Modi's food security test

Indian Express, 14th June 2013

Is the BJP ready for a new economic philosophy? Can Modi give it?

With his appointment as the BJP's poll panel chief, Narendra Modi is being decisively propelled into national politics. Whether as prime minister or as the leader of opposition in Parliament, Modi will no doubt move from Gujarat politics to national politics. But regardless of which role the BJP plays after the elections, of ruling party or of opposition, it will need a clear and well-articulated economic philosophy.

In the two terms of UPA rule, India has seen more entitlement programmes and a bigger shift towards a welfare state than ever before. Although when the NDA was in government the BJP focused on public goods such as building highways, when in opposition, it failed to oppose policies that were against its politics. Indeed, it opposed some of the very initiatives that it had taken when in government, simply because it was now an opposition party. The GST, which the NDA had proposed as a reform that would give India a single market, was opposed by the BJP. It also failed to support the pension reforms bill that it had proposed to give India a defined contribution scheme, replacing the defined benefits scheme of the Congress era.

Not only did the BJP fail to support the reforms it had proposed when in power, it also failed to oppose largescale entitlement schemes like the NREGA when they were introduced by the UPA. While the role of the NAC as an extra-constitutional body was attacked by BJP leaders in their speeches, when it came to its stance in Parliament, the party seemed to lack any economic philosophy. Not just that, when it has discussed the NREGA in Parliament or state assemblies, it has supported the policies, demanding better implementation. For example, the BJP's concern has been that the full amount of money allocated under NREGA has not been spent.

Was the party going along with the Congress's entitlement programmes because it actually believed in them? Was it not opposing them believing that opposing such entitlements would make it lose popular support? In other words, was silence a populist strategy to avoid a negative impact? Or did the BJP believe that supporting them would somehow translate into votes for its governments in states which implemented them well? In this way, the Centre would spend the money, and the BJP government at the state level would benefit.

The food security bill is the latest entitlement programme proposed by the Congress. Even though it is seen as a vote-fetching flagship programme of the Congress for the 2014 general election, the BJP agreed to support the bill, though it has disagreements on small issues in it. This lack of opposition to legislations promising entitlements has characterised both terms of the BJP as an opposition party. Modi's recent speeches suggest that he believes in small government and does not support such entitlements. With Modi as leader, will the BJP's policies change?

It is likely that the BJP will still shy away from articulating its economic philosophy. It may take the easier way out by fighting the 2014 election on the plank of Modi's governance in Gujarat. However, once Modi moves to the Centre, the 2020 election cannot be fought on the Gujarat governance platform. Even a mid-term election will be hard to fight on the basis of a chief minister's performance in the past. The policies of the Congress have given us a crash in GDP growth. If Modi believes in growth, he will inevitably have to question these policies and not just their implementation.

So if Modi is playing for the long run, seeing his appointment as poll chief of the BJP as his entry into national politics, he may take the option of defining an economic philosophy that distinguishes the BJP from what he calls the "crumb throwing" Congress. He may choose to offer an economic vision different from the muddled philosophy the BJP displayed as an opposition party in the last two Lok Sabha terms. His leadership of the poll strategy offers him his first opportunity to do so. The first impact of such a decision should be seen on the BJP's position on the food security bill, which appears likely to be introduced in the monsoon session.

While Modi may or may not become PM, there can be no doubt that he will, from now on, play a role in national politics. If the NDA does not win the election, the BJP could again become the opposition party, and Modi the leader of opposition in Parliament. Some element of the support Modi receives from corporate India is based on the belief that he will be able to offer India what he has been able to offer Gujarat, a focus on infrastructure and a functioning government that provides investment opportunities. At the same time, an element of the disillusionment of industry with the Advani-led BJP stems from its its failure to play the role of a responsible opposition party. The disenchantment of industry with the Congress is ultimately about bad delivery on GDP growth. Whether as ruling party or as opposition, the BJP will need to shift gears to think more carefully about being a part of the Indian growth story, and not just mindlessly block legislation or the functioning of Parliament. If the BJP continues to misbehave, then industry will also get disenchanted with it.

If Modi fails to lead his party to victory in 2014, and becomes leader of the opposition in Parliament, he will get the opportunity to play the role of a responsible opposition and change the image of the BJP as a disruptive party. His time in Parliament will also offer Modi a chance to distinguish the BJP's ideology from the entitlement-based ideology of the Congress.

The crucial question is whether this is the right time. Is the BJP ready for a new economic philosophy? Governance issues and easier issues like FDI in retail, where the BJP already opposes the Congress, may be much discussed in debates on the BJP's manifesto. But the first test of Modinomics will be the BJP's position on the food security bill. That would be the beginning of the end of the BJP's muddled era.

Can't bank on it

Indian Express, 04th June 2013

The RBI board makes no attempt to review its regulatory failures

According to a recent press release by the Reserve Bank of India, its board met in early May. This was the first board meeting after the Cobrapost expose, revealing widespread failure by banks in adhering to the RBI's Know Your Customer (KYC) regulations. What did the RBI board discuss and what decisions did it take?

The first set of Cobrapost exposes happened on March 14, implicating three banks. On April 6, a second set of news stories exposed more banks. The exposes revealed widespread failure by banks in enforcing KYC regulations.

When the RBI central board met in Srinagar on May 9, one would have expected the board to take some decisions to look into the issue of KYC regulations. At the very least, the board might have asked for a report on the enforcement of KYC regulations, or a review of the audits carried out on banks by the regulator. Alternatively, the management of RBI would have informed the board of the steps to be taken to review the working of the KYC regulations. The board might have highlighted the need for better regulatory oversight.

The press release says that the board, however, took "four major decisions": one, banks are to enhance the Credit Deposit Ratio (CDR) in the state from 36 per cent to 40 per cent by March 31, 2014. Two, the state government should legislate the SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Securities) Act in the state. Three, the state government and banks are to take up electronic benefit transfer on a pilot basis. Four, banks are to have an active role in skill development for horticulture and other social activities in the state.

There are two important things to note. First, the RBI board did not express a view on the KYC regulations. Second, none of its decisions were about banking regulations or what the regulator may do. All its decisions were about about what the state government and banks will do.

The first decision related to commercial banks is not about risk, safety, or regulatory compliance. Giving more credit to increase the CDR is a commercial decision of a bank. The second decision is an instruction/ suggestion to elected legislatures of the state. While the RBI may assist the legislature on making the laws, it is not within the powers of the RBI board to decide that "The state government [has] to legislate the SARFAESI Act in the state". Similarly, the decision of the RBI board that the J&K government take up a pilot project or that banks engage in skill development in horticulture are not decisions that the board of a financial regulatory authority should be taking.

None of the four major decisions of the RBI board had anything to do with its regulatory failure. There was no attempt at reviewing why the failure took place. There was no attempt to say what the RBI would do to prevent such failure.

The key function of the board of a regulator is to make regulations, to review the effects of the regulations, enforcement, performance review and cost benefit analysis. The board of any corporate body is created to maintain oversight of the functioning of the corporate body. For example, a company's board reviews the functioning of the company, orders investigation into serious issues and gives direction to the company. The decisions of the board are actionable orders to the management of the company. For regulators, the main functioning is making regulations. The board of the regulator must exercise control, oversight and review the functioning of the regulator. Many regulatory boards develop modern corporate governance systems like risk committees and audit committees to discharge their duties.

In addition, boards of regulators have a responsibility to the public at large. Companies use funds of shareholders, and therefore, the board's responsibility is limited to shareholders. For regulators, the entire public is the shareholder of the regulator. The board must also publicly demonstrate that it is discharging its statutory duties. Only issues that are decided to be sensitive may be closed to the public. To complete the cycle of accountability, it is important for the public to be aware of the outcomes of the decision of the board. A review of whether a regulation the board approved was enforced properly, and whether it achieved the purpose for which it was written, must be made public.

The Indian Financial Code, drafted by the Financial Sector Legislative Reforms Commission, addresses some of these issues. It incorporates modern-day developments in governance and oversight mechanisms for public institutions. The code requires every regulation to be approved by the board of the regulator through a resolution. Unlike the present system, the only regulatory instruments the regulator is allowed to issue are regulations. Today, the RBI issues regulations, circulars and master circulars that are not required to be approved by the board.

In contrast, at the RBI board meeting in Srinagar, the issue of the Cobrapost expose and KYC was not even discussed. No review of the KYC regulations was done. No decision was taken about KYC. The board's major decisions were ones that the RBI cannot implement. It is not even clear that the RBI board has the constitutional authority to decide what the J&K legislature will legislate, or even whether it can decide if banks should have a role in social activities in the state.

Though the IFC lays down in detail the role and functioning of the board of regulators, it is not necessary for the RBI to wait for adopting these good practices. The current RBI Act, Section 7 (2), says: "Subject to any such directions, the general superintendence and direction of the affairs and business of the bank shall be entrusted to a central board of directors which may exercise all powers and do all acts and things which may be exercised or done by the bank." Under these powers, the RBI can transform its board from taking decisions advising banks to develop horticulture skills to writing better regulations that prevent money-laundering in India.

(Co-authored with Shubho Roy of NIPFP)

Stick to the line of control

Financial Express, 27th May 2013

Just redefine foreign investments by whether or not they seek to control the company they are in

Indian capital controls are amongst the most complex in the world. In this area the Indian bureaucracy blindly marched on in the spirit of the licence permit raj of the 1970s. Today, the system has become so tangled that it is difficult to implement all the various conflicting rules in place. Simplifying the system requires implementing the UK Sinha working group on foreign investment through current initiatives such as the Sebi working group on QFI, and the Arvind Mayaram group on FDI definition.

The gentle reader is requested to read the next few tortuous paragraphs, in order to get a sense of the scale of complexity that has been constructed in the Indian capital controls. Foreign investment into India has been cut up into a maze of categories. Foreign investors are classified as: Foreign Institutional Investors (FIIs), Foreign Venture Capital Investors (FVCIs), Non-Resident Indians (NRIs), Qualified Foreign Investors (QFIs) and Foreign Direct Investors (FDI). FDI includes a sub-route involving issuing ADRs/GDRs or foreign currency convertible bonds. Sebi, RBI and the finance ministry make rules and regulations governing foreign investment. Investment by each subcategory of investors in each sector has to be continuously monitored.

The FDI framework consists of acts, regulations, press notes, press releases and clarifications, etc. The Department of Industrial Policy and Promotion (DIPP), ministry of commerce & industry, frames policy on FDI through press notes which are notified by RBI as amendments to the FEMA regulations. To bring some clarity, DIPP attempts to consolidate the various circulars on FDI in a consolidated policy statement (which has unclear legal authority). Often, it seems to get tangled in the issues with other routes of investment. While FDI is permitted up to 100% in most sectors under the automatic route, in other sectors there are sectoral investment caps.

In addition, the rules cross reference each other. For example, RBI regulations on FIIs state that an individual FII can purchase up to 10% of the equity of a company and all FIIs together can hold up to 24%. In addition, there are caps for NRIs and QFIs. The same regulations give an option to the company to raise the aggregate FII limit from 24% to the sectoral limit prescribed by the FDI policy. Similarly, when the DIPP issues press notes governing FDI limit, it states the FII investment limit should stay within the caps on foreign direct investment. In some cases, the consolidated FDI policy overrides the regulations made by RBI. In print media, the foreign investment limit is 26%, which includes the limit by NRIs/FIIs/PIOs. This means that if a company with an FDI of 20% lists on the exchanges, FIIs and other portfolio investors will be allowed to the extent of only 6%. This contradicts the RBI regulations which state that FIIs can purchase up to 24% of equity of a listed company.

Similarly, if a foreign investor invests in the same company through both the QFI route and the FDI route, the total holding of the person in such a company cannot exceed 5% of the paid up equity capital of the company, at any point of time irrespective of the sectoral cap, if any. In addition, regulations often restrict FII/NRI/QFI investments in a company at various arbitrary limits and cap their total limit to the FDI limit.

The regulatory framework is further complicated by the lack of clarity on the nature of instruments classified as FDI. As an example, if a company raises funds through the issue of ADRs/GDRs, the resultant foreign investment is considered to be part of FDI. ADRs/GDRs are largely equity instruments and investments through these do not qualify as 'control' by the foreign investors as these instruments do not give voting rights to the investors.

This tangled mess is typical of everything that India did wrong in economic policy in previous decades. Just as we have simplified industrial licensing (by eliminating it) or indirect taxation (by moving to a single rate GST), we need to drastically simplify capital controls so as to reduce transactions costs, and shift the focus of the field away from fixers to genuine investors.

In the Budget speech 2013, the finance minister announced that India will follow international best practices in defining FDI and FII. According to OECD and UNCTAD norms, a stake of less than 10% should be classified as FII. The government proposes to provide clear definitions to FDI and FII, with an aim to remove ambiguity over the two types of foreign investments.

The key step is that of clarifying the objective of the FDI/FII classification and regulations. If the objective of regulations is to prevent foreigners from taking control of an Indian company (due to national security, politics, infant industry arguments, etc) then the regulations should not take into consideration the amount of portfolio investments in the company, since such investments are not for the purpose of control of the Indian company. The regulator may choose to classify any single large investor (say, above 10) as one seeking control and bring him under the limit, but overall limits for portfolio investment do not serve this purpose.

A simple solution of redefining the different foreign investment routes is by dividing investment into two categories: investment which is related to foreign control of the Indian companies and investment which does not lead to control of an Indian company. Under this system, the FII or, say, QFI investment will not be considered for FDI limits. It will simplify both the calculation of limits for FDI and the monitoring costs. The investments which do not lead to control of the Indian company should then be subject to a uniform registration requirement with emphasis on robust KYC norms.

(Co-authored with Radhika Pandey of NIPFP)

How do you prevent rupee trades?

Financial Express, 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

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

Financial Express, 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

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.