds is evident and interesting. RBI conducts monetary policy by dealing in G-Secs, which are issued by the government. The funds initially come from banks when they subscribe to these securities.

Next, they are picked up by RBI at a later date to infuse liquidity and thus the interest paid on these securities passes on to RBI. After covering up for expenses, the rest goes back to the government in the form of surplus transfers, which subsidise the budget that had generated these funds. This is not peculiar to RBI, but to all central banks and their governments.

Another curious item in the statement is earnings in foreign exchange. Last year (FY15) it was as high as R22,300 crore, out of a total income of R79,000 crore. Here too, there is a seamless flow of funds. The forex reserves with RBI are partly invested in securities of other governments, which are considered to be safe. The return is 1.3-1.4% (last year).

Intuitively, two factors increase RBI’s income and hence government revenue. The first is the overall quantum of forex reserves. All foreign currency earned has to be passed on to RBI except what is permitted to be held by banks.

So, when reserves begin to increase as the balance of payments improves, they are invested in securities of the US Federal Reserve or other central banks, which earn interest income. The cost for RBI is only monetisation of dollars, which is virtually free.

The second is the structure of global interest rates. As these rates change, so will the returns to the holders of these bonds. Thus, when the US Fed decides to increase interest rates, one of the beneficiaries will be the entire community of central bankers that park their surpluses there. The earnings would automatically increase.

Given this unique system of flow of funds, a question that can be posed is, are we using these resources in the best way? An argument put forward is that this amount should not be part of the budget and could be earmarked for other specific purposes, just like a cess.

There is some merit here, because unlike the other PSU surpluses which get transferred and are based on productive activity, in case of RBI surpluses are created through the peculiar status that the central bank has for printing currency.

Removing this lever will provide a true picture of the finances of the government, which is analogous to the disinvestment debate.

Given that this income is generated from the financial system, the gain should be earmarked for improvement of this sector, and one argument put forward is that it should be used for recapitalisation of banks.

While such provisions are there independently in the budget, they fall well short of these surpluses—maybe around one-third of the surpluses. By earmarking such funds, a commitment by the government to the PSBs would be refreshing and assuring.

This should certainly open the doors for a new line of thinking, given the capital problem with the PSUs that belong to the government, which has first charge on the surpluses of RBI that is also a part of the system. It can be the anvil for future growth too.

Bandhan: The Making of a Bank: Financial Express 14th August 2016, Book Review

The name Tamal Bandyopadhyay is synonymous with banking and his views on any aspect of the subject are compelling. From being a journalist to a banking specialist, whose insights compare well with any banking analyst from an investment bank, Bandyopadhyay has moved on to becoming an accomplished author. He wrote a biography on HDFC Bank to begin with, and followed it up with a superb investigative book on the Sahara story. His latest book is on the Bandhan Bank, which is probably one of the more interesting cases of an MFI-turned-commercial bank, with the RBI being convinced that it can add value in the area of inclusive banking.

Bandyopadhyay starts by saying that while he has links with the bank, this is not a biography, but a narrative of the creation of Bandhan Bank, hence making it clear that it’s not a sponsored book. He initially gives us a background of the creation of the MFI, where Chandra Shekhar Ghosh took his chances. Ghosh had actually seen women borrow R500 everyday from a lender and pay it back in half a day with an addition of R5. One can calculate the implicit interest rate on such a deal if R5 is reckoned as a half-day payment, which would be R10 a day. But the women did not mind, as they felt they had earned enough on the initial R500 to pay R5 interest. Thus germinated the idea of an MFI, and the creation of Bandhan, which went on to become one of the most successful institutions, and was finally vindicated by the faith reposed in it by the central bank in granting it a banking licence.

The road was bumpy and the enterprise grew with a set of committed colleagues who were with Ghosh from 2002 onwards. Conditions were tough continuously, as they had to deal with the challenge of availability of funds that led to the building of a culture of parsimony and high discipline. This remains the hallmark of the bank today, where attention is paid to costs, discipline and hard work. From what Bandyopadhyay has painted, the bank is not a liberal organisation from the point of view of being employee-friendly, and it’s only those who are fully committed to doing social good in the banking field who find this culture palatable. Compared with most organisations that are moving towards being more employee-friendly, with easier working hours and free time to rejuvenate the mind, Bandhan is a tough taskmaster. But the fact that there are a large number of employees here does show that the model works.

Some of the tales told by Bandyopadhyay about bringing in technology in the MFI are quite droll, especially the tryst to usher in technology. Ghosh and his team had to go about explaining the basics of computers and clarify that a ‘clear all’ instruction did not mean that the screen had to be cleaned with a cloth and also that computers did not have to be locked in cupboards at the end of the day. The distance that had to be covered by Ghosh to reach out to his employees, as well as the lowest-income groups to make them conscious of borrowing, was evidently long.
Towards the end, the writer has a chapter on both Vijay Mahajan of Basix and Vikram Akula of SKS to allow the reader to draw inferences from their stories. They could not last after the AP scandal came through and while Bandhan was fortunate not to be affected, being based more in the eastern part of the country, these two leading MFIs encountered serious problems of existence.

However, Bandhan had to face other challenges in its evolution. First, it had to fight the all-pervasive institution of chit funds in Bengal. Next, given the set-up and the concentration in the interiors, getting honest people to work was an issue, and this is what led Ghosh to closely monitor all activities and micro-manage affairs, which has become a habit today. Third, the bank also had to face the nightmare of an income-tax raid, being one of the largest tax-payers in the state. Fourth, the initial collaboration with the ASA of Bangladesh faced a different set of issues concerning poaching, which had to be addressed. Further, Bandhan had to continuously fight hard to ensure that there was no trade unionisation, having over 14,500 employees. But these were addressed well by Ghosh.

Bandyopadhyay also provides an almost day-by-day run-up to Ghosh getting a banking licence, competing with other big names like IDFC and L&T. This part does get interesting and reads like a thriller, with the difference being that this is a real-life narration and not fiction. The model is unique because an institution that already has a large clientele of borrowers could use the same base for collecting deposits once converted to a bank. However, this is simultaneously a challenge, as the size of the deposit will be small, which has to be serviced through a debit card and other banking facilities, thus putting pressure on profits.

The writer poses an interesting question of Bandhan becoming a small universal bank. Here, he also posits the future challenges in the area of technology and innovation to keep the business moving. Language Internet has not really taken off in the country in a big way and hence has to be addressed through multilingual modes of delivery. Also, pricing of loans will be a challenge, as the spreads that they could earn being an MFI—which could go to 10%—will no longer be available.

Bandyopadhyay does have admiration for the innovation, risk-taking and leadership qualities of Ghosh, which is reiterated throughout the book. His never-say-die attitude is significant. This is quite creditable, as Ghosh comes from a very humble background and is one of those typical rags-to-riches stories.

The book is definitely engaging, with the credit going to Bandyopadhyay for writing this narrative on one of the brighter institutions that has a future. His journalistic expertise helps in making this book readable for anyone seeking inspiration. He is able to keep the reader glued, even though all corporate biographies run the risk of readers losing interest, which was the case with his book on HDFC Bank too. But he manages these problems with dexterity and deserves a lot of praise. Those who would like to do things differently in their own fields like Ghosh can choose from several ideas from this book.

Do we need more banks? The challenges are immense

Do we need more commercial banks in the system? This may sound heretical at a time when RBI has announced that it will provide licences on tap, subject to appropriate qualifications and prerequisites that have to be adhered to. Evidently, there would be a lot of scrutiny before permission is given.

This was the routine last time too, when only two entities were awarded a licence, which interestingly were closely related to the banking sector. The broader question is, whether we really require more banks at a time when we are trying to move more towards the disintermediation route and are working towards consolidating existing banks with size being one of the criteria?

The argument for having more banks is always compelling. More players means more competition, which leads to better products and services—this, in turn, benefits both deposit holders and borrowers. Importantly, it prevents the cartelisation of the business, which was the case before 1992. One area where this impact can be seen is in the differential interest rates offered by various banks even on savings deposits, thus actually providing options for the household. This was not heard of earlier. Further, with similar products being offered like credit cards and ATM facilities, the cost should logically come down as banks compete to maintain their market share.

In that case, what can be the counter-argument against having more banks? First, we have already given licences to several payments and small banks. There has been some hesitation shown by certain players in terms of apprehension after being awarded licences. Theoretically, these two categories of banks address the objective of inclusive banking in both the deposits and lending spaces.

Payments banks would be busy collecting deposits, while small banks will be lending to the underprivileged category classified under the priority sector. If this were to work out, then there would be a crowd in this space, which is relevant as these new banks have to adhere to the priority sector norms.

New banks would more likely be urban-based, to begin with. The conversion of existing offices in the rural areas to ‘rural branches’, especially if they are currently NBFCs or MFIs, will permit seamless transition. But will they be able to add a ‘delta’ in this space where there are several other players who are already there and who are competing in their own way with the aggressive Jan-Dhan of existing commercial banks?

This is a matter of conjecture. Therefore, unless there is a metamorphosis of an existing financial entity, which could be in small lending or truck finance or personal loan segments, starting afresh will be a challenge.

Second, in an era where we are talking of bank consolidation, especially in the area of PSBs, having more commercial banks could appear to be odd. The reason for consolidation is that smaller banks will not be able to meet the challenges of future growth of the economy. Therefore, having new banks start afresh will always be steps behind the existing players.

It has also been seen that so far the major success stories have been institution-backed private banks. The old private banks have managed to hold on and continue to operate in their limited territories, being community-based. There are, however, a few examples of non-institution backed banks which have done very well, but would be exceptions.

Given the scale that is required, we could be duplicating efforts if all the new banks open branches in the metro cities in areas where other banks exist. This will necessarily follow in case they are retail-based as this is where the money lies.

Third, RBI has been reiterating that it would like to divert customers to the corporate bond market because banks cannot bear the onus of financing infrastructure, given the asset liability management (ALM) issues as well as the NPA problem, which is rampant today. This being the case, having more banks begs the question: for who are we creating these new structures? Based on the central bank’s thinking that has been interpreted, banks are to remain more in the area of providing short-term finance with the bond market taking on the responsibility of long-term funding.

Fourth, if we look at the banking structure, almost always banks have kept excess statutory liquidity ratio (SLR) of up to 5% on a continuous basis, which gives a clue that either they are not enough worthwhile projects or there are companies seeking finance that do not impress with the credit rating, leading to hesitance on the part of banks to lend. Also, it has been observed that companies are progressively accessing the commercial paper (CP) market, where the cost is lower than that what is charged by banks.

Hence, having more banks may not really lead to more borrowing as long as this differential exists.
We certainly do have a curious situation in the financial sector. The so-called shadow banks, which includes NBFCs, MFIs, finance corporations, etc, would like to become commercial banks because they get access to cheap funds in the form of demand and savings deposits. This structure is well-defined and structured, which makes operations easier.

From the point of view of RBI, giving them legitimacy by allowing them to convert to banks makes sense, as these institutions come under the ambit of prudential regulation.

But, in the current context, where there are different waves of thinking on the banking system, having more banks just for the sake of having them may not look convincing from either the business angle or from the point of view of society. It would make a lot of sense for the entity in case it is an MFI or an NBFC, as it helps them to merge with the banking system.

Putting these points together, it can be argued that we may not really need more commercial banks today. There are incentives for existing institutions to convert to banks, which makes sense, but for a new entity coming in afresh, the challenges are immense. There are issues with gathering deposits as there is a bit of saturation in major deposit collection centres.

In case of lending, the priority sector is already being addressed by small banks as and when they start operations. For non-priority sector lending, the system is currently less willing to lend and prefers government paper.

Besides, RBI is looking at the corporate bond market as being the growing avenue for accessing funds. Against this background, it will be interesting to see how many applications are made for the licence.

Evaluating economic reforms: 25 years on, need to change direction Financial Express, 2nd August, 2016

 has become fashionable these days to evaluate the performance of governments and RBI Governors over short time-spans. This, though interesting, may not be logical, but has nonetheless become an acceptable habit. Evaluating economic reforms, however, requires a longer time-span and this is where a retrospective on this package—which started a quarter century ago—is pertinent.

Two points should be kept in mind when we speak of economic reforms. The first is that there has been a continuity over the years, notwithstanding the government in power. While it is interesting, if not sensational, to typecast certain parties as being for or against reforms, ex post it has been proved that all governments have worked in the same direction. The pace of change could have differed depending upon the circumstances. Also, the law of diminishing returns sets in after the initial outburst. This makes it possible to have only incremental changes subsequently, as the economies of scale are exhausted and the resulting contradictions are resolved.

The second point, which may not be familiar to those who became cognisant of the economic surrounding post-1991, is that this entire package was, in a way, not voluntary, but enforced by the IMF when the nation was close to bankruptcy and required resuscitation. Such conditions being imposed by the IMF were common; ironically, these have been criticised of late by economists such as Joseph Stiglitz and Paul Krugman for being one-sided which worked against these nations.

Interestingly, various members of different governments have contended that these ideas were already on paper and were on the verge of implementation. There could be some merit here, as while the reforms package were comprehensive in 1991, we had witnessed several measures such as delicensing, broad-banding, FDI enhancement and trade liberalisation in limited doses in the 1980s. The post-1991 phase accelerated these measures in more areas.

Economic reforms must be interpreted more in the terms of changing the environment for enhancing economic activity and removing impediments that were offshoots of a different ideology pursued prior to the period. While it is tempting to juxtapose data in the ‘before’ and ‘after’ periods, the linkages could be due to serendipity, as there are cyclical movements in economic variables due to a plethora of factors—both domestic and global—that affect them. Hence, just like it cannot be concluded that industrial reforms have failed, given three low-growth numbers leading to FY16, we cannot exult in saying that FDI has moved from $5 billion to $50 billion due to reforms; global liquidity had played a more important part. Thus, evaluating reforms depends largely on how one looks at them subjectively.

A different way would be to look more at the environment created in this era. One, the banking sector has witnessed a major transformation in the last 25 years and the foresight shown by the Narasimham report is remarkable. Cleaning up the banking system, changing accounting systems, making banks cognisant of asset quality and adhering to global best norms on capital would be the major innovations that came about. Add to this the freeing of the banking sector from restraints, permitting more banks to operate and making the system resilient through calibrated reforms—all this has made the Indian banking system stand out in the global context.

Two, the sea-change seen in the capital markets has been quite amazing. While the primary and secondary markets have witnessed substantial buoyancy in activity, the entry of FIIs has added a new dimension in terms of both providing liquidity to the system as well as providing important foreign currency to the economy. The creation of online exchanges with derivatives trading and a regulator for the same has worked very well to make the Indian market a more distinguished one.

Three, a major step was to make the rupee flexible as we moved away from a fixed exchange rate regime in stages. A controlled floating rupee has helped keep the currency closer to the fundamentals and provided a market rate which is essential to keep trade competitive. We can seriously talk of internationalisation of the rupee.

Four, trade liberalisation has made the economy more buoyant and responsive to global developments. With virtual freedom on imports, the government has made it easier for companies to procure goods, with selective intervention being exercised when there have been cases of dumping. Also, any measure to control imports has been through the tariff route (on gold) rather than by quotas, which is a more efficient way.

Five, reforms brought in the concept of fiscal discipline and the transformation has been done in a coherent manner. From bringing in the concept of fiscal deficit to ensuring that RBI does not monetise the same, we have come a long way through the FRBM which has been assiduously pursued especially by the state governments.

Six, tax reforms have come in a big way, and while we are on the threshold of getting in GST and direct tax reforms, the tax rates per se as well as the processes are being streamlined, which is positive.

Seven, while investors clamour for more, FDI norms have been substantially eased, with flows permitted in almost all sectors. The result is evidenced in the resulting flows into the country.

Last, liberalisation led to substantial changes in the corporate sector, which is vibrant with diversification, M&A activity, foreign acquisitions and innovation. This has made the sector look more than comparable with other developed nations, as some of the best global brands function in India.

While we do tend to take a lot of pride in the results presented by the economic data, one should remember that this was the phase when almost all countries did similar things to improve their economies. Hence, what could be more important is the ranking of India on a global scale. Here, the picture is mixed. The World Bank’s ‘Doing Business’ puts us at 130 out of 189 countries. The WEF’s ‘Global Competitiveness Index’ has us at 55 out of 140, which looks promising. We do quite disastrously at the UN’s HDI, where we remain low at 130 out of 188 countries. Transparency International’s Corruption Perception puts us at 76 out of 168 nations, while the World Bank Governance Index gives us a negative score on all the six parameters tracked, such as government effectiveness, corruption, quality of regulation, etc. We are also not a happy nation according to UN’s Happiness Index, where we stand at 118 out of 156.

The way forward is not so much as opening up more sectors for FDI or lowering the deficit, which is what global agencies ask for, but improving basic human conditions and governance; these are mammoth tasks, given that the absolute level of poor ranges between 300-400 million based on the criteria used—and the level of scruples ingrained in us is low. This is the biggest challenge for the government

The Industries of the Future by Alec Ross: Book review:Financial Express July 31, 2016

Just think of a world where robot suits allow paraplegics to walk, designer drugs melt away certain forms of cancer and computer codes are used as international currencies, as well as weapons to destroy physical infrastructure

Just think of a world where robot suits allow paraplegics to walk, designer drugs melt away certain forms of cancer and computer codes are used as international currencies, as well as weapons to destroy physical infrastructure. At first, you might think this isn’t possible, but if you give it deep thought, you will realise that all these trends are gaining momentum and our world is definitely drifting in this direction. In fact, ripples of these examples can already be felt in our system and it’s only a matter of time when these will turn into full-fledged waves. In this context, Alec Ross, the author of The Industries of the Future, talks about six industries that will dominate our canvas in the next 10 years.

Five of these are robotics, advanced life sciences, codification of money, cyber security and big data, while the sixth is more in the realm of geopolitical, cultural and generational contexts from which they are emerging. Ross also cautions that all this innovative transcendence will not be without negatives—just like the steam engine made a certain category of labour irrelevant, these disruptive innovations, too, will have their own repercussions. For instance, robotics and artificial intelligence, along with changes in life sciences, will surely alter the way we live, but these will also negatively impact labour forces in, say, agriculture or industry. Similarly, advances in life sciences will let people live longer, but will be restricted only to those who can afford it. Things could also get awkward when some of these innovations, like big data, are misused or hacked.

Ross gives some examples to drive home the point. Toyota and Honda have already created robots to take care of the geriatric population—there’s a home assistant that helps in doing all the household chores, while other robots can emote like human beings and also converse with us. Robotic limbs are also getting more common these days, while driverless cars will soon eliminate chauffeurs, as well as cabs.

In the field of life sciences, the day is not far when a liquid biopsy involving a tiny drop of blood will be able to tell you where a tumour is located. Medicines will then be administered that can stop these mutations. Hence, every part of the body will be open to medical hacking. But the unintended consequences of such innovations are the creation of designer babies who can swim or become good athletes, attain a pre-specified height, etc.

As far as codification of money is concerned, it’s already in place. Mobile payments are rampant in Africa and the author gives the example of Congo, where large amounts of monetary transactions happen through mobile phones. The sharing economy, too, has manifested itself through Uber and Ola taxi services across the world. But the biggest revolution has been the Bitcoin, which goes beyond PayPal and eBay in terms of enhancing financialisation. The credit goes to the anonymous Satoshi Nakamoto, who started the independent financial mode of transaction that keeps aside all central banks and their currencies. It has been motivated by the loss of faith in states and the way in which they manage currencies. Bitcoin, limited in number and accepted by several merchants, has provided an alternative, which is ‘hacking-proof’.

Hacking is a major concern and the author gives the example of how the computer systems of Saudi Aramco, a Saudi Arabian national petroleum and natural gas company, were hacked by Shamoon—also known as Disttrack—a modular computer virus. This impacted the entire energy business. Interestingly, while the Internet was created to survive nuclear attacks, it has also led to a new class of attacks. In 2014, there was a successful cyber attack on Sony from North Korea, and similar possibilities can’t be ruled out in the future.

Big data is the fifth industry, which will take over, as all of us get ‘catalogued and monetised’. Big data, which is used for research purposes, is very useful for precision agriculture and will help improve productivity. The advantage is that it’s located in the Cloud and not on earth. Algorithmic trading is already rampant and will accelerate, as we move ahead. But with these sophisticated systems, it’s possible that everything about us is out in the open.

Finally, the author has an interesting take on the geography of markets, where he contrasts differences in countries in similar conditions. The difference is with having an open or closed system, which provides us some direction for the future. The Web has changed the living conditions of women in Pakistan. Estonia and Belarus started off similarly, but Estonia resembles any western European country today, while Belarus stagnates. Ukraine has also slipped by following Belarus’ model. Chile and Columbia have fostered innovation and technology, while Venezuela and Ecuador are dysfunctional even today. China brought about women empowerment, while Japan could not. Rwanda has recovered to become a leader, while Congo stagnates. Russia is where it is, as it has not embraced the Internet and worked towards spreading knowledge and information.

Some interesting innovations, which have local adaptations, are also mentioned. ‘Icow’ in Kenya is a voice-based mobile messenger, giving all information on cows—menstruation, milking, marketing, etc. ‘Grainy bunch’ in Tanzania is the intelligence service on food grains, which analyses the main links of the product: production and procurement, storage and distribution. These local innovations are on the rise, as countries make use of low-cost solutions to address their problems.

This book is interesting and paints a futurist picture, which is in its infancy. The only thing that remains to be seen is how soon it will happen across the globe. The world will definitely see this through just like it did the industrial and technology revolutions in the last couple of centuries. Surveillance will be important to check cyber attacks, while mankind auto-adjusts to the new wave of innovation. That’s the basic message of this very enjoyable book.

To deepen corporate bond market, start one for junk: Economic Times 20th July 2016

It is now agreed that we need to have a vibrant corporate bond market to meet funding requirements. We also know that this market has not evolved the way it was visualised for a variety of reasons, the chief one being that we have limited players, who ‘buy and hold’ only highly rated instruments. The RBI is working on moving large exposures of banks to the bond market since the system has its own challenges. The conundrum that emerges is that if this starts from 2018, will there be any buyers for such paper? One way out is to create a junk bond market.

These bonds typically have high yields and low rating and would not be touched by insurance companies and pension funds. If AAA-rated borrower can get funds from banks at, say 9%, which is the base rate, the same may come at 50 bps lower in the debt market. But a junk bond can go at say 10-12%, which will be lower than the rate charged by banks. In the west, such bonds were issued for leveraged buyouts and were serviced by the profit made through such actions. But the risk of a collapse cannot be ruled out.

It is for this reason that we also need to have some covers provided on these bonds. Banks lend to all kinds of clients excluded from the bond market as they are backed by collateral. As these clients are bankable, we need to mimic such structures to develop this market. Once this takes off, the positive ripple effects can be seen in the corporate bond market. First, a credit default swap should be made mandatory for any bond with a rating of say less than AA, which has become the unofficial norm in this market. This will simultaneously lead to growth of the CDS market, too, as the class of CDS-writers emerges.

Secondly, banks should be allowed to provide credit enhancements on these bonds. Currently, it is permitted on infra bonds. The same can be extended to junk bonds and will reside as a contingent liability, which puts less pressure on capital allocation. Consequently an A-rated bond can move to AA with this enhancement. Thirdly, there can be a mandatory escrow of the income flows with a first charge on interest payments and then the debt repayment, which is addressed by the trustee. Lastly, the enactment of the bankruptcy bill will help this cause. The rules of the game would be that any default for say six months would automatically mean impounding of the assets and subsequent sale. This will address the issue of moral hazard. It is quite timely that the issue of bankruptcy has been taken on in earnest by Parliament and will go a long way in addressing this challenge.

The evolution of a junk bond market will automatically add depth and width to the corporate bond market. There will be more players on both the buy and sell side. Retail interest will be elevated because of the returns as a conventional bank deposit earns 7-8%, while such bonds could give doubledigit yields.

Mutual funds and other institutional investors could be willing to apportion a part of their portfolio to these bonds. The concept of credit enhancement would make some of these bonds investment worthy for insurance companies, pension and provident funds.

The sequencing of the creation of this market is important. Firstly, it should be permitted in non-infra industries where there is a capital asset created that can be sold in the worst case scenario. Secondly, we should begin with A-rated bonds and then move down the pecking order to BBB and then BB. Thirdly, it must be made applicable for existing companies rather than new ones as this will enable prospective investors to evaluate the balance sheet more effectively.

Any form of disintermediation is a winwin option for both the parties. The investor gets more and the borrower pays less as the intermediation costs come down. As long as the rate for the borrower is lower than what is paid to the bank, it would be attractive. More investors would also make the instruments tradeable and the platforms on NSE and BSE would provide exit routes.

There are several imponderables admittedly in such a model, but the regulator can work around them to move towards a workable solution.

Back To The Future: Business world 12-25 July 2016

This collection is an excellent coffee table book with all the gloss, which can occupy the space for a couple of decades now, writes Madan Sabnavis
The world in 2050 is a collection of essays which construct futuristic scenarios for the world. Looking into the future is always a tough job but Harinder Kohli is able to get some of the best professionals to do some crystal ball gazing. The book is a collection of projections by 26 authors from 12 countries and includes well-known practitioners like Michel Camdessus, Pascal Lamy, R. Mashelkar, M.S. Ahluwalia, among others. 

The ideas put forth by the authors convey a simple message — the world economy is going to be dominated by the emerging markets, with Africa being the surprise part of the story. There will be wide-ranging changes in the structure of trade and finance with new roles being taken on by the existing institutions and greater participation from a wider group of countries. It is argued that while growth is fine, there is also a need to pay attention to the environment and the problems of availability of water where the challenges will be deeper. The world should also become less unequal with a frontal attack on poverty if this is to be eliminated completely. This is why governance will play a key role and will also be the key factor in deciding which countries will complete the race.

The author goes about his narrative through 10 mega trends that will emerge in the areas of demographics, urbanisation, globalisation, trade and financial sector, middle-class domination, rise of emerging markets and technological changes on the positive side as well as concerns on climate change, finite resources and fundamentalism on the downside.

Let us look at some of these interesting trends. For demographic dividend it has been argued that Africa which will gain the most while most emerging economies will benefit till 2040. Related to population growth, there will be rapid urbanisation, which will see more jobs being created. For this, we have to build the requisite infrastructure where funding challenges remain. The belief is that governments cannot provide this quantum of finance, and user charges and PPPs are the way to go forward.

Some novel thoughts have been expressed on the monetary system. It is believed that the IMF will be reformed and made more effective, with emphasis shifting to surveillance to eschew financial crises. Besides changing the structure of voting, there is an interesting suggestion to replace the hegemony of the dollar with the SDR, which will also help in bringing about discipline with the US budgets. The clamour for a neutral currency has been debated in the past too; but will become a necessity soon. The book also espouses wider participation of different countries and while G-20 is an improvement over G-7, the voices of other nations have to be also heard as they will be the future growth centres. 

The growth and dominance of the emerging markets is the main theme which resonates with the authors. These countries will be the hub of future innovation and growth and will have to work to balance challenges such as finance, investment, inclusive growth while paying attention to sustainability. It has been projected that India’s share in world exports will increase from 2 per cent to 7 per cent and that of China from 12 per cent to 15 per cent. The US and Europe will witness a decline while Africa will increase sharply from 3 per cent to 10 per cent.

But there is a warning that we cannot take growth and sustainability for granted. The financial crisis exposed the cracks in the western economies, but with rapid globalisation, which will be the driver in the years to come, a contagion will always be lurking when there is integration of trade, finance, technology, etc. Therefore, there is a pressing need to create new institutions which can manage risk well. Further, the demand for food has to be satisfied with the growth of the young population besides tackling issues of inequality and poverty.

At the non-economic level, the worry which has been reiterated is the growth of fundamentalism which can send us back by years and has to be addressed continuously. This would be more prevalent in the developing countries with the Islamic nations being more vulnerable.

Quite interestingly, the Piketty proposition of the dangers in the return on capital being greater than the growth in GDP has been refuted in this book. The view here is that lowering inequality through progressive taxation does not benefit anybody and leads to sub-optimal solutions as governments are not efficient. Therefore, improvement in material well-being and social wellbeing are not mutually exclusive and can progress parallelly.

This collection is an excellent coffee table book with all the gloss, which can occupy the space for a couple of decades now. The views expressed may not be novel but are backed by research and not based on speculation. Kohli has done a good job in collating all the pieces, which makes this book engaging. 

Should India create a ‘bad bank’ to battle NPA’s? Financial Express Debate: 12th July 2016

The subject of non-performing assets (NPAs) has caused sufficient worry for the banking system, especially when restructured assets are also included. The number of 11.5% is quite scary and needs to be addressed. One idea which is not really a bad concept is the concept of a ‘bad bank’. As the name suggests, such a bank will buy bad assets or NPAs from banks and then get around to reviving them or disposing them off. They will be bought at a lower value and could reside in the books of the bad bank until they are sold or even be returned to the bank once they cease to be delinquent.

In fact, it does resemble the outcome of the Bankruptcy Bill, with the difference being that instead of banks getting together and deciding, the assets are offloaded to this new entity and thenceforth it will be business-as-usual for banks.

 The objective is to have banks clean up their balance sheets. If they are permanently selling their bad assets, they write off the loss in year one, and then restart on a clean slate. The capital adequacy ratio improves as they are shrinking their balance sheets, and the level of NPAs and the provisions that have to be made come down sharply. This appears to be a panacea for public sector banks (PSBs) which are currently the focus of attention. Once the balance sheets are cleaned, then they can raise capital as they become stock-market worthy.

The issue is as to who will start this bad bank? Such a bank needs share capital and will have to raise funds to buy these assets and pay off the banks. One idea is to have the government start such a bad bank.

This is different from capitalising a PSB as it involves actually purchasing the assets and then trying to realise the best value. In case of capitalising the bank, one is only covering the liabilities side and not addressing the issue. When assets are bought, it directly lowers the delinquent assets and is hence superior.

As the problem has arisen due to a large-scale clean-up operation of the Reserve Bank of India (RBI)—and the banks affected the most are government-owned institutions—it makes sense for the government to buy the assets, which, in a way, is analogous to a loan waiver scheme in a modified form, as the recoveries will accrue to the government. Having the private sector create a bad bank is similar to an asset reconstruction company (ARC), which currently does not have the financial strength to handle these large amounts.

The creation of bad banks has been pursued after the Asian crisis in 1997 in the East Asian economies. The model has involved an outright purchase, which is called the Swiss approach, and a repurchase option, which is the German way of doing things. The idea is nonetheless compelling because it addresses the issue in a full-hearted manner. There, however, have to be conditions attached to such a bank being crafted which buys bad assets.

The first is that it should be based on a criterion as any such exercise creates a moral hazard which should be eschewed. Second, there have to be strict performance criteria for the banks selling such assets. This can be through a multi-stage approach where these assets are bought piecemeal by the bad bank based on how future incremental assets perform. Third, the criteria for buying assets should be transparent and a pecking order must be drawn up where probably the restructured assets get priority. Last, a competitive approach should prevail among the banks so that they work hard to qualify for the sale of bad assets to the bad bank. This, in fact, will ensure better governance standards too.

We certainly need to attack this problem and, given the scale, the government has to play a role here. The challenge is to structure it in such a way that moral hazard is avoided, which is also the issue with all loan waiver schemes. Fiscal support is a corollary that has to be provided for in the budget and has to be done. Similar to how the UDAY scheme involves state governments working out ways to reduce losses of state electricity boards, the Union government has to take on this responsibility to address the bad assets created by banks owned by them. This would be the ultimate justification for the same.

This clean-up operation will make banks stronger and in a position to lend money when the economic cycle seems to be on the verge of looking up. If it is not done, the regulatory factors could constrain their lending ability. Therefore, this option should be explored and implemented.