Indian bond trading is in need of better market making: MInt 20th August 2021

 https://www.livemint.com/opinion/online-views/indian-bond-trading-is-in-need-of-better-market-making-11629389415171.html

RBI's Index on financial inclusion: A very timely initiative: Business Standard 17th August 2021

 The Financial inclusion index brought out by the RBI is very timely and important as it attributes a number to everything we talk of on the subject. Financial inclusion has been on the agenda of all governments and regulators and goes beyond the concept of providing a deposit account or loan. The index includes 97 attributes that are extensive and one assumes that they cover capital markets insurance and other banking services. The index is to be announced every July and as of now the RBI tells us that the index is at 53.9 as on March 2021, compared with 43.4 in March 2017. It includes three main attributes: access, usage and quality.

The dates chosen are interesting, as 2017 comes just as we came out of demonetisation, where people perforce had to go digital, which provided an impetus to digital banking. This was also the time when there was widespread use of the Jan Dhan account, which has now become the conduit for channeling any cash transfers to beneficiaries. Therefore, there has been a big push given by the government to inclusion through this account. Hence it is expected that access and usage would tend to increase automatically as funds keep passing through these accounts. Also, with digital banking picking up fast, it would add weight to this index.

It may be recollected that the government launched some rather aggressive insurance schemes for farmers and individuals, which means that there has been a tendency for greater coverage of the population under insurance. The PM health insurance scheme has been popular and actually enhances insurance coverage to all the needy people. This gets reflected in the score going up by around 10 points.

The index has to be read as a number and is not linked to a base year. Hence a number of 100 would mean that based on the criteria used the entire population is included in the financial system. One can hope that this number only increases with time. The pace of increase will be important here.

Some thoughts that come based on the limited information provided by the RBI on the index are the following. First, in terms of banking we may have reached the optimal situation as incremental Jan Dhan accounts have been slow. Also with the currency situation normalising, the push to digitisation is less intensive. Second, for this number to increase, non-banking services have to increase. Here the population has to use more of mutual funds and insurance products. Will this really accelerate? Insurance companies and mutual funds have a challenge here as typically low income people are small-ticket customers and the cost of inclusion is high and may not be worth their while. Third, even for banking it would be interesting to see if the transactions being witnessed go beyond the forced Jan Dhan accounts which receive wages, pensions and transfers. People actually need to use these accounts for regular transactions and hopefully the detailed index should reflect this aspect of quality.

Ideally it would be useful if the RBI would break this index up across various segments so that there can be concentration on the specific sector. The progress so far is impressive for sure, but there could be a bias towards banking and further to areas where the government has pushed financial products as part of its social development programmes. This is a very good start made by the RBI which should be monitored regularly to gauge the pace of progress as it will help future policy formulation in the right direction.

The Libor’s last tango: Important to get a sense of the costs of Libor regime ending & consequent shift to new benchmarks: Financial Express 12th August 2021

 RBI had estimated in November 2020 that around $50 billion of debt and $281 billion in derivatives would expire after 2021.

RBI’s recent Guidance to banks as well as companies calls for being cognizant of the fact that LIBOR will be going off the market from next year; it warns entities against getting into such contracts. More important, they need to handle contracts that are expiring post-2021. LIBOR is a sort of financial truth used globally for plethora of transactions. Once the LIBOR loses its sanctity, there is the question of how to handle the same.

There are two aspects. First, globally, there is already a large volume of outstanding transactions linked to LIBOR (around $223 trillion, of which $74 trillion could be maturing post-2023). The bulk is in derivative contracts—around $213 trillion. Second, even though the ICE Benchmark Administration (IBA) had announced that it would no longer be providing these benchmarks, several transactions were still reckoned.

Now, with the advice that all the transactions and contracts must be recalibrated to a new benchmark, the latter should ideally be an inter-bank rate. LIBOR gets into almost all risk models, valuation tools, and product design (even MIFOR of India is linked to LIBOR and will now fall out of use). Mortgage rates are set against the LIBOR. Market-players are looking at SOFR (secured overnight finance rate) as an alternative, as this was recommended by the Alternative Reference Rates Committee (ARRC). The fixing of spread adjustments by the International Swaps and Derivatives Association (ISDA) provides an economic link between LIBOR and selected risk-free rates (RFRs) for referencing contracts that expire after end-2021. But, any new benchmarking will mean that there will be losers and gainers, and the amounts involved may be large.

Once the reference is decided, there must be agreement on the basis (yield difference) between the old and the new benchmark. This can lead to considerable subjectivity, since, even though historical data can be used for creating these links, the robustness of this is questionable. SOFR is an overnight rate based on actual data and is not forward-looking, while LIBOR was for different tenures (of one day to one year) but based on market-experts’ opinion.

RBI had estimated in November 2020 that around $50 billion of debt and $281 billion in derivatives would expire after 2021. There are also government contracts that are linked with LIBOR. There is clearly a risk being carried by companies and banks on these contracts, as borrowings or deposits would directly get affected by the differences in cost that may arise when the benchmark is changed. Interest rate swaps (IRS) are benchmarked with MIFOR, which includes LIBOR.

Companies and banks would need to seek a hedge to counter potential losses. For new contracts, the players will know in advance the benchmark, say, the SOFR, and accordingly decide on pricing. The running contracts will be a concern. The $50 billion of debt would be equivalent of Rs 3.75 lakh crore and even a 0.1% variation can mean a potential loss of Rs 375 crore.

It will be interesting to see how RBI adapts to the absence of LIBOR. At present, all ECBs are benchmarked against the LIBOR, and companies are allowed to raise money at LIBOR-plus-a-certain-interest-rate. RBI’s decision will set the tone for others. RBI, of course, is not dealing with the LIBOR here, but merely using it as a reference point for commercial borrowings.

Taking this forward, the threat of risk posed to the financial system needs to be evaluated and it would be useful if banks are asked to make such disclosures as part of market risk carried and the mitigating measures. The same holds for companies which need to evaluate and state in their quarterly investor meeting the possible cost that would have to be borne on account of this transition. It is important to get a sense of the cost of this change for Indian entities as well as RBI’s thought process on the benchmark to be used.

Growth still not durable and inflation transitory, markets not convinced: Mint 7th August 2021

 After much waiting for the Reserve Bank of India’s (RBI’s) stand on interest rates and policy stance, it is now understood that there will be no change. The reason is simple. RBI, like other monetary authorities, have reiterated time and again that it will do everything to stabilize growth. And growth does not happen fast; and also, the path is not even. Improvement in purchasing manager’s index or goods and service taxes collections in one month may reverse the next month. Moreover, there are statistical base effects which may cloud one’s judgement.

Under these conditions, the policy must be read carefully for three reasons. These perspectives relate to growth, inflation and liquidity. Here too, the path is predictable as the direction is clear once growth is given precedence over inflation. Therefore, when the monetary policy committee treats inflation as being transitory, the question to be asked is how one can define inflation as being temporary or transient. In the last 15 months since the pandemic struck, consumer price index-based inflation has been above 6% in 10 months, 5-6% in two months and 4-5% in three months. Quite clearly, the view of inflation being transitory can be debated. RBI’s opinion is that inflation will still be 5.9%, 5.3% and 5.8% in the remaining three quarters, which shows that it is more permanently in the 5-6% range. Hence, interpretation of inflation is one of perception.

How about growth? Here, there is a bit of irony. Growth will be 9.5% (CARE Ratings believes it will be lower by 0.5-0.7%), and for the quarters, it would be on a declining slope of 21.4%, 7.3%, 6.3% and 6.1%. The irony comes from the fact that while growth actually picks up in the economy as the unlock becomes more wholesome with services also being allowed to function, numerically, the growth numbers will come down due to the base effect. Therefore, logically, these numbers may not matter much as they will not reflect the reality on the ground, which holds for most “real" variables this year where sharp dips last year will provide the buoyancy this time.

It would be interesting to try and interpret the permanency of the growth path based on the MPC discourse. The term used is “growth on durable basis" which is open to interpretation. The three engines are firing at different paces—consumption, investment and trade. That is the good part. If this is so, then growth is clearly on the right path and there should be less concern. In fact, if we add what the chief economic advisor had to say about growth being 11% this year, it looks like that growth is back for sure. The governor also said that until one is convinced on growth, inflation will not be looked at too seriously. But if the growth path is certain, there is reason for the MPC to look at inflation because we are living in a world of negative returns for savers. At some stage, this reality has to be accepted and the growth argument will no longer hold. Quite clearly, this question will pop up in the next policy when growth will be up and so will inflation. It would be useful for the market if the MPC could define the criteria for feeling assured that growth is back. We may have to start increasing rates just as the Fed has also been talking on these lines.

RBI has taken a neutral view on liquidity, with the caveat that any opening given to banks to park their funds does not tantamount to withdrawal of the stimulus. This is important because the V3R (variable rate reverse repo) scheme which offers banks a chance to deploy their surplus funds for a longer tenure is not mandatory but an option being provided. There is a chance for rollover of the surpluses which is useful for banks. To balance the same, RBI has also kept open the on-tap targeted long-term repo operations (TLTROs) and marginal standing facility (MSF) open till December. This may not really matter as there has not been any interest shown in the on-tap TLTRO scheme so far.

A broader question to be posed is that when there is surplus liquidity in the system, what exactly is the gameplan for banks when they sell their holdings of government paper under the G-sec acquisition programme (GSAP). This is pertinent because the funds that they get are not being lent but being put in the reverse repo window which offers 3.35%. Therefore, giving up on a coupon rate of around 5.5-6.5% through the GSAP for investment in reverse repo does not sound an optimal action unless they are in a state to start lending in a big way. For example, RBI announced the purchase of the 5.63% 2026 paper which has a yield of 5.76%. Giving this up for reinvesting in 3.35% is puzzling. But as said by the governor, the average amount deployed in the reverse repo has only been increasing to a high daily average of ₹8.5 trillion in August from an average of ₹5.7 trillion in June. Banks have clearly been losing out on at least 200 basis points on these excess deployment in the reverse repo auctions, which finally affects their profit and loss (P&L).

How have the markets reacted? The 10-year bond has seen an increase in yield from 6.20 to 6.24% which shows the continuation in scepticism which has been witnessed also in successive auctions on Friday when paper goes unsubscribed or devolves on the PDs. Interestingly, the auction of 6.10% 2031 paper was not subscribed. The market is still not convinced.

MPC reassures status quo on rates, but changes view on inflation: Business Standard 6th August 2021

 

The temporary supply shocks that have led to higher inflation has been kept aside by the MPC while focusing on growth

The credit policy announced on Friday was not expected to come out with anything very different from the earlier announcements. There are no changes in policy rates as expected with the Reserve Bank of India (RBI) reiterating commitment to growth, which is still in early stages. But yet there are some things that the market always looks forward to in terms of numbers and language. Both are important. Any change in forecasts would make economists rework their models to see if they need to change their assumptions. The language is important, as it could talk more about what to expect from Mint Street in the future.

The RBI has left the GDP forecast unchanged at 9.5 per cent and the quarterly progression would follow the earlier path. There have been minor changes here at 21.4 per cent for Q1, 7.3 per cent in Q2, 6.3 per cent in Q3 and 6.1 per cent in Q4. Therefore, we can expect a diminishing growth rate during the four quarters, which is more based on the base effects weaning rather than absolute growth slowing down. In fact, absolute growth will be picking up. The RBI is confident that there has been revival in all the three engines: consumption, investment and external demand. Here it can be argued that it still needs to be seen if this has worked out, because base effects have tended to make several initial indicators look good.

On inflation, the RBI has become slightly more hawkish as the overall forecast has changed from 5.1 per cent to 5.7 per cent with the predictions being 5.9 per cent, 5.3 per cent and 5.8 per cent respectively in the last three quarters. This is interesting because there is acceptance that inflation will be elevated throughout the year, notwithstanding the fact that there will be a good kharif harvest. We are definitely talking of numbers in the region of 4 per cent and the range is between 5-6 per cent. The problem evidently will be on non-food products, including oil-related goods.

Here one can say that the RBI has taken a dualistic view. The first is that while growth is picking up, it remains fluid given the possibility of the third wave. Therefore, the RBI will continue to focus on growth. The second is that inflation is seen as being transient even today, and this is the important part of the commentary. The temporary supply shocks that have led to higher inflation have been kept aside by the MPC while focusing on growth.

The RBI is happy with the status of liquidity and the transmission of interest rates by banks, which has helped lower the cost for most borrowers. So far, it has been seen that while interest rates have come down, the willingness to lend has been a problem as banks have been careful on this score. In fact, of late even retail loans are facing challenges given that the non-performing asset (NPA) levels have gone up of late.

The language this time has been more predictable. It may be recollected that in the earlier policy, the Governor did talk quite definitely on the objective of managing the yield curve. This was significant because it gave a clear indication that the RBI would ensure that bond yields remained stable. But the market had other views and we have seen the yields rise very gradually with the ten-year bond now touching 6.20 per cent.

Therefore, overall the RBI has not quite changed any view on ideology. The 10-years bond went up from 6.20 per cent to 6.23 per cent as the Governor concluded his speech. Maybe the market still is not too convinced given the high inflation and government borrowing programme.

Removal of retro tax will send positive signal to foreign investors: Business Standard 5th August 2021

 

This change in retro tax law will reflect well on the govt's efforts to improve the ease of doing business environment

The removal of retrospective taxation for deals reckoned prior to 2012 is a very progressive step taken by the government. This, ostensibly, comes on the back of the litigation that is on in the International Arbitration Tribunal relating to Cairn Energy. But this has been a legacy issue with successive Indian governments where retrospective taxation was an effective way of garnering revenue. The indication given by the government alongside is that there could be refunds given to the companies without interest.

Retrospective actions are always retrogressive, and this is a correction required in the Indian tax system. While Cairn and Vodafone are lingering issues involving large amounts of money of around Rs 20,000 crore-Rs 30,000 crore put together. The fact that the Cairn deal was in 2006 just reveals how anachronistic are these laws. In case of Vodafone, the Supreme Court had also ruled in favour of the company, but the retro rule, pushed it back. Withdrawing such a measure is a good signal for companies looking to invest in India. Around a dozen companies have been impacted by such measures. This is a big regulatory risk that the players face when investing in any country where laws change. This cannot be avoided but making them effective retrospectively is never a good idea even though it does look tempting for governments.

India has been trying to reach out to foreign investors by providing a better enabling environment to do business. The recent discussion on IBC is also timely as that has also been a sticky issue with investors. Tax laws are probably even more important as they affect companies directly. Companies always run the risk of tax laws changing in any domain, and that is acceptable. However, making any new tax law effective from an earlier date is not acceptable as the regulatory cost increases and sends a wrong signal.

From the point of view of the government it can be argued that there is a potential loss of income. However, often such cases can go into litigation as has been the Cairn case, where the cost in terms of time and money also increases besides sending conflicting signals. Such amounts are not normally buffered in the Budgets on account of the time taken to recover the amount even when imposed. Therefore, such a law will be fiscally neutral and would have a positive impact only when it is received.

This should also give the government an idea to also follow the same path whenever tax exemptions are withdrawn, or rules changed for any savings instruments in the domestic economy. It may be recollected that when equity capital gains were introduced there was grandfathering introduced. However, when the debt mutual funds were to be taxed on capital gains for a period of 3 years rather than 1 year, it was done retrospectively. Therefore, it is essential to ensure this also holds in the domestic context so that domestic investment is also sure.

One of the guiding principles of investment is certainty in environment. This is provided by a regulatory structure at the time of investing. Changing laws during the course of time may be inescapable. However, when it comes to taxation doing so with retro effect sends wrong signals and it is good that the government has withdrawn this rule. This change in retro tax law will reflect well on the government’s efforts to improve the ease of doing business environment for sure.

Where reforms didn’t deliver: Businessline 2nd August 2021

 

The scorecard on health, education and employment is poor

The three decades of economic reforms since 1991 have certainly ushered in major changes in India’s economic architecture, leading to a better standard of living and access to more goods and services through global integration. But there are some issues that have not been tackled appropriately.

The average GDP growth in the three decades was 5.8 per cent per annum compared with 5.6 per cent in the 1980s, which was the period where there was a cosy coexistence between socialistic mindset and liberalisation. Therefore, while there were qualitative changes, the GDP growth moved up only marginally. However, compared with the three decades preceding 1991, it would seem impressive as the growth then was a meagre 4.2 per cent. But such a comparison would be improper as the country was beset by wars, droughts, famines, and the first oil price shock.

At the socio-economic level, the country has failed quite badly in the area of health, which got exposed during the pandemic. Leaving healthcare to the private sector was a wrong move, as it has exacerbated inequality and has healthcare has become unaffordable for a majority of the population. Poorly maintained health centres, absence of doctors and nurses and widespread corruption in handling resources reflect a rather sorry state of affairs.

Poor infrastructure

Second, education has taken a back seat. Here again, the poor infrastructure provided by the state has made those who can afford private education to move away to those facilities. The tendency to propagate education in local medium means that students without an English education are left with the chaff when it comes to procuring jobs. The inequality starts at this stage in life and builds up along the way. Having multiple boards with different standards ensure the rich are able to do better in life.

Third, poverty. There has definitely been an improvement in the poverty ratio. Going by the World Bank’s poverty line measure of $1.90 per day, India had 109-152 million poor people in 2017. The $3.20/day standard of low middle-income class was large at 543-630 million. Though there can be different interpretation of these numbers, the protagonists of reforms would argue that this is an improvement compared with 1991.

Fourth, the World Inequality Database for 1991-92 and 2018-19 shows that the top 10 per cent had 36 per cent of the national income at the time of reforms, which rose to 57.1 per cent by the terminal period. The top 1 per cent increased their share from 10.4 per cent to 21.7 per cent during this period. Clearly, reforms have made the rich richer, and while the poor may have seen some improvement, it is clearly not what would be acceptable by the Piketty School.

Fifth, employment. With there being no standard measure of the unemployment rate unlike in the West, the fact that the unorganised sector still dominates the scene tells how this picture has evolved. The government sector has lowered the pace of job creation while the private sector has resorted to greater use of technology making existing skill sets redundant. While the youth who are trained do get employment, it is more of an urban phenomenon. Rural jobs remain simplistic and unsustainable.

The approach so far has been to provide cash transfers rather than sustainable jobs. The MGNREGS is good, but it is more of a dole as the projects involved create little value. The PM Kisan scheme is good in that it provides supplementary income, but does not give assurance of value-added jobs. Hence commercialising rural India has to be the theme going forward.

On the markets front, successive governments have blown hot and cold. While maintaining a commitment to reforms and less intervention, the markets are not quite free. Banks, for example, are allowed to set their interest rates unlike in the pre-reform period where the minimum lending rate was fixed. But today there is a lot of regulatory intervention. The formula for fixing the lending rate is decided by the regulator and interest rates for some loans are to be fixed to a benchmark. This is unique to India where the central bank decides on commercial rates. Similarly, while the interest rates on government securities are to be market determined, monetary policy actions are taken to ensure that the rates remain low.

On the agricultural front, politics dominates economics. Price fixation through MSP (minimum support price) is based on the interests of farmers and markets are not allowed to work. One sides taken are taken of either the consumer or the farmer, the the market mechanism gets distorted. The same holds for industrial goods, where government intervention through higher tariffs on imports is antithetical to liberalisation. India Inc cannot have it both ways.

The issue of regulatory capture has been observed in several cases. The capitalist-political nexus exploded with the NPA issue, which has pushed back the economy by at least 5-7 years. Natural resource allocation was more than controversial. Corporates siphoning off bank funds has impacted the financial system.

The symbiotic relations between capitalists and bureaucrats have come to the fore often. While the present NDA government has taken a lot of effort to streamline operations, it has been challenging. Transparency International’s Corruption Perception Index put India at 88 out of 180 nations in 2020. In 2010 we were 91 out of 178 countries. In 2005 we were ranked 88 in 159 countries.

A big change in mindset is required to address all these issues. Unfortunately, the electorate never votes out parties for non-performance on these parameters, which has helped to cement the status quo. People need to demand permanent jobs rather than handouts and a clean bureaucracy.