RBI has just about set the tone for the rest of the financial year by highlighting concern on inflation while being sanguine about growth. It has pitched a lower WPI inflation rate of 5.5% for the year on the assumption that the monsoon will be normal and the relentless pressure witnessed on prices last year will not recur this time. If one combines the high growth expectation of over 8% with an eye on inflation, it appears that RBI is speaking the Keynesian language of demand-pull forces that need to be tackled head on.
The 25 bps hike across all rates was a minor surprise because while the market expected an increase, it was pitched at a higher level of 50 bps. Considering that RBI has already increased rates in two phases in this calendar year, the approach may be seen as being gradual but more frequent. The markets should be prepared for further interventions, even between policies, and the WPI number will have to be actively monitored with negative real interest rates likely to prevail for some more time.
The inflation concern is palpable because there has been a shift from primary to manufactured products, and even within manufactured products it is the non-food items that have started to show an increase. There are two reasons for this phenomenon. The first is that the global prices for metals have started to increase on the back of an economic recovery in the western countries and continued acceleration in China. With the price correlation for all these products being high with domestic prices, the feedback into the system will only get more pronounced. Second, RBI has also pointed out that there has been an increase in capacity utilisation in several sectors, which means that demand is rising on both the consumption and investment fronts. Hence, it is not difficult to conjecture that this segment will continue to exert pressure on prices.
RBI’s move may also be interpreted as a further withdrawal of the stimulus that began with the Union Budget, which sought to reverse the tax concessions that were given earlier to keep the economy afloat. This is indicative of the fact that the government is really serious about being back on track and that the economy does not really require extraneous government support to continue growing, which is a good sign. In fact, the significant point here is that while the western governments have spoken of a phased withdrawal, ours is one of the first to actually do so. The only factor that could have averted this move would have been a fall in inflation, which has not been witnessed, despite the higher projected rabi crop this year.
While banks in the past have been equivocal in raising rates when RBI has announced increases in the repo/reverse repo rates, anecdotal evidence suggests that higher interest rates do not normally impinge on industry, especially when there is an upswing in activity, which appears to be the case today. Hence, it appears that there is no contradiction between growth and stability, notwithstanding the higher rates that may be charged by banks.
Liquidity will be under pressure, with both the private sector and government claiming bank resources against a withdrawal of liquidity through the enhanced CRR. Based on RBI’s projections of growth in deposits and credit, the banking system could finance around Rs 1.2 lakh crore of the borrowings of Rs 3.4 lakh crore. RBI would have to be active in the GSecs market with its open market operations (OMO) to provide liquidity when needed and also enable the borrowing programme in a non-obtrusive manner. The fact that foreign funds will continue to flow in provides comfort to the extent of increasing the available resources for lending. Last year, RBI used a combination of MSS bonds and OMO sales to support the government-borrowing programme. The former will not be available this year as RBI is pitching for mobilising these bonds to the extent of Rs 50,000 crore on the expectation of higher foreign inflows.
Interest rates would definitely not come down in such a situation, though banks will face a bigger challenge in aligning their base rate computations with the policy rates. Currently, all policy and deposit rates have moved into the negative real zone. Bond yields will tend to increase and the 10-year yield will remain above 8% during the first half of the year, when inflation continues to be high. RBI will have to persist with its noncommittal ideological approach to monetary policy—using a monetarist tool à la Friedman to tackle a Keynesian phenomenon of demand-pull inflation.
Saturday, April 24, 2010
What RBI has in mind for April 20: Financial Express, April 16 2010
The Annual Credit Policy to be announced on April 20 is significant for several reasons. To begin with, we would get a clearer picture of the state of the economy. For the moment, we have claims made by various ministries on the progress of their sectors such as agriculture, industry and trade as well as the forecasts of various analysts. RBI’s review will tell us whether the overall GDP growth figure is at 7.2% or closer to more optimistic numbers in the vicinity of 8.5%. The GDP growth number may not have been more than a number in normal circumstances, but at this point in time, the entire policy stance for the year hinges on the actual state of the economy, which, in turn, is encompassed in this number. This will be the starting point of the theme of monetary policy for the rest of the year. Now, conducting monetary policy has often been likened to manoeuvring one’s vehicle through inclement weather with a fogged windshield, keeping an eye on the rear view mirror and shuffling one’s foot between the accelerator and the brake. This analogy will prevail during the year that will make monetary policy more interesting. The 2009-10 picture is the rear view, which should be clear at the time of the policy announcement when we will find out whether we are back on a high growth path. The windshield will continue to be foggy given the imponderables such as monsoon, industrial growth, foreign inflows, global recovery and actions of other central banks, inflation, etc. The decision has to be taken based on these silhouettes. But, what is certain today is that inflation will be the big challenge during the year, even though numerically it would be lower than the current double-digit rates due to the high base year effect. A double-digit level of both WPI and CPI is serious business and while it has been argued that these numbers were brought about on the food side, the scenario is changing gradually. The high IIP growth numbers show a distinct sign of robustness that is supported by the better trade numbers. Hence, there is reason to believe that the economy may be heating up and that core inflation will begin to surface. This is a close call that RBI has to take since monetary policy has to be forward-looking and pre-empt inflation rather than act when inflation has occurred. So, any action on interest rates will be the revealed stance towards the quality of inflation. The GDP growth figure will only make RBI’s decision a bit easier to take, as the classic trade-off between growth and inflation does not exist if growth is robust. But what about the CRR? Currently, there is adequate liquidity, as evidenced by the flows into the reverse repo auctions, which are of the order of over Rs 50,000 crore. RBI has already buffered for the government’s borrowing programme of Rs 4.57 lakh crore by announcing higher level of auctions of GSecs during the first half of the year, which by itself is an effective way of absorbing surplus liquidity while simultaneously meeting the fiscal deficit requirement. Also, RBI has announced that it would start picking up MSS bonds worth Rs 50,000 crore. These bonds did come in handy in 2009-10 in helping RBI complete the borrowing programme of Rs 4.51 lakh crore along with steady OMOs. The two did help to cover 24% of the gross borrowing programme. Therefore, given that RBI has set high targets for the first half for the government’s borrowing programme as well as MSS, there is reason to believe that a CRR hike may be deferred for the time being and the focus will be more on interest rates. However, the reaction of banks to rate changes appears to be uncertain. In the past, it has been observed that they have been swifter to change deposit rates rather than lending rates. Over the last year, while the average PLR has come down by just 50 bps, deposit rates (1 year tenure) came down by 150 bps. Further, the implementation of the base rate concept would make banks rework their rates, which may not be in alignment with the policy rate changes. However, RBI’s core focus will still have to be on liquidity management, as it has to balance the government’s borrowing requirement with the demand from industry for bank funds. Last year there was lower growth in both deposits and credit, which is unlikely to be the case this year. Demand from industry will increase and hence monetary policy has to be interactive through the year to balance liquidity with demand. Hence, we should probably be prepared for more fine-tuning à la Keynes during the year.
Saturday, March 20, 2010
What fiscal stimulus was all about : 19th March 2010 Economic Times
Fiscal stimulus in the Keynesian framework consists of extreme affirmative government action through the Budget to boost economic activity. Traditionally, this concept would refer to increasing fiscal deficits wherein the government spends, through high borrowings or printing of currency, to provide purchasing power to the people so that demand is sustained.
Therefore, the pre-requisite of a fiscal stimulus is a high fiscal deficit. Such deficits are brought about by either higher expenditure or lower tax rates. The objective here is to analyse the routes chosen by the government and the extent of their success.
Table 1 shows that the stimulus was exhibited sharply in 2008-09 through the big increase in fiscal deficit by 166%. Subsequently, the increase in 2009-10 was moderate at 23% and has been largely withdrawn in 2010-11 . The interesting observation is that the stimulus does not appear to be really driven that much by expenditure, as total expenditure , as indicated by the size of the Budget had actually increased sharply before the financial crisis in 2007-08 , when the deficit was at 2.7% of GDP. The maintenance of this increase in 2008-09 was actually more due to higher inflation as inflation-adjusted total expenditure increased at a slower rate in 2008-09
Even in case we look at nominal expenditure , the increase in 2008-09 was on revenue account — the typical Keynesian variety of NREGA, where income was provided for the poor to spend money and got reflected in Plan expenditure. But the government did not spend on projects as seen in the decline in capital expenditure in 2008-09 , which was subsequently brought back to the 2007-08 level in 2009-10 .
The view evidently was the short run where the thrust was on reviving consumption by addressing issues of poverty. Further, the government spent more on the three critical components of non-development expenditure, i.e., subsidies, interest and defence, in 2008-09 . Subsidies were just about maintained in 2009-10 at 2008-09 level. The conclusion is that while there was nominal increase in expenditure in 2008-09 and 2009-10 , the stimulus was sharper in 2008-09 . A gradual withdrawal was evident in 2009-10 that has been hastened in 2010-11 .
How effective were these expenditures ? It must be realised that the country’s GDP growth had slid to 6.7% in 2008-09 from two successive years of over 9%. This was so as both, growth in private consumption expenditure and capital formation, had slowed down to 6.8% and 4.0% respectively in 2008-09 from 9.6% and 16.9% in 2007-08 . Further , in 2009-10 , growth in consumption and capital formation was tardy at 4.1% and 5.2%.
Therefore , the higher spending invoked by the government, which gets reflected in the social services and government administration component of GDP, displayed a high growth rate of 13.9% in 2008-09 and 8.2% in 2009-10 . This was a classic Keynesian stimulus of higher government expenditure compensating for the loss of demand generated by the private sector.The question now is really whether lower government expenditure will be substituted by the private sector to kickstart the economy in 2010-11 . Government expenditure of the non-projects variety cannot lead to sustained growth and can, at best, compensate for any shortfall in private sector activity. This is a major conclusion here.
How has the private sector been affected by the Budget? The government simultaneously has taken a major hit in its tax collection in 2008-09 and 2009-10 by reduction in excise and Customs duty rates that it seeks to reverse in 2010-11 through its duty rate reversals. Table 2 provides information on growth rates on the revenue side as well as effective rates. The effective duty rates have been calculated as follows: Customs collections to total imports and excise collections to GDP from manufacturing.
Table 2 reveals that indirect tax collections actually declined in the two crisis years and the effective tax rates have come down quite drastically by 3.7% in the case of Customs and 5.6% for excise duties. This was the stimulus provided on the production side to industry in particular that will be reversed in the coming year.
What are the takeaways from this analysis? The first is that the expenditure stimulus was more in 2008-09 than in 2009-10 . The second is that it was directed not at creating capital but more at providing relief at the lower level of income. The third was that it helped to compensate tardy growth in private consumption and capital formation.
Fourth, following from this thought, it may be explained that even though the fiscal deficit was high, the borrowing programme was non-obtrusive as it did not put pressure on the system as growth in credit was also tardy and there was enough room for this borrowing. Fifth, the lowering of tax rates provided an impetus for sure, as the government took a hit on tax collections. Therefore, it was Keynes at both the ends.
However, the point for debate is whether the present reversal of liberalism in this area will be compensated by the private sector growth. This will surely be the subject of debate in the coming year.
Therefore, the pre-requisite of a fiscal stimulus is a high fiscal deficit. Such deficits are brought about by either higher expenditure or lower tax rates. The objective here is to analyse the routes chosen by the government and the extent of their success.
Table 1 shows that the stimulus was exhibited sharply in 2008-09 through the big increase in fiscal deficit by 166%. Subsequently, the increase in 2009-10 was moderate at 23% and has been largely withdrawn in 2010-11 . The interesting observation is that the stimulus does not appear to be really driven that much by expenditure, as total expenditure , as indicated by the size of the Budget had actually increased sharply before the financial crisis in 2007-08 , when the deficit was at 2.7% of GDP. The maintenance of this increase in 2008-09 was actually more due to higher inflation as inflation-adjusted total expenditure increased at a slower rate in 2008-09
Even in case we look at nominal expenditure , the increase in 2008-09 was on revenue account — the typical Keynesian variety of NREGA, where income was provided for the poor to spend money and got reflected in Plan expenditure. But the government did not spend on projects as seen in the decline in capital expenditure in 2008-09 , which was subsequently brought back to the 2007-08 level in 2009-10 .
The view evidently was the short run where the thrust was on reviving consumption by addressing issues of poverty. Further, the government spent more on the three critical components of non-development expenditure, i.e., subsidies, interest and defence, in 2008-09 . Subsidies were just about maintained in 2009-10 at 2008-09 level. The conclusion is that while there was nominal increase in expenditure in 2008-09 and 2009-10 , the stimulus was sharper in 2008-09 . A gradual withdrawal was evident in 2009-10 that has been hastened in 2010-11 .
How effective were these expenditures ? It must be realised that the country’s GDP growth had slid to 6.7% in 2008-09 from two successive years of over 9%. This was so as both, growth in private consumption expenditure and capital formation, had slowed down to 6.8% and 4.0% respectively in 2008-09 from 9.6% and 16.9% in 2007-08 . Further , in 2009-10 , growth in consumption and capital formation was tardy at 4.1% and 5.2%.
Therefore , the higher spending invoked by the government, which gets reflected in the social services and government administration component of GDP, displayed a high growth rate of 13.9% in 2008-09 and 8.2% in 2009-10 . This was a classic Keynesian stimulus of higher government expenditure compensating for the loss of demand generated by the private sector.The question now is really whether lower government expenditure will be substituted by the private sector to kickstart the economy in 2010-11 . Government expenditure of the non-projects variety cannot lead to sustained growth and can, at best, compensate for any shortfall in private sector activity. This is a major conclusion here.
How has the private sector been affected by the Budget? The government simultaneously has taken a major hit in its tax collection in 2008-09 and 2009-10 by reduction in excise and Customs duty rates that it seeks to reverse in 2010-11 through its duty rate reversals. Table 2 provides information on growth rates on the revenue side as well as effective rates. The effective duty rates have been calculated as follows: Customs collections to total imports and excise collections to GDP from manufacturing.
Table 2 reveals that indirect tax collections actually declined in the two crisis years and the effective tax rates have come down quite drastically by 3.7% in the case of Customs and 5.6% for excise duties. This was the stimulus provided on the production side to industry in particular that will be reversed in the coming year.
What are the takeaways from this analysis? The first is that the expenditure stimulus was more in 2008-09 than in 2009-10 . The second is that it was directed not at creating capital but more at providing relief at the lower level of income. The third was that it helped to compensate tardy growth in private consumption and capital formation.
Fourth, following from this thought, it may be explained that even though the fiscal deficit was high, the borrowing programme was non-obtrusive as it did not put pressure on the system as growth in credit was also tardy and there was enough room for this borrowing. Fifth, the lowering of tax rates provided an impetus for sure, as the government took a hit on tax collections. Therefore, it was Keynes at both the ends.
However, the point for debate is whether the present reversal of liberalism in this area will be compensated by the private sector growth. This will surely be the subject of debate in the coming year.
Don’t just bank on new banks : Mar 15, 2010 Financial Express
The Union Budget has given a signal that the government is not averse to having more private sector banks in the country. The reason ostensibly is to spread the reach of banking and usher in more competition. The introduction of new private banks did bring in technology and better quality of service; and the logic of competition forced public sector banks to follow suit. This has been the good part of the story. There is also the other side to this story which needs to be kept in mind. One may recollect that of the original 7 private banks, only three have survived, which are institution-driven. Three have sold out to other banks, while one was taken over by a public sector bank. Therefore, the history of new banks doing well and surviving has been a mixed one. One is not too sure if the promoters are after valuation or out to create value for the system. Banking today could be seen as a steady business which also gives high valuation in the market. There could be an incentive to finally sell out to the highest bidder in due course. Here, RBI would need to take a commitment from the promoter that there could be no exit route under normal circumstances for a fixed period of time. The other issue really is the physical infrastructure. RBI has been reiterating its stance on the need to obviate the creation of duplicity in infrastructure in the banking infrastructure such as ATMs. The concept of shared ATMs has gained currency in the country. The creation of new banks would necessarily have to address this issue. Similarly the question of having branches in areas which are already heavily ‘banked’ may not add value. If the aim is to spread to new areas, the same could be permitted for the existing ones. The more obvious issue that has to be addressed is the one relating to promoters’ background. There would be a conflict of interest in case the promoter has a business which depends on finance. Corporate houses so far have been kept out of the ambit, which is likely to change in the new scheme of things. While regulation should ensure that such conflict of interest does not arise as there could be rules on the dos and don’ts of banking, the broader issue really is of the risk in non-banking activity spilling over to the.banking sector. This would need to be separated clearly, especially in the light of the recent financial crisis, where spillover of risk from one business segment to the other had hastened the process of decline. The NBFC business, which is relatively more risky would have to address this question when converting to or floating a bank. At the ideological level the question to be raised is whether there is really need for more banks. Two issues emerge. The first is whether there is a lacuna in provision of banking facilities. The answer here is no, because the network is large and mere additions of new banks which would focus on urban centres on grounds of viability, will not address the issue for the un-banked people. Further, the reasons for a large section of people being out of the system are not the absence of adequate banks but one of access on account of their creditworthiness. Small borrowers can be addressed through micro-finance institutions and not more banks. The other issue is whether more banks will add to competition. Banking is largely regulated by RBI with all interest rates of products being monitored. Further, when banks had freedom in pricing of services, there were instances of profit-seeking by some banks, which forced the Ombudsman to reinforce control over these rates and also usher in transparency. Often it is felt that there is not much difference between banks, as the menu of products and services are almost identical. In such a scenario, the addition of say another 2 or 3 banks is unlikely to change the canvas. While a free society should allow more players to enter, the entry and regulatory costs are high. With restrictions on banking operations within the present circumference, getting in more players may not achieve the goal. Instead, our thoughts should get centralised on making the existing banks stronger, especially in terms of capital, which can be organic or inorganic through the M&A route. The other set of institutions such as RRBs, micro-finance institutions, cooperative banking and NBFCs should be made more vibrant, because these are the institutions that are actually operating in areas which require more banking or quasi-banking facilities. Even if we do allow new private banks, it should be more on the principle of liberalisation, rather than the mistaken belief that they would even remotely do what the present structures are striving for.
Four good steps that will yield results:Mar 05, 2010 Financial Express
The finance minister has quite correctly put agriculture on the radar in this year’s Budget against the background of the drought that has somewhat spoilt the otherwise amazing growth story. He has focused on the immediate requirements as well as the medium-term goal of making agriculture self-sustaining. The four-pronged approach to be pursued, covers issues relating to making agriculture stronger through the spread of the Green Revolution, improving logistics support for this revolution, providing immediate relief to farmers affected by the drought, and probably using the food processing industry route to complete the chain through firmer binding.
It has been a constant plea to the government to restart the Green Revolution, which was quite successful in the seventies. To refresh memory, the approach was to use better HYV seeds (high-yielding variety), fertilisers, pesticides, irrigation facilities, etc to improve farm productivity. The Green Revolution, however, turned out to be a wheat revolution and was confined to the states of Haryana, Punjab and Western UP. As is normally the case, once agriculture became stable, there was a distinct dwindling of interest in pursuing the goal, as the nation preferred industrialisation as the engine of growth from the mid-eighties onwards. The current approach to the Green Revolution is two-fold. The first is to stretch it to new regions, as the soil in the states of Bihar, Jharkhand, Orissa and Eastern UP is fertile and should be leveraged to enhance production. This will also help the farmers to move to higher income levels and to that extent reduce the level of regional imbalances.
The second is the focus on pulses and oilseeds. The idea is to create 60,000 pulses and oilseeds villages with an outlay of Rs 300 crore. One can assume that the money would be spent specifically on improving production levels in targeted areas. This is significant because India walks the edge on these two sets of crop. The conundrum here is that while shortages in oilseeds can be met through higher imports of vegetable oils—India imports around 40-45% of its edible oil requirements—the same does not hold for pulses.
Further, as was witnessed this year, even within pulses there is a schism, where substitution is not that easy between, say, arhar and chana or urad and chana. As pulses are staples, this move, which hopefully is an initial step in a series of other measures that will be taken, will help to tide over the problem. India does import 10-20% of its pulses requirements, but given the limited supplies and variations in harvest seasons, there are invariably phases of price stress when domestic crops fail.
The second strategy is directed towards reducing wastages. It is estimated that the total losses in farm production could range between 10% and 30% for various crops due to the limited supply of cold chains, transport and warehousing facilities. The Budget has stressed the problem at the level of the FCI, wherein procurement and storage of grains has resulted in considerable wastage due to the non-availability of warehousing space. The FCI, CWC and SWCs combined has warehousing space of around 45-50 million tonne, which is inadequate, and timely availability of private space is a problem that accentuates the possibility of wastage. Reduction in wastages would automatically lead to higher availability of farm products.
This strategy has been linked to the food-processing sector as part of the third prong, where the forward linkage to making agriculture more commercial has been built in. ECBs have been permitted to set up cold storage facilities. This was necessary, since it has been estimated that there is a 60% gap in supply of stationary cold storage facilities and 80% gap in mobile cold storage facilities in the country. The Budget’s approach is fairly wholesome, as it interweaves overall production with logistics, and makes it more commercial at the retail stage.
The fourth route taken by the FM is to address the immediate concerns of farmers in terms of availability of credit and interest subvention. Credit availability is less of an issue today and the problem pertains to repayment of loans, especially at times when crops fail. By taking on the cost of subvention, immediate relief has been provided by the government so that banks can go ahead with the overall Plan.
The FM’s approach is fairly cogent and comprehensive and does not leave any loose ends. The total allocation of around Rs 700 crore (plus interest subvention) may not be too large and will have to be increased in subsequent years, as any effort towards making agriculture robust involves relentless focus and outlays, given that the canvas is expansive and the treatment must be deep rooted, both literally and figuratively.
It has been a constant plea to the government to restart the Green Revolution, which was quite successful in the seventies. To refresh memory, the approach was to use better HYV seeds (high-yielding variety), fertilisers, pesticides, irrigation facilities, etc to improve farm productivity. The Green Revolution, however, turned out to be a wheat revolution and was confined to the states of Haryana, Punjab and Western UP. As is normally the case, once agriculture became stable, there was a distinct dwindling of interest in pursuing the goal, as the nation preferred industrialisation as the engine of growth from the mid-eighties onwards. The current approach to the Green Revolution is two-fold. The first is to stretch it to new regions, as the soil in the states of Bihar, Jharkhand, Orissa and Eastern UP is fertile and should be leveraged to enhance production. This will also help the farmers to move to higher income levels and to that extent reduce the level of regional imbalances.
The second is the focus on pulses and oilseeds. The idea is to create 60,000 pulses and oilseeds villages with an outlay of Rs 300 crore. One can assume that the money would be spent specifically on improving production levels in targeted areas. This is significant because India walks the edge on these two sets of crop. The conundrum here is that while shortages in oilseeds can be met through higher imports of vegetable oils—India imports around 40-45% of its edible oil requirements—the same does not hold for pulses.
Further, as was witnessed this year, even within pulses there is a schism, where substitution is not that easy between, say, arhar and chana or urad and chana. As pulses are staples, this move, which hopefully is an initial step in a series of other measures that will be taken, will help to tide over the problem. India does import 10-20% of its pulses requirements, but given the limited supplies and variations in harvest seasons, there are invariably phases of price stress when domestic crops fail.
The second strategy is directed towards reducing wastages. It is estimated that the total losses in farm production could range between 10% and 30% for various crops due to the limited supply of cold chains, transport and warehousing facilities. The Budget has stressed the problem at the level of the FCI, wherein procurement and storage of grains has resulted in considerable wastage due to the non-availability of warehousing space. The FCI, CWC and SWCs combined has warehousing space of around 45-50 million tonne, which is inadequate, and timely availability of private space is a problem that accentuates the possibility of wastage. Reduction in wastages would automatically lead to higher availability of farm products.
This strategy has been linked to the food-processing sector as part of the third prong, where the forward linkage to making agriculture more commercial has been built in. ECBs have been permitted to set up cold storage facilities. This was necessary, since it has been estimated that there is a 60% gap in supply of stationary cold storage facilities and 80% gap in mobile cold storage facilities in the country. The Budget’s approach is fairly wholesome, as it interweaves overall production with logistics, and makes it more commercial at the retail stage.
The fourth route taken by the FM is to address the immediate concerns of farmers in terms of availability of credit and interest subvention. Credit availability is less of an issue today and the problem pertains to repayment of loans, especially at times when crops fail. By taking on the cost of subvention, immediate relief has been provided by the government so that banks can go ahead with the overall Plan.
The FM’s approach is fairly cogent and comprehensive and does not leave any loose ends. The total allocation of around Rs 700 crore (plus interest subvention) may not be too large and will have to be increased in subsequent years, as any effort towards making agriculture robust involves relentless focus and outlays, given that the canvas is expansive and the treatment must be deep rooted, both literally and figuratively.
Saturday, February 20, 2010
The deficit saga continues: Mint 10th February 2010
With state expenditure unlikely to be reduced, RBI will have a hard time managing the national balance sheet
The fiscal deficit number is relevant for two reasons. First, it tells us about the ability of the government to match its expenditure and income; second, it gives an indication of the borrowing programme for the coming year. While theory suggests that the government’s budgetary exercise targets expenditure first and then works out how to garner revenue—with the fiscal deficit becoming a residual item—things are different today. The fiscal deficit ratio—the deficit as a percentage of gross domestic product (GDP)—appears to be the starting point of the exercise. But how much will the government in New Delhi be able to do about it?
As the government draws closer to presenting the Union Budget, two issues are being debated: Will the budgeted fiscal deficit ratio of 6.8% be maintained for 2009-10, and what would the ratio be for 2010-11? The Reserve Bank of India (RBI) has indicated that the number for 2010-11 could be in the region of 5.5%.
The Union government can take credit for keeping the fiscal deficit ratio at less than what was budgeted in the first four of the five years that comprised its first term in office (the exception was 2008-09). This was managed through the twin horns of controlling the numerator and growing the denominator: The lower numerator (fiscal deficit in rupee terms) suggests control of the deficit in nominal terms, while a higher denominator (nominal GDP at current market prices) was, in a way, fortuitous.
The 2009-10 Budget presented in July assumed that the denominator would grow by 10.1%, which is much below the normal growth of 14%. Based on RBI’s revised forecasts of 7.5% GDP growth and inflation at 8.5% for this fiscal year, the nominal GDP at current market prices would increase by 16%.
Based on the denominator growing at a higher rate, the government could actually increase the fiscal deficit from Rs4 trillion to Rs4.22 trillion for 2009-10, and still adhere to the target of 6.8%. This implies that the fiscal deficit in monetary terms can be exceeded by around Rs22,000 crore.
The government’s borrowing programme for this fiscal year is almost complete and further borrowing to this extent should not upset the apple cart. The fiscal deficit ratio target can still be met despite the fact that tax revenues may not have been very buoyant. Therefore, slippages on tax collection or expenditure will not affect the final ratio within this limit.
The other issue pertains to budgetary numbers for 2010-11. The view that the ratio can be capped at 5.5% is debatable. This is so because it would mean that nominal GDP has to grow by 17.5%: This will be difficult as real GDP growth could go up maximum to 8.5% and inflation would be at 5-6%, bringing the nominal GDP growth number, the sum of these two components, only to 14.5%. The only way out would be for the fiscal deficit number to come down in absolute terms. But is that possible?
The starting point would be expenditure, where around 70% comes under non-Plan expenditure—spending that doesn’t finance the Five-year Plans. The overall expenditure of Rs6.95 trillion for 2009-10 would be difficult to lower. Interest payments for the enlarged borrowing programme will anyway increase by at least Rs30,000 crore. Subsidies will be difficult to lower. In fact, subsidies would increase to alleviate the condition of the poor through interest rate subventions (in the aftermath of a drought year) and loan write-offs. Also, defence expenditure has never been lowered in the past.
The brakes then have to be applied to Plan expenditure, which again looks unlikely given that development schemes such as the National Rural Employment Guarantee Scheme have to be sustained to create the balance of inclusive growth. Besides, Plan expenditure has never declined: It has usually increased by 20-30% annually in the last five years. The onus thus falls on revenue generation.
With a delayed goods and services tax (GST) and a direct tax code still in draft form, tax reforms aren’t on the cards. The crux will be on having the economy grow at a rapid rate and using the inherent buoyancy in the tax system to generate revenue. In the last five years or so, indirect taxes such as customs and excise duty collections have tended to decline.
So corporate profits have to be more buoyant to provide funds for the government. Unless the government focuses more on service tax—a challenge given that only around 50% of the services are in the organized sector, the rest being virtually outside the tax ambit— the increase in tax collections can, at best, only keep pace with growth of individual sectors in the economy.
Therefore, it would be quite a task to rein in the fiscal deficit and, hence, the borrowing programme. That means RBI will have a tough time balancing liquidity and interest rates with growth and inflation.
So, one way or the other, the pressure may not be really on the finance ministry in New Delhi, but remains with the central bank in Mumbai, which will have to be accommodative to bring about growth and the requisite tax collections. But a buoyant economy triggers demand-pull pressures—more money chasing goods—which call for hardening rates and absorption of liquidity. RBI does have tools at its disposal. But the next year would nevertheless be one where, to borrow an analogy from the examination system, RBI has to appear for regular unit tests.
The fiscal deficit number is relevant for two reasons. First, it tells us about the ability of the government to match its expenditure and income; second, it gives an indication of the borrowing programme for the coming year. While theory suggests that the government’s budgetary exercise targets expenditure first and then works out how to garner revenue—with the fiscal deficit becoming a residual item—things are different today. The fiscal deficit ratio—the deficit as a percentage of gross domestic product (GDP)—appears to be the starting point of the exercise. But how much will the government in New Delhi be able to do about it?
As the government draws closer to presenting the Union Budget, two issues are being debated: Will the budgeted fiscal deficit ratio of 6.8% be maintained for 2009-10, and what would the ratio be for 2010-11? The Reserve Bank of India (RBI) has indicated that the number for 2010-11 could be in the region of 5.5%.
The Union government can take credit for keeping the fiscal deficit ratio at less than what was budgeted in the first four of the five years that comprised its first term in office (the exception was 2008-09). This was managed through the twin horns of controlling the numerator and growing the denominator: The lower numerator (fiscal deficit in rupee terms) suggests control of the deficit in nominal terms, while a higher denominator (nominal GDP at current market prices) was, in a way, fortuitous.
The 2009-10 Budget presented in July assumed that the denominator would grow by 10.1%, which is much below the normal growth of 14%. Based on RBI’s revised forecasts of 7.5% GDP growth and inflation at 8.5% for this fiscal year, the nominal GDP at current market prices would increase by 16%.
Based on the denominator growing at a higher rate, the government could actually increase the fiscal deficit from Rs4 trillion to Rs4.22 trillion for 2009-10, and still adhere to the target of 6.8%. This implies that the fiscal deficit in monetary terms can be exceeded by around Rs22,000 crore.
The government’s borrowing programme for this fiscal year is almost complete and further borrowing to this extent should not upset the apple cart. The fiscal deficit ratio target can still be met despite the fact that tax revenues may not have been very buoyant. Therefore, slippages on tax collection or expenditure will not affect the final ratio within this limit.
The other issue pertains to budgetary numbers for 2010-11. The view that the ratio can be capped at 5.5% is debatable. This is so because it would mean that nominal GDP has to grow by 17.5%: This will be difficult as real GDP growth could go up maximum to 8.5% and inflation would be at 5-6%, bringing the nominal GDP growth number, the sum of these two components, only to 14.5%. The only way out would be for the fiscal deficit number to come down in absolute terms. But is that possible?
The starting point would be expenditure, where around 70% comes under non-Plan expenditure—spending that doesn’t finance the Five-year Plans. The overall expenditure of Rs6.95 trillion for 2009-10 would be difficult to lower. Interest payments for the enlarged borrowing programme will anyway increase by at least Rs30,000 crore. Subsidies will be difficult to lower. In fact, subsidies would increase to alleviate the condition of the poor through interest rate subventions (in the aftermath of a drought year) and loan write-offs. Also, defence expenditure has never been lowered in the past.
The brakes then have to be applied to Plan expenditure, which again looks unlikely given that development schemes such as the National Rural Employment Guarantee Scheme have to be sustained to create the balance of inclusive growth. Besides, Plan expenditure has never declined: It has usually increased by 20-30% annually in the last five years. The onus thus falls on revenue generation.
With a delayed goods and services tax (GST) and a direct tax code still in draft form, tax reforms aren’t on the cards. The crux will be on having the economy grow at a rapid rate and using the inherent buoyancy in the tax system to generate revenue. In the last five years or so, indirect taxes such as customs and excise duty collections have tended to decline.
So corporate profits have to be more buoyant to provide funds for the government. Unless the government focuses more on service tax—a challenge given that only around 50% of the services are in the organized sector, the rest being virtually outside the tax ambit— the increase in tax collections can, at best, only keep pace with growth of individual sectors in the economy.
Therefore, it would be quite a task to rein in the fiscal deficit and, hence, the borrowing programme. That means RBI will have a tough time balancing liquidity and interest rates with growth and inflation.
So, one way or the other, the pressure may not be really on the finance ministry in New Delhi, but remains with the central bank in Mumbai, which will have to be accommodative to bring about growth and the requisite tax collections. But a buoyant economy triggers demand-pull pressures—more money chasing goods—which call for hardening rates and absorption of liquidity. RBI does have tools at its disposal. But the next year would nevertheless be one where, to borrow an analogy from the examination system, RBI has to appear for regular unit tests.
Base lending rate ensures transparency : Economic Times: 19th Feb 2010
The base lending rate is an improvement over the PLR as it reflects the actual cost to banks that has to be covered through their lending operations. The PLR has lost relevance, given the opacity in its determination and the tendency for several loans to be reckoned at sub-PLR rates.
The guidelines announced by RBI on base rates of banks are interesting for several reasons. The definition provided by RBI has four components: cost of deposits, negative carry on CRR and SLR, overheads cost and returns on net worth.
Based on this formula and the numbers available for 2008-09, the base rate has been calculated for a set of banks.
Based on the 2008-09 numbers, the base rate varies from 5.22% for Citi to 8.91% for OBC. Broadly speaking, foreign banks have the lowest rate followed by public sector banks and then private banks. Given that the present PLR is 11-12%, the difference with the calculated base rate varies from 3-7% points, which is quite significant. However, there is a major exclusion here in the base rate calculation, which is a provision for NPAs. Given that the ratio of gross NPA to total advances varies between 1% and 2% points for banks, this has to be included for the base rate calculation. By including this provision, the base rate moves up to between 6.5% and 11%.
The basic question is, how should these components be fixed? The past profit ratio may not be indicative of the future, as normally adaptive expectations are followed where banks factor in an increase in this ratio, which will impart an upward bias to this number. Similarly, overhead costs by their nature are fixed in size and increase at a trend rate and are not linked with movements in business numbers. While the SLR and CRR would be more or less fixed or change proportionately for all banks, the cost of deposits will change dynamically, depending on how overall policy rates move, and will hence be variable.
The reason for having a base rate as a substitute for the PLR is that today there are a number of loans that are reckoned at sub-PLR level, which makes this benchmark irrelevant. In fact, the average return on advances for most loans lie in the region of 8-11%, of which only part may be explained by the legacy issue of loans being provided at a lower rate in the past. Housing loans, for example, are usually at sub-PLR while there are others which are fixed by RBI and linked to the PLR such as farm loans or export finance. The creation of a base rate will provide the minimum that has to be covered by the bank. The final lending rate would simply be the base rate, plus the risk-cost attached to the credit rating perception of the borrower by the bank.
At the ideological level, the question to be posed is whether RBI should be fixing such a formula in a free-banking system. While transparency is needed, as banks should let the customers know about their rates, the method of arriving at the rate should be left to the banks as they should have the power to decide on the levels for each of the components, especially overheads and profits. In fact, RBI should decouple various kinds of finance to the base rate or PLR as the case may be, to reflect free pricing, especially since there are anyway quantitative norms to lending that have to be adhered to by banks.
Today, the PLR of banks are more or less the same across banks. An interesting outcome would be that once the base rate scale is known to all and varies according to a uniform predetermined formula, potential customers would have a choice provided the banks have the willingness. It would be interesting to observe as to how would the higher base-priced banks respond in such a situation.
The guidelines announced by RBI on base rates of banks are interesting for several reasons. The definition provided by RBI has four components: cost of deposits, negative carry on CRR and SLR, overheads cost and returns on net worth.
Based on this formula and the numbers available for 2008-09, the base rate has been calculated for a set of banks.
Based on the 2008-09 numbers, the base rate varies from 5.22% for Citi to 8.91% for OBC. Broadly speaking, foreign banks have the lowest rate followed by public sector banks and then private banks. Given that the present PLR is 11-12%, the difference with the calculated base rate varies from 3-7% points, which is quite significant. However, there is a major exclusion here in the base rate calculation, which is a provision for NPAs. Given that the ratio of gross NPA to total advances varies between 1% and 2% points for banks, this has to be included for the base rate calculation. By including this provision, the base rate moves up to between 6.5% and 11%.
The basic question is, how should these components be fixed? The past profit ratio may not be indicative of the future, as normally adaptive expectations are followed where banks factor in an increase in this ratio, which will impart an upward bias to this number. Similarly, overhead costs by their nature are fixed in size and increase at a trend rate and are not linked with movements in business numbers. While the SLR and CRR would be more or less fixed or change proportionately for all banks, the cost of deposits will change dynamically, depending on how overall policy rates move, and will hence be variable.
The reason for having a base rate as a substitute for the PLR is that today there are a number of loans that are reckoned at sub-PLR level, which makes this benchmark irrelevant. In fact, the average return on advances for most loans lie in the region of 8-11%, of which only part may be explained by the legacy issue of loans being provided at a lower rate in the past. Housing loans, for example, are usually at sub-PLR while there are others which are fixed by RBI and linked to the PLR such as farm loans or export finance. The creation of a base rate will provide the minimum that has to be covered by the bank. The final lending rate would simply be the base rate, plus the risk-cost attached to the credit rating perception of the borrower by the bank.
At the ideological level, the question to be posed is whether RBI should be fixing such a formula in a free-banking system. While transparency is needed, as banks should let the customers know about their rates, the method of arriving at the rate should be left to the banks as they should have the power to decide on the levels for each of the components, especially overheads and profits. In fact, RBI should decouple various kinds of finance to the base rate or PLR as the case may be, to reflect free pricing, especially since there are anyway quantitative norms to lending that have to be adhered to by banks.
Today, the PLR of banks are more or less the same across banks. An interesting outcome would be that once the base rate scale is known to all and varies according to a uniform predetermined formula, potential customers would have a choice provided the banks have the willingness. It would be interesting to observe as to how would the higher base-priced banks respond in such a situation.
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