A comparison of the economic record shows that both regimes had their fair share of hits and misses

It is always tempting to analyse which government has done better on the economic front when elections are on.

The truth is that governments provide a framework for economic agents to operate and the reforms that are implemented help facilitate growth.

There are always time gaps between policies and the effects; and spillovers are imminent. Also, careless practices can have negative impact after a lag. Therefore, it is hard to separate the two.

The government directly affects economic activity in the area of the Budget. But even here it has a limited role as the direct action is found in State budgets which are one-and-a-half times bigger than that of the Centre.

Therefore, the linkage with economic growth and development while being positive in a subjective way cannot be quantified objectively.

Yet governments tend to take credit for everything that goes right while passing on the blame for anything amiss to another regime. Logically this should not be the case but it is part of gamesmanship and is accepted.

Here it is assumed that the BJP-led government takes credit and the blame for everything that happened during 2014-15 to 2018-19 while the Congress-led government does so for the preceding years. This is in sync with the media’s treatment about the relative performance of the two governments. Fourteen indicators are used to compare the two regimes in an objective manner where the average numbers are used to a large extent (summing of numbers or changes at end points have been done for some variables).

Table 1 gives the areas where the BJP government has been associated with better economic numbers.

Official data has been sourced and the revised past series on GDP has been used notwithstanding the controversy surrounding it.

Also CPI for industrial workers has been used to maintain comparability while the IIP numbers have been used with a spliced series in the absence of a past series. In general with all the qualifications standing, the performance has been more or else evenly balanced.

Table 1 shows that the BJP-led government has scored better than the UPA on seven leading indicators which may be considered to be the primary variables which reflect the state of the economy. Growth has been higher during this period and inflation lower than in the previous regime.

Favourable factors

While it can be argued that a lot of this was due to good luck as international prices of crude had come down and the monsoons were satisfactory, the government can definitely take credit for keeping inflation under control.

There was a strong monetary policy framework which kept tabs on inflation even as fuel prices were marked to market in this situation. The BJP has done better on the fiscal deficit front too making it easier to achieve the FRBM targets.

This also coincided with a lower CAD and with support from favourable global commodity prices, the economy did better on both the deficits.

Gross FDI inflows were higher by around 50 per cent on a cumulative basis and the policies that were invoked on doing business as well as opening up of certain sectors did work well for the government. The strength of the external account was reflected in the increase in forex reserves which rose by around $108 billion in the five-year period while it was around $40 billion in the preceding period.

Hence while all of these achievements may not be directly linked with the government and its policies, the party can definitely take credit for such a performance.

But the Opposition too had its share of laurels as can be seen in Table 2.

The UPA seems to have done better in some of the secondary variables where again it could have been more on account of serendipity. The Sensex boomed mainly due to the after effects of the Lehman crisis when the indices had gone down sharply and the base effect worked well.

FII investment too was much higher during their 5-year tenure, though an average of $24 billion per annum was not really very high. The lower inflows subsequently had more to do with the Fed reversing the QE and increasing rates which affected markets all across the world including India.

The NPA legacy

The NPA (non-performing asset) levels too have increased prodigiously in the NDA regime though it can be argued that it was recognised during this phase while they were essentially created in the past when there was relatively more easy lending norms pursued by the banks.

The Congress-led government did convincingly better in three areas. First was farming where despite the drought years growth was better.

Second was capital formation which averaged 4 per cent higher than in the NDA regime (higher NPAs could have affected only the last two years). Third was growth in exports which has been much lower during the NDA regime.

Hence, if a variable-to-variable comparison is made between the two governments, they seem to be almost even in terms of number of successes.

But as has been pointed out earlier, taking credit for some of the numerical achievements may actually not be ‘causal’ in nature and could be more a case of chance where such targets have been achieved.

But the game of realpolitik will carry on.

No quick-fix: Growth is a slow process, there are limits to what policy can achieve: Financial Express April 26 2019

It has to be understood that growth is a slow process and cannot be achieved by either cutting the repo rate by 100 bps or increasing the fiscal deficit by 1%

Are there limits to policy-induced growth? This question is in the air even as the debate over the efficacy of monetary policy and fiscal policy is still ongoing. In fact, when the financial crisis and its aftermath is examined, it does appear that notwithstanding the efforts made by governments and central banks, the world economy has not yet regained the robustness and confidence that existed prior to the crisis. Even China is struggling now and the policy of building more roads and trains helped to a large extent but has subsequently led to stagnation when consumption has lagged. The lesson is there is no quick-fix solution for growth; and, counter-intuitively speaking, if such a solution was there, it would have been used by now and there would be high growth everywhere.

Therefore, if one looks at India and the role of monetary policy, the feeling is that we are expecting too much from the repo rate. The government, corporates and the media have always been nudging RBI in different decibel levels to keep lowering the repo rate as if it were the ‘be all and end all’ for our travails. While critics tried to link policy with the Governor’s preferences, this issue has also been addressed by having the MPC, where 6 members decide on the course of the repo rate and, so far, the majority has thought the same. Therefore, there is no individual bias involved in decision taking here.

Now, a common argument put forward is that banks have been slow to react to repo rate changes. This is the classic case of the transmission mechanism being sluggish. How far is this true? The data from 2001-02 to 2018-19 has been put together and the coefficient of correlation between the two i.e, changes in repo rate and changes in PLR or base rate have been mapped. The relation is actually strong at 0.65. Therefore, to say that banks have not been reacting positively is incorrect. Correspondingly, a secondary argument is that the quantum of response has been lower than that of the repo rate. Since the base rate and MCLR are both formula-determined, banks have to first change the deposit rate and then the lending benchmark rate changes accordingly. Banks have a conundrum. When deposit rates are changed, it is only incremental deposits that are either new or renewed ones that are subject to the new rates. In case of loans, most of them get re-priced at the new interest rate. Therefore, the quantum of reduction in deposit rate tends to be higher than that in lending rate.

Another interesting statistical relationship is that between change in rate of growth in credit and change in repo rate. It is low at 0.10 but positive which is against what theory dictates. The explanation is not hard to put together. Lowering the rate is just one part of the story where supply of funds is made cheaper. Firstly, even on the supply side, enough liquidity should be there or else it gets rationed out and here the government borrowing programme can be a ‘crowding out’ factor. Banks, too, have been cautious after the NPA debacle and have been cherry-picking clients and, hence, would not lend to companies where the NPA ratio is high. Retail lending has tended to benefit more from rate cuts.

Secondly, the demand side is important for growth in credit to take off. Here, some of the higher rated companies have accessed the bond market to raise funds. Further, with capacity utilisation rates being in the region of 70-72% (of late it has increased to 75%), there has been less reason for companies to borrow for investment. Most of the borrowing is for working capital and a number of companies have been deleveraging given the low growth conditions in the economy. Therefore, for growth in credit to take place, both demand and the willingness and ability to lend must increase. This is why there is a gap between interest rate action and growth in credit.

If monetary policy has its limitations, can something be done? In the US, followed by the Eurozone, unconventional policies have been followed like central bank purchases of non-government bonds. If supply of funds is an issue (which is not the case as RBI has been proactive with OMOs and LAF), can RBI think of lending to banks against corporate loans (corporate bond repo already exists).

The Keynesians argue that government spending is the way out and that we should pay less regard to the FRBM as it unnecessarily chokes up policy options. The point made is that the government should expand on the deficit which was what was done when there was the financial crisis in the west. In fact, at that time, the repo rate was reduced and the deficit then increased. This can become a part of the policy—so goes the argument.

A regression where GDP growth is mapped to both a change in repo rate and the level of fiscal deficit ratio from 1991-92 onwards gives some interesting insights. The overall explanatory power is reasonable (coefficient of determination) at 0.38. However, both the explanatory variables have a negative sign with the change in repo rate being ‘not significant’. This means that while the decline in repo rate leads to an increase in GDP, the relation is not significant. In case of fiscal deficit, the coefficient is significant but goes with a negative sign, thereby meaning that a higher fiscal deficit leads to lower growth. Is Keynes wrong then?

Keynes had given the solution of fiscal expansion only for a recession when there is a glut as people do not spend and the only way out is to have the government spending. But India has not been in a recession which is defined as negative growth in two successive quarters. GDP growth has slowed down at times but has never been negative. Therefore, the efficacy of Keynes is strong when there is a sharp slowdown in growth. Otherwise, it could have a negative impact insofar as crowding out the private sector and pushing up effective interest rates is concerned.
What then is the solution? It has to be understood that growth is a slow process and cannot be achieved by either cutting the repo rate by 100 bps (as some economists argue) or increasing the fiscal deficit by 1% (as some Keynesians aver). The economy is led by the private sector and aggression from the government or central bank can have limited impact. In fact, hyperinflation in some countries in Latin America and Africa has been due to unbridled Keynesianism. Countries like China, Turkey, etc, have kept their cost of funds deliberately low to prop up growth which works to an extent, beyond which it becomes impotent.

The government needs to have the right policy framework in place and keep working away at capex in the budget. Central banks have to be cautious in rate cuts and not bow down to pressure. As cricket is the flavour of the season, growth is a five-day match affair, and hitting out wildly in the 20 over format can lead to a situation where all wickets fall before the 20 overs are completed and we run short of policy options.

Book Review: Modi and Markets by Dhiraj Nayyar: Financial Express April 21, 2019

A collection of articles from the past, delving into Modi’s achievements as PM and his work towards setting up a meritorious economy, reads dated.

When you pick up a book titled Modi and Markets whose author, at the time of writing this collection, worked with the Niti Aayog, you know what to expect. The PM has been associated with everything positive about the markets since he took over, as he ushered in a spate of reforms to provide a boost to sentiment. As the Niti Aayog was the creation of the PM, there is expectation that there will be eulogies for Modi. The book does not disappoint here and, to an extent, the praise can be justified, as the PM can’t be faulted on policy, as the framework has provided the ideal platform for ushering in higher growth.

Dhiraj Nayyar, the author of the book, is better known today as a corporate economist and has been a reputed journalist who worked at some of the best publication houses. Therefore, his praise for the PM appears to be more out of conviction than a sense of belonging for the organisation he was associated with when the book was written.

Modi and Markets is a collection of Nayyar’s articles in the media over the years, which have been put together and presented in two parts. The first part, Mr Modi, is on the PM and the second is called Markets. While the former extols the positive achievements of the PM, the second contains articles that put on the table several weaknesses of the previous government, which was essentially the Congress.

The handicap of the book surfaces depending on the time when it’s read. This is so as some of the articles were written just when Modi took over as the PM and presented his pro-markets view and abhorrence to freebies, as he worked towards setting up a meritorious economy. However, in the past few months, there has been a tendency to join the bandwagon of politicians doling out freebies, which understandably, is the call of the day. Hence, what was considered to be an anathema at one time is the leading plank for the government today. Hence, these articles are contextual and might look out of place today. This is probably the challenge of bringing out such a book, which has articles from the past, which may not always convey the same meaning in a different time period.

The book, however, makes for interesting reading because the reader could have a very different view from the author on several points. Take, for instance, demonetisation. Nayyar has stated that it was good and necessary, and the impact will be felt over the years. He highlights the fact that digitisation has caught on and this is testimony to the success of the scheme. But that was in 2016. Today, there are well-researched books on the subject like the ones by Arun Kumar or the late Meera Sanyal, which use data to show that it was a failure and that digitisation was never a stated objective of the scheme and became collateral ex-post justification.

Similarly, Nayyar is quite aggressive while attacking the Congress on freebies and price control. But unfortunately, this is part of the political economy of India, where every government has to revert to such policies, as the recent cash transfer in the Budget shows. The book was compiled before the Budget and would not have foreseen the compulsions of the pre-elections time. In fact, the present government has been more aggressive in increasing MSPs and also increasing the allocations under the NREGA, which is an antithesis to what the PM stood for when he took over.
At another point, Nayyar salutes the government for keeping prices under check. Here, it can be counter-argued that lower inflation in the past few years was mainly due to good supply conditions, as well as oil prices. This was not the case in the earlier tenures of government when crude prices hit all-time highs and pushed up inflation, which was topped by droughts.

The second part of the book is on markets, where the articles were written commenting on the approach to growth, and the problems faced thereon have been highlighted. These appear unbiased. An interesting article, which was written on FDI and the Congress, raises some questions. The author has posited that anti-markets are typical of dynastic politics. The explanation is not clear, but the hypothesis is interesting and needs to be explored. It is hard to accept the view that dynastic parties tend to be wary of markets.

The author distinguishes between ‘populist’ and ‘popular’, and feels that one can be popular while being ‘unpopulist’. This he buttresses when he talks of the government increasing rail fares, but provided better services in the form of cleaner coaches. This is arguable, as there is scant evidence to show that the quality of services has improved. As for fare hike, people have no choice, as it is the only mode of transport available.

Nayyar is spot on when he points out the challenges for the government that it needs to take on with urgency. He indicates that, in 2015, he had written about the need to end tax terrorism. Demonetisation gave the opportunity, but tax reforms still lag. There is a need to reassure investors here. The same is extended to agri reforms, which should make it market-driven. Here, it can be said that as it’s a state subject, the central government has its hands tied and can work well only where the same government is in power.

The book is a good compilation, which will be debated, given that the articles are from the past where the context was different. With approaches of various governing regimes tending to converge, one may tend to disagree. It would be interesting if the author would like to revisit these views today.

Secondary market for loans is the right way to go: Financial Express April 18 2019

RBI has mooted the idea of creating a secondary market for bank loans in the latest credit policy. The idea already exists in modified forms for certain categories of loans. Impaired assets were being sold to other takers which could be institutions or ARCs.

RBI has mooted the idea of creating a secondary market for bank loans in the latest credit policy. The idea already exists in modified forms for certain categories of loans. Impaired assets were being sold to other takers which could be institutions or ARCs. Takeout finance, by its very nature, involves rolling over loans periodically from one bank to another. Securitisation is the packaging of loans, usually done in the retail segment to other banks and institutions. Hence, there is a secondary market for some kinds of loans.

The present idea can be interpreted as one where loans that are originated by a bank are sold to others at a later stage. There would be a difference in the interest cost as well as liability of the selling bank. These loans would be any kind of corporate loans of any rating and hence the idea is not restricted to impaired assets only. The options at this end can be explored.

The reason for a bank to sell loans can be for two reasons. The first can be that the bank would like to sell some loans to save on capital which can help it give other loans and hence churn its portfolio. Hence, too much exposure to the power sector can make a bank sell power loans and then originate loans for, say, electronics. Secondly, the bank may be interested in matching its asset and liability tenures. Therefore, a residual tenure of, say, 2 years may be sold so that capital is released and the same is deployed for a longer or shorter tenure. This can hence be a part of ALM management where deposit tenures are matched with those of loans.

For the buying bank, the reasons can be the same too, which will lead to intention matching. Further, at times, smaller banks may not be good at originating loans and hence would prefer to buy them from another bank so that the basic due diligence is done. Further, the buying bank would also like to take on a loan which has proved its credit worthiness over time and hence gets a lot of comfort from the fact that it is a tested exposure. To this extent, it can hold on to a cleaner portfolio of loans.

Therefore, creating a secondary market for corporate loans sounds like a good idea and, though not pervasive, does exist in countries like the US. It helps in better utilisation of capital and could also be lowering the quantum of risk taken by banks which have less expertise in certain areas. It may be pointed out that large loans are syndicated wherein a group of banks take on an exposure with the smaller ones pecking in with smaller amounts and hence riding on the expertise of the others. It is not uncommon to have smaller banks tagging on to larger ones with the belief that the loan is a good one. A secondary market will be an extension of this practice.

Should the market be an OTC or a market-based platform? A market-based platform would be preferred finally, though, to begin with, an OTC approach is advisable as banks can make their deals and then report to the CCIL or any other reporting authority. Here, the bilateral deals may tend to have distorted pricing and a market platform will actually help in better price discovery. It may be mentioned here that it did take time before the derivatives market developed in forex, which has historically been a forwards market on the OTC platform. A market platform can get in more players and the universe will hence not be restricted to just banks but also other NBFCs, HNIs, FIs, infra funds, etc. The churning of the loan multiple times will help in deepening the market and lead to better price discovery which does not happen today as, invariably, all loans are fixed unilaterally by the bank in a situation where the large ones with a dominant presence become the price setter.

How does one choose the asset? Here, a credit rating will be critical and, hence, just like the corporate bond market has the concept of independent credit ratings being mandatory, so should it be for loans being sold in this market. It has to come from the rating companies and not banks, which have their internal rating, as there would be an incentive to overstate the quality of the asset by the selling bank. This can be a leading indicator for price discovery or else it will be hard to distinguish between loans. Presently, credit ratings ignore the collateral value and, hence, a different rating scale may be considered where the value of the collateral is also reckoned, just like it is done for loans against property or gold.

What about a cover for defaults? While the IBC exists and the lender can take the borrower to court for settlement, this would also be an opportune time to bring in the CDS and make it compulsory. The CDS has been a non-starter in the bond market and by making it mandatory in the secondary bank loan market, the concept can crystallise from the amorphous form it is in today. In fact, the CDS is a powerful tool for risk management in the bond market as it provides security against defaults where the writer comes in and provides cover. Once successful here, it will feed back to the bond market and help in growing the same, something that has been the objective of the government, RBI and SEBI in the last couple of years.

Are there any risks to this model? The existence of a secondary market and the buffers of ratings and CDS can lead to higher risk taking by banks, which originate loans knowing very well that it can be sold off on the platform. Also, there can be a case of giving more teaser loans to garner business and meet targets as they can be sold and capital can be churned. This cannot be ruled out, and this was the case when the financial crisis took place in the West where financial engineering of a different sort (CDOs, MBS, CDS, etc) led to higher levels of funding which eventually collapsed. Therefore, strict regulation is the order of the day and should be pursued by RBI to ensure an orderly development of this market.

Anecdotally, it has been seen that there has been a positive correlation between the turnover in the secondary market for loans and performances by companies. In the conventional model, the discovery of a NPA is often left opaque while, in cases of bonds, it comes out in the open. Therefore, companies have an incentive to perform better and keep away from defaulting. Quite surely, this idea will add value to the bank loan market once formalised and introduced by RBI.

Liquidity crunch was a blessing!: Economic Times 17th April 2019

FY19 has been a year of liquidity management when the central bank worked relentlessly to ensure that the rupee and interest rates remained stable amidst inflation volatility. At the end of the year, it has been a win-win situation for the government, RBI and banks as the liquidity issue was addressed more than adequately with the recent dollar swap being the surprise. The liquidity problem had its genesis in the phenomenon of bank deposits growing at a slower rate than bank credit. Deposits were affected on two scores. First, financial savings kept going down and second, due to low interest rates, households migrated to the capital markets with mutual funds being the beneficiary. The interesting fallout of a liquidity crunch is that the RBI intervened regularly in the market through LAF as well as OMOs. As the government borrowing programme was large (central and states), the problem was exacerbated. This is where the RBI stepped in and has so far bought back around Rs 3 lakh crore of securities from the banks. Two things stand out here. First, the RBI has actually increased reserve money and hence money supply. While the concept of automatic monetisation of fiscal deficit was abandoned in 1997, the same has been done through the back door where fresh issuances are subscribed by banks and other FIs. At stage 2, the RBI buys back older stock of securities and in return actually earns an income in the form of interest. Assuming a rate of 7.5 per cent on these securities, the RBI earns an additional Rs 22,500 cr of interest on Rs 3 lakh crore. The more fascinating part of this story is that the same additional income which the RBI earns, under ceteris paribus conditions, would add to the surplus of the central bank which will get transferred back to the government which had paid this amount on the securities in the form of the coupon payment. As far as banks are concerned, this is a good move as they extinguish GSecs which give say 7.5 per cent and use it to lend which at the January WALR would be 9.8 per cent yields, a net interest income of 2.3 per cent or Rs 6,900 crore. As most of the lending has been to the retail sector, this would also have low risk. To the extent that corporates get these funds, they would also be better off as tight liquidity would have raised their cost of funds. The dollar swap is also a win-win situation. Banks have with them forex assets of around $18.2 billion, of which $5 billion has been exchanged for cash. The successful programme yielded a premium or implicit forward rate of 3.75 per cent. If we look at it from the point of view of banks, this works well. They get cash for idle dollars being held. They can earn 9.8 per cent on these funds and hence get a net return of a little above 6 per cent. They run the risk of the rupee appreciating instead of depreciating. The 10-year forward rate was 3.6 per cent but could change in the next two years and hence the 3-year cover of 3.75 per cent is of advantage. If the money is lent, they would earn Rs 2,100 crore a year. The alternative would have been to raise CDs or keep rolling over through the repo, which is higher at 6.25 per cent. Therefore, a cost of 3.75 per cent is very low and money can be lent for longer duration. Even if invested in GSecs, the net return would be 3.75 per cent (assuming a return of 7.5 per cent), and banks will be better off. The RBI too is better off because when it adds to its forex kitty, the returns in net terms is around 1.1 per cent. Now the RBI can still earn this 1.1 per cent as its forex reserves increase, but can top it up with the 3.75 per cent gain, which is being paid by banks. Therefore, the RBI is actually earning around 4.85 per cent, which is nearly Rs 1,700 crore. If another round is used, this amount will double as earnings will increase. Again as these are new measures used by the RBI for balancing liquidity, these gains will show up in the surplus of the central bank which gets transferred to the government in the form of non-tax income. Therefore, the entire liquidity balancing operations of the RBI has brought about a truly Pareto optimal solution where all participants – government, RBI, banks and borrowers — are all better off and no one is worse of.

Lok Sabha elections: Why continuity would resonate better for markets than change: Financial Express April 16

The stock market is known for its idiosyncratic ways, and, hence, it is hard to predict which way it will go. The indices are driven by a variety of factors, and most of the effects are for specific sessions, before it is business-as-usual (BAU) again.

The stock market is known for its idiosyncratic ways, and, hence, it is hard to predict which way it will go. The indices are driven by a variety of factors, and most of the effects are for specific sessions, before it is business-as-usual (BAU) again. The monetary policy or Budget can spook the market but, normally, after a couple of sessions, it is mean-reverting. The same holds for corporate results or any major political upheaval or even natural disaster. At times, it is felt that the market movements before a major event like say elections could be indicative of the mood or expectations. In this context, it is interesting to examine the question ‘how have markets reacted to elections in the past’. Are there any patterns based on past information?

The BSE Sensex can be tracked for specific months before and after the elections to ascertain any such patterns. The last six elections have been considered here and plotted, where the monthly Sensex values three months prior to the Elections, the period of voting and two subsequent months after a new government came to power are mapped. In case the elections have been conducted in two months, they have been included separately. It must be stated upfront that this is an ex post exercise, and several factors affect the market indices such as FPI flows, monetary policy action, Budgets, currencies, fiscal path, global political and economic developments and so on. Often the final outcome, in terms of movement in indices, could be more due to these factors than elections. But with the benefit of hindsight, it is nonetheless interesting to map these movements with election outcomes and formulate patterns, if any, in market behaviour.

Some of the trends that emerge are very interesting. The first is that till the run up to the elections there is a tendency for the Sensex to show some bit of nervousness when the outcome is uncertain. In 1996 and 1998, the market moved both ways until the elections were conducted. In 1999, it was a direct upward movement which was replicated in 2009 and 2014, when the market looked confident. In 2004, which is when the UPA-1 came in, there was apprehension as the index looked downwards.

The phase of elections lasts for 1-2 months depending on when they commence. Except for the 2009 elections, the markets have tended to be cautious and shown a ‘nervous stable’ or downwards tendency as they wait to know the outcome. In 1998, there was confidence even though the outcome was, in a way, uncertain, given the factions that existed. In 1999, when the NDA government came to power, it had actually declined for the two months as the same government was not able to hold on to power in the previous elections. The scepticism continued in the 2004 elections when the NDA seemed popular, but ultimately lost to the UPA.

The third aspect is the post-elections scenario, where the market reaction can be gauged based on how they look at the result in terms of expectations from the new government voted to power. Here, there are some interesting trends based on ex post knowledge of what had transpired after the elections. In 1996 and 1998, there appeared to be a clear thumbs-down for the government, which was fractured as parties with differing ideologies and stances came together to form the government. The markets probably guessed that these governments may not last the complete term. However, when stronger alliances and a leader was chosen which gave a semblance of stability, the stock market reacted positively—the case in the last four elections.

The markets subsequently tend to cruise along the BAU path, where the other factors come back into play. The present trend looks different.

Compared with January, the Sensex moved downwards in February and then been resurrected in March though admittedly the strong FPI flows have boosted the market. The FPI action is normally based on extraneous factors, but the expected elections outcome could also influence them at the margin. It needs to be seen how the market reacts in April and May when the elections are conducted and the final response post the verdict.

The stock indices are considered to be an appropriate barometer of the sentiment in the country which includes the economic, business and political environment. While there is no overt tendency to move up or down on account of the elections, the market is efficient and absorbs the news that provides clues on the final outcome. As the nation, including market participants, forms a view on the outcome, there would be a tendency to react to the evolving scenarios that get sketched along the way. While a strong majority government which could be a single party or an alliance is desirable, the differing ideologies would also be influencing the mood swings.

If the past trends are to be reflective of the future, then the index should remain largely stable in the next two months when the elections would be on. It would be surprising if this does not materialise as the elections outcome is still unclear, given that there are no clear indications of a single party getting absolute majority. Depending on how the final government is formed in terms of alliances, the Sensex could take a specific turn in June and July. Continuity in the regime would definitely resonate well for the market while any change will cause more speculation.

Limits to real interest rate as a concept: Business line April 5 2019

In a capital-starved economy where savings lag investment, a low real interest rate cannot reflect the true cost of credit

The concept of real interest rate is quite nebulous but it has entered the monetary policy lexicon where such benchmarks are used to justify interest rate actions. As there is no standard definition of which interest rate to use, in the Indian context, the RBI’s reference rate — the repo rate — is used, which is then linked with the inflation rate.

Here too, there can be a different approach when defining inflation. But the logical way of looking at the real interest rate is to see which index is being targeted in the monetary policy, which in our case is the CPI.

The RBI at times has spoken of an ideal real interest rate, to mean one that is in the range of 1-2 per cent. There is no formal reason for choosing such a range, but it is normally benchmarked with those in different countries. Here it may be pointed out that depending on the countries chosen, the benchmarks can vary significantly. There are two issues which can be examined here. The first is the structure of interest rates — both nominal and real — prevailing in comparable countries today, and the second is whether or not there can be any acceptable reasoning for using such benchmarks.

The idea of emphasising on the real rate is that nominal interest rates do not matter just as nominal GDP is not spoken of. High inflation will statistically overstate real production, which also tends to lend an upward bias to interest rates. By adjusting nominal interest rates with inflation the real interest rate is arrived at, which is the true cost of capital.

Hence, if the RBI sets the repo rate at 6.25 per cent (brought down to 6 per cent now) and inflation is 2.5 per cent, the real cost for the economy is 3.75 per cent. Whether this is high or low can be gauged by making a global comparison. The borrowing cost or deposit rate would similarly be adjusted for inflation. Therefore, if the lending rate is 10 per cent, the real cost would be 7.5 per cent.

The table shows the average real interest rates of various countries in March 2019. There can be variants used by central banks, such as average rates for the year or preceding year to form benchmarks, as inflation tends to vary over months.

Inflation numbers

Also, at times, countries may choose to use core inflation numbers rather than headline inflation as the latter includes food and fuel prices which tend to be quite volatile and distort the price picture. The table is nonetheless indicative of the dispersion of real interest rates across countries.

The relatively more developed countries tend to have low real interest rates while the emerging markets have higher rates. Emerging economies are more vulnerable to food and fuel inflation. As inflation tends to increase monetary authorities tend to keep a margin for the saver and borrower which gives incentive to do banking business. A negative return means that policy rates are very low and actually give negative returns to banks when dealing with their central banks. India and Indonesia, as can be seen from the table, have the highest real interest rates from the policy rate perspective. Assuming that the price indices being used are comparable, the wider question is can these benchmarks be used to drive policy? In other words, can monetary policy be drawn on the basis of real interest rates in the system rather than nominal ones?

On deeper thought, the answer is no. Interest rate is the cost of credit and should reflect the same. In a capital scarce economy where savings lag investment and countries typically run a current account deficit it becomes imperative for capital to be priced in a different manner. Using a benchmark of say 1-2 per cent based on real rates in developed countries would not be appropriate. It should, prima facie, be higher.

Further, even when talking of deriving the real policy rate which is probably the best rate in the country, the government’s deficit becomes important and should be factored in. Emerging countries tend to have higher fiscal deficits as governments need to support development work. Also the pressure to run social welfare programmes is higher here, which makes pricing of deficits more expensive.

 Therefore, the 10-year government bond, which is taken as the proxy for government borrowing, also varies significantly across such nations. Countries like India, Indonesia, Russia, the Philippines, Mexico, and Brazil typically have yields of above 6 per cent and, at times, over 8 per cent. The US, the UK and Germany, on the other hand, have yields of less than 3 per cent. Intuitively it should be seen that even the central bank rates should reflect this difference.

Hence, if at all we are referring to real interest rates, the range for emerging markets should be much higher to reflect the fiscal responsibility as well as the cost of capital, which is linked to the scarcity aspect. Also, one has to be careful about which inflation number one uses. The headline inflation is often influenced by food and fuel prices, which can be either high or low. Core inflation makes more sense, and in the Indian case would mean a real repo rate of 75 basis points, with the index being in the range of 5-5.5 per cent. Therefore, one can get a different set of conclusions based on the concept of inflation that is used.

Another variant that can be used is the expected inflation rate (which will have another sub-concept of core-expected inflation) which can yield a different core inflation number. As the concept is still amorphous and leads to different conclusions depending on the way the inflation numbers are defined, it may be better not to bring the concept in the monetary policy framework.

While the concept of real repo rate does sound theoretically alluring, using it in the policy framework is fraught with anomalies that can lead to incorrect signalling and is hence best eschewed.

A blow to the IBC process? Financial Express 4th April 2019

February 12, 2018, would go down as a milestone in banking as RBI brought out a circular wherein it came down hard on borrowers who were in default. The one-day rule kicked in, from whereon the two parties had to discuss to restructure, failing which the loan was referred to the IBC after 180 days, which then entered the resolution chain. This has been struck down by the Supreme Court on April 2, after the case was referred to by some of the aggrieved companies, especially in the power, sugar and infrastructure sectors. What does this mean?
It does seem that what was objectionable was that the circular looked at all companies in a similar manner. If a company was having problems because of external conditions, then it could not be bracketed with a wilful defaulter.

Hence, if every such default was referred to the IBC, the asset could finally get sold and the promoter could lose the company, which was not fair when there was a genuine problem. The power sector had a grievance that if a generating company could not pay the loan, it was due to problems like the non-availability of coal, absence of PPAs being signed, default on the part of state-run discoms and so on. Therefore, special treatment was required here.

The circular said ‘no’ and treated all defaulters the same. The implicit logic was that if an exception was made to the power sector, it could be extended to telecom and steel and so on, and hence one could not draw a line. After all, in the absence of a wilful default that is hard to prove, business failure can always be linked with the environment. This made it contentious.
The fallout of the circular was that as banks started the talks with the customer on day 1, companies were performing better on an incremental basis as the fear of being referred to the IBC made them service their debt on time. But things now get reversed.

First, from what it appears, RBI would have to go back to the circular and work out a fresh resolution mechanism. The February 12 circular had made this generic while it should have been specific according to the interpretation made in the legal fraternity, as was done for the first 12 and 28 cases. Therefore, the gates have to be opened once again and all the avenues that were there, like CDR, S4A, SDR, JLF, etc, could be considered for resurrection.

Second, banks still have the prerogative to take the company to the IBC if a resolution with the borrower is not possible. So, the onus will be on the bank to decide if harsh action can be taken. But for sure when it is not binding, this situation can lead to more litigation where defaulters can appeal to courts when they are pushed to the IBC, and this delays the process.
Third, banks will have an incentive to be liberal with NPAs now and drag things along as they were doing earlier when the IBC did not exist. This will help reduce their NPAs and hence provisioning requirements. In a negative manner, the pressure on the government to recapitalise PSBs will reduce as they will now be more profitable. This was precisely the problem with the CDR structure where the committee of bankers decided to restructure NPAs to avoid the blemish of calling them non-performing. This can happen again.

Fourth, companies will also have the incentive to dodge payments, knowing they cannot be penalised immediately. This was the case earlier and will happen again at the margin. It is hard to identify a wilful defaulter today as this is rarely evident. Macro factors today will always be adverse as commodity prices will be volatile, laws varying, business cycles more common, and geopolitical tensions around the corner. At what stage should the bank pull the trigger?

Clearly, the clock can get turned back. When RBI came out with the AQR, it was hailed as being quite singular, as for the first time a harsh step was taken to clean up the books. Banks scurried to recognise these NPAs and, in the process, a lot of this negative information came out in the open as the strict moralistic code set in. Several bank chiefs were held responsible for the build-up of these assets and were chastised. Now there can be a drift backwards as the compulsions are no longer there.

An interesting complexity that has come up now is how one deals with the past cases? What happens to assets that went to the IBC due to the February 12 circular and were sold as part of the resolution process? What happens to the cases that are in the process of being resolved? Will they be pulled out of the IBC? What is the future of the IBC now, considering that structures were set up starting from the IBBI? The assets already sold that were driven by the February 12 circular could go for appeals. Those that are in the pipeline may stream out of the system. There will hence be a new set of complexity in the system in such cases. Also, now that it is the end of the year, how would banks define their NPAs? How would the divergence issue be treated now that this ruling has come in? All this will have to be answered when preparing the books of banks. For sure, there will be a lot of reconciliation to do.

The after-effects of this judgment need close monitoring because a relapse into the past cannot be ruled out. Rudimentary game theory suggests that when both the parties have an incentive to dodge the system, it becomes an efficient solution. The question is, what does the regulator do now? It had taken a lot of effort to come this far and now with the dilution taking place, the banking system becomes more vulnerable. To top it all, the pre-elections pitch is to make not repaying farm loans only a civil case. Banks have already been told to lend more to SMEs and then restructure those that are not being serviced within a time frame. Top this with loan waivers being announced, which give a reason not to pay up, and we are headed for a very different kind of a loan culture.

Growth targeting: Should the monetary policy framework be reviewed? Financial Express 29th March 2019

Is it time to revisit the mandate of the MPC? The MPC had to target CPI inflation at 4% within a band of 2% on either side. Over the last two years or so, interpretation became hard for the market as different decisions and stances were taken on this number based on the distance from this norm. Further, inflationary expectations, too, kept the market guessing as policy outcomes would be different based on the same conjectures. To top it all off, the MPC also provided a stance which could be viewed as either neutral or one of calibrated tightening. The earlier lament of slow transmission exists even today. And, above all, singular targeting of inflation had, at times, led to growth being given a pass which was a view expressed by industry. It may hence be useful to relook at the principles.

Certain questions need to be posed. Firstly, is the CPI inflation the best inflation index to target or should we look at another indicator? Secondly, how often can the stance of policy change and can it be parameterised? Thirdly, should there be an inflation forecast every two months or should it be not more than twice a year? Fourthly, should growth enter the mandate of the MPC so that it is not just inflation that is being targeted?

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Using the CPI for tackling inflation through monetary measures runs the challenge of targeting a number over which monetary policy has little control. The weight of food items in this index is 46%, which is not affected by interest rates as rarely does one borrow to buy food. Other components like clothing, rent, medical, entertainment, education, fuel, etc, also are not driven by credit. Therefore, in a situation of rising inflation, increasing the repo rate with very good transmission is unlikely to bring inflation down.

The anomaly is stark when one looks at the factors that drove core inflation up in recent months. Rent is actually reckoned on the basis of cost of government employees that went up due to the Pay Commission’s recommendations. It is notional and is not reflective of inflation per se. More recently, the health and education indices increased which also cannot be tackled by monetary policy. These charges get revised periodically where fees of professional institutes are increased as are medical service charges.

The WPI is always a better inflation target because it is influenced by cost of funds as around 64% of its weight resides in manufactured goods. It, however, excludes services which can add to inflation as has been the case with the rent, health and education indices. Alternatively, it may be useful to create a new price index that reflects all sectors and aligns with the GDP composition (see attached graphic). This is the only way to make monetary policy effective as it can curb excess demand forces across the economy. Presently, most of the inflationary impulses emanate from the supply side where costs increase.

The stance of the policy has come to be interpreted as the possible change of direction in the coming months. Ideally any ‘stance’ should remain for some time unless there is a shock of an immense nature. The idea of a stance is that it has to be forward-looking and a precursor of future action taken before the change is invoked. Presently, there has been a tendency to make a change in rates accompanied with a change in stance which then makes the concept of stance amorphous. The third part of the policy is the inflation forecast. Can the forecast change every time the policy is announced? Ideally, such forecasts should be once or twice a year with the second one being a review along the way. The forecasts cannot be changing every two months, especially if there is a range being provided. Constant changes in forecasts cause volatility in the market that then tries guessing future rate actions as these forecasts have had a bearing on policy.

Curiously, ever since the monetary policy framework has been put in place, by a matter of coincidence, inflation has remained low at around 4% which was not the case earlier when CPI witnessed successive increases in the range of above 8% (2009-13). The policy, stance and forecasts have worked well so far as the inflation number has gravitated to 4% with the market guessing whether rate cuts happen when actual inflation comes down or expectations come down. It would be interesting to see how rates react when inflation soars, which is possible if there is a monsoon shock or oil prices start moving up.

The last consideration is whether inflation targeting should be the only variable that is looked at or should growth be as well. It has been seen that the critique of monetary policy has often had political language that borders around obsessions with inflation to the neglect of growth. If that is the case, should there be change in the legislative action that also includes growth as a variable to be targeted? It may be recollected that, in the past, monetary policy always spoke of growth and inflation and while there was no overt target for inflation, the general direction of movement of prices provided a clue on what the policy would be like.

The growth versus inflation dilemma has also been witnessed in the US where its president has been vocal in pointing a finger at the Federal Reserve. It is normally believed that interest rates are a panacea for growth. But this did not quite work out post the financial crisis where the Fed had to resort to unconventional measures to stimulate growth through quantitative easing programmes. If it is to enter the frame then, it would be necessary to state specific numbers that have to be targeted, which can be 7.5% or 8%. But then, balancing the two targets will be more complex.

Quite clearly, there is a need to revisit the framework. Firstly, the economic conditions have been quite congenial so far and have not tested stressful positions. Hence, if inflation starts going up due to a bad toor crop, and inches towards 6%, should there be a series of increases in rates? Further, if inflation moves towards 10%, then should the repo rate be closer to 8% or 9%? These questions would arise when the situation gets sticky. Secondly, the current battle against inflation is out of sync with the power of monetary policy. Higher rates cannot change prices of food, or medical treatment or education or rent. Therefore, a new index can be considered. Thirdly, continuous revisions in forecasts of inflation can create uncertainty in markets and hence should be limited. Lastly, some growth perspective should also be part of the monetary policy package if the government feels it is important.

The experiment, so far, has worked well under virtually no stress conditions. It may be useful to revisit the framework and make alterations if required to make it more inclusive. This would mean moving away from exclusively being monetarist to the neo-classical.

Book Review: The Wisdom of Finance by Mihir Desai Financial Express 24th March 2019

The subject of finance is interesting as it involves, at the end of the day, dealing with money and making profit irrespective of whether it is an individual or a company. The subject and the terminology could, however, be hard to understand at times. This is so because even though the concepts are plain enough, they are cloaked with a lot of jargon, which is so in any subject. We all know what is ‘risk’ and the dangers of taking too much of it in life; and as a corollary the need to mitigate the same. But as a practitioner, it is a challenge because there is a lot of theory that goes into it and when everyone plays along, all cannot gain. This is what has engendered a lot of interest in the subject. Also, almost any major economic upheaval in the world in the last century has germinated in some aspect of finance that has caused serious disruption through market failure.

There are different ways of approaching the subject, especially for a beginner. Standard books take you through the maze through arithmetic, graphs and all the jazz. When you read Mihir Desai’s book titled The Wisdom of Finance, you would be enthused because the approach is different. It is a storybook-kind of narration, where he takes us through some of the major concepts and relates them to novels, TV shows, movies and political developments. The concept of an ‘option’ in finance is quite rudimentary as it gives the person exercising it the right, but not the obligation, to go ahead and consummate a deal that has been entered into. When the author relates this to marriages in the novel Pride and Prejudice, the comparison looks agreeable as marriages in the western world (though not necessarily in India) would always be guided by this principle. But this is where the analogy ends, as further elaboration is missing.

The parable of ‘Jesus and the talents’ is used to explain what ‘value’ is. If I give you something and you return nothing more after a period of time, then you are a failure and are to be condemned. The same holds when your money is invested by, say, a mutual fund or a PE fund, which does not deliver an acceptable return. The person who you trusted your money with has not created value for you. Hence, investors expect something more than what was initially put on the table to agree that value has been created. Again, this sounds good, but the reader can say, “But, what next?”

Similarly, Desai extends this story to ‘becoming a producer’ where the principal-agent relation is explained well. The owners are seldom the managers, who create conflict of interest, as while the latter are to work for the former, one can never know. He gives the example of a situation where the CEO, who could be Tim Cook, decides to shift his office to the poshest part of Manhattan, which costs a bomb. Is that self-serving or is it for the better image of the company?

Hence, the book picks up some basic, though interesting, concepts in finance and gives interesting stories of how subjects like insurance came into the picture or how leverage is not bad and works well to create value and is, hence, useful. The latter is important because such an act was always historically considered to be perverse and was a hush affair without fair connotations. Shakespeare’s Merchant of Venice example is given to show how this works along with the implications. In fact, there are stories also on bankruptcy and how they are to be resolved, and in this context, Desai shows how Robert Morris, who was to feature on the dollar notes, finally went into oblivion due to bankruptcy!

There is another interesting story woven around the theme of ‘no romance without finance’. For one who has seen Harrison Ford and Melanie Griffith in the film Working Girl, this would appeal. Desai then goes on to explain at a completely different level the relation between the automobile manufacturer Ford, and Firestone, the tyre manufacturer, whose partnership did not last and ended in divorce due to commercial incompatibility, though the marriage in the family was cast in stone and candied with romance.

The book, hence, links common-day occurrences with various concepts of finance, which makes understanding easy. But the complaint could be that the concepts per se are rudimentary and it is only their working or interpretation that has become difficult of late with the complexities of mathematics and modelling that appear to pervade their presentation. Here, the reader would receive little assistance.

Desai, nonetheless, must be complimented for attempting to explain finance in a rather innovative way. The reader should not expect too much detail of how things work as it is the principles that have been linked to everyday instances. A problem with the book could be that the stories narrated resonate well only if the reader is familiar with them. Otherwise, it could mean moving from one dark corner to another searching for the light that is being attempted to be shown. So if you want to know what an option is, this is the place to go. But if one wants to understand the way they work or are priced and how they have failed, then the search for answers would be outside these pages.