Being responsible: How CSR can be a double-edged sword and how to do it right: Financial Express 30th October 2022

 

Raghunathan puts forward the counter argument, but does not quite take a call on whether it should be mandatory or not.

• Click to share on WhatsApp (Opens in new wind
• 
  

Likewise, everywhere there is the argument on privatisation that is based on the premise that the government should be out of the business of production as it is not good in doing so and should concentrate on social welfare.

If the reader wants to know everything about corporate social responsibility, Doing Good is the book to peruse. The author, Meena Raghunathan, who also manages the CSR activity of GMR Group, provides a rather comprehensive account of the evolution of the concept as well as the progress made by India in this respect. The author has been a CSR practitioner for 15 years, having been involved with CSR operations in India both before and after the Act that makes it mandatory for corporates to deploy funds for this purpose; and also has a boardroom perspective on it.

As the phrase suggests, CSR is all about companies giving back to society and hence is laudable. There are, however, some caveats here. There have been companies that have been indulging in philanthropy even before this concept of giving was made mandatory. Today when we talk of CSR, it is more of a mandate from the top (Section 135 of Companies Act 2013) that all companies which meet a criteria that has been specified in terms of profit have to devote 2% of the net profit for certain purposes which come under CSR. Therefore, from being something which came from within, it is more of a mandatory compliance.

The author points out that once such an action is made mandatory, companies end up looking to comply with the order and would not really like to get involved with the quality of this spending. Now here it can be counter argued that companies are out to make money for their shareholders and hence would not really like to spend time on CSR activity. It is the job of the government to undertake these activities. Raghunathan puts forward the counter argument, but does not quite take a call on whether it should be mandatory or not.

In fact, she highlights the fact that economist Milton Friedman had argued that the job of companies is to make money and not take on ventures that the government should be involved with. Likewise, everywhere there is the argument on privatisation that is based on the premise that the government should be out of the business of production as it is not good in doing so and should concentrate on social welfare. This is where the problem really is.

Now the author talks on how companies only pay formal obeisance to this requirement and end up putting the money in certain activities such as education, which appears to be the favourite. She mentions that 35% of the amount goes here, followed by health, sanitation and drinking water. This becomes a low hanging fruit for the companies. Or else they are channelled through certain NGOs or government funds (Swach Bharat or PM CARES) which qualify for the same. It can be argued that companies cannot be blamed for such an attitude because there is a strong support for the view that they would ideally not mind paying an additional tax of 2% instead of deploying their human resources for ensuring that there is compliance. In fact, now regulation has become tighter with board-level committees also having to be set up to oversee such activity. This imposes an additional cost for companies, which at times adds significantly to the 2% that is being spent.

Such an issue will be hard to resolve easily. Interestingly, Kiran Karnik, in the foreword, would like such funds go through private NGOs so that there is more flexibility in terms of deployment of these resources. Interestingly, he points out that when public sector enterprises have to spend money on CSR, it is through a tendering process where the NGOs are at a disadvantage as they do not know how to handle such issues and have to outsource the same to a third party.

The author, however, raises some pertinent questions which will lead to debate. Is CSR about doing good or being good? Is it about how profits are made, or how they are spent? This is really the larger issue which companies have to address. At what stage does a company work for the stakeholders rather than only the shareholders? This is pertinent because often the economic activity, which is say construction or mining or petrochemicals, causes harm to society. Companies may spend less on lowering polluting processes and prefer to make profits of which 2% is spent on doing good. Is this acceptable? Clearly there are no clear answers here.

CSR does not really have a clear conceptual and operational definition which is universally acceptable. In fact, today, the focus is on ESG which becomes even more complex. Too many such pressures lead to the concept of greenwashing where companies are more in a race to comply with everything and in the process the spirit is lost. In fact, it is also alleged that by allowing companies to choose their routes to CSR spending in some countries they effectively get policy making powers.

The author also appeals to corporates to pursue this goal in the right spirit. Being a good company would add value in future. This would be in terms of reputation, employee connect and even finance as the day is not far off when lending can get linked to the work done on the ESG front.

The book also is a guide for NGOs which are seeking such contracts as it gives a step-by-step account of how they should approach companies. At the same time she provides a template to companies as to how they should address the issue of carrying out the task of meeting the regulatory requirement in the right spirit and have the right people to monitor the same. She believes that the impact is more important than the action. The detailing of processes from all sides is quite comprehensive and would add value for all stakeholders in the business of CSR.

The problem with using data for comparison: Free Press Journal 29th October 2022

 

Global comparisons even for basic economic indicators are always hard to make. The dominance of an unorganised sector, and the tracking system used, makes it hard to get the right numbers

The Global Hunger Report evoked mixed emotions in India. Those who believe India is the best performing economy in the world have taken the view that the report is disparaging and needs to be junked. Those on the other side feel that this is a wake-up call for the government to do something as growth which does not address the needs of the poorest sections is not one to take pride in. How are we to read these global reports in general?

The interesting thing is that the Global Hunger Report has been coming out every year for the last two decades and our rank has always been very low in the region of 100. Therefore, those who find this objectionable should remember that the methodology followed has been something we have not had a problem with since 2000. In fact in the past this data was used to push the case for more grass root reforms by various governments.

As to the concept of hunger, the critics have said that using 4 parameters such as malnutrition and children being under weight, short and dying early (infant mortality) is not really capturing hunger. This can be debated as even within the country we find it hard to measure poverty numbers based on calories and have reverted to an income based approach.

But this is a challenge for any ranking system, which can be of countries or management institutes or companies where the critics can always argue that the concept is not fair. It is hence necessary to understand that when any such cross-country comparison is made, the organisation upfront gives the approach which is standardised across all nations. This is the only way to make the concept homogenous for comparability. Therefore, theoretically this is the right way of going about the task.

The second issue is that when a certain standard is laid down for say ranking countries on competitiveness, or doing business or hunger or governance, it has to be based on a sample which is relevant. Choosing the right sample is critical; and generally the organiser looks at the peer level persons/institutes for responses. Hence when ‘doing business’ was assessed by the World Bank, it is but natural that a set of companies or associations are contacted. There will be a bias for sure as it may not cover the entire cross section of say the SMEs and hence the results can be tilted. Besides this could not be done across the country and hence the parameters were assessed for two regions. For the Global Hunger Report, the sample size was 3000 while for the Doing Business Report (which showed India in very good light), the sample was less than 100. Hence, one should read such reports as being at best indicative as it is possible that if the scope or concept was changed or the sample enlarged, the results could be different.

Global comparisons even for basic economic indicators are always hard to make. For the most basic concept used like GDP, every country has its approach which is not comparable. The dominance of an unorganised sector, and the tracking system used, makes it hard to get the right numbers. There is use of proxies when calculating these numbers. In our case we use corporate results to calculate value added which then is used for various sector growth rates. But such data is not available for the smaller companies and comes with lags and is a limitation. This holds even in other countries too depending on the availability of data.

Therefore, when the domestic authority calculates the numbers, it is hoped that they are honest in their effort and do not overstate numbers. This has been a constant complaint with economic numbers of China. One may recollect that even in our case when the new set of GDP numbers were calculated, the direction and quantum of change varied from the previous series causing considerable controversy. But for sure, international agencies like IMF and World Bank have to necessarily rely on domestic agencies for most of the data. Hence their final growth numbers tend to converge with the official numbers and it is only their forecasts that would be different.

The same problem surfaces when it comes to forecasts which vary across agencies. For example in India’s case for FY23 there are forecasts from 6.5% to 7.5% by multilateral agencies and credit rating firms. Clearly their assumptions are different and can at best be taken to be indicative. The final numbers will be very different and in general 80% of the forecasters get the number incorrect (if a margin of 0.2% on either side is permitted). In fact, even the NSO which collects and computes official data has significant variations in the advance estimate to final estimate. For a normal year like FY19, the advance estimate of 7.2% came in at 6.5% ultimately while for FY20 5% came down to 3.7%.

Therefore, data is as a rule is tricky and can at best be taken to be indicative. The reason is the data flow system has limitations given the size of the country. And when comparing the same across a set of 150 nations it becomes even more challenging. This is why all global ranking systems keep the concept simple with few parameters so that then probability of error comes down.

Bernanke’s Nobel: What about the unfinished part? Free Press Journal 17th October 2022

 

A question really is that when bestowing the Nobel Prize especially to a practitioner, should the consequences of a policy that was successful in its time in terms of immediate impact also be a consideration?

The Nobel Prize in Economics has gone to Ben Bernanke, Douglas Diamond and Philip Dybvig for work done in banking. While the latter two have been academicians, the first has also held the most important position of Chairman of the Federal Reserve. The subject for which the prize has been awarded is for banking and finance with bankruptcy as a supplement. While theory and approach to solve financial crises cannot be contested as they add to the wealth of literature, Mr Bernanke’s name also raises some further questions in the context of the present crisis as there is an unfinished agenda.

While he was credited with the Quantitative Easing (QE) programme which helped the system, there have been several other consequences which have caused considerable distortions in the global financial system for over a decade now. This leads to the conclusion that while his solution was unique, it has become harder to exit without causing substantial disruption. What exactly is the argument?

Mr Bernanke was also known as Helicopter Ben, as he had advocated in 2002 that money be poured into Japan to revive the economy. The analogy was for a helicopter to fly by and drop currency which could be spent to drive the economy out of a recession. This is similar to what John Maynard Keynes had advocated where people were paid money to do mundane jobs. But it is different because when money is provided by central banks to players the consequences are dissimilar to the effects of individuals spending more due to government payments. But is this the most prudent way out?

The idea of QE was compelling then and also alluring today, as the same was persisted with when Covid struck and the world was in a phase of lockdown. Central banks vowed to ‘do everything’ to support growth which meant lowering rates to zero and persisting with funding. But as a central banker, he had brought in the concept and used it effectively. But, it was the first part of the story which was left to other central bankers to take to the logical end.

Two issues however remain nagging in the critic’s mind. The first is the unintended consequences of such easing. And the other is the struggle for subsequent chairpersons to get out from this easing.

Pumping in more money through buyback of various kinds of securities on a large scale did infuse liquidity. But, it did not all get used in the US and a large part of these funds were invested in the emerging markets. In fact, the US economy has still to get back to the pre-Lehman days which is now 14 years ago. This strategy helped to brighten up the stock indices in all the recipient countries and they enjoyed the benefit of running high balance of payments surpluses. India too benefited from the same through the FDI and FPI routes. This posed other problems for central banks which had to sterilise such flows, and inflation became an issue as money supply increased.

This approach was followed even during Covid times in India where the focus was on providing liquidity to those who required it. Hence we had the long-term repo operations (LTRO) where specific sectors were targeted. This was followed by GSAP (government securities acquisition programme) where the RBI bought securities from banks in return for liquidity. ECB, Japan, Bank of England and several other central banks followed suit. This was done even though the lending capacity of banks was low and borrowers few. Often these funds were used to repay expensive loans.

Here comes the second challenge for central banks. Stopping the QE and changing it to tightening has always been a problem for global markets. One can recollect the taper tantrums that shook stock, currency and bond markets all over when it was expected that the Fed would roll back the QE programme. Stock markets crashed at this prospect and investors started to sell when this announcement was expected. The bond market goes into a tizzy as prices fall and yields rise every time the Fed talks of QT. These movements involve a lot of money.

Similarly reducing interest rates to close to zero is a good strategy in crisis times which also got replicated during covid. But moving back to saner or normal levels become a worry for everyone as everything done by the Fed or ECB has ramifications for all countries. With globalisation now fully set, all Fed actions permeate the policies of other countries too as rates have to keep pace to ensure that investment does not migrate outwards.

Getting out of the quantitative syndrome is hence a major challenge for the Fed in particular. The RBI has managed to do so primarily because the amounts involved are lower and these funds have moved to either lending or government paper (as the government borrowing programme has topped Rs 13 lakh crore for three successive years). For the Fed and ECB they have moved overseas.

A question really is that when bestowing the Nobel Prize especially to a practitioner, should the consequences of a policy that was successful in its time in terms of immediate impact also be a consideration? Mr Bernanke surely has made a mark as an academician, but there is an unfinished agenda in one of his more talked of polices, QE. This has not mattered in this case, but should it?

The twin challenge: Indian express 25th October 2022

https://indianexpress.com/article/opinion/columns/oil-and-the-dollar-indias-twin-challenges-8227835/

Food first Takeaways from global hunger report: Businessline 21st October 2022

 The Indian economy is typified by dualism. We can take credit for being the fastest growing economy. Our potential is vindicated by the large flows of foreign investment over the years. India will remain probably the top three fastest growing nations for at least another decade.

But we also have witnessed growing inequality where the disparity between the haves and have nots has exacerbated over time. The trickle-down theory has not quite worked.

There is impatience when it comes to achieving something new — roads, technology, high speed trains and the like. In this haste we tend to ignore the concept of quality of life. This is what is reflected in the Global Hunger Report.

The indignation expressed over the GHR (an index where India has been ranked 107 out of 121 with a ‘serious’ malnutrition score) is probably justified. The report is based on a survey of 3,000 people which may not be representative of the true picture. But then even the Ease of Doing Business ranking (which has been withdrawn due to methodological issues), that gave us a big promotion to 63 in 2019, had a sample of less than 100. So clearly all these methodologies have limitations.

Need for introspection

But we need to do some introspection to address the issue, as a country that has made remarkable strides in growth numbers, the trickle down effects are weak. The silver lining is that with effective policies we can tackle the problem.

It has been counter-argued that the government has been spending a lot on welfare which is true. There is the PM Kisan scheme where cash is transferred and the PMGKAY scheme which has provided support to over 800 million people in the last two years and continues to do so. The challenge is to make this money work better.

The GHR looks at the level of malnutrition (across population) and associated height and weight of children besides infant mortality. A theorist would question the criteria as these variables are related to each other and hence involves multiple counting. Yet the question to be asked is whether we can do better.

The onus is really on all three levels of government — Centre, States and local (municipals or panchayats) to ensure that delivery of a food package is available to all children. This is important because the country does have the advantage of a favourable demographic composition. A prerequisite for earning any dividend from this transition is a healthy young population. We do have some effective templates which are already being implemented in some States.

Mid-day meals 

First, States such as Maharashtra, Tamil Nadu, Andhra Pradesh have been running a mid-day meal scheme for children which have made an impact. The idea is to spread this scheme to all States. In fact, it may make sense for the Finance Commission to specify a proportion of the Budget to be allocated for mid-day meal schemes.

Alternatively if it is Centrally sponsored, it can be earmarked for this purpose. The meals must adhere to strict quality norms linked with calorie intake, where the frequency can be increased to twice a day.

Second, the Centre can consider revamping the PM-Kisan Scheme where annual outlays are around ₹60,000-68,000 crore. Around half of this allocation should be set aside for promotion of nutrition for children through a meal scheme that covers all government-run schools. The panchayats can be assigned the task of providing meals in the homes of the children who do not go to school.

Third, it is mandatory for corporates to keep aside 2 per cent of profits for CSR. They usually channelise funds to schools where water coolers or computers are provided. This has added value for sure.

As part of this exercise of improving nutrition levels of children, an alternative could be to map all corporates involved in schools to deploy this 2 per cent of profits to specific schools in remote areas and tie up with kitchens which provide the meals.

The government would also be helping to set up kitchens formally across the country that would cater to these requirements. Despite the methodological short-commings, there may, after all, be some useful takeaways from the GHR.

on TV: ET Now on 19th October

 https://www.timesnownews.com/videos/et-now/shows/festive-mood-check-is-the-sentiment-upbeat-india-development-debate-video-94973283/amp

Getting IPO pricing right: Financial express October 20 2022

 

The banks that take the call on pricing must have more skin in the game. One way to ensure this could be to have a rating of banks based on how often they got the pricing right and how often they over-stated this.

The IPO market has always been an enigma. The past year was a boom time, with several companies, especially start-ups, riding the wave with their IPOs. The premium charged was quite phenomenal in most cases as the market had the appetite for the same. As the market has subsequently moved southwards, their performance has been mixed, with roughly half the set quoting lower than the issue price. Some of the big IPOs have also turned out to be very disappointing.

The regulator, Sebi, is concerned, since many investors have lost money. Normally, this should not be a consideration, given that everything is okay in the market provided adherence to all rules. There can be no complaints here. However, the problem is with the pricing of IPOs. Sebi has always talked of the misselling of products, and the same applies here. Only, here the mis-selling is not from the agents but through the pricing.

Ever since free pricing of shares (since the past three decades), there is no formula involved, and it is the investment banks handling the issue that arrive at the price band. The band is misleading as it would be in a range of Rs 10-20. That does not help when the basic price is over-stated. Sebi is right in asking for transparency, though the layman will never know what this means given that the red herring report runs into hundreds of pages.

The numbers that a potential investor looks at is the profit made by the company. Intuitively, when a company is making losses for, say, three years in a row, the valuation should be low. For traditional companies, this makes sense. However, the market logic changes when it comes to start-ups where the valuation is based on future prospects, which cannot be linked with the past, which is always under a shadow. This is what we end up reading in all the business columns where the experts talk of the future potential of these companies due to a very strong business model. Often, when there has been an investment by a PE investor or a fund house, their valuation becomes the anchor for valuation for IPO. Therefore, transparency may not help, as there is a logical basis for such valuation.

There is a rather large canvas of opinion-makers with expertise in corporate valuation, who provide a rosy picture of the issue. Even if there is dissent on valuation, rarely does the other view talk of something which is even 25% lower than what is quoted. While there can be some red flags raised on the future growth stories of these start-ups, it is never a case of saying that the price is wrong. This, along with the frenetic advertising that goes into the IPO, creates the buzz that is required for success.

A way out is to ask for a detailed evaluation of the IPO. This can foment some debate, but it will be more in the vein of different forecasts made on any economic variable. Besides, most of the assumptions made would sound logical, and the investor will not be able to read anything adverse.

Another option is to have a regular list of all the IPOs on Sebi’s site where the investment bank’s name is also stated, so that investors can do some analysis regarding which ones have a tendency to over-state the price. This will be a check on the bank that assigns this value because if they tend to be wrong more often than not, their credibility will be affected. There will, of course, be justification for the price movements as the overall market comes into the picture. But, a thumb rule can be that if the price at the time of listing is lower than the issue price, then there is a problem in valuation. Ideally, there should not be a crash within a week or 10 days after the listing takes place. Arguably, subsequent price movements can be due to several factors and, hence, cannot be feasible yardsticks.

In fact, going ahead, all investment banks/lead managers involved in the valuation process of IPOs should ideally be graded or rated purely on performance by an independent credit rating agency. This will evaluate how the entity has tended to perform in terms of pricing IPOs. This is quite different from IPO grading, which was once made mandatory and then abandoned, where the evaluation was more on how strong the promoter was, and it was explicitly stated that there was no call taken on the price. The rating would not be of the IPO but of the entities which fix the price. The judgment can be extended to cover not just the listing price but also how the stock has performed against benchmarks over a period of, say, 6-12 months.

There is a need for some checks on over-valuation of IPOs where there is no existing price benchmark. The test is more of the banker that fixes this price, and credibility is of supreme importance. Such valuation should be free of the promoters’ influence and based on objective criteria. Potential investors would be better off taking a decision once they see this rating of the banker, which in turn would be a bit more circumspect once this process is in place. In short, they should have skin in the game.

Conceptual haze around CBDC: Business Line 17th October 2022

The RBI’s concept paper on CBDC (Central Bank Digital Currency) sets in motion the process for its introduction. On the face of it, with a lot of digitalisation already in place, the question that arises is whether a CBDC would add any additional value. This has been explained by the RBI.

There are different stages of evolution in digitalisation and CBDC is the last frontier. True, we are transacting with cards, RTGS, NEFT, IMPS, UPI, etc. Having a digital note in the pocket is the ultimate level of sophistication.

The concept paper spells out the broad contours of how the CBDC will play out. The essential features of ‘money’ are that it should serve the requirements of being a medium of exchange, store of value and unit of measurement. Being currency-like means that the CBDC serves these prerequisites. In fact, this is where it scores over cryptocurrencies which have no legal value and cannot qualify as currency as they do not meet these requirements. As CBDC comes from the RBI, there is no risk involved.

CBDC has been defended on grounds of its being more efficient, innovative, being able to foster financial inclusion and reduce operating costs. For it to work smoothly, however, it needs to be accessible to all, especially the poor who may not have access to any electronic device. This can be a challenge when it comes to serving the purpose of financial inclusion.

Cost reduction

Operating cost may not matter for the RBI. But given that physical currency moves across banks through vaults and ATM machines, CBDC will help in cutting down costs. However, it would make several industries like ATM manufacturers and security forces less relevant. Given that the RBI has stated that CBDC will not replace currency but provide an alternative, the fear may not be fully founded.

There are six issues which have been flagged as being part of this exercise. The first is technology. The major challenge here is to make it accessible to those who have limited access to electricity or internet, or are not comfortable with technology, especially smartphones. A large elderly educated population is not comfortable with digital banking.

The question is how does one make “offline CBDC” available to any individual in these categories? Will it be by way of a loaded card? Its use will depend on internet and electricity supply. Besides, parties to a transaction have to be digitally in sync. Will the transfer of funds be akin to G-Pay, PhonePe, etc., or managed differently? There are many unanswered questions here.

The second issue relates to whether this should relate to only wholesale or retail transactions. Here the view is that both would be included; hence the design of the CBDC will be one that can be accessed by not just corporates and banks but also the man on the street. Then, it shall be universal.

The third issue relates to the issuance mode. The paper debates the issuance and maintenance by the central bank or the commercial banks, as both options exist. It opts for the latter which sounds fair as it would mimic how currency is dealt with. Just as individuals go to a bank to withdraw money and not to the RBI, the CBDC would also be managed by the banks through the accounts of the deposit holders.

The fourth aspect of the CBDC relates to the form of issuance. Here the paper talks of it being token based like a currency note or account-based which is akin to bank deposits. The view taken is that the former is appropriate as the holder is the owner and hence there would be no account maintained as such. To this extent it would be like physical currency. This sounds logical.

Fifth, the design of the instrument is addressed. The option is to pay an interest rate on the CBDC which will be an incentive to the holder. Here it states that doing so will put it in conflict with banks which can visualise deposits being converted to CBDC rather than lying with the bank. Alternatively, it could be without interest just like currency.

Interest payment

Since the concept bats for being token rather than account based, logically the vote goes for there being no interest paid. If adopted, theoretically, all e-wallets become redundant and hence this industry should be watchful. Given a choice to lodge balances in the CBDC or a private e-wallet, the former sounds a safer bet.

Stock market analysts would pay attention to the listing of such companies, which would be competing for the wallet’s share with the CBDC.

Last, the concept paper discusses anonymity. There is admission that there will always be a trail once we go digital as the identity of the holder will always be known. Yet if CBDC is to be akin to cash, it is important to note that cash is favoured for its anonymity. While the government has imposed restrictions on the amount of cash that can be used for commercial transactions, currency still has its charm. It can be used for social functions, property transactions, jewellery purchases, etc., where one can remain anonymous.

While the concept paper says that small value transactions will remain anonymous (but every SIM card is identified with an individual), the higher ones will be under the IT radar. Further clarifications are needed.

The RBI has mentioned that everything will be done in a calibrated manner. This is a prudent way forward. But interesting outcomes are possible. Banks today hold on to demand deposits which are part of the CASA balances to shore up revenues.

With wholesale CBDC coming in, companies may prefer to switch or demand add-ons from banks to continue to bank with them. As mentioned earlier, e-wallets may become less relevant as CBDC catches on and currency is replaced, ATMs and rental spaces and accompanying infrastructure would become less important.

There are interesting times ahead for the monetary system as the RBI has switched on the ignition with this rather comprehensive concept paper. 

Notch up lower rated paper to bond with the bond market: Economic Times 15th October 2022

 https://economictimes.indiatimes.com/opinion/et-commentary/notch-up-lower-rated-paper-to-bond-with-the-bond-market/articleshow/94867895.cms

How economics Nobel winners guided policy on banking crisis: Mint 11th October 2022

 

We all know that the non-performing asset (NPA) problem of banks was more irksome than any monsoon failure or any of the other irregularities in the awarding system of natural resources. The reason is simple. The banking system is the fulcrum for growth, which it funds. Everyone who needs money has to go through the financial system, where banks play the pivot.

It is, hence, not surprising that this year’s Nobel Prize in Economics has been awarded for work done on banks and financial crises. The two go together, and while we all want banks, we are apprehensive of crises as they become self-fulfilling. The subject looks simple as almost everyone is familiar with the activity of banking. But its potential to spark growth or a crisis, which is the flip-side, is immense. The three awardees are familiar to all: Ben Bernanke, Douglas Diamond and Philip Dybvig.

 In their view, banks perform a very important role of intermediation, which involves collecting deposits from savers and lending to those who require funds. This is a function performed quite seamlessly through an institutional framework that is well defined across the world. The major task for anyone with surplus money is how to deploy it. Banks provide savers an option. Similarly, those who want to invest money in projects need funding. Banks provide it. Thus, information asymmetry is addressed by the banking system.

In fact, through the system of fractional reserves, banks are able to create credit multiple times and hence enhance liquidity in the system. Banks, hence, blend the interests of both sets of players. Deposit holders have the comfort that they can withdraw their money when they wish. Borrowers are assured that they will not be called upon earlier than the scheduled time to return the money. By pooling the money of savers, banks enable continuous ‘maturity transformation’, as the term periods of savings and borrowings vary.

This brings in the second reason for having banks around, which is superior knowledge of borrowers. Banks evaluate the credit worthiness of borrowers and introduce safeguards to ensure that loans are serviced and there is less chance of default. More importantly, banks closely monitor the loan in terms of progress made in the project for which money is borrowed and ensure debt is serviced on time. This ensures that the loan book stays healthy.

The academic research by the Nobel laureates is on cases of bank runs. Bernanke, especially, studied the Great Depression, worsened by bank runs and collapses. The question is what happens if all savers want their money back at the same time? It’s conceivable as a simple rumour can trigger a run. Banks cannot ask all borrowers to return their money whose contract is linked to a schedule. When such news spreads, panic ensues and deposit holders of other banks also rush to get their savings out. In such an environment, bank will cut down on lending, which in turn will slow down the wheels of growth and lead the economy into a recession.

 

The laureates argued for deposit insurance in this context. This will ring a bell in India because we have also had runs on cooperative banks, resulting in panic. There have also been instances of bank failures in commercial banking like Global Trust Bank. The panic was still moderate, as it was believed that the Reserve Bank of India (RBI) would protect the interests of deposit holders, which was fulfilled through a takeover. However, in the cooperative banking sphere, there is less comfort.

An interesting thing here is that even bank ownership is important. Public sector banks have been through various phases of challenges in the last two decades, the NPA crisis being the most recent one. There were banks which were under RBI’s prompt corrective action framework. Yet, there was never any panic attack, as government ownership provided stakeholders the assurance of survival. This does not hold for banks in the private sector; and after the Lehman crisis, which turned the myth of being ‘too big to fail’ into an argument for rescue action, the reaction of savers has been different.

The question is: Who monitors banks? There are two parts. The first is internal discipline. Banks ensure that funds are put to good use, as it would benefit their financials. The second is the role of regulation. The central bank has various checks in place to ensure that rules are obeyed and the system stays healthy.

In fact, a point missed by Bernanke, Diamond and Dybvig is that there remains a conflict of interest between deposit holders and shareholders that often tilts towards the latter when higher risks are taken. This is why regulation is critical for maintaining the sanctity of the banking system. When bankers have perverse incentives like stock options and pay-cheques linked with performance, there is a tendency to overextend the boundary of prudence, perhaps on the assumption that problems will only surface at a later stage, when the personnel in charge would be different. This is something RBI has also tried to plug.

While the subject looks rudimentary, this award will ignite more discussion and hopefully bring in more checks on the financial system across the world.

The role rupee trade can play in external front stability : Mint 7th October 2022

 One interesting point made in the Reserve Bank of India’s (RBI) credit policy was that 67% of the decline in foreign exchange reserves was due to “valuation changes". Simply put, this means that our forex reserves are held in various assets (cash or mainly bonds) like euros, special drawing rights (SDR), gold, yen, pounds and so on. With the dollar strengthening, the value of our overall vault has diminished. This is both good and bad news.

It is good news because there has been an argument made often that RBI is burning away reserves to defend the rupee, which cannot be infinite and is hence not a prudential approach. This follows from the fact that these reserves are built from capital inflows since we do tend to have a perpetual current account deficit, and hence using foreign direct investment, foreign portfolio investment, external commercial borrowings and non-resident Indian inflows to support the rupee is not a good idea. But if the depletion of reserves is not primarily due to the sale of dollars but valuation, this argument is weak.

The bad news is that if two-thirds of the decline in reserves is due to this external factor, then it exposes the helplessness of any country. All central banks like to keep diversified assets in their forex vaults. But if the dollar value falls even under ceteris paribus conditions, then vulnerability intensifies. Even gold has taken a hit with the dollar strengthening, which sends this component down independently, just like SDRs. If reserves were denoted in euros, say, then the picture wouldn’t be as gloomy.

But given that such valuation changes are beyond the control of any country, the concept of trade in local currency (i.e. rupees) becomes important. This is an idea whose time may have come, as countries have been exposed to a series of external forces that are not always economic. There is a need to have a strong forex arsenal for sure. When our balance-of-payments weakens, there will be a tendency for an outflow of reserves to maintain equilibrium. The currency will fall, which could hasten if RBI does not sell dollars to steady the rupee. One solution is to reduce outflows. Hence, allowing trade in rupees is a compelling option. The issue here is that for rupee trade to work, it has to be acceptable to counter parties. An oil company in Russia, say, will not have much use for rupees received unless it is converted to roubles by the government. The system that India has recently notified asks receivers to get their banks to maintain Vostro accounts for transactions, but their balances have to be invested in government bonds, which is not attractive for manufacturers that would prefer cash to financial investments.

This means that for any rupee trade facility to work, governments must be involved. If New Delhi signs agreements with say Russia, then trade will be in rupee-roubles. All roubles earned on exports will be channelled through the Indian government or banks that give rupees to exporters. The roubles earned will in turn be sold to those who import from Russia.

This will work where the volume of trade is significant between India and the other country, with a trade deficit at our end. For example, in 2021-22, India’s exports to China were $21 billion while imports were $73 billion. Hence, we had a deficit of $52 billion. A deal that would work is where the two countries agree to an amount of about $20 billion for which the exchange rate between the rupee and yuan would be fixed (through the dollar route presently). Our exports would be paid in yuan, which RBI could then sell to Indian importers who buy from China. This way, bilateral trade transactions would work.

Our second-largest export destination after the US is UAE, to which we export $28 billion and import $45 billion worth of goods. Here too, a predesignated amount could be agreed upon for rupee-dirham trade, with currencies sold to importers by the respective central banks. And in case the other currency is acceptable in third countries, like the yuan, then the volumes could go higher. This would encourage the formation of currency blocks across the world.

Since we have been talking of the internationalization of the rupee, countries with which we have a trade surplus, like Bangladesh and Sri Lanka, and those with which we have deficits, like Malaysia and Indonesia, can form a block where trade can take place in accepted currencies. This will reduce dollar dependence.

Will such arrangements solve our forex problem? Only to a certain extent, because while demand for dollars would come down, so would their supply through exports, as the raison d’être of bilateral currency trading is mutual acceptance. These arrangements would only address the issue of disruptions caused by the world economy’s dollarization. Today, as Western sanctions on Russia show, politics has taken over economics. Such bilateral currency arrangements will reduce dollar dependency and smoothen payment systems for trade, but may not address the challenge of dollar inflows.

The crux to addressing the currency and reserves challenge would lie in boosting exports in a globalized world where interlinkages are strong. Bilateral currency trading will address issues of valuation to an extent and help trading in a relatively non-dollarized environment. But, ultimately, fundamentals have to be strengthened to emerge stronger. There’s no other way out.