The Age of Stagnation book review: Dark & stormy: Financial Express March 27, 2016

The Age of Stagnation: Why Perpetual Growth is Unattainable and the Global Economy is in Peril
Satyajit Das
Tranquebar
Pp346
R699
THE AGE of Stagnation is a book of gloom that promises little hope for us even as various economists and policy makers are charting out new growth paradigms for all the nations. Satyajit Das, the author, is quite blunt in stating that the way we have progressed, we are moving towards deep stagnation with little chance of revival. More importantly, we have reached the limit of growth and all that our economic theory books have spoken of this limit being boundless are, in fact, incorrect.
His starting point is the financial crisis, which has not just dealt a body blow to the world economy, but also sown the seeds of deep-rooted stagnation. While a large number of experts believe that tackling the financial crisis and getting it out of the abyss was good enough, the author argues this may not necessarily be so.
The main challenges are growth, productivity, innovation, employment, work force, resources, environment, etc. All these factors, which have been assumed to be given with the trajectory being upwards, are not necessarily true as we have reached barriers. He points towards two specific anomalies. One is on the exchange rate front and the other on interest rates, where countries have followed the policy of ‘beggar my neighbor’ by bringing about competitive policies, which, in turn, has enhanced volatility in the markets. Easy money has impacted economies and led to enhanced debt at a time when companies are less than profitable. This process hence has sown the seeds of future crises of indebtedness, especially since revenue growth is not keeping pace with the debt servicing requirements.
If we put things in perspective, he points out four reasons for the financial crisis. First there was great dependence on borrowing to create economic activity through the NINJA loans. Second, there were imbalances in consumption, investment and savings, leading to over investment and debt. Third, rapid financialisation added to the woes as it was an area that was alluring but less understood. With rapid growth in financial engineering, the crisis was deepened. Last, several governments followed large entitlement programmes and hence broke economic rules of prudence. The question we naturally need to ask is whether or not we are doing the same now also, with the liberal dose of QE across major economic blocks being the starting point. This is because it was the prevalence of similar policies of easy money which led to the creation of the crisis.
Now let us look at some specifics that make Das believe there will be more stagnation. He quotes John Hicks, who said that true growth is the amount that can be withdrawn without affecting the ability to produce more growth in future. Otherwise, growth today is at the expense of future growth. Here we have not succeeded. There is a shortage of resources and our tryst to push up farm output has actually over exploited land with higher doses of irrigation, seeds, fertilisers and pesticides.
Second, there is reverse globalisation in action. The flow of funds from developed countries to emerging markets, which spawned high growth, has moved in the reverse. Regulation, which is a masquerade for protection, is the rule, with all countries trying to protect their turfs.
Third, the emerging markets that were to be the bastion of growth have slowed down in this process. Chinese slowdown, which has made headlines in recent times, will be a drag on the world economy.
Fourth, Das highlights the bane of inequality, which has grown over time and quotes from Thomas Piketty. This entire episode of financial crisis and its resolution was all about bailing out the rich.
Fifth, he laments quite forcefully the democratic deficit that has emerged, with US and Europe still dominating institutions like the IMF and World Bank that were to help the developing countries. It is not surprising that all over, households have shifted from financial investments and savings to gold and land as policies appear to be skewed in favour of the rich.
Last, Das speaks of the loss of jobs and stagnant wages for the majority that will push growth downwards.
Two things stand out in this book. The first is that while he is quite forthright with his views, the author does not provide any solutions. The second is whether or not it is really doomsday, or has the author gone overboard when interpreting the business cycle which is natural in the Schumpeterian world of creative destruction?
Most of what the author has said is true but has probably been looked at from one side of the prism and the positives have not been considered. This is important because when we had the boom just before the crisis set in, which was called the Great Moderation, no one expected a collapse, which did take place. In hindsight, it is easier to be wise. Similarly, presently, while conditions do not appear too bright, would it be right to assume that the direction is only downwards? This is where the reader should draw her own inferences.

Why fret over small savings rates? Business Line 25th March 2016

It is hard to believe that these schemes — just 7 per cent of bank deposits — restrain banks from lowering rates

The decision to lower the interest rates on small savings is curious not so much because it was considered to be the order of the day, but because it has been put forward as a solution to the problem of low transmission of interest rates in the banking system.

By linking this rate to market movements of G-Sec yields on a quarterly basis one can guess the final direction of these returns, which could reach a new low over a period of time. Numerically, however, this does not sound convincing.

Higher rates

Outstanding small savings were around ₹6.41 lakh crore as of August 2015, while bank deposits were about ₹90 lakh crore. With small savings being just about 7 per cent of bank deposits it is hard to believe that banks are not in a position to lower interest rates because small savings returns are higher and that there will be a migration.

In fact, within small savings, deposits account for around 64 per cent of total, followed by certificates with 30 per cent and PPF with 7 per cent. If at all there is competition between these forms of savings it would be with post office deposits which would account for just about 4.5 per cent of bank deposits.

Hence, to argue that a savings avenue like post office term deposits, which is less than 5 per cent of the banking system deposits, is potent enough to erode the funds base of banks can be questioned. Within small savings, certificates are contracted savings which have a fixed return when purchased. Here it will be the only incremental certificates that will carry a lower interest rate.

PPF would be the biggest beneficiary for the government as the existing deposits would also get re-priced at the new interest rate structure. PPFs have the advantage of being immobile as the motivation is different, and one keeps putting in the amount of up to ₹150,000 irrespective of the interest rate due to tax benefits. It becomes almost committed — much like the EPF schemes.

Also, there is a limit that cannot be breached and hence household surpluses would have to be invested in either the capital market or bank deposits.

Hence, the argument that small savings can substitute bank deposits may be a bit exaggerated. Further, on an annual basis small savings increase by roughly ₹20,000 crore which is very small compared to bank deposits which would be increasing by between ₹12-14 lakh crore.

More importantly, though it sounds logical to see some substitution between bank and post office deposits, it actually does not happen. One of the reasons is the class of customers tends to be different. Just as how customers do not move out of one bank to another due to the differentials in interest rates on deposits, the same holds even more so in the case of post offices, as the classes involved are different.

Matter of experience

Small savings were meant more for the lower income groups and were targeted at the non-metropolitan level to help in financial inclusion. Therefore, schemes such as monthly income deposits or recurring deposits came into the picture as they appealed to these groups.

Hence, data also reveal that while there are gross receipts coming in, albeit in small quantities, the net incremental savings remains small as there are continuous withdrawals. The small savings schemes have hence not been very appealing to the urban household, which typically is the big saver using bank deposits as the major avenue.

Besides, the customer normally has a complete relation with a bank like access to cards, loans, online facilities, etc. and would feel less inclined to shift to a post office term deposit.

Also the approach to customer service is different in case of post offices and one may not relish the idea of standing in queues to make such deposits.

Lowering of rates is more likely to benefit the government as the lower cost on such instruments means less payout. Based on an increment of ₹20,000 crore, the cost savings for the government at 60 bps cut would be savings of ₹120 crore as interest payments. As a part of this goes to the state governments, this will help reduce the outflow on this score.

Add to this the PPF which gets re-priced immediately, which is a round ₹55,000 crore, and the savings increases by ₹330 crore. The amounts are not really significant for the government.

There are two points here. The first: there is a desperate attempt being made to have interest rates lowered by banks. It started off with the argument that the transmission from RBI policy to banks was sluggish and investment was affected. It was followed with suasion and then was followed by the proposed marginal cost pricing of base rate.

However, banks have been quick to lower deposit rates at a faster pace than the policy rate. While repo came down by 75 bps in FY16, the average deposit rate declined by 92.5 bps. But lending rates came down by just 62.5 bps.

Therefore, the problem has not been so much on banks not being able to lower their deposit rate but reluctance to bring down their base rates. This may be attributed to the present environment of NPA issues as well as higher credit risk perception. It is also true that the non-AAA rated companies continue to pay a much higher mark-up on the base rate due to this reason.

Do we need them?

The second issue relates to the high spreads in the system. The Indian banking system continues to reap one of the highest interest rate spread of around 3.5 per cent (return on advances – cost of deposits) while net interest margin (NII/total assets) is around 2.75 per cent.

Quite clearly, the RBI should also be pressuring banks to be more efficient and reduce these spreads which are sub-optimal and being earned due to oligopolistic power being exerted by the system.

At an ideological level we can pose the question as to whether or not we really require small savings. This is so as most States feel this cost is much higher than the market rates. Deposits can be shifted directly to commercial banks or the new small and payments banks. Certificates can go as long term papers issued by banks.

PPF serves just as an addendum to the existing EPF and VPF with a different interest rate, but serving the same purpose for those who are not salaried. With Post office Bank coming up, this issue would have to be tackled anyway. We do need to think on these lines.

A case against bank mergers: Financial Express March 21, 2016

The merger of public sector banks (PSBs) is now the war-cry because everyone believes that it is a panacea—or at least a part of the solution—for the problems which confront them. Management consultants argued for this over a decade back, based on what has happened in other emerging markets. The FM spoke of it recently and RBI reiterated the same; hence, it is not surprising that the subject has come to the discussion board. But, have we stopped to think about the feasibility of the same?
Mathematically, merging a weak bank with a strong one can’t be disputed as the final result will look better than the current scenario. At the limit, the aggregate picture of all PSBs put together enhances overall performance. By merging a weak bank with high NPAs and negative net worth with a better performing one (invariably, SBI will be expected to carry this cross), the sum looks better in all respects. But, break it up into the component banks, and the cracks become visible.
Two sets of issues come up. The first is the feasibility of such mergers at a pragmatic level and the second concerns ideology. Looking at feasibility, some practical questions can be posed. First, what do we do with the multiple branches, as all banks have several branches in all important centres? The top 100 centres would have multiple branches of almost all banks, as this is where business lies. Sitting in an arm-chair, it is easy to say that we can close down the one which does less business or sell the property or close the lease. But, is this really possible?
Second, there is the issue of staff. In nationalised banks, typically 50% of the total employees consist of support staff, while for the SBI group, it is closer to 60%. To top it all, the staff is unionised and has to be taken along if such mergers are to work. This situation is hence different from the mergers we have witnessed in the case of private sector banks, where pink-slips are handed over under the guise of voluntary retirement schemes and there is no recourse available to the employees. This is a hard call, given the number involved is nearly 8 lakh employees.
Third, there are challenges at the higher echelon levels too as there will be duplication of positions. There will be multiple CMDs and MDs and EDs who have to be sifted, and this will entail a lot of pain as some may have to leave.
Further, several departments have to be realigned or closed, such as treasuries and risk management, as these activities are really scalable where volumes growth does not justify commensurate increase in This has been relatively easier when two private banks have merged or a bank bought over. The private sector is ruthless and the higher pay scales carry an unemployment trade-off as they use euphemisms such as shareholder value for downsizing. This is not the case with the public sector where there is surety of tenure even as compensation is substantially lower—the earnings of a private sector chief could be 25 times that of a PSB head. Interestingly, it has been argued in some quarters that if the same logic were to be applied to, say, the government where there are multiple ministries that can be potentially merged (i.e. steel, textiles, commerce and industry, SMEs, the bureaucracy would become less heavy). As a corollary, it has been asked whether we are prepared to do the same rationalisation for secretaries and their ilk in the government.
Fourth, there are cultural issues and while we do tend to paint them with the same brush, the approach to banking, work culture, customer centricity varies between North-based banks and South-based ones. How do we resolve this conundrum?
Fifth, the orientation of banks is different. Some are more into rural banking while others have a strong industrial or infrastructure proclivity. Hence, besides looking at performance indicators, the business blend of such mergers has to be judicious, else, we will be concentrating risk in some areas.
Last, the issue of technology is also important which has to be resolved before any action is taken. While most could be using similar platforms, they have to be compatible. But this may be the least of all the worries,
At the ideological level, interesting questions pop up. First, by going in for such mergers we would be creating huge oligopolistic structures which may not be desirable. This is so because at some time they will be privatised which in turn will make them different entities. In every industry, we are trying to induce competition, while in banking we are reducing this level by design.
Second, the whole idea of multiplying the system with small and payments banks appears to be against the ethos of creating such big structures. We need to ask ourselves as to whether or not there is a contradiction here. At a later stage, will we opt for merger of these small banks and payments banks, because they would also be facing similar challenges as size will matter?
The point really is that we are missing out on addressing the core issue and going around the periphery to address the problem. We have to identify the motivations for such mergers and address them appropriately like strong credit processes, governance, non-interference, competence, etc. Merging banks will serve little purpose if we have fewer structures with the same blemishes.
If government interference is the reason, it should move away from running banks. If there are governance issues, they should be addressed forthrightly. If there is absence of talent and the decisions taken are out of incompetence, then we need to get the right people. If there is no incentive structure, it should be brought in. There is no point in PSBs earning profits and paying the government a dividend if it has to come back to recapitalise them. Instead, if pay scales are made attractive, there would be the right talent.
Merging PSBs may be myopic in nature when alternatives exist to strengthen them. Decentralisation has been the buzz word when we talk of the rest of banking or even geographic demarcation of our states as they work better. Weak banks can walk the road of narrow banking until such time their books are clean, which is preferable to doing things in a hurry as it sounds neat today. For sure, we should think deeper.

Bitter fizz: Financial Express March 20, 2016

 Book review: Soda Politics: Marlon Nestle

ALL OF us are aware of the harm caused by the consumption of tobacco; the games played by these companies and their lobbyists are well-documented. Perhaps less known is the soda business, which refers to the colas that are consumed quite liberally by all of us. Marion Nestle, a professor in health and nutrition, puts before us facts about colas, with the story surrounding how Pepsi and Coke operate. The revelations are shocking and will make one think harder, not only about how these companies work, but also the way in which a camouflage is created. In fact, what holds for sodas also holds for several other products that we consume. If we extend this story to a wide array of products, the picture is quite scary.
Colas are known to have excessive calories from sugar, which contributes to dental problems, as well as obesity, besides being one of the major causes of Type 2 diabetes. While consciousness is growing about their ill effects, their consumption is still very high across the world.
The product as such is very rudimentary, with a very low cost of production. The main raw materials are just water and sugar. Yet these companies end up making a huge profit. In particular, they have targeted children, and while several countries have put restrictions on sale near schools for children below the age of 12 years, it does not really work. Further, they have targeted lower-income groups, which are primarily the Hispanics and coloured sections in the US, where it is popular. The economics of pricing ensures that large bottles and cans sell cheaper than smaller ones, so that people end up drinking more. They have also spread out to developing countries, with China and India being two targets, where the population and consumption is high.
Nestle, in her book, exposes all the techniques used by these companies to maintain their image. They sponsor sports events, which ensure that the consumption is even higher than the sponsorship money. Next, they contribute substantially to educational institutions, but also ensure that they have only their cola available. Most managements fall for this, as the money is attractive and helps to cover overheads.
Further, they do a lot of good work in terms of social good, which is done mainly to maintain their image as being companies that care for society—never mind that they have been responsible for guzzling water. While their product per se does not use that much water, the sugar usage, which is 10 spoons per can of 10 ounces of the drink, is based on sugarcane, which, in turn, requires a lot of water during cultivation. Starting from cane-growing to the content, bottles and packaging, it has been estimated that half litre of the drink can use 170-310 litres of water, which is mindboggling. And to ensure that they are on the right side of the government, they are large contributors to all political parties, which just reinforces their clout.
The author also points out that while there has been a lot of criticism of the ill effects of drinking colas, both Coke and Pepsi have commissioned and influenced studies that are equivocal on the use of these drinks and say that reasonable consumption is safe. But these limits are never specified. It is not surprising to find reputed medical experts placed in important positions who serve as conduits for their advocacy. Also, health experts are taken on board and made known to the community, as the assumption is that if these professionals are involved, the product has to be safe. Similarly, they have had several management experts and critics write on all the good they have done for society, which camouflages the harm caused by these drinks.
The soda, or rather the cola industry, involves a long value chain in the production process, which goes beyond the company. The syrup producer is critical, as is the bottler, distributor and retailer. These layers add to the cost and are big industries on their own in various countries, and have to be taken along by the industry. Colas have been priced strategically higher than water, which is also sold by these companies, to ensure that one drinks more soda and less water. Higher sales hence add to the profits of the entire value chain.
Nestle, interestingly, traces their marketing strategy, which provides clues to all FMCG companies on what they should do to make customers addicted to their products. The first is advertising, without which the product cannot remain high in the customer’s mind. The second is to have a strategy that appeals to human desire, where the image is more important than the product. Third, the product has to be ubiquitous and should be available everywhere, so that after the first two goals are achieved, it becomes a household name. Fourth, all methods should be used for marketing, like supermarkets, mass retailers, drugstores, vending machines, etc. Fifth is the really important use of music and sports celebrities for endorsements. In India, we have witnessed the use of film stars, who probably are better known than music personalities. Sixth, the product has to be cheap. In India, as colas are still considered to be an expensive drink, we have seen smaller bottles being sold or larger ones at an economical rate to attract customers. Last, it is made attractive to all communities. To give an example, these companies support the LGBT community to gain a share of their wallet.
This book is quite interesting even while being controversial, as it exposes the games played by these companies. One can assume that all the criticisms are true, as they are based on a lot of evidence of what goes on in the background. Or else, the author could run the risk of libel, given the power that these companies wield. The reader will certainly think twice before bringing these drinks home; this reviewer has actually given up colas after reading this book.

Freeing bank boards: Financial Express March 15, 2016

The creation of the Banks Board Bureau (BBB) is motivated at making PSBs more efficient and free from government interference, as it is believed that, in the current context, their boards are not really independent. By transitivity, the same also holds for the management of banks, which are constrained by similar pressures. Is there a pragmatic way out of this conundrum?
The measures taken so far are to appoint the chairmen of some banks in a non-executive capacity, while certain MD and CEOs have been taken from outside the system—meaning thereby that non-PSB professionals have been placed in these positions. The criteria really cannot be that private bankers are better, because some of the big bank failures have emanated in the private space. Therefore, the approach has to be getting the right people without background consideration.
Having the BBB is one thing, but to make a difference our approach has to change, because if we have only a different set of experts appointing the same set of people, it will not achieve the purpose. A way out is to take a route which, at first sight, may sound heretical.
To begin with, the government must stop having nominee directors on the boards of banks. As we keep talking of interference all the time—and the government has taken a stance that it does not want to interfere—the logical solution is that no one from the government or its nominee should be on the board. Having either of them on the basis of government’s prerogative by virtue of ownership vitiates this objective. It is believed that any nominee director even from outside active government would still act as a messenger of the realm.
Second, the directors which are appointed, including non-executive chairmen, must have qualification and competence. It has become almost axiomatic that a successful MD or CEO, who has retired, automatically qualifies for the post of a director of another bank or company. This may not always be the right assumption to make, and often their involvement is limited as they hold multiple positions in companies and may not really be in a position to add value. So, while these are good names to have in the annual report, they may not be the right persons.
While there can be a qualification for becoming a director in terms of age, experience, etc, subsequently there should be an examination which would be a combination of the UPSC/CAT variety, and which the BBB designs. Ideally, case studies could be a way of testing the ability of a director, while psychometric tests can evaluate whether the person has the aptitude for the same. This may not be palatable, but is essential, as often we do have directors on companies who could well be past the present and not in touch with changing corporate climate. There are CEOs who retire from office and are still less tuned to technology or HR practices and may not be able to comprehend such issues in a company where they are part of the board.
Another way out is for all potential directors to be rated by, say, credit rating agencies (CRAs). Here, the CRA can have a model that is presented and approved by the BBB. The potential directors can then be evaluated by the CRA and graded. While normally such a process involves personal interviews, which may not be forthcoming, interactions with staff of their current/earlier organisation/bank would be an alternative. Here, the BBB can call for applications for potential directors and ask them to make submissions to CRAs. Those who choose not to enter this process can be excluded.
Sometimes people of eminence are approached by companies to join the board based on their past performance or stature. The individual likes to be on board of leading companies, while the company gains with the brand of the individual. Though this is a common practice in the private sector, for the PSBs it has to be altered, to ensure that the process is free of bias. It is not surprising that persons who served successfully as heads of PSBs earlier get appointed as directors, which carries an inherent bias.
While having an effective board is important, the top management, especially MD and CEO, is also critical. Here again, the head tends to be a government appointment and we do generally read of there being 50 eminent persons being considered for five positions which go to the ministry. There is intense lobbying for these posts in all public sector organisations. To get out of this circle of bias and influence, a new system can be devised, including the shortlisting process as well as tenure.
The UPSC-CAT should be the criteria for appointing professionals to the position of executive director, deputy managing director or other board-level designations. This is needed because all executive directors become potential managing directors and should have the ability to own the balance sheet, which does not come easily to everyone. At present, a combination of seniority and lobbying could be influencing such decisions. A transparent screening system can act as a filter, after which the BBB can keep interviewing this sub-set for the position of the head of a bank.
The issue of tenure is also important and it has to be fixed for five years, such that the person can deliver with a renewal prospect of another 3-5 years in case the performance criterion is met. When the tenure is short, the head is not able to do full justice, as one tends to be myopic and may not see the big picture or draw up a long-term strategy. It is also the case that when the tenure is short, the new incumbent tends to reverse the earlier strategy to be different.
It has been observed that in private organisations some of the heads go beyond two terms and run the organisation successfully. But governance principles must ensure that there are opportunities for others and a second line develops—as well as infusion of new ideas which tend to get stunted when the MD remains unchanged. Usually, competent professionals look for jobs outside when the MD and CEO appears entrenched and is not willing to pass on the baton. This, however, holds more in the private space than in public.
While it is challenging to change a system of appointment—given that the shibboleths once established are not malleable—the BBB would hopefully take a fresh view on these appointments, especially since the weak links have been identified. By not taking a different approach, we could just drift into what Milton Friedman would have termed as “tyranny of the status quo.”

Banking capital: It is the wizard’s hand: Financial Express 10th March 2016

The deferred tax assets arising due to timing differences are permissible up to 10% of a bank’s Tier-1 capital. (Photo: Reuters)

The financial sector is known for financial engineering and its success has been legendary. However, our banking system is no less engineered, and while the effects look good to begin with, the probability of conditions moving in the other direction can be high.
Let us look at the latest regulation regarding the calculation of regulatory capital for reckoning Tier-1 capital under the Basel III framework. Three changes have been made.
First, the revaluation reserves arising from change in carrying the amount of a bank’s property consequent upon its revaluation would be considered as Tier-1 capital instead of Tier-2 capital at a discount of 55%.
Second, foreign currency translation reserves arising due to translation of financial statements of a bank’s foreign operations to the reporting currency would also qualify at a discount of 25%.
Third, deferred tax assets arising due to timing differences are permissible up to 10% of a bank’s Tier-1 capital.
There is nothing amiss in this concept as we are following the global practice when calculating capital. There are, however, some questions or issues which come up.
One, if this is a global concept, why was this not down earlier? The timing has a touch of irony as it comes when public sector banks (PSBs) have challenges with capital; and in one stroke of the regulatory pen, Rs 40,000 crore is released into the system which will justify lending of Rs 4 lakh crore, assuming a Capital Adequacy Ratio (CAR) of 10%. The market has cheered and the movement in stock indices seems to vindicate this move, bringing out the sun rays suddenly through the dark clouds.
Two, such reclassification while shoring up capital does not provide resources to lend as this would be more of an accounting entry. So, while the adherence to prudential norms looks better, the ability to lend will not change.
Three, can there be a perverse incentive that will develop where banks can, say, have assets revalued regularly at a higher level to meet the prudential norms? This can lead to caution being kept aside when operating loan books.
Four, are we just delaying the inevitable, which is that a tough call has to be taken on disinvestment or mergers of PSBs as the government has limited fiscal space to capitalise banks? Even if this is not the intention, it will help in procrastination.
The banking system has never been free from such controversy. The concept of restructured assets, it may be remembered, was often interpreted as a camouflage for ever-greening of bad assets. When this concept came into the banking lexicon, it was defended quite vociferously by all. The rationale was that large infra projects in particular ran into temporary problems because of extraneous reasons, which had to be reversed by more sympathetic treatment of these assets. The logic was warped as this justification can be used for any asset which turns bad, because except where there is wilful default or where companies are very badly governed, all NPAs would have had their genesis in the economic slowdown, policy paralysis (of the earlier government), etc.
Interestingly, we did not treat this issue with concern until the level went up to a very high 7-8%, when they were reckoned as part of the stressed assets and were repeated in all policies with a blend of disdain and awe. But the issue was well known and allowed to both germinate and proliferate as several companies took refuge under this umbrella, which provided protection in a progressive manner. And today, there is a major scare that the stressed assets have reached astronomical magnitudes, leading to disruption in bank balance sheets.
More recently, the issue of NPAs has again caught attention in terms of classification. Several banks had treated NPAs as performing, as long as their loans to companies were being serviced, while others which were not paid on time by the same companies classified them as performing. This anomaly had to be corrected, which took some tough talk to ensure that the books were cleaned up. This has dented the profit and loss (P&L) of several banks in Q3FY16, and it is anybody’s guess as to how long it will take to clean them up permanently, though most banks claim that March 2016 would be the terminal point.
While it is true that one can always be wiser after the event, since if the dangers were known, the systems would have been tightened earlier, the larger question is why was this not done earlier? It is similar logic which comes to mind when the classification of capital has changed at a time when there is desperate need for capital which is not forthcoming that easily. The problem really is that with this additional comfort being provided, banks could just go slow on thinking of reforming their balance sheets. The owner of these banks, i.e. the government, would get breathing space to take further action, and the market demand for higher capitalisation has been addressed in a jiffy. We have definitely deferred the problem, though there is a possibility that there could be misuse of these definitions by some banks.
The message is that we have to look at banking reforms afresh and review processes as well as accounts of all the banks. Studying global practices sounds good, but the issue is that countries follow different rules and regulations, and it is always possible to borrow templates from systems which are convenient for us. This should be eschewed and a balanced view taken. An independent committee looking at various banking issues, especially in the areas of quality of assets and capital, can make the outcome more credible. We have come a long way with Narasimham and his two committees which brought about a lot of fairness in banking practices. Reviewing the system afresh is the way out. Knee-jerk reactions to prevalent circumstances may be tempting, but not a permanent solution.

Budget not crucial for monetary policy : Business Line 9th March 2016

That’s because interest rates are aligned to inflation rather than fiscal deficit, and the Centre’s borrowings seem stable

March 8, 2016:  

It is a healthy practice that advice is passed on from the Ministry of Finance (MoF) to Reserve Bank of India (RBI) and vice versa; it means that the two arms of policy are talking to one another.

Such discussion should not be construed as being intrusive. However, the more pertinent issue is the policy significance of the Budget, or rather government borrowing and fiscal deficit targets, for setting monetary policy.

An inflation targeting monetary policy, which revolves around consumer price inflation, lends added importance to the question. The Budget has also formally spoken of the monetary policy committee to be set up, which will ostensibly be guided by the same objective.

Of course, CPI is said to be driven by food prices, which are not within the purview of government deficits.

Little inflationary impact

So far, there has been limited demand side inflation emanating from the government side. In fact, when subsidies were high they provided insulation from inflation to an extent. Pay Commission hikes in the past have been beneficial for consumer durables and auto segments – but could not really have been linked with inflation.

In fact, if the Pay Commission impact of ₹1.1 lakh crore is to be broken down, it appears that about ₹70,000-80,000 crore would have been provided this time. Of this 20-25 per cent would flow back to the government as tax revenue, while another 30 per cent would be saved.

Hence, only half of the incremental amount would be spent in industries where demand conditions are low. Higher demand will only help these companies in a non-inflationary manner.

The other reason for analysing the Budget from a monetary policy viewpoint could be to make an assessment of future liquidity, especially if the borrowing programme is large. The government has ensured that the borrowing this year will be around ₹4.25 lakh crore. But here it is not exactly monetary policy action (or rates) that matters, as much support during the year is through OMOs (open market operations) by the RBI, based on immediate conditions of liquidity shortage.

Interest rates and fiscal deficit

Recent experience shows that governments evolve different ways of containing the fiscal deficit. How critical is this number for the RBI?

The table gives the revealed nature of monetary policy behaviour. The fiscal deficit ratio has been coming down since FY13 but the repo rate has been aligned more to inflation.

In FY11 when the deficit decreased, interest rates were increased as inflation remained high at above 10 per cent. This means that the fiscal deficit ratio per se may not be very pertinent.

The level of net borrowings has remained broadly range bound at ₹4.3-4.7 lakh crore in the last five years and hence has not come in the way of monetary policy. In two years, FY12 and FY15, interest rate action was aligned with the quantum of change in borrowings, while it was opposite for the other four years.

The RBI response to liquidity conditions through OMOs has not been linked with the net borrowings in the system and is more of a reaction to the prevailing conditions.

Therefore, whether we target a 3.7 per cent or 3.5 per cent deficit target for 2016-17, the net borrowings will be budgeted in the same range as there will always be other income streams like disinvestment to balance the same.

Importance of Budget

Further, inflation targeting is the dictum to be pursued, where price shocks have emanated primarily from the food side. Now, with global commodity prices being low, in the current context, decisions can be made without worrying about demand pull inflation. Liquidity, however, will be a concern especially if private demand picks up. But then one can never be sure if this will happen and the OMOs have to be used based on prevailing conditions.

Hence, it is possible to argue that the budgetary outcomes are not really be very pertinent from the point of view of monetary policy action.

However, the content of the Budget is of relevance for the central bank to take a view on the state of economy and its prospects. The two can proceed quite independently and there can be little reason for one to wait for the other.