Ila Patnaik's Blog

How do you prevent rupee trades?

2013-05-10T14:28:00.000+05:30

Financial Expres, 10th May 2013

Even if Indian firms stop offering such overseas trades, the market will continue to thrive

In a recent circular, the Reserve Bank of India (RBI) prohibited Indian entities owning foreign entities that facilitate trading in offshore rupee derivatives. Since the rupee is not a convertible currency, it cannot be traded outside India. Trading in rupees derivatives, even when it is in non-deliverable products, which may not technically be trading the rupee, constitutes a violation of the Foreign Exchange Management Act (FEMA). RBI feels that such trading makes the job of managing the rupee harder.

While RBI does not have regulatory jurisdiction over foreign exchanges that offer platforms for such trades, FEMA gives it jurisdiction over entities even those outside India if they are owned or controlled by a person residing in India. Indian entities facilitating offshore markets require its permission. According to the present law, those entities which, fully or partly, own businesses that offer such products need to take permission from RBI. Today, such firms have three choices. Either those derivative products must not be sold any more, or the businesses have to exit their participation in the ownership of those exchanges, or they must receive RBI's permission to continue the facilitation of offshore rupee derivative products. While at one level this appears is an attempt to curb the growth of the rupee market for hedging and speculation, the real issue lies in the legal framework of capital controls.

The first is the question of the path to capital account convertibility. As long as the rupee is not convertible, i.e cannot be bought and sold in foreign markets, and as long as RBI is required to administer FEMA, issuing and enforcing such regulation is part of RBI's responsibilities. While the usual arguments can be made about the need for RBI to encourage growth of the market, their usefulness in today's context are limited. Unless there is move towards convertibility, and unless the present FEMA is repealed, RBI, with the responsibility to see that it is not violated, will have to enforce it. Within the present framework of non-convertibility and the present regime of capital controls, a violation of FEMA is an offence under the law. If the law is changed to make the rupee fully convertible and RBI is required to administer that law, such a regulation would not be feasible. For the time being, Indian companies participating in such activities are required to operate within the legal boundaries of FEMA.

Today, the arguments for making the rupee convertible are stronger than before. As India integrates both on account of trade and financial flows with the rest of the world, it needs to move to allowing the currency to trade abroad. This can be done in limited ways and in a slow and cautious manner. China has already started pushing ahead on making the remnimbi international. In a recent agreement with Australia, China will allow Australia to hold 5% of its reserves in remnimbi. India can start the same with neighbouring countries that have a large share of trade with India. Countries in the neighbourhood that peg to the Indian rupee and which are holding convertible currencies as reserves should be able to hold Indian rupees. Such a move can be done by agreements and treaties until India ultimately repeals FEMA.

But let us say India chooses to keep the legal framework for capital controls in place. Then, there is a need to address the manner in which financial sector laws are administered. Under the present FEMA, RBI is not required to carry out consultations with stakeholders or show a cost-benefit analysis of why a regulation should be issued. In the recently-drafted Indian Financial Code (IFC) proposed by the Financial Sector Legislative Reforms Commission (FSLRC), the regulator would be required to show what will be achieved by the regulation. In this case, for example, it is well known that there exists a large offshore market for Indian rupee derivatives. Offshore markets for the rupee exist in Singapore, Hong Kong, London, Dubai and Bahrain. A report by the City of London on NDF markets for BRICS currencies shows that in London the rupee NDF market is the fastest growing among BRICS currencies. Between April 2008 to April 2012, NDF trading volume in the Indian rupee has increased from $1.5 billion to $5.2 billion, an increase of almost 250%.

RBI should adopt the practices of reasoned order for issuing regulation and showing a cost-benefit analysis at its own initiative even before the IFC becomes law. In a cost-benefit analysis, RBI will need to show the impact of the regulation. It will have to show by how much it will be able to reduce the size of the NDF market, thereby making its job of rupee management easier.

At first blush, greater benefits from the present regulation are not obvious. Even if Indian companies withdraw from equity participation in the exchanges on which NDF trades take place, the market will continue to thrive, keeping rupee management difficult. Also, since RBI has moved to a flexible exchange rate, the benefits from curbing the size of the market are limited.

If the cost-benefit analysis does not show greater costs but, say, RBI has other concerns, such as those of money laundering, it should not be able to issue regulations under the powers given to it under FEMA. It should then have to issue them under the Prevention of Money Laundering Act. At the same time, it would need to develop the supervisory capacity to examine the books of financial firms to uncover how the money laundering was undertaken. Today, such supervisory capacity is lacking, and given that regulators do not have to give the rationale and cost-benefit analysis of their regulations, they may have the incentive to use a nuclear option of banning such activities rather than carefully supervising them.

Further, RBI should engage with the entities to indicate to them not to participate in businesses that result in a violation of the law. This would offer greater business certainty and lower risks in case of those arising from difficulties in the interpretation of the law.

Some chit chat

2013-05-08T10:06:00.000+05:30

Indian Express, 08th May 2013

To protect investors, make the formal financial system more accessible and attractive

News of investors losing their life savings in Ponzi schemes like Saradha has become recurrent in recent times. It seems that as long as the real estate sector was booming, these schemes were able to survive as new money kept coming in. But with employment and incomes growing slowly, finding new investors to pay off old ones might have become more difficult. It should not be surprising if many more such schemes collapse in coming days.

Chit funds alone attract millions of investors. It is estimated that registered chit funds have collected Rs 300 billion worth of deposits. The real story apparently lies in unregistered funds, who, it is estimated, have collected Rs 30 trillion. This is nearly half of the Rs 64.8 trillion held in commercial banks (in February 2013). But while all chit funds may not be fraudulent, the danger of some being so, given the weaknesses in regulation, is very high.

The origins of India's unregulated financial system lie in the poor and outdated financial regulatory system that India has clung on to. The banking regulator is proud of the fact that there have been no bank failures, no complex derivatives and the banking system survived the global crisis - a system, it claims, that offers an example for the world to learn from. The sad reality is, however, that as much as half the Indian population does not have access to this banking system. Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.

This is fertile ground for unscrupulous individuals. A Ponzi scheme like Saradha can be set up. The law does not require all financial service providers to register with any single regulator. If a firm says it is a collective investment scheme, it is required to register with SEBI and be regulated by it. If it claims to be a chit fund, it is regulated by state governments. If it says it is a private company taking deposits for its business, it must be regulated by the registrar of companies as Sahara has claimed it should be. If it takes public deposits, it should register as a non-banking financial company and be regulated by the RBI. It may actually register with no one, as Saradha didn't.

If any one regulator finds out a company is guilty of fraudulent practices and tries to stop its activities, it has to approach other regulators. The financial firm, in the meanwhile, can go to court, claiming the regulator has no jurisdiction over it, as in the case of Sahara. It can continue to collect money. The regulator has to prove in a court of law that the firm was indulging in activity that is under its jurisdiction, and then, during the long delays in courts, watch helplessly as thousands more get duped by the firm. Section 11AA of the SEBI Act, under which SEBI has been acting, defines "collective investment schemes" in terms of principles that identify such schemes. It, however, includes exemptions for institutions such as chit funds, nidhis and cooperative societies.

Will passing a more stringent law, as the West Bengal legislature has done, solve the problem? Do state governments have the capacity to regulate financial firms? Even if some well-governed state governments are able to regulate chit funds, the regulatory capacity of other state governments can be quite limited. Perhaps the way forward should be that state governments with weak regulatory capacity choose to hand over powers of such regulation to the Centre.

But even after that is done, institution-based regulation would continue to provide legal cracks in the system for unscrupulous firms to slip through. To address this issue, the Indian Financial Code (IFC), proposed by the Financial Sector Legislative Reforms Commission, suggests that the definitions of financial products and services be broad and principle-based, with no statutory exemptions. All kinds of deposit-taking and investment schemes, including chit funds, are covered by the proposed definitions. For example, a deposit, in the draft law, is defined as a contribution of money, made other than for the purpose of acquiring a security, which may be repayable at the demand of the contributor. As a consequence, anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the regulator. The IFC proposes two regulators. Under the proposed law, either a financial firm must obtain a bank licence from the RBI, or it must register with the Unified Financial Agency (UFA), the regulator of all financial firms and activities other than banking. This would eliminate the legal tussles over jurisdiction seen today. In addition, the IFC proposes powers of investigation and prosecution for the financial regulators to prevent further fraud.

But it is not sufficient to give regulators the powers to catch criminals. The origin of the problem, that is, the inaccessible and unattractive formal financial system, also needs to be addressed. Today, regulators have an incentive to ensure there is no failure of the financial firms they regulate, leading to over-regulation. Saradha depositors may be paid by a West Bengal tax on cigarettes, and SEBI may be given additional powers to prosecute. But beyond this legal patchwork, India needs a comprehensive legal framework for financial regulation if it is to protect investors and reduce such fraud in future.

Growth pick-up still a mirage

2013-04-30T12:13:00.000+05:30

Financial Expres, 30th April 2013

Even if all projects were to get clearances tomorrow, we may see actual activity in less than half

The Prime Minister's Economic Advisory Council (PMEAC) report suggests that higher GDP growth next year is achievable if government policies and administrative actions support investment. Primarily, if the government clears stalled projects, and environment and other clearance are given for projects through the Cabinet Committee on Investments (CCI), Indian GDP growth can rise to 6.7% next year.

The problem of stalled projects has seen some progress in recent weeks as the CCI gave clearances to oil and gas projects. The mandate of the CCI is to give clearances to large projects. While this is a step in the right direction, and would lift investment and growth even if only a few large projects get kick-started, there are additional difficulties that would need to be addressed before growth can pick up to 6.7% next year.

First, some of the projects that are stalled today were bid before the 2008 crisis. Remember the pre-crisis years? Growth in India was in double digits, the world economy was booming and almost every investment project looked attractive. The pegging of the rupee to the dollar led to a high growth of forex reserves and consequently bank credit. Some of the bids by the private sector were quite aggressive based on its over-optimism. In today's far more sober environment, it is not clear that even if given clearances, all of those projects would be attractive. At least a third of them might appear to be unattractive.

Second, the projects that are stuck in mid-way for many years have had financial implications for the balance sheets of the companies and banks involved. Long delays in completion of projects has meant that companies have not been able to pay back loans taken for the projects. Banks that had given loans have seen these loans get into trouble. Many banks are reluctant to call these non-performing loans. Many loans have been re-structured. RBI data shows that the growth of restructured advances has been much faster than credit growth of banks. Between March 2009 and March 2012, while total gross advances of the banking system grew at a growth rate of less than 20%, restructured standard advances grew by over 40%. Public sector banks account for a disproportionately large part of this. Restructured accounts have grown at a rate of 47.86% in public sector banks as against a growth rate of credit of 19.57%. Loans to industry, especially large industry, have seen the most restructuring. Public sector banks, especially after the recent corruption scandals, may be reluctant to lend to companies in distress even when they can.

The above suggests that even if a project bid by a large company obtains a clearance, the company may no longer be in a position to undertake fresh borrowing to undertake the project. Or banks may no longer lend to it for new projects beyond the lending they are doing to recover old loans. This may account for another one third of the stalled projects not being revived even if given clearances.

Further, the terms of restructuring loans to companies in distress usually assume that in a couple of years the economy will recover and the company will be able to pay back the loan. Figure 1 shows the sharp decline in GDP growth, down to 4.5% in the quarter ending December 2012 as one of the sharpest downswings in growth in recent years. The seasonally-adjusted quarter-on-quarter growth was 3.5%.

Nor have we seen investment pick up. Figure 2 shows the seasonally-adjusted quarter-on-quarter growth of investment by the private corporate sector. It was 0% in the January to December quarter. When investment is 0% and GDP growth is 3.5%, it will take a strong change in the business environment and sentiment for them to pick up.

Figure 3 shows that those signs of change in business perceptions are not to be seen yet. It shows new project announcements per quarter by all sectors and all categories of investors. Project announcements as a share of GDP have been declining quite steadily since 2010. When sentiments improve, this is the first place where we expect to see the optimism. Even if projects are not finally implemented, they must at least be announced for the investment to kick off.

What we might see in the next few months may be a pick up due to some projects being revived. Once investment activity starts, it may induce optimism. Yet one must be aware that even if all projects were to get clearances tomorrow, we may see actual activity in less than half. We will be fortunate if growth does not fall below that of the 5% we appear to have achieved in 2012-13.

China's rebalancing act

2013-04-30T11:14:00.000+05:30

Indian Express, 30th April 2013

Its tilt to consumption-led growth is good news for India and the global economy

Unlike in India, the slowdown in Chinese growth appears to be not merely a cyclical downturn, but lower trend growth rate that Chinese policymakers see as desirable. It forms part of China's strategy to rebalance the domestic macroeconomy towards a slower growth rate of employment, lower investment and higher consumption. This is good news for global rebalancing as China's exchange rate policy should now become more flexible, Chinese current account surpluses should come down and accumulation of Chinese forex reserves should slow down or stop. For India, a relatively more consumption-oriented China could mean higher exports, both to China and the rest of the world, lower commodity prices and less of a pressure from exporters for exchange rate intervention.

After growth at double digits for many years, China grew at a much slower 7.7 per cent in the first quarter of the year. At a recent conference in Beijing, I heard Chinese policymakers sounding fairly comfortable with this lower growth. Indeed, they argued lower growth in China was desirable. It almost seemed that it was planned.

The main arguments in favour of lower growth - an average of 8 per cent in the next 10 years and 7 per cent thereafter - was mainly China's demographics. As the Chinese working-age population starts shrinking due to the replacement of the current working population by those born after the one-child policy was put in place, there is less need for high job growth. The last few decades were ones in which China was trying to meet two objectives: earn foreign exchange and create jobs. The high growth rate of job creation was necessary to absorb the large number of people joining the labour force. If the same growth rate continues, China will have labour shortages. With a slower growth of the working population and labour force, wage growth rather than employment growth will be the focus.

Second, China has undertaken significant infrastructure investment in recent decades. In coastal areas, China has met its targets for infrastructure investment. It now needs to utilise better the infrastructure that it has created. Some estimates even show that China's infrastructure investment has been excessive. The need for additional investment in infrastructure is lower, and so the investment strategy will be modified accordingly.

A shift towards domestic consumption-led growth will make the Chinese growth model less dependent on exports. In episodes of global slowdown like the recent one, the Chinese economy can then continue to grow more steadily. The decline in the Chinese trade surplus and slower exports after the crisis have made it evident that, even if desirable, the policy of export-led growth was unlikely to be sustainable.

At the recent IMF-World Bank meetings in Washington DC, China has indicated that it will allow the renminbi to move in a wider band than it has hitherto. This effectively means that it will allow the yuan to appreciate. This will make Chinese exports more expensive and imports into China cheaper. Such an exchange rate regime will be more suitable for a domestic consumption-led, rather than an export-led growth strategy.

An appreciation of the yuan will also allow other emerging economies to permit their currencies to be more flexible. Today when China sustains a policy of an undervalued exchange rate through its intervention and sterilisation, other central banks often come under pressure to do the same. The context in which China has been able to financially repress the system and pay low or negative real interest rates to households is unlikely to work in more market-oriented and democratic countries. It will be a relief for other EM (emerging market) central bankers not to have the kind of pressure they face thanks to China today.

One of the origins of the global crisis was diagnosed to be the cheap funding available in the US economy owing to Chinese purchase of US treasury bills. The high level of liquidity, asset price bubbles and, finally, the meltdown were said to be caused by the Chinese policy of keeping consumption low, savings high and then pushing those savings into the US, where households consumed too much and did not save. This arrangement was facilitated by the Chinese exchange rate policy. A change in the Chinese policy is expected to lead to a global rebalancing.

For India, which has had an economy much more based on domestic consumption, where the domestic savings to GDP ratio is closer to 30 per cent, in contrast to China's 50 per cent, a rebalancing in China is good news. Not only is a more rebalanced world a better and more sustainable business environment, with less vulnerable risks, but India could gain directly as it is often seen as a competitor to China. In areas where India can compete with Chinese products for a share of the market, its exports can benefit. In addition, if India is able to enter the market in certain products, it stands to gain. As China focuses more on growth in services, as it has seen recently, as well as high-end products, away from the low-end manufacturing that dominated its growth model, Indian exports stand a better chance.

Lower investment in China is likely to lead to a softening of global commodity prices. As a large commodity importer, India stands to benefit from softer prices. Though it may be argued that global growth may slow down if China slows down, as the Chinese policymakers argue, if the growth can be higher quality growth, protecting the environment and reducing pollution, with higher wage growth, more innovation and less distortions, the world stands to gain.

Economic stability is not the only issue at stake. Political stability in China is a challenge as inequality has grown. If China does not follow a wider consumption-based growth model, the bigger challenge may be political rather than economic stability. It seems that the Chinese government has set the forces for domestic rebalancing in place, it remains to be seen how successful the policy will be.

Selling it right

2013-04-11T17:46:00.001+05:30

Indian Express, 11th April 2013

Consumer protection should be at the heart of the financial regulatory framework

Does India need a new law for consumer protection in finance? One lesson from the global financial crisis is that unsuitable housing loans sold to poor, uneducated consumers could pull down the world's financial system. Very few people would have believed that sub-prime loans, which constituted a very small part of housing loans and that too only in one country, could trigger a crisis that led to banks failing, money markets crashing, governments falling, countries going bankrupt, millions becoming unemployed and the GDP of many nations going down. This is not to argue that the sale of unsuitable housing loans was the only regulatory failure that led to the global crisis, but an important lesson is that a regulatory system that does not prevent the sale of unsuitable financial products to consumers could be putting the financial system and the entire economy at risk. Not only is consumer protection an important end in itself, if it lies at the heart of financial regulation, bad practices that result in the failure of firms and markets can be checked.

Today in India, there is very little reference to consumer protection in primary legislation in the financial sector. Not surprisingly, none of the financial laws on which regulation is based, and which were written long before there was clear thinking about the need for consumer protection, provides consumers with basic rights or protections. Nor do they give regulators a specific set of relevant powers to pursue the objective of consumer protection. It is not treated as a core pillar of financial regulation. Many countries are rewriting laws to bring this perspective into financial sector regulation.

Some regulators have issued regulations based on the general rule-making powers given to them in their respective laws. For example, SEBI issued Disclosure and Investor Protection Guidelines in 2000. Various guidelines have been issued by the RBI and IRDA to protect consumers in banking and insurance. However, consumer protection regulation remains weak and varies across different sectors and services.

The approach adopted by the Financial Sector Legislative Reforms Commission (FSLRC) is that consumer protection needs to be treated as a core part of the legal and regulatory framework. So the first step towards ensuring consumer protection is to have good primary legislation that provides for it and makes it a priority for regulators, empowering them adequately. The primary law should require all regulators to formulate regulations that ensure consumers are protected from unfair practices. If, in a contract, there is a term that permits one party (often the financial firm) but not the other party (often the customer) to avoid or limit the performance of the contract, or to vary the terms of the contract or the services provided, the contract is unfair. If the conduct of the financial service provider, who often has greater market power, is misleading or abusive or coercive, such conduct is unfair.

Similarly, consumers should have a right to financial privacy, data ownership and data security. The laws were written before it was easy for an employee to sell a CD containing the digital records of his firm's customers for a small price. So the laws, unsurprisingly, were not geared to handle this eventuality. Today, we can argue that consumers should have the legal right to own their financial data. Consumers dealing with financial institutions must have the right to expect that their financial activities will have a reasonable amount of privacy. They must have the assurance that the data is secure.

Additional rights and protection need to be given to retail customers, who may be individuals or businesses, carrying out small value transactions. They are often at an even bigger disadvantage. Retail consumers should not be sold unsuitable products. The suitability of a financial service or product depends on the profile and needs of the specific consumer. The lack of knowledge often makes it difficult for the consumer to decide what will work best for her. The law should make it a right for the consumer to be given sufficient time, relevant information and, if possible, sound advice to help her decide on the suitability of the financial product she is buying.

For example, if a consumer is considering buying life insurance, in most cases, simple information disclosure is inadequate. There should be an assessment of the consumer's need. Proper advice would be necessary to ensure that the consumer purchases the right kind of insurance, with the optimal level of coverage. For certain services, the regulator may mandate advice. Providers of such services would then not be allowed to approach the potential consumer without some kind of a basic process of needs assessment and advice. For example, regulations could mandate that before a financial institution makes a recommendation to a consumer regarding a specific financial service, it gathers sufficient information from the customer to ensure that the service is likely to meet her needs and capacity.

Under the draft Indian Financial Code (IFC), advice would typically be accompanied by increased responsibility for the financial service provider, making it accountable for consumer outcomes, leading up to compensation for consumers if they have been poorly advised. Most services should come with a high level of responsibility for the providers, especially if the providers approach the consumer.

Consumers should also be given reasonable time to take the decision. For example, consumers going in for certain financial services with long-term implications could be allowed a cooling-off period, during which they may cancel the contract or decide not to enter it.

Consumer protection regulation is ineffective if consumers do not have an effective ex-post grievance redressal mechanism. At present, this is highly inadequate and varies across sectors. The draft IFC proposes to set up a fast and efficient non-sectoral, widely accessible consumer redressal mechanism.

It seems fairly obvious that consumers should have protection against unfair conduct and terms. But we need to put that in the law, because unless it says so, regulators cannot write regulations that ensure such protection or penalise firms that violate these principles. The draft IFC proposes to enshrine these principles in law.

Turf war in the offing

2013-03-26T14:14:00.001+05:30

Financial Express, 26th March 2013

FSLRC recommendations would be challenged by the financial regulators

Two of the most important committees on financial sector reform in India in recent years-the Raghuram Rajan Committee and the Percy Mistry Committee-have recommended a change in the regulatory architecture. The problems of regulatory gaps, overlaps, turf wars, and tension with the government have only increased since these committees submitted their reports. While the Percy Mistry report recommended a single unified regulator, Raghuram Rajan recommended a more conservative approach-a banking and non-banking regulator, keeping RBI as the banking regulator. The Financial Sector Legislative Reforms Commission (FSLRC) has taken the more conservative approach of two reports, keeping banking with RBI while proposing a merger of other regulatory bodies into one regulator.

In almost every country where regulators have been unified as the financial system has become more complex and as regulatory walls have become hurdles to better regulation, existing regulators have fought back. The past and present staff of various regulatory bodies are amongst the biggest opponents of regulatory institutional change. No doubt, in India too, turf war will take place. The commission, in recommending a non-sectoral law, will no doubt make regulators and many regulated entities, happy in the present set up, quite unhappy. The debate on the draft law in public discourse will need to go beyond who will administer the law and beyond the unhappiness of regulators who find their turf encroached upon to the contents of the law. In many ways, who administers the law is the least important part of the recommendations of the commission.

Financial sector reform in India has been a slow process of responding to the needs of a growing economy. Other than the initiatives in the equity market, most changes in the framework of financial regulation in India have been made in response to the need of the hour. This has meant piecemeal changes to the various laws that give powers to regulators to regulate finance. In addition to the many amendments to the laws, there have been many committees looking into the difficulties of finance. A slow consensus has grown which recommends changes in the regulatory framework. However, many of these changes were not possible since the basic structure of the law did not allow it. The FSLRC was set up to review, rethink and redraft the basic laws so that Indian finance can be reformed to prepare India as a growing modern economy, without having to constantly amend existing laws to incorporate changes in technology or other innovation.

This commission, which submitted its report to the finance minister on March 22, 2013, was not a quick and dirty response to political pressure in a crisis situation. It was a serious, consultative, well-researched effort at rethinking the objectives of regulation, of regulatory governance, and of the independence and accountability of regulators in India. The job of the commission, which began two years ago, was not to simply tweak and fix the things that were not working, but to question the fundamental arrangements between regulators, the government, the regulated and the consumer for whose protection regulation is ultimately being done. The commission involved more than a 100 people doing research, learning lessons from the global crisis and consulting regulators, market participants and various stakeholders.

What is the most important element of the new draft law-the Indian Financial Code. This law puts consumer protection at the centre of all regulation. Whether we have to reduce the risk of failure of banks or an insurance company, so that depositors and policy holders are protected, whether we have to find ways of rescuing failing entities with minimum cost to the taxpayer, whether we have to find ways to ensure that a household is not sold unsuitable products, or whether we wish to prevent a disruption of financial services on the scale of the system as a whole, the objective of the regulation is to protect the consumer without putting the burden on the taxpayer.

The need for regulation arises because of the asymmetric power and information that customers of financial services have, in contrast to the providers, and they must be protected from unfair practices, or from the provider taking very high risks to earn high returns. In this framework, the objective of micro-prudential regulation, i.e. regulation of entities in the financial sector, is to protect customers. If regulation entails a higher burden on owners and shareholders, in proportion to the risks they take and the commitments they make, in order to protect customers, the burden may be justified. After the global financial crisis, whose origins lay first in the sale of unsuitable financial products to consumers, and then in the lax regulation of financial firms that were holding those assets, the commission has focused on the extremely important role that good regulation can play in making the financial system resilient.

A major theme of many of the recommendations of previous committee reports in India has been the opposite problem of those that led to the global financial crisis. Instead of suffering from too much innovation as the US is supposed to have witnessed in the run up to the financial crisis, Indian regulators have often been found to do excessive regulation and strangle of innovation. This issue can be addressed by giving regulators clear objectives, through enumerated powers. If the regulator simply wishes to ban something so that he does not have to witness any risk on his clock, the law will not give him the power to do so. He needs to demonstrate that the regulation is required to meet the objectives assigned to him, and is within his powers to do so, and that a cost benefit analysis of the regulation shows that the additional cost, monetary or otherwise, of complying to this regulation is going to bring clear benefits to the economy. The regulator would be hopefully restricted by the proposed accountability mechanisms not to prevent all innovation. Further, even if he does go ahead and issues regulations that do not meet the objectives that are given to him, the regulation can be challenged in a newly set up Financial Sector Appellate Tribunal.

Once the draft code becomes law, regulators would be required to write regulations in line with the powers and role given to them by the new law. The process may take time, but the framework provided by the FSLRC would lay the foundations of a well regulated modern financial system in India.

Caps unlock

2013-03-20T16:34:00.000+05:30

Indian Express, 20th March 2013

Finance Minister P. Chidambaram is reported to be considering removing FDI caps in various sectors. The imperative for the removal of caps in sectors where they are below 100 is to attract capital flows to India in a situation where the current account is expected to be 5 per cent of the GDP. While FDI in multi-brand retail, pensions and insurance have become political issues, in other sectors such as credit information, asset reconstruction or private security agencies, where the issue is not political, it may be possible to remove restrictions more easily.

Even though it makes good economic sense to ease unnecessary capital controls at times when the country needs inflows, opponents often whip up fears of what might happen when controls are reduced. Instead, we need to determine what the objectives of controls are, the kind of controls that the country would like to keep, and which ones are detrimental and should be removed.

Capital controls, or controls on the cross-border flow of money for sale and purchase of assets, are imposed for three broad reasons. In largely open economies, concerns about terrorism or money laundering require that information be provided before money can be transferred across borders. When a country becomes a member of the Financial Action Task Force (FATF), it is required to pass laws that require it to prevent money flows from being used for such activities. These require financial firms to fulfil various know-your-customer (KYC) obligations. When India became a member of the FATF, it introduced these laws. The regulations in India that flow from these laws are, it has often been felt, far more stringent than in other FATF member countries, involving proof of residence and paper documents beyond proof of identity. While the excesses would need to be sorted, controls arising from FATF obligations will have to remain.

A second reason for capital controls is national security. Again, almost all countries in the world, including the most advanced ones, have laws that prevent foreign ownership of, say, ports, airports or other infrastructure facilities where the government feels that the security of the country may be compromised. For example, the government may choose to prevent FDI in a port by a foreign government or an entity owned by it, especially by a government it does not trust. Such capital controls are in place in India as well as in advanced open economies and it is unlikely that such restrictions will go away as long as national security remains an issue.

In addition to the above, capital controls have been seen, primarily in emerging economies, as tools for macro-economic policy. When emerging economies witness pressure on their currencies, they loosen or tighten capital controls. These controls are of many kinds. They include price-based measures or quantitative restrictions. Controls may be on various kinds of asset classes such as debt, equity, derivatives, bank capital, mutual funds or direct investment. Controls may differ according to whether residents or non-residents are investing. They may differ depending on whether they concern inflows or outflows.

Emerging economies often have many of the above kinds of restrictions. When the domestic economy is doing well, foreign inflows come in search of higher returns. This may lead to an upward pressure on the currency. In such situations, a country may impose controls on capital coming in. Similarly, when domestic business cycle conditions are bad, money may flow out, putting pressure on the currency to depreciate. The country may respond by imposing controls on outflows.

Whether such controls are able to reduce the pressure on the currency is still not settled. There is a large empirical literature examining whether controls achieve their objective at least for a short time and whether that is useful, considering the costs they impose. However, one thing appears to be clear - almost all emerging economies have slowly removed controls that permanently impede cross-border capital flows. The two exceptions are India and China. Countries such as Brazil have opened up their capital account, but have kept in place transparent price-based controls that can be imposed by the government.

In India, we have tied ourselves up in knots. Even at a time when the country needs capital inflows, it is not easy for the government to move at the required speed. The U.K. Sinha committee on capital controls documented the complex maze of capital controls that has taken the power of switching controls on and off, depending on the need of the hour, away from the government and into the hands of a number of financial regulators. Various financial sector laws and regulations treat foreign investors differently from Indian investors, with a bias against foreign investors. This has created a situation in which, even when macroeconomic stability requires that at a time when the flow of capital is weak, when the current account deficit is strong, when the government wishes to reduce capital controls, it is unable to do so.

Today, even when the FM does roadshows abroad, when he sends out the message that India wants to attract foreign capital, the experience of foreigners with the Indian financial regulatory system, the legal complexity and the tax uncertainty are such that capital does not flow in easily. As the experience after last year's Union budget showed, we cannot take foreign capital flows for granted. Considering how vulnerable a large trade account makes the country, it is not surprising that other emerging economies have got rid of the complex capital controls and moved to simple, transparent frameworks.

Hopefully, the finance minister will be able to attract more foreign capital as he proposes to. But it is equally important that the system of controls now be re-examined and rationalised keeping in mind the objectives they serve.

Budget has two faces

2013-03-05T09:28:00.000+05:30

Indian Express, 5th March 2013

How a Congress-friendly budget also addresses the markets

Initial reactions to the Union budget, 2013-14, were based on an analysis of numbers as Finance Minister P. Chidambaram chose to represent them in his budget speech. The budget was seen as a tax and spend document - expenditure on the Congress's pet projects was increased, to be financed by higher taxes on the super rich. The budget was mostly in line with the Congress's politics of the last ten years. It was pro-rural poor and anti-rich.

The disappointment that followed was mainly due to expectations from Chidambaram, who was seen as more market-friendly than the rest of his party but had failed to present a budget that pushed investment and helped growth, or to defy the party line. Arguably, the budget was not more market friendly than that which could have been presented by any other Congress minister.

There seem to be two issues here. First, shouldn't it have been expected that the last budget before the elections would be one that represented Congress ideology? In the last ten years, the Congress has not portrayed itself as pro-business or even pro-market. It is only when the economy started slipping into a bottomless hole that the party brought in its most competent and most market-friendly cabinet minister to take charge. Chidambaram's job was to convey to the markets that it was not a complete return to the days of the licence-permit raj. But to expect that the Congress was ready to give up its agenda of welfare programmes, or the pro-poor, anti-rich image it has been trying to build, was perhaps unrealistic.

As a consequence, the budget essentially had to be a tight-rope walk between the instincts of the Congress and the needs of a government rapidly losing the confidence of industry, foreign investors and credit-rating agencies.

The second issue concerns the message of the budget speech. The reaction to the speech was perhaps what the finance minister calculated it would be. The budget would be seen as pro-rural poor and anti-rich. After all, in his speech, the minister chose to interpret his budget numbers as he liked. The speech was more Congress-friendly than market-friendly. But the same budget may have been used to convey a very different message - one of moving towards a smaller government and restricted spending on welfare schemes.

For example, in his Congress-friendly speech in Parliament, Chidambaram said: "I have been able to set the budget estimates of total expenditure at Rs 16,65,297 crore and of plan expenditure at Rs 5,55,322 crore."

A market-friendly version of the same numbers would have read: "I propose to allocate Rs 16,65,297 crore for total expenditure, thus raising expenditure by 11 per cent over last year's budget estimates. Since I expect the GDP to grow by 13.5 per cent in nominal terms, this means reducing the size of the government in the total GDP."

Similarly, Chidambaram said: "Hon'ble Members will be happy to know that plan expenditure in 2013-14 will be 29.4 per cent more than the revised estimate of the current year."

A market friendly version of the budget numbers might have read: "Plan expenditure in 2012-13 was budgeted to be Rs 65,000 crore. Owing to the difficult fiscal situation, I propose to allocate only an additional Rs 3,000 crore, or Rs 68,000 crore for planned expenditure in 2013-14. This will mean that the amount budgeted for plan expenditure will shrink in real terms."

Further, in his Congress friendly speech, the finance minister said: "The ministry of rural development steers a number of flagship programmes. We estimate that they will be able to spend Rs 55,000 crore before the end of the current year, and I propose to allocate Rs 80,194 crore in 2013-14, marking an increase of 46 per cent. MGNREGS will get Rs 33,000 crore."

A market friendly version of the same speech might have read: "Last year the ministry of rural development got a budget allocation of Rs 76,000 crore. This year I propose to allocate Rs 80,194 crore, a contraction in real terms. Expenditure on MGNREGS was budgeted to be Rs 33,000 crore in 2012-13. I do not propose to raise the allocation for MGNREGS in 2013-14. This implies almost a 10 per cent reduction in the allocation for MGNREGS in real terms."

This is not to say that the Congress is actually moving towards a smaller size of government. If there has been a contraction compared to what was proposed last year, there has been little change in the long-run growth path of government spending, at roughly 15 per cent.

Similarly, the tax on the super rich might yield less returns in terms of economics and more in terms of politics. The finance minister clearly ignored the advice of the chief economic advisor, who said, "higher and higher tax rates impinge more and more on incentives to undertake taxable activity, while encouraging tax evasion". Higher taxes on luxury goods, a surcharge on corporate income tax and dividend distribution may raise tax revenue in 2013-14, but it is unlikely to facilitate a good tax policy for the country in the long run. That can only come with a simpler tax code, fewer exemptions, increased compliance through a GST and lower taxes discouraging evasion. The increase in non-tax revenue based on spectrum sale and disinvestment may be able to finance the budgeted expenditure next year while keeping the fiscal deficit down, but it will not lay the ground for sustainable fiscal consolidation. The tight-rope walk of a finance minister trying to marry Congress ideology with the need for growth and investment in the economy cannot be a long-term strategy.

In the shadow of the deficit

2013-02-26T09:47:00.000+05:30

Indian Express, 26th February 2013

Finance minister must strike a balance between poll pressures and imperatives of reform

When Finance Minister P. Chidambaram stands up to present Budget 2013 later this week, he will have to walk a tightrope between a budget that makes investors optimistic about India and one that satisfies his party, especially those in the Congress who want welfare programmes and subsidies. In Chidambaram's earlier stint as finance minister, walking this tightrope was not as difficult as it is today because the economy was growing fast, the fiscal deficit was under control and the current account deficit was much smaller than it is today.

The forthcoming budget is expected to be the last one this government can present. Next year, there might be a vote on account, in view of the elections that will follow soon after. That makes this budget the last chance for the UPA to fulfil all the election promises it made. If Congress MPs feel that they are not going to win the next elections, the desperation to expand welfare programmes will only increase. This could involve a stepping up of expenditure, which the government can ill afford at the moment.

Introducing new programmes like the food security bill, or continuing old programmes and increasing expenditure on them, needs money. With a slowing economy, tax revenue growth is unlikely to be buoyant. Even if the finance minister tries to come up with proposals to tax the rich more, it is unlikely that he will raise much revenue from them. Further, even if he is able to introduce the GST, revenues might not go up in the first year. Infrastructure issues, compensation to states for Central sales tax cuts, and the costs of implementing the new system will mean that he cannot depend on higher tax revenues in the coming year.

So will Chidambaram project a higher budget deficit? No, because that would be a problem with domestic and foreign investors. Consequences of the fiscal deficit, such as higher inflation, private investment being crowded out by large government borrowing and the spillover to the external sector, remain concerns, as in the past. What is new, perhaps, is how close we are to a credit downgrade. If credit rating agencies believe that our fiscal deficit is going to be higher in the coming year, India could get a downgrade. That would push up the interest rate Indian companies have to pay when they borrow abroad.

The domestic banking sector, with its rising number of non-performing assets and loan restructuring, has seen its balance sheets weaken. External loans remain an important source of borrowing for large corporations. Domestic interest rates are also unlikely to come down very much unless inflation goes down, of which there are few signs so far. Unlike in previous years, when the size of the fiscal deficit was an academic debate rather than something that bites the corporate sector, it is different this time.

If Chidambaram is under pressure to increase expenditure in some areas, as his party desires, he has to cut expenditure in others. The freeing up of diesel prices has been an important development in curtailing expenditure. First, it has indicated Chidambaram's commitment to containing expenditure on oil subsidies. Second, the price hike passed relatively peacefully, without creating a political storm, as most people might have expected. This bodes well for the finance minister's plans. He can make projections of not just the oil subsidy going away in the coming year but also of other subsidies going down to provide, for example, for an increase in food subsidy.

The second major concern of business is the investment environment. While Chidambaram set up the Cabinet Committee on Investment a few months ago to speed up stalled projects, investors have not seen any action on that front. It has not inspired confidence and encouraged investment again. With no change in the legal framework, few believe that a government committee could solve the problems. However, many were willing to give Chidambaram the benefit of doubt, and to wait and watch. Here again, we run into trouble with politicians in the party who might want to say they stand for tribal rights, environment and land rights, much more than they would have when not faced with an upcoming election. If legal changes are proposed this year, they may not be in keeping with the kind of balance that India needs to strike between development and the protection of various affected groups. If they are not proposed, investors will continue to have low confidence.

A major concern of the minister would be to keep foreign capital coming in to fund India's large and growing current account deficit. One small mistake in the couple of hours when Chidambaram makes his speech could cause a loss of confidence, months of flight of foreign capital and a depreciation of the rupee. It could be new foreigner unfriendly taxes, such as the GAAR of last year. It could be a capital gains tax, since in India, taxes are not residence based and foreigners are taxed. Or the budget speech could talk about renegotiating the Mauritius double taxation treaty. Or it could be something else that the zealous tax department thinks of in its attempt to reduce the budget deficit. Any tax on capital inflows, at a time when the country needs to finance its current account deficit by attracting them, would not be pragmatic.

Not only does Chidambaram need to be careful about taxing foreigners, Part A of the budget speech, which is the government's reform agenda, has to be persuasive, investor-friendly and inspire confidence. Part B of the speech, which includes his tax and expenditure proposals, has to keep the deficit under control and his party colleagues happy.

With a non-performing government, a party seeking to buy votes, a declining economy, an uncertain global environment, persistent inflation, a large deficit and colleagues wanting an election-friendly budget, Chidambaram clearly has a tough job ahead.

Can't figure it away

2013-02-12T10:19:00.000+05:30

Indian Express, 12th February 2013

Arguing over GDP numbers won't convince investors. Government must focus on fiscal correction

The ministry of finance has responded strongly to the Central Statistics Office (CSO) estimates for GDP growth of 5 per cent in 2012-13, saying that it is an underestimation. Normally, it would be surprising to see the ministry respond to growth numbers as loudly as it has done this time. But in this case, it was not entirely unexpected. The CSO's estimates can upset the finance ministry's promise of a lower fiscal deficit number. On his recent foreign tour, Finance Minister P. Chidambaram promised a 5.3 per cent budget deficit. This rests not only on projections of revenue, expenditure and the gap between them, but also on the denominator, GDP.

All the important assumptions made in the projections for the 2012-13 budget deficit have gone awry. During April-October, tax revenues grew by 14.54 per cent. This was lower than the 20 per cent growth assumed in the budget. Expenditure growth, at 14.6 per cent, on the other hand, was higher than the 13 per cent expenditure growth.

The fiscal situation is already difficult. With unmet disinvestment targets, a large subsidy bill that has yet to be impacted much by higher fuel prices and a newly launched cash transfer scheme that is unlikely to give efficiency gains or any reduction in expenditure in this budget, cutting expenses on the big ticket items is not easy. The finance ministry's credibility is already fragile. The CSO's GDP estimates can further hurt it. A smaller GDP number will yield a higher fiscal deficit to GDP ratio.

Under the current system of budget making, the government makes an assumption of GDP growth while preparing estimates for the budget. The ministry has insisted that growth will be 5.5 per cent. Since these are all only projections of production in the economy till March 31, 2013, it is surprising how anyone can be very confident about what GDP growth is going to be. Indeed, during the last two years, most projections of GDP growth for India have been slashed. The IMF's projection for GDP growth for India in 2012 is 4.5 per cent. Looking at the relentless decline in investment growth, it seems a more plausible estimate than the ministry of finance's 5.5 per cent. Even if the ministry is seeing green shoots of recovery, none of the publicly available indicators show them yet.

As it is natural for the government to try to show a low ratio for the fiscal deficit, it has the incentive to choose an implicit GDP growth rate that is higher, making the budget deficit ratios smaller. The best way to address this issue is to set up an independent panel to provide GDP forecasts.

Today, there are a number of independent forecasts for the Indian economy being made by those monitoring the economy. In general, these forecasters are conservative in that they tend to move with the consensus and their assessment may not be very far from what the government itself is saying. However, to the extent that they are not conflicted, in that they are not producing the budget revenue and expenditure decisions and the deficit ratios, the forecasts they produce are independent. These should go into the budget process.

Chidambaram has made an effort to cut expenditure and raise revenues in the last few months. Many positive steps, especially where policy decisions were in his hands, have been taken. The significance of cutting the deficit and its impact on the economy is high at this moment. A clue lies in the fact that the FM undertook a foreign tour to reassure foreign investors at a time when he would normally be busy with the details of the budget. The macro picture of the budget is extremely important today and that is why, perhaps, the ministry responded so strongly to the CSO estimates.

The reasons for the importance of the macro picture lie in the difficulties currently being faced on the balance of payments. India has had a large current account deficit of 5.4 per cent of the GDP. This means India needs to keep up an inflow of capital despite falling growth and worsening public finances. This can be done if foreigners are assured that in the long run, India is a good investment opportunity, that India is on the path of implementing reforms that will ensure a strong currency. A decline in capital flows can cause a rupee depreciation. A rupee depreciation would put further pressure on the fuel subsidy bill as the price of every barrel of imported oil will increase. Further, it will put pressure on domestic prices. While it is unlikely that a small change in the fiscal deficit number would stop foreign capital from flowing into India, it shapes views on future current account deficits and the strength of the rupee.

In addition, a large fiscal deficit could cause a ratings downgrade for India. This would increase the cost of borrowing by Indian companies abroad. Domestic credit growth has declined. Banks are reluctant to lend because their own balance sheets are not looking healthy. External financing is relatively cheaper, but only so far as the credit rating is good and the rupee is not expected to depreciate. Both these require the fiscal deficit to remain low.

A slightly higher denominator in the budget deficit to GDP ratio may appear good in the immediate context. But if the health of India's fiscal condition does not improve, no one is going to be fooled for long. The difficulty may get worse if the current account balance does not improve. Instead of focusing on how to defer the bad news, the government needs to focus on how it will actually do a fiscal correction. If the government is going to introduce the Food Security Act, there should be a clear indication of what it means for this year's and the following year's government expenditure. Unless such careful analysis is done of various government programmes, no amount of relatively good news obtained by arguing over GDP figures is going to convince any investor that India is worth the risk.

Right hand, left hand

2013-02-05T09:58:00.000+05:30

Indian Express, 5th February 2013

Government hasn't thought cash transfers through. Food security bill adds to the confusion

Does the UPA government believe that the public distribution system is broken and cash transfers are needed, or does it believe that the PDS works well and can serve a multiple of the numbers it is currently catering to?

In the budget session of Parliament, the government is expected to further push subsidy expenditure through cash transfers. In the same session, it is expected to table the food security bill. Surely, it is clear that there is a contradiction between the philosophy of the two. The strategy of cash transfers, when it means giving money to poor households to bring them above the poverty line, is based on the philosophy that households should be free to choose what they buy. Providing subsidised cereal to households is a policy that is based on the notion that it is best if the state decides what is good for the people and provides it. It is unlikely that in the mind of this government, that has not yet clearly articulated the full policy, cash transfers are designed to be like a negative income tax where freedom of choice is given to the individual and the family, which can buy what it chooses to. A badly designed cash transfer scheme would be one linked to consumption of specific items - food, education, kerosene, fertiliser, etc. Under this scheme, the choice of where to buy would lie with the household.

Currently, cash transfers are limited to a few small items like scholarships and pensions. They can be kept limited to these items and incrementally expanded to include a few more. Or, they could be expected to cover all subsidies, where an income subsidy amount is paid directly to the beneficiary, rather than through a price subsidy on particular items. If the logic of cash transfers was to be carried forward, each poor household would be given a sum to money to pull it above the poverty line. Like an income tax, which is paid by better-off households to the government, this would be a benefit or a "negative income tax" the government pays to households.

Giving poor households money is based on the belief that no one understands the needs and priorities of the household better than the individual and her family. If she chooses, a person below the poverty line could pay for the transport that takes her to a hospital instead of buying 10 kg of rice. Cash transfers are genuinely meaningful if they become the main plank of a government's anti-poverty programme. If it is one of many programmes, then it has a marginal impact on both efficiency and government expenditure.

Cash transfers in, say, scholarships or pensions, can only solve the problem of delay in payments. If combined with Aadhaar, there will be some additional saving for the government, as ghost and duplicate beneficiaries can be removed from the system. This might save as much as 10 to 15 per cent of the expenditure under that head. The big savings through cash transfers can come if, instead of paying a price subsidy, say on wheat, the government could transfer money directly to a family to buy a minimum consumption bundle to rise above the poverty line. That would enable the government to get rid of a large number of price subsidies, such as those on kerosene, LPG and food. Families would then buy these directly at market prices. The theft and wastage from the public distribution system would go away.

The food security bill, as proposed to be tabled, is based on a completely different philosophy. Not only does it assume that it is best for the poor in India to eat wheat and rice - instead of pulses, fish, vegetables, eggs or milk - it also assumes that the state will handle the purchase, storage and sale of this wheat and rice better than the market can. It assumes that this wheat and rice (often rotting, as it is stored in the open due to the shortage of warehouses with the Food Corporation of India) will be bought by the people. It assumes that people are not buying large quantities of wheat and rice because the price is too high, and that once it is supplied by the government at a low price, they are going to buy it.

Several assumptions about individual preferences are being made here. It is being assumed that the behaviour observed in household data that shows that diversity in food, and particularly the preference for protein such as dal, eggs, fish, chicken and meat, does not hold true or will not hold true as incomes rise. But the evidence suggests otherwise. In the last few years, there has been an increase in the price of proteins and some observers have linked the price rise to the increase in demand resulting from rural incomes going up. On the other hand, cereal prices have not been the fastest growing prices. The prices of non-cereal food items have grown the fastest, reflecting growing demand.

In addition to the issue of preferences is the problem of leakages from the PDS. The problem is well known and understood to be large. Many committees have suggested shutting the PDS down and replacing it with food vouchers. If the bill is passed, then for providing 67 per cent of the population some 50 million tons of cereals, the PDS will have to be expanded.

The answer to why the government is moving in two opposite directions does not appear to lie in the political beliefs or philosophy of the Congress. Maybe it lies in the strategy of providing goodies to voters in whatever way possible. If the strategy works and the Congress is voted back to power, the food security act will likely become one of the biggest headaches of the next government. Instead, the government should focus on fiscal consolidation and growth in this budget, and not promise more money down leaky pipes.

Reform, then remove STT

2013-01-28T11:13:00.000+05:30

Financial Express, 28th January 2013

The rate must be lowered, foreign participants should be reimbursed, and finally the tax must be removed over 4-5 years

Realistic discussions about whether the Union Budget should propose to remove the securities transaction tax (STT) or introduce a commodities transaction tax need to be more balanced than simply saying a complete no or yes to either. The first principles of public finance teach us that we should not tax transactions. Taxes like customs, octroi or excise-which tax transactions-have to be removed. All the tax revenue of the government must come from three sources: income tax on individuals, the goods and services tax, and property tax. This is the long-term direction of tax policy.

In this setting, STT was clearly a move in the wrong direction. But, in 2012-13, it was estimated that it would raise R5,920 in tax collection. This is a sizeable amount of money. To be pragmatic, it is unlikely that at a time of fiscal crunch, the tax would be removed completely. It can, however, be reformed slowly, in the following three stages. The first stage is to lower the rate by increasing the tax base. This would be revenue-neutral and reduce the visible distortions associated with the tax. The second stage would be to reimburse foreign participants, as is done with zero-rating of VAT. The third stage would be to set a timetable for removing the tax over a four or five year period. These steps add up to a feasible strategy for the reform of STT.

The introduction of STT in the equity market has given distortions in the financial system. There are four components of the financial system: currency, fixed income, commodities and equities. The imposition of STT upon only one-the equity market-has given incentives for market participants to focus on the other three. There is an artificial avoidance of equity market activity, with employees, public participants and capital shunning the equity market in favour of the other three markets.

All taxes are distortionary, and a basic principle of public finance is that we should have a low rate that is spread across a large tax base. It would hence make sense to cut the magnitude of STT and apply it across all organised financial trading-i.e. equities, currencies, commodities, and fixed income. This would generate no adverse impact in the short run while reducing the distortions in the economy where market participants are avoiding activity on the equity market.

A major problem that India now faces is the loss of market share of onshore finance. The most important financial products of India are stock market indexes-Nifty and BSE Sensex. In both cases, severe competition is now found from overseas markets which do not have an STT. Nifty futures, trading in Singapore, have no STT. This puts the onshore market at a disadvantage. As figure 1 shows, the offshore market has rapidly gained market share in Nifty futures.

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. The magnitudes of the impact on the economy is vastly bigger than those seen as tax revenues for the government through the existing STT.

In this situation, a reduction in the magnitude of STT on the equity market would help in two ways. First, it would bring capital and labour back into the equity market to a greater extent, and thus increase liquidity of the onshore equity market. This would, of course, benefit the domestic economy. In addition, a foreign market participant would be more inclined to send an order to India as opposed to Singapore when the Indian market is more liquid. The second and direct impact would come through the impact of a reduced STT which directly reduces the cost faced by a foreign investor operating in India.

This first stage of STT reform-reducing the rate and applying it to all organised financial trading-is revenue-neutral. In the jargon of economists, implementing it would be 'Pareto superior': it yields gains without hurting anyone.

The second stage of the STT reform should be the establishment of a system through which foreign investors are refunded the transaction taxes paid by them. The decision by a foreign investor to send an order to Singapore versus India should not be distorted by tax considerations. We have already done this in the field of goods. When steel is exported from India, the entire burden of indirect tax suffered in India is refunded through 'zero rating of exports'. By the same principle, when trading services are exported to a non-resident, the entire burden of domestic taxation should be refunded to him.

Through this, we would get a level-playing field on taxation, in the eyes of foreign investors, about trading in Singapore versus trading in India. The competition between Singapore and India in finance should be played on genuine factors, such as pricing and service quality. It should not be about avoiding policy mistakes in India.

This second stage of the STT reform costs money for the government. Given that FII transactions account for roughly 15% of turnover, it would involve a direct reduction of revenue for the government of roughly R900 crore a year. At the same time, some of this difference would come back to the government through increased tax revenues on the increase in GDP that comes when foreign transactions that are going to Singapore shift to India.

The third stage of the STT reform is linked to a broader programme of fiscal consolidation. Indian public finance is in very poor shape. The strengthening of public finance critically relies on building the GST, removing subsidies, and on scaling back the UPA's welfare programmes. These changes will not be achieved in a short time. Hence, the government must commit to a five-year programme through which the taxation of financial transactions would be phased out. This is the kind of time horizon over which the GST, and efforts are reducing subsidies and welfare programmes, would kick in.

Bank for the buck

2013-01-24T12:12:00.000+05:30

Indian Express, 24th January 2013

This year the government will put in Rs 12,500 crore for recapitalising public sector banks. Year after year, the ministry of finance puts more money into PSU banks. To expand banking in India, the government has chosen a two-pronged approach: putting more money into public sector banks while giving new licences for banking to private companies. In the present Indian system - with its lack of transparency, absence of the rule of law and pervasive corruption - a better policy to expand banking in India would be to divest public ownership of banks and convert them into widely held private banks.

Such a policy would address some of the RBI's concerns about industrial houses owning banks, limit the use of taxpayer money to support inefficient banks and give the country a competitive banking system. India's experience with public banks that have become widely held private banks, such as HDFC and ICICI, has been better than with new private banks, where family-dominated firms obtained licences.

Policy-makers in India like to claim that we have not had a banking crisis for a while. This claim is called into question when we witness the stream of money that has gone into PSU banks. Almost every year over the last two decades, the government has injected taxpayer resources into PSU financial firms. If we had done a recapitalisation of Rs 100,000 crore at one shot, it would have been obvious that there were big failures of financial regulation and policy. But when we dribble it out as Rs 10,000 crore per year for 10 years, it is not seen as rescuing a failing financial system.

PSU banks are not profitable enough to grow on their own steam. This reflects the failure of bureaucrats as bankers. Normally, profits are reckoned after paying for bad loans, and retained earnings are ploughed back into the equity capital of the bank. The equity capital with a bank determines how much of deposits it can take. A PSU bank that does not have equity capital will be forced to not take more deposits from the public. This constraint does not bind it as much as it should, as the RBI has often been lenient, tolerating the inadequacy of equity capital.

Indian banking has been rigged in favour of PSU banks in numerous ways. The RBI has blocked the entry of foreign banks and new private banks in an attempt to protect the cosy domination of PSU banks. A man who deposits money in a PSU bank knows it has the backing of the government. This is not the case with their competitors, and that helps increase the market share of PSU banks. Despite these violations of competition policy, PSU banks have failed to be adequately profitable. This makes them go back to the finance ministry for more equity capital.

At present, we have a finance ministry that is tightfisted when it comes to putting equity capital into PSUs owned by other ministries and discusses disinvestment of its holdings, but it is willing to put in additional capital when it comes to banks that are in its domain. The finance ministry needs to be as sceptical about putting equity capital into PSU banks as it is about putting equity capital into any PSU. If Air India does not get money, why should the SBI?

India is in a dire fiscal crisis and every single opportunity for cutting expenses should be harnessed. Even if there was money available for spending, it has better applications. In recent years when we have typically been lavishing Rs 10,000 crore every year into PSU financial firms, India would have done better if this same Rs 10,000 crore had been spent on building 2,000 kilometres of highways, or a metro system for a mid-size city like Nagpur.

A better option is to dilute government ownership in PSU banks and allow them to run and grow as normal private banks. In 1969, when banks were being nationalised, Indira Gandhi's economic policy team thought it was wise for government to have 51 per cent ownership of PSU banks. We have reversed almost every element of Indira Gandhi's economic policy framework, and this should be no exception.

We have two successful privatisations of PSU financial firms before us: HDFC and ICICI. Both were once controlled by the government and both are now dispersed shareholding companies. They were not sold off to some family, they became modern corporations. This roadmap - building dispersed shareholding private companies that are controlled by no family - should be followed for all PSU banks. This will require carrying legislation through Parliament, and it would make good use of the scarce political capital that the UPA possesses.

The government has made a case for giving out new licences for private banks. The RBI has rightly expressed concerns about banks run by industrial houses. In the past, Indian banking has suffered as the mechanism to prevent theft of depositor money by private banks lending to their business interest has been an issue. Banks must be dispersed shareholdings with professional managers - as is the case with ICICI or HDFC. In an ideal situation one would argue that the banking regulator should give licences to firms that it deems fit to run banks, but in today's India, most people, and perhaps the regulator itself, is correctly concerned about the political pressure that may be brought to bear on the regulator if it opens up the gates to new private bank licencing. It would be wise to gather experience with enhanced supervision of lending to conglomerates before venturing to give bank licences to large industrial houses, who are often the ones with the money to apply for such licences. As the recent IMF financial stability assessment report also points out, in the current context, the risks of this policy may outweigh its benefits.

Another option to expand banking in India is to open up the sector to the entry of foreign banks. At present, India limits foreign banks, in all, to 18 bank branches per year. A much more open policy framework is required, through which foreign banks can build subsidiaries in India, who are then regulated by the banking regulator on the principle of ownership neutrality and given national treatment, including the lifting of all restrictions on opening branches.

The government should consider these policy options more carefully to give India a safer and more competitive banking system.

A finer balance

2013-01-10T13:23:00.002+05:30

Indian Express, 10th January 2013

India's current account deficit has risen sharply to above 5 per cent of the GDP. Finance Minister P. Chidambaram is reported to have reacted to the balance of payment statistics by saying that he may have to increase the import duty on gold. If the solution to the country's balance of payment problems lay in high import duties, India would never have had the 1991 crisis.

Fortunately, in the July-September quarter, the previous finance minister's budget proposals on taxing foreign capital flows were not implemented, otherwise the balance of payment situation could have been much worse. The government should now conduct a stress test capturing the scenario of a sudden drop in foreign investment flows and its impact on the economy. This should form the basis of thinking about a policy framework in which the Indian economy would be resilient to such shocks.

The current account deficit in July-September 2012 stood at 5.4 per cent of GDP. Thanks to foreign investment inflows, both direct and portfolio, India did not witness a sharp depreciation of the rupee during this period. Depreciation would have made the already high inflation worse. It would have put a lot more businesses, already looking for debt restructuring, in greater difficulty. Portfolio inflows between July and September 2012 were $7.6 billion. In the same quarter of 2011, there was a net portfolio outflow of $1.4 billion. Suppose a similar swing takes place in the next quarter - what will be the impact on the economy?

Complacence on the part of policymakers would be a mistake. The total quantities of exports or imports are not determined by the government. Policies can only change incentives to buy or sell globally traded goods and services. If, due to a change in global conditions, there is a change in global financial flows, the current account deficit would be financed by trade credit or debt flows. This could potentially pave the way for a much bigger crisis. There would likely be greater pressure on the rupee to depreciate. The government would, in all probability, step in with a number of knee-jerk reactions to stop capital outflows, to prevent dollar borrowing, to push the RBI to intervene to prevent rupee depreciation, to first impose higher duty on gold and then post additional customs officers as well as have stringent checks at international ports and airports to prevent smuggling. Measures with origins dating back to the licence quota raj will be conjured up, with the hope that this time they would work.

The most important aspect of the recent BOP statistics is that the rise in the current account deficit is due to a decline in exports, not a sudden increase in imports. In fact, imports are lower as well. As the world economy has slowed down, so has export demand. Even with a relatively weak rupee, the effect of a slowdown in the US and Europe has reduced exports.

For now, service exports have held up. But if difficulties in the West continue, it is hard to see how Indian exports can keep growing. We certainly should not have policy frameworks that avoid a crisis only in the very optimistic scenario of Indian exports growing fast or foreign investment flowing to India, despite all the turmoil in global markets. Today, that is our policy framework for the external sector. How will a fall in exports, a depreciation of the rupee, a sudden stopping of foreign investment affect our balance of payments? To make the economy resilient in the face of lower export demand and in the event of a fall in foreign investment flows, we need to ask whether our policies make imports elastic as well.

Imports of gold, silver, precious stones and gems, mainly used in jewellery exports, fell in July-September 2012. Other imports, meant for domestic consumption, however, continued to grow. If we believe that demand responds to changes in prices, as we seem to in the case of gold, we should think about our bizarre policy of subsidising imported goods and making them cheaper. Our biggest import, petroleum, and its products, such as diesel, kerosene and urea, are sold to consumers at subsidised rates, encouraging consumption of these products. Exchange rate changes to these products are passed on slowly as the government fixes diesel prices in rupee terms and changes in administered prices are made only after huge delays. If market prices had prevailed, a fall in exports would have led to a rupee depreciation. This would have pushed up the price of imported oil and, at least in the long run, reduced consumption.

Subsidising imports is different from subsidising a domestically produced non-tradable service like education. If the expenditure is financed by borrowing, not only does it push up domestic demand, it does so for an import-intensive good. This was not an issue in the first decade of the 2000s, when Indian exports were growing rapidly. The main focus of the debate in the context of the oil subsidy was the large subsidy bill, the fiscal deficit, the price distortion, the leakages, the adulteration of diesel with cheaper kerosene and so on. But now that the current account deficit has risen to more than 5 per cent of the GDP, we need to think about oil subsidies in terms of the impact they have on the current account deficit as well.

For many years, economists have been crying themselves hoarse about the dangers of a large fiscal deficit. They have warned that large deficits may lead to higher demand, resulting in inflation, and spill over into a current account deficit. But the Indian economy seemed to defy this logic. As the world economy did well, exports, both merchandise and service, grew rapidly. At the same time, as India's financial integration increased, dollars came into the capital account, financing our trade deficits. So, not only was the current account not very large, usually between 2 to 3 per cent of the GDP, the dollar flows kept it easily financed and there was no crisis. But this time may be different.

Why reforms aren't lifting growth

2012-12-28T11:59:00.002+05:30

Financial Expres, 28th December 2012

Investment is unlikely to take off as highly leveraged firms and stressed banks can't take on more risk

Recent initiatives by the government-the postponement of GAAR, FDI in multi-brand retail, and the proposal to set up a Cabinet Committee on Investment (CCI), earlier called the National Investment Board, have not started showing up in pushing growth up as yet. This is not surprising because deeper problems remain. Power projects still face problems in obtaining coal as raw material and collecting money for power distributed and sold to states. Highly leveraged companies and banks with stretched balance sheets are in no position to take further risk. Investment is likely to remain low till policy changes to solve deeper problems and companies and banks have time to clean up their balance sheets. The cautious optimism that came with policy reforms has not yet started giving signals of a growth upswing.

Recent data on output, exports and credit do not show an improvement. Under these circumstances, GDP growth in 2013-14 could well hover around 5-5.5%. The government seems to be banking on fast track clearances to stalled projects. This is unlikely to be have a large effect in the short run. Few companies are in a position to start investing in new projects today. Few banks are in a position to lend to them. Perhaps these are among the reasons why data is not showing a pick-up so far.

Let us look at the most recent data. Monthly and quarterly data needs to be seasonally adjusted before it can be used. Otherwise, seasonality in the data can make month-on-month comparisons meaningless. But once this is done, it offers more insights into the most recent trends in the economy than the yearly growth rates do. Instead of being an average of the last 12 months, the data can reflect the month-on-month moving average. This indicates what year-on-year data would do with a lead of about 5 months. We look at a few leading and coincident indicators of the economy using seasonally-adjusted data below. This data is available at here, from where it can be downloaded. In most cases, the data shows the 3-month moving average of the month-on-month seasonally-adjusted variable.

Figure 1 shows the seasonally-adjusted growth rate of GDP. This number has now settled just about 5% and is not showing up and down swings of the kind that were happening till 2010.

Similarly, figure 2 shows the 3-month moving average of the seasonally-adjusted IIP growth. Again, once growth declined after 2010, it has not swung back. The monthly volatility has dampened and growth is fluctuating around zero.

Figure 3 shows the growth in non-food credit. This is measured in nominal terms, unlike production data indices, which are measured in real terms. Again the month-on-month seasonally-adjusted rate has slowed down, and on average the growth has been roughly 15%, which is just a little higher than the inflation rate. Credit growth has thus slowed down to the growth rate of roughly to about 5%. Credit growth usually rises before an upswing in production. The slow growth shows that the credit has not started expanding yet.

Figure 4 shows the increase in the rupee value of non-oil exports growth. We focus on non-oil exports since oil exports have more to do with the domestic fuel pricing policy induced refining in India, rather than an indication of business cycle conditions. Again, the month-on-month growth data is dismal. While export growth depends on the conditions in the rest of the world, it is sometimes a leading indicator for output in the Indian economy. When exports start rising, other production rises in response.

Figure 5 shows the growth in the rupee value of non-oil imports. This is often a coincident indicator as higher production requires higher import of raw materials, and India is a large importer of raw materials. More investment requires more imports of machinery. But, as we see, import growth shows no upswing.

To summarise, the variables that are in general seen to show an upswing when the economy shows an upswing, are not showing improvement so far. This does not bode well for the economy. Other evidence, which shows that investment growth has slowed down this year, from more than 12% to around 5%, has been a cause for concern. Returns from projects in which companies have invested appear to be low, or are zero, as companies grapple with missing infrastructure, stopping of raw material supplies due to delay in environmental clearances and concerns over forest peoples rights. These companies are highly leveraged, have capital trapped in large projects that have been stalled due to government incompetence or corruption issues. In many cases, these companies have had to go in for debt restructuring of their bank loans. These companies are not particularly in a mood to invest. Even if interest rates are lowered, there is likely to be nothing more than a marginal increase in investment, if at all.

Will the CCI, that will push to getting stalled projects started again, be able to bring back high GDP growth. First, there are questions about the power and the legal framework in which the CCI will function. The committee might not have had the required powers to work had it been under the ministry of finance. Other ministries had objected to it giving clearances to projects that the relevant ministries had not given. It has, therefore, been brought under the Cabinet, which can play the role of coordination and apply time lines for all clearances. But it still remains to be seen how well this will work and whether projects once cleared do not get embroiled into controversy and get stuck again in court battles.

Further, will the committee be able to push all stalled projects? First, a large number of projects may have been stalled as they seem profitable under favourable conditions when the world was looking good, the economy was in a boom and credit was growing at over 30% with real interest rates zero or negative. Even if clearances are given, these projects may not be attractive today. Second, while a large number of projects may have originally got stuck due to, say, a land acquisition problem, but during the delay, the balance sheet of the company weakened as it was unable to get the returns it expected and make the payments it needed to, including interest payments to banks. Infrastructure companies, for example, would be far more cautious today about investing money in a stalled project. The bureaucracy, regardless of whether it is in the ministry of finance, or in the environment and forest ministry, will be far more cautious in giving clearances today than last year. It seems that it will be some time before a see a pick up in investment and economic activity.

It's Delhi's move

2012-12-27T12:15:00.000+05:30

Indian Express, 27th December 2012

Don't let bureaucracy or politics of reciprocity hold back trade with Pakistan

In a significant step towards better India-Pakistan bilateral economic relations, Pakistan is expected to operationalise the Most Favoured Nation (MFN) status to India in the next few weeks. Under this regime, Pakistan will give trade treatment to India at par with other nations, which will allow more Indian goods to be imported into Pakistan. India took the lead in giving Pakistan MFN status in 1996. India should similarly take the lead in further increasing trade in goods and services, and in the flow of capital from Pakistan.

Prime Minister Manmohan Singh initiated unilateral trade liberalisation in India in 1991. In his current tenure, he has worked towards improving the India-Pakistan relationship, despite the many conflicts that obstruct peace in the region. Combining the two elements - unilateral trade liberalisation and the objective of improved relations with Pakistan - is the next step. Instead of being held back by the bureaucracy and the politics of reciprocity in trade agreements, India must move first. India is the larger economy, and the prime minister understands the gains from trade liberalisation and from better relations with Pakistan.

The need to increase economic cooperation between the two countries as a means to build stakes in peace was reiterated in the recent Track II dialogue at the Chaophraya initiative, a forum of interaction for academics, parliamentarians and media of both countries. The need for building economic bilateral relations was emphasised, even as security issues create a trust deficit in other areas. Trade and investment across the border will help create lobbies and interest groups that would engage with each other, and put pressure on both governments to improve political relations and work towards solving other more difficult questions on Kashmir, terrorism, Afghanistan and nuclear security.

The recent agreement on the liberalised visa regime between India and Pakistan is a small step in the right direction. Granting visas for business will help facilitate trade relations. These initiatives need to be followed by measures to increase services trade. The removal of the remaining restrictions and red tape, even in areas where agreements have been signed, should be a priority.

Research suggests that India-Pakistan trade is lower than the volume of trade that takes place between countries that are so close, geographically and culturally. This is because of a large number of barriers, both tariff and non-tariff, that prevent trade. The proof that there is a demand for each other's products is demonstrated by the large amount of illegal trade that is taking place between the two countries. Since the countries are neighbours, the cost of transportation is low. However, there are restrictions on the kind of products they can import from each other. Trade for such products takes place through Dubai or Singapore, with the "made in" labels changed. The restrictions add additional transport costs to trade. A lot of wasteful expenditure and effort is being undertaken on both sides to prevent this trade. Other difficulties that hamper trade are the lack of transport facilities, warehouses, banking services, insurance, etc. The removal of barriers, reduction in tariffs, improvement of facilities and trade in services are needed for progress to be made on this front.

As people grow richer, cost is not the only basis for imports. Variety provides an important reason for trade. Greater trade between India and Pakistan will result in greater variety, such as in mangoes, textiles and spices. Consequently, an increase in India-Pakistan trade will not necessarily lead to competition on the basis of costs and destruction of industry and employment. Instead, customers will gain from the increase in the varieties they have access to. The response to the clothes and fabric from Pakistan in the last trade fair in Delhi indicated the interest of consumers.

At the same time, in another move forward, India has allowed FDI from Pakistan. A large part of global trade takes place within firms. Intra-firm trade can happen when companies span both countries. This would not only create avenues for greater trade, but also create the stakes for peace as more and more businesses have assets across the border. India should grant the equivalent of MFN status in FDI investment to Pakistan. In other words, it should treat FDI from Pakistan at par with investment from other countries such as Singapore, to which the most liberal investment regime is offered.

To monitor and ensure that the government's commitments translate into progress on the ground, the prime minister should set up a committee with representation from the private sector, government and independent experts. It must assess the implementation of the measures the government announces to improve economic relations with Pakistan. It should identify the difficulties that exist and propose changes to policy and implementation. The operationalisation of the MFN status to India will likely lead to an increase in trade. Both governments will need to identify the problems and work to solve them. Trade disputes that arise will need to be solved while trade facilitation will need to be increased.

In the case of India-Pakistan trade relations, even beyond the obvious economic interests, it is in India's strategic interest to increase economic cooperation between the two countries if it contributes to bringing prosperity to Pakistan. Then, India will have a neighbourhood with less poverty, less illiteracy and less unemployment and their negative social fallout.

In other words, better economic relations between India and Pakistan will not only bring economic prosperity, as is usually the objective of trade liberalisation, but it will also build greater stakes for peace and lobbies that are interested in continuing the businesses they have set up that depend on good relations between the two neighbours. This will create a deterrence to conflict.

Watch out for capital flows via trade

2012-12-20T13:25:00.000+05:30

Financial Expres, 20th December 2012

In the recent discussion on capital flight from China, the country's State Administration of Foreign Exchange denied the speculation that there was capital outflow. While capital flight through official channels can be observed directly on the capital account of the balance of payments, when capital flows on the capital account are restricted, flight may take place through the current account. Since the trade account for China is large, it provides a channel for capital movements. The discussion on whether there is capital flight from China cannot be settled without an analysis of its trade account.

In the 1970s and 1980s, when the literature identified capital flight through trade misinvoicing, countries had significant restrictions on trade. Even then, misinvocing offered a serious channel for capital flows. It was found that in countries that have capital account restrictions, greater trade integration creates greater opportunities to shift capital through trade misinvoicing.

Trade misinvoicing only captures flows through merchandise trade. Services, and the difficulties of assessing the price of, say, a client-specific software, by a customs officer, offer further channels for misinvoicing, and are not accounted for in the trade data. Even beyond this, not all movement of capital through mispriced trade results in a difference between export and import values. For example, a form of trade mispricing that facilitates movement of capital or profits across borders is transfer pricing by multinational corporations. Such mispricing does not result in any discrepancy between the import and the export values. Trade misinvoicing thus underestimates the extent of capital flows that can take place through the current account. The accompanying table shows that flows on account of misinvoicing are as significant as net capital flows to a country.

In a recent paper, my co-authors and I found out that capital controls in countries with large trade flows are correlated with high levels of trade misinvoicing. After controlling for factors such as macroeconomic stability, corruption, currency overvaluation, and political instability, the openness of the capital account still has a significant role to play in determining trade misinvoicing. Trade misinvoincing should be viewed as a channel for de facto capital account openness. During 1980 to 2005, the average extent of misinvoicing induced capital flows in developing countries was of the amounted to around 38% of official flows, and 7.6% of GDP.

The magnitude of trade misinvoicing is conventionally estimated by juxtaposing trade data from the importing and the exporting country. A firm interested in moving capital out of a country would underinvoice its exports, thus bringing reduced foreign exchange into the country. Similarly, overinvoicing of imports would allow the domestic importer to gain access to greater foreign exchange than required. Both these mechanisms leave domestic firms in control of hard currency assets overseas. Underinvoicing of imports, on the other hand, can result from an attempt to evade taxes on imports including customs duties and the value-added tax (VAT) on imports.

The overall misinvoicing of imports that is computed using macroeconomic data reflects a certain cancelling out between certain firms who are engaged in underinvoicing of imports and other firms who are engaged in overinvoicing of imports. Similar considerations apply with misinvoicing of exports. To the extent that firms have heterogeneous goals, the measured misinvoicing is likely to understate the true scale of gross capital flows being achieved through misinvoicing in an economy.

The traditional literature focussed on two broad motivations for misinvoicing. First, it emphasised high customs duties. When firms pay high rates of customs duties or VAT on imports, they have an incentive to understate the true value of imports. Second, misinvoicing was viewed as a method for achieving capital flight, which was, in turn, motivated by fears of expropriation in interplay between unsound economic policy and political instability.

A critical factor influencing trade misinvoicing that has been identified in the literature is the extent of exchange rate overvaluation. An overvalued exchange rate as well as high inflation rate raise expectations of depreciation in the near future and stimulate capital flight. Research on the determinants of the large outflows of capital from Latin American countries in 1980s and Asian economies in late 1990s has identified explanatory variables such as macroeconomic instability, large budget deficits, low growth rates and the spread between foreign and domestic interest rates. These factors, as well as others such as corruption, political freedom, and accountability were significant in explaining capital flight from sub-Saharan Africa.

We find that the extent of misinvoicing is seen to be higher among developing countries than industrialised countries over the period 1980-2005. Also, misinvoicing has declined steadily in industrialised countries, while with developing countries, this trend remains mixed. By the logic of this traditional literature, when countries like India and China achieved high GDP growth and cut customs duties, the motivation for misinvoicing should have subsided. In this paper, we find that by and large, such a decline in misinvoicing is not visible.

The evidence on misinvoicing suggest that studies on the effectiveness of capital controls should also take into account unofficial flows through the trade account as these may be further eroding the effectiveness of capital controls.

Open and shut

2012-12-13T09:29:00.000+05:30

Indian Express, 13th December 2012

FDI in retail will bring competition to non-tradable services, and make Indian firms globally competitive

India removed barriers to trade in goods in the 1990s. Removing protection brought global competition and raised productivity. But introducing global competition in services is harder. In certain services that are tradable, like legal or financial services, the removal of trade barriers can introduce competition and increase productivity. But these often involve complicated and time-consuming multilateral negotiations. In other services that are not tradable, like retail trade, global competition can be introduced and improvement in productivity can be achieved by opening up the sector to foreign direct investment.

Reducing protection in the market for goods, cutting custom duties on imports, and removing quotas and other restrictions on trade raises few questions today. The case for trade liberalisation in goods is well understood by now. Trade liberalisation exposes local firms to global competition. Domestic firms have to innovate, produce better products, improve their technology, and reduce costs of production when imported products enter domestic markets. Under such pressures, these firms become more productive. These productive firms become exporters. The most productive firms invest abroad. Both face further competition in foreign markets and productivity growth continues. In contrast to the pre-trade liberalisation regime, productivity in the economy is higher and keeps growing. This results in higher growth of incomes and standards of living in the country. Trade liberalisation has transformed many countries, such as those in East Asia.

India has also seen the benefits of reducing protection in goods markets. Trade liberalisation in the 1990s, which continued into the early 2000s, saw Indian industry transform. At the same time that barriers to trade were reduced, domestic restrictions on production imposed through the licence raj were removed so that incumbents, who had long outlived the infant industry stage, faced both domestic and global competition. The FDI regime in manufacturing was, however, accommodated continued support to Indian industry. While opening up manufacturing to trade and to foreign investment, policy encouraged joint ventures that gave an advantage to Indian firms by not allowing 100 per cent FDI. The limit on how much could be invested by a foreigner was only slowly raised over the years. Clauses such as Press Note 18, which did not permit the foreign investor to start new ventures without the permission of its domestic partner, were put in place to support Indian firms. The result of higher competition and a carefully calibrated policy environment has been to create Indian firms that are strong enough now to become multinationals. Without the process of reducing tariff barriers and removing protection for Indian industry, Indian firms would not have ended up being so strong in world markets today. More than 300 Indian firms are multinationals now. They compete successfully with foreign companies on their turf.

Just as reduction in trade barriers brought competition to goods markets, tradable services can also be opened up to competition if the barriers are brought down. Services trade was growing rapidly before the global financial crisis, but it still represented a small share of the international economy. One reason for this, as a study by Sebastien Miroudot et al suggests, was high trade costs. In the goods markets, these costs include tariffs, non-tariff measures, transport charges, "behind-the-border" regulatory measures, and frictions related to geographical, cultural, and institutional differences. In the services sectors, trade costs are largely related to regulatory measures that either create entry barriers or increase the cost burdens faced by firms, in addition to geographical, cultural, and institutional differences. According to the World Bank's Services Trade Restrictions Database, which measures protectionism in services across the world, there are huge barriers to services trade. The absolute levels of trade costs in services are very high in the major economies; over 100 per cent ad valorem in all cases, and over 200 per cent for India. Trade costs in services markets are much higher than for goods and a multiple of two or even three times is sometimes seen. Trade costs in services can, therefore, be reduced by reducing trade restrictions.

Any reduction in trade restrictions in services is, however, likely to involve long and complicated multilateral negotiations. In many cases, improvement in domestic regulation, such as in finance, will be a precondition before trade in services is opened up. Competition, and the consequent higher productivity in tradable services, may therefore still take a while.

But for non-tradable services, such as retail trade, there are no such trade barriers to be removed or difficult negotiations to be held. This can be achieved by opening up these sectors to FDI. Sectors of the economy whose productivity is low can benefit from this. For instance, though modern retail has grown in India, especially in the last decade, the sector remains largely informal and this growth has been limited. Unlike trade in goods, the advantages of FDI in retail, such as better technology, management and the move to a modern, formal, tax-paying sector, will probably unfold slowly. There are many hurdles retail businesses have to cross before investment spending can begin.

The government might have supported FDI in retail to make a political point, to send a signal to investors, or to bring in foreign capital and prevent rupee depreciation. But whatever the reasons, this move takes India a step closer to increasing competition and achieving higher productivity in non-tradable services. With 51 per cent, rather than 100 per cent, FDI being allowed in multi-brand retail, large Indian companies that are either already in the business or have planned to enter it, are likely beneficiaries. Chances are, in twenty years it will be Indian companies running retail stores in towns and cities all over the world.

Identify this

2012-12-03T09:29:00.000+05:30

Indian Express, 3rd December 2012

Financial justification for Aadhaar doesn't require it to cover entire population or have multiple uses

Some people think of Aadhaar as a magic bullet for India. Others oppose it for privacy concerns. The government has showcased Aadhaar as a tool for targeted subsidy payments. As with all government programmes, the public should be sceptical, and the government must demonstrate through a cost-benefit analysis that the expenditure of public money is justified. Aadhaar can only address the issue of subsidies having ghost and multiple beneficiaries. In addition to the money spent on Aadhaar, there are the complexities of Aadhaar-integration for each subsidy scheme. The costs are front-loaded, the benefits come much later. Is it worth building Aadhaar? In a recent study at the National Institute of Public Finance Policy (NIPFP), we undertook a cost-benefit analysis of Aadhaar from this perspective. We find that the internal rate of return on building Aadhaar is over 50 per cent. This suggests that we should proceed with Aadhaar in order to run subsidy programmes better. The concerns about privacy can be reduced by limiting Aadhaar to those individuals who benefit from subsidies.

The main conclusion of the study is that it is worth undertaking the expenditure on Aadhaar, if only to plug leakages arising from ghost and duplicate beneficiaries. The financial justification for Aadhaar does not require it to cover the entire population, and it does not require the scheme to have multiple uses.

In developing countries, proposals to spend money on subsidy programmes are generally seen positively. We think that having good intentions in establishing a government programme or a government agency is sufficient for good results. What is needed, instead, is clarity of purpose for each government scheme, activity or agency. Once the objectives are clear, we should be measuring outcomes, and asking about the extent to which the stated objectives were met. The moment outcomes are measured, it becomes possible to ask bang-for-the-buck questions: Is there a way to achieve this goal at a lower cost? Given two different ways to achieve a stated outcome, which one is better?

The subsidy programmes run by the Indian state suffer from immense problems that come from not asking such questions. Once we look beyond the halo of moral purity, there is, typically, a lack of clarity on objectives, failure to deliver on objectives, scanty knowledge of how much money is being spent where and of who the beneficiaries are.

For example, the purpose of the public distribution system (PDS) is to deliver cheap wheat and rice to the poor. It is easy to calculate how much it would cost if, say, 100 kg of cereal per year were gifted to 20 per cent of the poorest people in India. What we have instead is a vast and sprawling enterprise that distorts the market for cereals, which is characterised by theft at various levels, and has failed to eliminate hunger among them.

Many people who think about public policy in India are fairly convinced that a biometric identification system would help reduce leakages in subsidy programmes. But while the expenses of having the Unique Identification Authority of India (UIDAI) and enrolling everyone are evident, there are also substantial integration costs when programmes such as the PDS are UID-enabled. At the same time, the scale of waste in existing subsidies is very large. The UIDAI is not a magic bullet either; it will not solve the problem fully. It will only solve two things: payments to non-existent persons, and payments to one person multiple times.

The key impediment to a high quality cost-benefit analysis of UIDAI is the lack of data and research about existing subsidy programmes. The very problems of subsidy programmes, as presently run by the Indian state, make a precise analysis of improvements in their process engineering difficult. The NIPFP study overcame this constraint by making a series of conservative assumptions.

When these estimates are put together into a formal cost-benefit analysis, they demonstrate that the internal rate of return on building UIDAI is around 50 per cent in real terms. We often find that discussion on costs and benefits turns into a disagreement about assumptions. To allow analysts to modify assumptions, a spreadsheet with the full calculation, clearly showing all assumptions and formulas, has been released on the Web. This makes it easy for anyone to modify the assumptions and get new estimates if they disagree on some of the assumptions.

The construction of the UIDAI, and the consequent transformation of the existing subsidy programmes, is thus well justified. If the government must run subsidy programmes, it should make sure there are no leakages. These leakages are not just about wasted money: we also have to worry about the political economy of business strategies that are rooted in subverting state structures and stealing.

That leaves a distinct policy debate about the problems of privacy. There is merit in civil liberty groups' concerns about the threats to freedom in India, as well as in the concern about the implications of better data in the hands of the government. A reasonable compromise, which could satisfy everyone, consists of emphasising the use of UIDAI for the beneficiaries of subsidy programmes. For the people who wish to take money from the government, we would intrude on their privacy to the extent of their having an Aadhaar number and potentially suffering from the consequences of greater tracking. It should be possible for a person who stands on his own feet - who does not even buy subsidised LPG - to organise his own life with zero tracking by government or security agencies. Such an approach, where one is vigilant about information in the hands of government, would strengthen the foundations of Indian democracy.

Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy?

2012-11-20T21:07:00.000+05:30

A recent article: Did the Indian capital controls work as a tool for macroeconomic policy, Ila Patnaik and Ajay Shah. IMF Economic Review, page 439--464, volume 60, 2012.

At the main page for this paper, you will find all the materials: a video presentation, PDF paper, link into the journal, a compact summary on voxEU.

Growing pains

2012-11-16T11:22:00.000+05:30

Indian Express, 16th November 2012

Clarify policy and ease bottlenecks to spur investment

Preventing India's growth slowdown is a difficult but not impossible task. The government needs to follow a two-pronged strategy to put India back on a high-growth path. On the one hand, it must focus on putting stalled projects back on track. On the other hand, it must put in place policy frameworks for the allocation of land and natural resources, as well as for environmental standards and the rule of law.

Episodes like the 2G spectrum sale and the coal block allocation issue demonstrate that the lack of a clear framework can seriously disrupt investment and growth. Though there are no easy answers to these questions, arriving at policy frameworks through research, public consultation and discussions among stakeholders, and implementing the rule of law, should make them more tractable than they are today.

One somewhat simple way to address growth slowdown in the short run may be through fiscal and monetary policies. But in India, macroeconomic policy choices, even in the short run, are going to be very difficult. The latest data on output and prices confirm the stagflation that has been on its way. We now see growth slipping below 5 per cent, even as consumer price inflation reaches 9.75 per cent. This is almost the reverse combination of what India witnessed a few years ago at the peak of the business cycle.

As output growth slipped in September 2012, with the IIP data showing an actual contraction in economic activity, consumer price inflation continued to rise, hitting almost double digits. The trade data released also showed a higher trade deficit. Stagflation is a much more difficult problem than overheating, which happens when prices and output are both rising, and which we saw in 2006 and 2007. That is when fiscal and monetary policy both need to be contractionary. Tackling stagflation is also more difficult than facing a recession, when fiscal and monetary policies both need to be expansionary. When faced with stagflation, no standard recipes work. Contractionary fiscal policy would mean raising tax rates, something that would hurt investment further. Easing monetary policy would mean cutting interest rates, something that would make inflation worse. The experience of other countries like the US, which has seen stagflation in the past, suggests that simple solutions can only worsen economic conditions.

Standard macroeconomic stabilisation policies are not the answer to India's economic problems today. One clear area of failure, which needs government action, is governance issues. These are responsible for having created an environment that has put on hold various projects and discouraged further investment. The stalling of a large number of investment projects since governance problems began, especially after 2010, have reduced investment and worsened supply constraints, particularly in infrastructure. Various bottlenecks, especially bureaucratic and judicial, are now holding back the economy as never before. The tools of macroeconomic policy are meant to address an economy operating around its full capacity output. That framework assumes that problems such as India's do not exist. India is not at its long-run, steady-state growth rate. The output gap is not caused by investment inventory cycles, which can be addressed by macro policies.

To address immediate governance issues, the government has proposed a National Investment Board (NIB) to speed up stalled projects. This could help push up output as well as bring down prices. But the environment minister, Jayanthi Natarajan, has opposed routing environmental clearances through the NIB. This brings us to the question of how the NIB will work. Can the bulk of issues on which investment is stalled be resolved without transparent policy frameworks in place?

There is no doubt that the reforms proposed by Finance Minister P. Chidambaram created optimism among investors, both foreign and domestic. But while it is true that the gloom and doom went away, it was replaced only by a very cautious optimism. Investors need to see the government take concrete steps before making investment decisions. If large projects and large sums of money continue to be stuck in governmental processes, and investment decisions keep getting postponed, it will not encourage them to invest. Not only are resources limited, an increasing number of bad assets reduces the banks' ability to lend. It is not just that companies are constrained by their capacity to incur further risk, there is a trust and governance deficit. Equally important are the worsening finances of the banking sector. The government needs to act quickly.

But if the laws that create a policy framework are not in place, there are fears that the very clearances that such a board gives could be challenged in court the very next day. Therefore, the second element of the strategy is to understand why projects were stalled and to correct the existing policy frameworks.

There will be no simple answers. In the process of economic growth, there are trade-offs between protecting the environment, forests and land rights on the one hand, and creating infrastructure, generating power, making dams, encouraging mining and other economic activity on the other. Any solution that swings to one extreme will not work. It will be very easy to stall projects if citizens who are losers in the process, or those that support them, go to court or use political pressure to stop economic activity. Any attempt to push through projects in a non-transparent or arbitrary way will not be acceptable either. There is no doubt that India will have to industrialise, but in such a way that the environment and forests are protected. It is essential to put in place the rule of law and processes to ensure that such issues do not hijack politics and economics.

Most countries face similar problems when they grow fast. As the Indian economy has grown, the stakes involved have become very high. With that, corruption in high places has become more attractive. What must be a priority is the creation of policy frameworks, for example, strategies for the sale of natural resources or public sector enterprises, through auction or otherwise, should be formulated in a transparent, consultative process, with independent research and discussions with stakeholders, where the public understands the debate and buys into the solutions.

NIPFP study finds large returns from Aadhaar project

2012-11-15T19:39:00.001+05:30

The National Institute of Public Finance and Policy (NIPFP) released a study on a cost-benefit analysis of the Aadhaar programme, showing that Aadhaar can plug problems ofleakages and yield very high returns to the government.

This study is significant in the light of the current debates on how to reduce the subsidy bill.

The study finds that substantial benefits would accrue to the government by integrating Aadhaar with schemes such as PDS, MNREGS, fertiliser and LPG subsidies, as well as certain housing, education and health programmes. Even after taking all costs into account, and making modest assumptions about leakages, of about 7-12 percent of the value of the transfer/subsidy, the study finds that the Aadhaar project would yield an internal rate of return of 52.85 percent to the government.

Integrating Aadhaar with government welfare schemes will improve identification and authentication. Hence, the leakages due to duplicates and 'ghost beneficiaries' can be tackled. Plausible estimates about such leakages are available mainly for MNREGS and PDS programmes in government reports and the academic literature. Using these estimates as benchmarks, for the components of the leakages that Aadhaar can directly address, the NIPFP study extends the analysis to include other government schemes where transfer to beneficiaries takes place. A reduction in leakages is considered a benefit to the government since the funds can be saved and used for other purposes.

For the PDS, the benefit accruing due to integration with Aadhaar is assumed to be in terms of reduction in leakages in the delivery of foodgrains (rice and wheat) and kerosene. For MNREGS, using the wage expenditure data and several social audit reports, the reduction in leakage in wage payments through muster automation and disbursement through Aadhaar-enabled bank accounts has been estimated. For fertilisers and LPG distribution, the diversion is estimated as a percentage of the government subsidy, which is assumed to be getting leaked or diverted for purposes beyond the subsidy's rationale. For other schemes, which include the Indira Awaas Yojana, Janani Suraksha Yojana, various pension schemes, scholarships, and payments made to workers under NRHM and ICDS, the leakages due to identfication errors are estimated as a percentage of the value of the transfer payment.

The costs of developing and maintaining Aadhaar, as well as integrating Aadhaar with the government schemes is computed in the study.

Thus, comparing the benefits with the costs, the NIPFP study concludes that the internal rate of return in real terms of the Aadhaar project is 52.85 percent. This analysis shows that even with modest assumptions on benefits, the Aadhaar project yields a high internal rate of return to the government.

The NIPFP study focuses on certain tangible benefits accruing to the government, and therefore does not count the benefits to the economy and the intangible benefits to the government and society. Many benefits of the program are intangible and therefore difficult to quantify. For example, by making every individual identifiable, existing government welfare schemes can become more demand-led. Beneficiaries are better empowered to hold the government accountable for their rights and entitlements, thus influencing the way these schemes can be designed and implemented. Also, with digitised, non-local information on workers seeking jobs, labour mobility and migration experience will become easier.

The study argues that if we were to add more programs and expand the scope of the analysis, and consider the intangible benefits, it is likely that the returns will be higher.

Full details of the calculations have been released on the NIPFP website. Other scholars and policy analysts can modify some assumptions and explore alternative outcomes.

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NIPFP Macro-DSGE Workshop, 2012

2012-11-07T10:52:00.002+05:30

Organised by: Macro/Finance Group

Conference Program

Date: November 12, 2012
Time: 09:30 A.M.

Venue: Conference Hall, Ground Floor, New Building
National Institute of Public Finance and Policy,
18/2 Satsang Vihar Marg, Special Institutional Area,
New Delhi - 110067

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Governance 2.0

2012-11-07T10:39:00.001+05:30

Indian Express, 7th November 2012

The idea of economic reform in India has largely been seen as the reduction of restrictions imposed by the government on economic activity - it must go beyond this narrow scope. The next wave of reforms needs to focus on governance. The lack of transparency in the government's functioning at present is increasingly unacceptable.

In its recent approach paper, the Financial Sector Legislative Reform Commission (FSLRC) outlined recommendations to bring about an improvement in governance, with a focus on financial sector regulation. These proposals hold lessons for the ways in which the government functions in other sectors as well.

Many government tasks can be outsourced to external agencies. This is motivated by two considerations: political independence and functional autonomy. The Election Commission should not care about pleasing the ruling party, so it should be politically independent. Tax administration should not be used by the ruling party to harass rivals and obtain election funding. Thus, tax administration should be politically independent. In finance, functions such as regulation and supervision should be immune to political pressure, much like tax administration should be distanced from politics. In addition, monetary policy should not be influenced by or subject to election cycles, which makes a case for the political independence of the RBI.

The second kind of autonomy is functional. This is rooted in problems that arise from the outdated ways in which the Indian government operates. It is difficult to construct competent and professional structures within the government, given the weaknesses of human resource processes, cumbersome procurement policies, etc. If bodies external to the government are freed from the strictures that depress its productivity, superior outcomes can be attained. Bodies outside the government can aspire to the professionalism, specialised staff capability and efficiency of the private sector once they are free to deviate from government processes.

These two reasons make a compelling case for political independence and functional autonomy in many situations. But we have to be mindful about accountability. When power is given to unelected officials working in agencies external to the government, what is the mechanism by which accountability can be ensured? Why will these officials pursue the public interest? Will they not, instead, pursue their own interests? In recent decades, we have watched agencies external to the government fail to cater to the interests of the people. They tend to do things that are convenient for existing officials, reduce the work of the agency and increase discretionary power. They also avoid taking responsibility.

It is important to consider the independence of these agencies, but it is essential that questions of accountability also be included in the discussion. A government agency is only well structured when it has the right blend of independence and accountability. Enshrining independence mechanisms in the law must go along with enshrining accountability mechanisms in the law.

The FSLRC has laid out four paths to accountability. The first is clarity of purpose. Poorly specified goals give officials a free hand to pursue their pet projects. So, laws must set down specific objectives and powers.

These goals must not be internally contradictory. For example, the Insurance Regulatory and Development Authority was given the job of regulating insurance companies and of developing the market for insurance. When it supported the unhealthy sales practices of insurance companies with the sale of unit-linked insurance plans, it could claim that it was sacrificing the regulation objective in favour of the development objective. The RBI is able to argue that it failed on inflation control because it has been holding interest rates low in order to pursue other goals, such as preventing exchange rate fluctuations, obtaining low-cost financing for public debt, preventing banks from failing, etc. Each department or agency must have clarity of purpose and not suffer from inherent conflicts of interest.

The second area of concern is the rule-making process. Parliament delegates the writing of rules to regulators, an enormously powerful tool to hand unelected officials. While it is valuable to have officials with professional expertise, we should be mindful of the extent to which unelected officials can pursue their own interests. Hence, the delegation of rule-making powers must be accompanied by an elaborate array of checks and balances in the rule-making process. Regulators must be made to demonstrate that the gains to society from a proposed rule exceed the costs of complying with restrictions. Draft rules must be released to the public and specific responses must be released for every comment. There should be convenient forums for appeal, where rules are subject to judicial scrutiny.

The third area of concern is the rule of law. India's economic policy today has seen numerous failures in that respect, partly due to the socialist policies of the past. There is a need to strip regulatory agencies of arbitrary power. Laws should be known before an action is taken; laws should be applied uniformly; when a law is invoked, it should be accompanied by the rationale employed for its use; and specialised courts for appeal should be available.

The fourth element of accountability is reporting. Once an agency has been properly structured and its objectives have been clearly defined, it should be asked to report on the extent to which it has met these objectives and how it will do better in the future. For instance, a government agency set up for the specialised purpose of addressing consumer complaints in finance must document the case backlog and the extent to which its orders were upheld on appeal, survey evidence about the satisfaction of citizens who filed a complaint, and report the cost of the process as seen by individuals, the compliance cost imposed on firms, etc. Annual reports today are filled with general platitudes about the economy, and reporting must shift away from that to include specific outcomes that the agency was mandated to achieve.

This approach to improved governance emphasises transparency, consultation and rule of law. The application of this approach in the financial sector and beyond will lay the foundation for improved public administration in India.

Policy easing won't lift investment

2012-10-25T09:46:00.002+05:30

Financial Express, 24th October 2012

India is facing the prospect of stagflation. Output growth has slowed down sharply, and is below the recent long-run average of around 7% and consumer price inflation seems to be stuck at around 9-10% (see graphs).

What should RBI's stance be in the forthcoming monetary policy meeting? Under the current circumstances, perhaps the best contribution RBI can make to India's long-term growth is not to give in to the pressure for cutting interest rates, and steadfastly hang in there till inflationary expectations come down. This may happen a few quarters after consumer price inflation rates actually come down. If it moves now, this may not happen.

There is an increasing clamour for RBI to cut interest rates. The government has announced a series of reform measures as well as steps to cut the fiscal deficit such as cutting subsidies on diesel and LPG. Additional plans for disinvestment have been announced. With these and better tax administration, the government hopes to reduce the fiscal deficit. RBI has been making the case that the government needs to bring the fiscal deficit under control for inflation to come down. With the present expansionary fiscal policy, RBI would need to keep monetary policy tight to keep inflation under control. The government is now suggesting that it is doing its bit to control the deficit, so RBI must now ease monetary policy to kick-start investment and push up growth.

RBI Governor Subbarao has a difficult call to make. Considering that inflation has remained high and above RBI's target rate of 4-5% for multiple years now, inflationary expectations have remained high. An easing of monetary policy at this stage will convey that a higher inflation rate is acceptable. This will keep inflation rates high as price setting, salary negotiations and contracts for the coming year will build in the higher inflation rate.

The biggest problem with the investment rate today is issues of government policy and implementation. Projects are stalled largely due to environment and forest clearances, availability of ores and minerals, which has become difficult due to mining bans or other processes that are under litigation or investigation, the difficulties of land acquisition, and the availability of power and water. The government is now setting up a National Investment Board that is expected to give clearances to all projects that cost R1,000 crore or more. Only when projects that are currently stalled due to these problems, bank loans that are being restructured due to these delays and investor sentiment that has been dampened due to the inability of investors to complete their projects on time, start moving ahead, will the private sector have the appetite to take any further risks.

While interest cost is obviously a component of any project, even if interest cost were zero, until the risk of putting equity money into projects can be justified by an expected positive return, many investors are not going to invest more money. Since projects do not run fully on loans, and the risks today posed by the governance problems are so serious, cutting rates will do little to ramp up investment.

In most public debates, there is rarely a lobby for raising interest rates. In general, industry lobbies who talk to media persons, investment advisors and equity market analysts almost always argue the case for rate cuts. They stand to gain from rate cuts and the loud clamour created by them ignores the potential negative impact of the policies they are arguing in favour of. In this case, interest rates are the price being paid by some to others. So there are two sides to the story. Those who lend, i.e the savers, are also impacted by rate cuts. The household savings rate has dropped sharply in one year from 25.4% of GDP in 2010-11 to 22.8% of GDP in 2011-12. Such a sharp and sudden fall in household savings should be a matter of concern. Where did this decline come from and why did it happen? What would be the impact of an interest rate cut on household savings?

This decline in household savings of 2.6% of GDP has come mainly from a sudden and sharp decline in household financial savings. In 2010-11, household financial savings stood at 12.9% of GDP, while in the following year they fell by 2.9% to 10% of GDP. Why did this happen?

The year 2011-12 saw a decline in the growth of bank deposits and small savings. Households prefer to save in real estate and gold. Physical savings of households continued to be high, and even rose slightly, from 12.4% of GDP in 2010-11 to 12.8% of GDP in 2011-12. The bulk of the increase in savings seem to have gone to gold. Last year, gold imports rose dramatically. After the hike in the tariff on gold in the budget, official imports of gold have fallen. Stories from travellers suggest that customs officials in Mumbai are actively trying to prevent gold smuggling in recent months.

World commodity prices are expected to remain depressed as the world economy remains sluggish. The rupee appreciation in recent months has helped reduce the costs of tradables. The slowdown in domestic demand will help stabilise domestic prices. When fiscal policy measures actually have an effect and the deficit comes down, the domestic pressure on prices will reduce. RBI should be in no hurry to ease monetary policy as it can do more harm than good.