A war runs through it" Indian Express 29th April 2022

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Let us pause to think about ‘freebies’ versus incentives: Mint 28th April 2022

 Let us digest some numbers. The bottom 50% of India’s population claim 13% of total income, and the middle 40% take another 30%, while the rest goes to the top 10%, of which the top 1% laps up 22%. On wealth, the picture according to the World Inequality Report looks like this. The bottom half has 6% of total wealth, while the middle 40% has 30%. The balance 65% is held by the top 10%, of whom the top 1% have 33%. This is the state of distribution of income and wealth as per the latest data. In such a situation, what is a government supposed to do?

Recent news on the collapse of the Sri Lankan economy has engendered a fresh debate on the state’s role. Its government cut taxes across the board and provided several free goods and services, as a result of which the economy collapsed and the heavily-indebted country has had no choice but to default on its commitments. As a corollary, the issue of freebies given out by Indian states has come under the lens here. The focus is more on states as they’re easy whipping boys.

The argument put forward is that states are habituated to giving freebies, be it in the form of loan waivers or free electricity, cycles, laptops, TV sets and so on. Is this sustainable? If states keep spending money in this fashion for supposed political gains, their finances will go awry and fiscal profligacy would prevail. The last bit may be far-fetched, as the Fiscal Responsibility and Budget Management (FRBM) rules are more binding on states; they can’t borrow beyond their limits and any deviation has to be approved by the Centre and central bank. Therefore, while states have flexibility on how they choose to spend their money, they cannot in ordinary conditions exceed their deficit ceilings. The Centre used an escape clause for its own limit, interestingly, but exercised restraint in its pandemic-relief expenditure.

Let’s try to define freebies. States like Tamil Nadu and Bihar are known for giving women sewing machines, saris and cycles, but they buy these from budget revenues, contributing to the sales of these industries. It can be considered a boost for the supplier industry and not a wasteful expenditure, given the corresponding production. Punjab has been criticized for giving free water and power that helps rich farmers. The contention is that only the rich have access to pump sets that are run free of cost to extract water. Such schemes curry favour with farmers at election time, but it can counter-intuitively be argued that wheat and rice prices would have been higher if those costs were borne. Therefore, this is an incentive to produce at a low cost. It is analogous to support-price driven procurement by the Centre, which is also aimed at farm income support.

Moreover, isn’t the same being done for industry with production-linked incentives (PLIs) which promise businesses around 5% of their turnover for meeting investment and sales criteria? Can we really criticize state hand-outs for ‘rich farmers’ in the form of a subsidy while hailing the same given to ‘rich industry’ as an incentive? This must make us stop and think, as there cannot be double standards for different producers. The difference is terminology. A ‘subsidy’ is looked down upon, while an ‘incentive’ is considered progressive.

Now consider farm loan waivers. When industry defaults and a non-performing asset (NPA) is created, the payout indirectly comes from bank funds, which includes deposits. With no NPAs, depositors could get better returns and borrowers could be charged lower rates, as NPA provisions and write-offs raise the cost of intermediation. Farm loan waivers involve payments made to lenders from state budgets. Here too, one cannot accept one and reject the other, as both sectors work under risk and uncertainty.

The budget objective of a government is to bring about redistribution and provide incentives in the right areas, so that growth is kept ticking and inflation is held in check. Fertilizer subsidies also ensure that food prices are kept under some control.

Redistribution is again worthy of debate. Most so-called freebies are given by the Centre rather than the states. For example, the PM Kisan scheme assures cash transfers to farmers and costs the exchequer about ₹65,000 crore. The rural job guarantee programme has historically been a Keynesian type of a scheme, analogous to ‘digging up holes to fill them up’, where not much productive work is accomplished but workers are paid wages. Here too, the government may be spending between ₹60,000 crore and ₹1 trillion (during the pandemic). Can we really object to such outlays, given that Indian inequality remains so stark and has not been addressed by the much talked-about ‘trickle-down theory’ of growth?

The Rawlsian theory of justice is applicable here for sure, given our income and wealth disparities. The classic principle of greatest benefit to the most disadvantaged needs to be invoked for government expenditure, especially now that it’s clear that the prevailing system does not let weaker sections escape their circumstances. It is true that states will have to handle their finances better and a line needs to be drawn on hand-outs. States tend to cut back on capital expenditure once they approach their FRBM limits.

Ideally, a proportion of state expenditure should be earmarked for so-called freebies. This would ensure better overall utilization of resources. But the term ‘freebies’ should also be defined better so as to distinguish cash transfers from ‘free gifts’, as the latter can act as a direct boost to supplier industries. A fair assessment of these would serve India well.

Will the investment environment turnaround this year?: Business line 28th April 2022

Given the uncertain geopolitical situation which has led to supply chain disruptions and inflation, investors will be in a ‘wait and watch’ mode this year

The Budget this year was announced amidst optimism, which was followed by an accommodative stance by the RBI. The Finance Minister had flagged concern on investment which was however supposed to change track in FY23 with an initial nudge being given by the government through higher capex.

But things have changed with the war erupting later in February and there being few signs of a solution in the near future. Things do not look the same from an investment perspective. There have been simultaneously other monetary action developments in the West which have made foreign investors rethink their options. How do things stand on investment — both domestic and foreign today?

After getting in around $80 billion as FDI in FY21, it was largely expected to be replicated in subsequent years. For the first three quarters of FY22 there have been flows of around $60 billion of which equity flows are around $43 billion. This was slightly lower than that in the previous year.

War clouds

FDI has been a useful source of funding for investment in the country as it supplements domestic efforts. However, there there are two things happenings here. The first is that the West has started raising rates ostensibly on the back of rapid economic growth (which would slow down due to the war), and this has opened new opportunities for investors.

The second is that the war and the resulting uncertainty which has been flagged through sanctions can make investors cherry pick their destinations. The first can affect the decisions to go out to the emerging markets or stay invested within their countries. The second can make investors tend towards being cautious and prefer to remain within the closed group of western nations.

The same also applies for portfolio investment where typically future returns based on valuations influence decisions. But it has been seen that FPIs have been whimsical in the equity market this year and tended towards withdrawal which can be attributed again to the uncertainty in the geopolitical situation. For debt the interest rate differential will be the clinching factor and as long as we have a very accommodative monetary policy, these dynamics may not be favourable.

Currently, the domestic investment scene is a mixed bag. On the manufacturing side, as per RBI data capacity utilisation rates appear to be increasing and had touched 72.4 per cent by December. Manufacturing seemed to be on the threshold of sustained improvement, which was expected to lead to higher investment as demand picked up. The crux is how households behave in these uncertain times as increase in consumption is a prerequisite for better capacity utilisation, which in turn leads to higher demand for investment.

There is now uncertainty over consumption mainly due to the sharp increase in inflation which is close to 7 per cent and is unlikely to return soon to the sub-5 per cent levels. Prices of all commodities have gone up. Food prices have gone up with pressures arising on the edible oil front as Russia and Ukraine are major suppliers of sunflower oil and disruption has affected prospects for all oils.

Wheat prices are up even with a very good crop as export opportunities present attractive options for farmers/traders. Fuel prices remain high and while it does look like that the equilibrium would be around $110/barrel for crude oil, the absence of any measure on the government’s part to lower taxes means that prices will remain high.

Inflation worries

Manufactured products had borne the brunt of the first round of inflation of 2021 for the first three quarters of the year and since September have been passing on the higher input costs to consumers. The new round of global commodity price boom will definitely invoke another round of price rise during the course of the year as companies work towards protecting their profit margins.

This is not good news for consumption because with broad-based higher inflation there will be a tendency for more money to be spent on necessities which include food items and daily products and services, leaving less money for discretionary consumption. This in turn will affect overall capacity utilisation and hence investment. Unless things change quickly in the next couple of months, such a scenario is bound to come in the way of investment.

The other area driving investment is infrastructure. The Centre has put in a lot of effort in enhancing the outlay for capex to ₹7.5 lakh crore for the year. This can contribute but not drive investment as the private sector has the most important role to play. There were expectations that this part of the puzzle would fall in place this year. In fact, given that the banks had put the NPA issue behind it after making all the efforts at resolution, they have become more open to long-term funding. This could have been a turning point.

But there are two forces at play. The first is that given the disruption in global supply chains and higher prices, the entry of private players in the infra space may take a backseat till there is more clarity. Second, interest costs have already started moving up, which is evident in the bond market to begin with. Banks too have been recalibrating their lending rates which in turn can be a subtle entry barrier for the private sector.

Therefore the entire dynamics of investment has changed in the last two months. To begin with, it was felt that the war cannot possibly last for a long period of time. The imposition of sanctions has not quite reduced the hostility but disrupted supply chains and prices significantly which has affected all countries in this globalised world. The exports scenario no longer looks that attractive and with surging inflation there is potential to push back consumption, investment and growth.

Forecasts are already lower than they were in February. Even a resolution of the war by June will still keep business jittery in this vale of uncertainty. It will be another year of wait-and-watch for investment.

Russia-Ukraine war: Should India diversify its forex basket? Free Press Journal 25th April 2022

 

Today there has been a tendency for most central banks to invest their forex reserves in dollar or euro-denominated deposits or bonds. Around 80% of global investible reserves are lodged in these two currencies with the dollar accounting for 60% and the euro 20%.

The Russia-Ukraine war may be one of its kind and there may not be similar altercations for some time. One outcome has been sanctioned being imposed by the western nations which affects almost all countries due to globalisation. But there was also the case of sanctions against Iran with certain exemptions. There are always lurking strains when it comes to geopolitical stability with suspicion increasing on how non-democratic countries could behave and the punitive actions that could follow. This has led to the question of whether central banks should diversify their foreign exchange holdings.

Today there has been a tendency for most central banks to invest their forex reserves in dollar or euro-denominated deposits or bonds. Around 80% of global investible reserves are lodged in these two currencies with the dollar accounting for 60% and the euro 20%. Another 10% is in yen or pound and the balance is distributed across other currencies including the Renminbi. Should there be more diversification?

The reason for investing in the dollar and euro is that they are considered to be strong global currencies that have also become anchors. The euro started by being a competition to the dollar but has not really succeeded as the Greek crisis exposed the shortcomings of a common currency across 19 countries that are very different. Therefore the dollar continues to reign supreme.

The problem today is that due to Russia being cut off from the SWIFT mechanism, it is hard to trade in any other currency. If other acceptable currencies were held it would be possible for central banks to provide a payments system. In a way, the USA operates a monopolistic currency system which has been furthered by the EU also following suit.

Also at a global level, there can be fear that if at some time the US decides to take a call on sanctions against any country, the dollar holdings of their central banks can be frozen, which is what has happened to Russia. In fact, China would be on guard now as any political aggression which is manifested against a neighbour country that is taken up by the US can lead to such punitive action. Therefore, countries will be in a quandary if there is a freezing of their forex reserves. Hypothetically the USA could take action against countries that do not fall in line with the sanctions that it imposes on any country by withholding funds. Therefore, there is a reason for central banks to look at alternatives that go beyond the dollar, euro, and pound.

In the earlier days, SDRs were a way out which was a basket of currencies that were globally acceptable though dominated by the dollar. Bringing back the SDR will help as the IMF remains a neutral organisation and offers help to all member countries. If all countries pitch for the SDR, then it could be the currency of last resort in case of such crises like situations. While a new basket of currencies can be constructed, the inclusion of non-democracies will always create ideological problems in times of crisis. Besides, there has to be an owner of the basket, which will be contentious. The IMF is a global institution and offers confidence and countries too should work towards moving to the SDR. The IMF will however have to work out a return that can be provided the same SDR which can be converted into currencies that can be used for on-lending purposes.

Countries also have to work out economic arrangements with countries like Russia and China which are non-democracies to create a structure for payments and settlement. The currency used for settling foreign trade must be expanded to a basket where bilateral trade is possible with domestic currencies. Hence, central banks should be stacking up currencies of important trading partners so that in case of such exigencies systems do exist for trade to continue. For this, the exchange rates have to be determined by an accepted mechanism. India for instance has friendly relations with all the West Asian countries and should be in a position to trade with these countries if they are blocked out from the global payments system.

The catch here is that this has to be a process that should be in place all through to allow for seamless trade during crunch time. Therefore countries should start having bilateral trade in their respective currencies so that there is continuity. This will automatically ensure that central banks also get to diversify their forex reserves holdings.

As we move away from globalisation and countries become more inward-looking there would be a strong case for several trading blocks to emerge. Settlement and payments have to be seamless and alternative modes have to be explored. Bilateral currency settlement makes sense provided exchange rates can be determined. It will not be surprising if cryptos become an option under these conditions. Central banks for sure must look for diversification into SDR, gold, and non-blue chip currencies to keep the basket flexible.

Imperatives for land monetisation: Financial Express 8th April 2022

 The setting up of the National Land Monetization Corporation (NLMC) is a progressive step in the quest to implement the government’s asset monetisation programme. The Centre has taken the view that there are assets lying idle with various departments and PSUs that can be better put to use through the monetisation scheme.

How would this work? The NLMC would pool together all the assets in the form of land and buildings owned by the government that can be sold and then implement a plan of either selling these or leasing these out to other parties(primarily be private players). The Railways, for instance, has a lot of land that will probably not be used and can be leased out.

The same holds for PSUs that have either acquired land for expansion and never used it or have legacy assets . There are several units which are non-functional and hence the property owned can be sold.

There is a big opportunity for the government to earn revenue. If the property is sold, it would be equivalent to disinvestment; if leased out, it would provide a non-tax revenue flow. Depending on the government’s priority, the decision can be taken on long leases or sales.

The NLMC is needed because it would otherwise be difficult for each entity or department to carry out the monetisation plan. The SPV set up for this purpose will professionally carry this out. As this idea takes shape and begins to deliver results, states can also consider the same as there are several idle assets that can be put to better use. One example is the several state-run educational institutions where the rooms can be rented out to,say, call centres or private coaching businesses outside of class timings. So far,, there has been no attempt to better use these facilities.

There are, however, some issues that have to be addressed once the NLMC is formed. Valuation is the biggest challenge when it comes to real estate. If land is to be sold, then we need to get the parcel valued and this is where there can be some difficulties.

There are normally state gazettes which provide a valuation. These tend to be different from the market rate. Despite all attempts being made by the government to bring in transparency in real estate transactions, there are still cash payments involved. If the NLMC goes by the official records, then the valuation may be lower–a loss for the government. Independent valuation, which may come up with higher numbers, could be seen as throwing up unrealistic tags and such sales will receive a tepid response.

The other question would be on the mode of sale. Ideally, an auction is the right way to go. We do have templates of what can go wrong with such sales, from the coal and telecom sectors. The auction system fits the bill with the reserve price being probably decided through the valuation exercise. This is to ensure that a due process is followed in the sale process.

The monetisation plan can also be linked with the government’s other priorities so that they are targeted towards specific segments. For instance, the government may be able to link bidders for a land parcel to a specific goal, say, affordable housing or a renewable power plant. A lower reserve price may be considered for some of these projects in the form of a subsidy.

For some of the loss-making companies which are no longer viable, the NLMC can work out modalities of selling out various segments—land, buildings, and plants and machinery—as the government takes a call on dealing with the staff, which can either be provided an exit route or re-deployed in other PSUs.

As we embark on the asset monetisation path, it should be remembered that, ideologically, one cannot go back from this measure. It has to be done in a calibrated manner so that it does not come in the way of future expansion of the PSU, if such plans do come up.

Companies where the government would like to completely exit would be the ones that would qualify for such an asset sale. Hence, an approach similar to disinvestment would be advisable, wherein the government has gradually lowered stakes in companies.

The other issue that pops up pertains to the usage of these funds. Can they be used to finance the budget (which is what happens to disinvestment)? This issue has been debated even in the past where it has been argued that any asset sale should be used for a capital expenditure.

Hence, it is imperative that such proceeds be reserved for future capex and this can be a useful source of financing the National Infrastructure Pipeline.

RBI monetary policy review: Clear sign that happy days are over: Business Standard 8th April 2022

 The Reserve Bank of India’s (RBI’s) policy review this time was always going to be special for several reasons. First is that after the optimism revealed in the February policy, things are looking very different. Russia's war in Ukraine has been a new exogenous force. The budgetary numbers were being discussed even before the year started, which means skepticism came in earlier. The currency has been volatile, though tamed by RBI intervention. The US Fed has increased rates and is now certain on quantitative easing (QE) rollback, and inflation perspectives look quite menacing.

The monetary policy committee (MPC) has sprung some surprises even though the repo rate has been kept unchanged. The stance has been kept accommodative. However, there has been a change in commentary, which says that there will also be withdrawal of accommodation keeping in mind inflationary concerns. This may sound a bit ambivalent as the stance has not changed, but comes with a caveat. It is not surprising that the 10-year bond touched the 7 per cent mark as the RBI governor spoke. The advice has been on gradual withdrawal of liquidity, which means that there will be a case for calibrated tightening.

The other surprise is the restoration of the 50 basis points (bps) corridor in LAF, but this comes with the standing deposit facility that will be at 3.75 per cent, while the reverse repo is at 3.35 per cent. But given that 80 per cent liquidity is being absorbed at close to repo rate, the market has been prepared for this change.

The concept of SDF is interesting as it will perform the role of the overnight reverse repo. Under the new liquidity framework this would become the floor, while the MSF the ceiling. This will also mean that the overnight reverse repo window may no longer be the preference for banks, which would put their surplus funds in the SDF. The SDF has the advantage of not requiring the RBI to hold on to government securities which is needed in case of reverse repo.

What was on expected lines are the changes in forecasts on gross domestic product (GDP) and inflation. Here, the RBI has been quite aggressive, especially on growth, which is down at 7.2 per cent from 7.8 per cent after highlighting more strengths than weaknesses. This will have implications for the government’s budgetary numbers as growth was targeted at a higher rate.

For inflation, the RBI has again changed the view from 4.5 per cent to 5.7 per cent, which is quite reasonable given that Bank of Baroda’s view is 5.5 – 6 per cent. The assumption on oil price at $100 (for the Indian basket) again looks on the higher side, though justifiable today. The RBI has rightly pointed out that it is not just oil but several other commodities like fertilisers, metals, gas, wheat, corn which are witnessing very high growth in prices.

What does this foretell for the future? There is definitely a sign that interest rates will be raised and two repo rate hikes look very likely in the next two policies unless inflation comes down sharply, which looks unlikely. Banks have been given a cushion on the HTM front, which will help in this rising interest rate environment. This also means that both deposit and lending rates will move up, which is good news for savers, but not so much for borrowers. In short, the days of easy money are over.

Join forces and join the dots: Economic Times 6th April 2022

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Can India sustain its export growth? 6th April 2022 Hindu Business line

 

Global factors play a key role. Meanwhile, SMEs should reorient themselves, even as ESG rules come into play

The crossing of the $400 billion mark is being seen as a sign of exports bouncing back strongly. But how significant is this landmark?

Logically the $400-billion mark would have been crossed at some point of time, just like the much-spoken-about $5 trillion economy where the GDP in nominal terms will cross the ₹375 lakh crore number in the next 4-5 years. Therefore, achieving this target is not such a landmark; in the past exports growth had turned negative after touching a high, before ascending again. Export growth turned negative in five of the last 10 years, reflecting a high degree of volatility.

This is quite unlike GDP growth which progressively increases and rarely falls into negative zone (the pandemic year being an exception). The reason for this difference is that exports tend to be mainly demand driven and hence any slump in the global economy gets hits their growth.

Exports over the years

The exports growth story is interesting as trends vary over various periods. In 1990-91, when the economic reforms were implemented, exports were at around $18 billion. From FY92 to the end of the century the CAGR was 8.2 per cent while exports in absolute terms just about doubled.

However, in the next six years, CAGR was 18.7 per cent as exports touched the $100 billion mark. In the next five years ending FY11, exports crossed the $200 billion mark jumping to $251 billion with CAGR of 19.5 per cent. FY11 had witnessed the highest growth of 40 per cent from $178 billion to $251 billion. The bull run in exports continued in FY12 with growth of 21.8 per cent, touching the $300 billion mark.

However, the climb from $300 billion to $400 billion has been arduous. It has taken a decade to traverse this route with a CAGR of just 3 per cent. This was the period where there were five declines in absolute level of exports. Therefore, sustainability of growth in exports is a question which will nag policy makers. The fact that FY23 has started against a backdrop of the Ukraine crisis means that global growth will witness a setback, which will hurt exports.

The high base of $400 billion plus in FY22 will provide an unfavourable base effect for growth. Therefore, while it is possible to conjecture growth in GDP and take a call on when the $5 trillion mark will be attained, it is unlikely that exports would hit the $1 trillion mark.

Merchandise exports are dominated by manufacturing, whose annual growth has been satisfactory at 5.9 per cent in the last decade. This implies that exports growth was affected mainly by global factors where demand conditions were tepid. Central banks have provided extraordinary support to support growth since the Lehman crisis of 2008. The rolling back of liquidity will affect global growth prospects and particularly foreign tradel.

The other interesting aspect of foreign trade is that exports and imports tend to move in the same direction. In fact, when exports grow at a high double digit rate, imports tend to grow at a faster rate. In this context it is useful to track the imports-to-exports ratio. This ratio has shown an increase in the last couple of decades.

In the 1980s it averaged 1.33 and then declined to 1.19 in the nineties which was the first decade of reforms. It rose to 1.37 in the first decade of this century ending 2009-10 and since then has gone up to average 1.49. Clearly the dependence on imports has risen quite sharply over the years which is a natural corollary of globalisation, as companies source their raw materials and intermediary goods from nations which provide them at a better cost.

Export basket

The two main challenges for exports are competition and product composition. The two are interlinked. The composition of goods though changing is still tilted towards traditional goods like gems and jewelry, textiles, handicrafts, leather products etc. which typically also face competition from other developing countries. This basket has a share of 25-27 per cent.

The price advantage enjoyed by other competing countries impacts domestic exports. Engineering and chemicals account for around 38 per cent of total exports. The domination of SMEs here implies that they need to work harder as a group, as quality issues as well as cost militate against rapid growth. The government has been providing a number of incentives starting from export processing zones to finance being facilitated by the RBI.

However, SMEs here need to get better organised to push exports. There are around 60 million units of which half would be in manufacturing, concentrated in the micro and small sectors, which makes the task more challenging.

The future of exports will be more challenging as the ESG rules kick in and countries get more discerning in choosing their imports. The price and quality factors which have been the dominant, will be replaced with compliance with ESG standards.

As the world moves in this direction, the entire exports ecosystem will have to reorient its production processes. The developing countries so far have leveraged their cheap labour which has been highlighted often in discussion forums but not been an exclusion factor. Things are changing and we need to keep this in mind as we move towards scaling up exports to $500 billion a year to begin with.

Think twice before taking a credit rating agency public Think twice before taking a credit rating agency public: Mint 5th april 2022

 Just picture this situation: A senior ratings professional in a credit-rating company is asked to leave on grounds of non-performance, even though the real reason is that the person is not flexible with ratings. The decision is a human resources one, and hence no one can complain. The board says it is an internal issue with no room for debate. Hence a strong message is sent down the line for analysts to comply. Such a situation is not inconceivable, though rare, and points us to the broader issue of business management and ethical ratings.

The credit-rating business is unique because it has no skin in the game. For a bank, if money is not lent properly, an asset turning bad will haunt it later on. But an incorrect decision by a rating agency can’t be contested because it is only an ‘opinion’ and there is no recourse. Human error is always possible. Credit rating agencies (CRAs) talk of reputation risk. But then all agencies have some defaults to their names and the standard business practice is for some agencies to showcase to clients the failures of others, so all the beans are spilled.

Curiously, all large investors like mutual funds, insurers and pension funds are supposed to do their research before investing in debt instruments. It is unfortunate that they do not do so, and this was exposed during the recent non-banking financial company (NBFC) crisis, when they pointed fingers at CRAs. Even for private debt placement, which does not require a rating, ratings are often demanded by potential investors.

India has seven CRAs, of which three are big, two medium and two relatively small. The size of the cake is not growing and there is competitive pricing. One way to get ahead is to be flexible in ratings to build scale. The curious thing about the business is that in reality, AA (-) or AA or AA (+) ratings are actually almost the same, signalling a low probability of default. Hence, if the most reputed agency gives a AA (-) rating, another one can take a chance and give AA or AA+ knowing that a default possibility is remote. This is rational economics.

The advantage of a notched-up rating is that it keeps everyone happy. It is a win-win all around. Investors can invest in highly-rated paper as per their guidelines, banks save on capital, borrowers pay lower interest and the CRA gets its revenue. Often, companies move from one CRA to another when it comes to annual surveillance, a time when higher ratings are offered.

Mass defaults happen probably once in 10 or 15 years. Hence, ratings generally stand the test of time and agencies use the cumulative default ratio to show that they have done well. But the trick is to just expand the denominator and this explains the rush for public sector unit (PSU) ratings, which are all AAA as they never default. This helps lower that default ratio. Recall that some PSUs paid just a rupee to get debt of over ₹10,000 crore rated! This is one reasons why revenue growth for CRAs is not commensurate with the volume of debt they rate.

How can one address perverse incentives in this business? The problem is that CRAs tend to get listed to unlock value for shareholders. Once listed, they have to give relentlessly high returns, which is not possible. Some CRAs with an exclusive rating business have had net profit margins of over 50%, rarely seen in other fields. The CRA business thrives on ‘rent’, as debt issuers simply have to get their debt rated. Bank loans above a threshold have to get a rating under Reserve Bank of India rules, while the Securities and Exchange Board of India mandates ratings for public issues and investors insist on ratings for private placements.

If CRAs were not listed, then their quest for profit would not exist. They ought to be treated as financial-service infrastructure and should ideally not be listed to avoid those temptations.

The other problem with CRAs is that some of them have consulting or advisory services lodged in subsidiaries. This should ideally not be permitted because of an inherent conflict of interest. The financial crisis of 2007-08 had its genesis in CRAs giving the same clients advisory services as well as debt ratings. This is not directly permitted by regulation, but subsidiaries can earn good fees for services provided to a client which also gets a rating from their parent. Often, the work is done by the CRA but accounted for by a subsidiary. If the client relationship is worth good money, its rating can get flexible. As it may be hard to compel CRAs to sell off their subsidiaries, a rule can insist that the same client cannot be offered both services.

Since a credit rating is a powerful tool for investment decisions, integrity is critical. Plain profit motivation, though, can encourage compromises in a thin market. The ramifications of debt defaults have reverberated through the country in recent years. As CRAs face no punitive measures for their failures, we need to go back to the basics.

Arguably, an incorrect decision could be a genuine error, just as a notch-up can be an exception rather than a rule. One approach can be for the regulator to allot business. But then the market can blame the regulator for its choice of CRA in case of a failure. Alternatively, as suggested above, ratings and other subsidiary-provided services should be strictly separated. Another idea is that ratings should no longer be mandatory, which could make the market more discerning. Further, external rating committees should be made mandatory, especially if the debt being rated is above a threshold of say ₹500 crore, to ensure fair play. With three CRAs already listed, all this is worthy of consideration.