Why reforms aren't lifting growth

Financial Express, 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

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

Financial Express, 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

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

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?

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

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

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

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

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

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.

One head is better than many

Indian Express, 16th Oct 2012

A single financial regulator, rather than sectoral ones, is what India needs

The Union cabinet recently approved two bills expanding the powers of relatively small financial sector regulators. The PFRDA bill and the FCRA Amendment bill, if passed by Parliament, would give statutory powers and greater teeth to the pensions regulator and the commodity futures regulator. Though this may appear to be a reformist move in the current context, it could create difficulties for longer term financial sector regulatory reform.

These two bills were first proposed before the government set up a slew of expert groups to examine financial regulation in India. Almost all these committees suggested that all non-banking financial regulation, at least, be brought under a single regulator. They argued from Indian and international experience that it is becoming increasingly difficult to effectively regulate modern financial firms through a sectoral approach.

It seems unlikely that the cabinet is turning down these expert recommendations, including those from a group chaired by its present chief economic advisor, Raghuram Rajan. It is more likely that in its attempt to fast-track reforms, it has approved all the financial sector and economy bills that had been placed in limbo, without re-examining them carefully in this post-global-crisis world.

The expert groups, including the Mistry, Rajan, Aziz and Sinha committees, have examined the role and function of various regulators and suggested that they be modified to remove the various conflicts of interest, regulatory overlaps and gaps that plague the system today. They also raise questions about economies of scale in the regulation of organised financial trading. At present, regulatory functions on organised financial trading are spread across SEBI, RBI and the Forward Markets Commission (FMC). This separation between multiple regulators has forced an inefficient partitioning within private firms too: for example, a brokerage firm operating on the stock market where it faces SEBI regulation is forced to create a separate subsidiary to trade on commodity futures markets with FMC regulation and a separate subsidiary to be a primary dealer, which involves an engagement with the RBI.

Given the nature of organised financial trading, there could be economies of scale and scope for both government and the private sector through unification of regulation of organised financial trading. This requires pulling together the functions related to the bond and currency market from the RBI, functions related to the stock market from SEBI and functions related to commodity futures markets from the FMC, and merging these into a single agency.

Further, the Indian financial system has changed from one almost entirely dominated by public sector firms to an incipient role for private and foreign firms, which has helped bring a substantial rise in the sophistication of the firms. This has given rise to large, complex financial institutions such as the ICICI and HDFC, which serve households and firms across all aspects of financial services. At the same time, these firms have chosen to organise themselves through a large number of sectoral financial firms, each of which fits the requirements of one financial regulator. But no single sectoral regulator gets a full picture of the risks in such large conglomerates.

The recent cabinet approvals may have consequences similar to the RBI Amendment Act of 2006, which established the RBI as a regulator of the bond market and the currency market. This was a step in the wrong direction, given India's reform agenda on the regulation and supervision of securities markets. In all the OECD countries but one, a single government agency - the securities regulator or the unified financial regulator - deals with all aspects of organised financial trading. In the US, the treatment of organised financial trading is split between the CFTC, which deals with all derivatives, and the SEC, which deals with the spot market. Apart from this, the OECD practice involves a single agency that regulates all organised financial trading, with a unified treatment of equities, commodity futures, interest rate, currencies, corporate bonds and derivatives.

This mistake led to serious consequences for the bond market. In the equity market, the strategy for critical financial infrastructure, exchanges, clearing corporations and depositories, was based on three principles. First, there was a three-way separation between shareholders, the management team and the member financial firms. Second, there was a competitive framework. Third, the regulator, SEBI, did not own critical financial infrastructure.

None of these three principles was applied to the bond market. The critical bond market infrastructure involved a depository (the SGL) and an exchange (NDS) both owned and operated by the RBI. This was a problematic arrangement because the RBI had conflicts of interest by virtue of being an owner and service provider, and at the same time, the regulator (after the enactment of the RBI Amendment Act of 2006). There was a loss of competitive dynamism when the RBI's policy decisions leaned in favour of blocking competition against NDS and SGL. Only financial firms regulated by the RBI, the banks and the primary dealers were allowed to tap into this infrastructure. This framework was thus unable achieve bond market liquidity. On paper, India has an impressive bond market with trading screens, a clearing corporation, etc. But the essence of a market is liquidity, speculative views, and the resilience of liquidity. None of these is found in the Indian bond market.

The Indian discussion on the role and function of government agencies in financial regulation needs to be examined in the context of the difficulties of staffing high quality agencies. Even when an agency starts with a clean slate, without institutional baggage from a pre-reforms India, without conflicts of interest and archiac legal foundations, without expert staff, there is still a substantial risk of failure in institution building.

In India, there are many delays in processing legislations. At every stage, the government should be checking back whether it still want to propose a certain legislation. A little more thought in 2005 would have prevented the RBI Amendment Act of 2006, and a little more thought today will prevent mistakes on FMC and PFRDA. The government already has the benefit of the views and recommendations of various expert committees, which have studied the issue in detail and set the direction of long-term financial sector reform. Government policies policies in the short run should fit with its long term goals.

What is regulation for?

Indian Express, 4th October 2012

The approach paper of the Financial Sector Legislative Reforms Commission (FSLRC) has proposed a new direction for financial regulation in India. While on one hand, half the Indian population still does not have access to finance, on the other, regulations have restricted the growth of financial services. In a country growing at such a rapid pace that the GDP doubles every 8 to 10 years, the needs of people and firms are constantly changing. In recent years, various government committees have pointed to the need for policy change. But it was found that the required changes could not be made under the existing, mostly outdated, financial laws. This prompted a review of the financial legislative framework.

The FSLRC was given the job of reviewing, simplifying and modernising the legislation that affects financial markets in India. It was asked to prepare legislation in tune with the present-day needs of finance. The commission has recently released an approach paper on its website. The paper discusses its strategy and philosophy.

News reports about the commission have focused on the FSLRC recommendations for India’s financial regulatory architecture. But that is only one of the many aspects of Indian finance that the commission was mandated to review. In its proposed recommendations, it has endorsed a transition to a modern regulatory architecture recommended by previous government reports such as the Raghuram Rajan and the Percy Mistry committee reports. These reports had described the problems in the Indian financial sector arising from regulatory cracks and overlaps. The novel element of the FSLRC approach is the emphasis on the modes of independence, accountability and the rule-making process of regulators in India.

The modern approach to financial regulation allows greater innovation. It emphasises the objectives of regulation. Regulation is needed when markets fail. The approach emphasises that the objective of regulation is to protect consumers. This can be achieved by creating a system in which it is difficult to indulge in unfair practices or sell consumers products that are unsuitable for their specific needs. Unlike in goods and services, where there may only be a small lag between payment and delivery, the lags in finance are long and often contingent on a state of nature. A customer keeps paying a premium to buy a promise from an insurance company to pay his family if he dies. The customer does not know if the company is taking on so much risk that when the time to pay comes, it will be bankrupt. It is the job of the regulator to protect him from fraudulent practices and prevent the company from taking on too much risk.

If consumer protection is the objective of the regulator, it must be empowered with instruments to ensure it. It should not be tasked with other objectives or with doing things “in the public interest”. It cannot prevent innovation as long as the financial firm selling the service is not engaged in practices which violate these objectives and if it is not taking on excessive risk. This requires that regulatory objectives are clearly defined, and the regulator’s powers clearly enumerated. Normally, a regulator might have an incentive to kill innovation so that risk is eliminated and no firm fails on its watch. But eliminating risk altogether will not allow finance to reach out to new customers, products and markets. Thus, the powers of the regulator have to be restricted. It has to be made accountable for what he does. If its regulations go beyond the objectives the law tasks it with, it can be questioned, its decisions can be appealed against. This is a mechanism to restrict the arbitrary use of power and lack of reasoned regulations and orders.

The regulator must not prevent the failure of financial firms completely. Firms that are prone to take very high risks or are very weak should fail. However, firm failure must be happen at minimum cost to consumers and none to the taxpayer. The owner should lose money. The FSLRC approach paper discusses the creation of a new resolution agency for handling firm failure through mergers, acquisition or a close-down before the financial firm goes bankrupt.

The approach paper discusses a consumer protection law and a microprudential law which would lay out principles on the basis of which regulators would write regulations. These laws would not contain detailed regulations, which would be only written by the regulator. These laws will be separate from the regulatory agencies that enforce them. A law, such as a consumer protection or microprudential law, can be enforced by a number of agencies, each in their sector. A single financial redressal agency would hear complaints for all sectors.

Regulators in this approach will be given independence under the law. At the same time, they will be accountable. Accountability will be ensured through clearly defined objectives, avoiding conflicting objectives, a well-laid out rule making process and an appeals mechanism (there would be a newly created non-sectoral financial sector appellate tribunal).

As the Indian economy grows bigger, its need for finance increases. Households and firms often do not have access to the formal financial sector. Until now, the approach in the formal regulated financial sector has been to give explicit permissions for some products or markets. The rest of the financial products and markets are banned. This approach has restricted innovation in financial markets as no market or product is allowed unless the regulator prescribes it. The FSLRC approach should bring about a change to the pace of innovation.

We are, today, at the other end of the spectrum from the American model, where too much innovation appears to be a regulatory challenge. The lessons from the global crisis, which FSLRC proposes to build into the new regulatory framework, will help us to maintain a fine balance between too little innovation as in India today, and too much innovation that might pose risks to the financial system.

Towards better financial regulation

Financial Express, 2nd October 2012

The Financial Sector Legislative Reforms Commission was set up to review, simplify and rewrite the legislations affecting financial markets in India. It has been asked to make legislations to bring them in tune with the changing financial landscape in India and the world. The commission, headed by former Supreme Court Judge Justice Srikrishna, has been deliberating since April 2011, and consulting with a spectrum of experts and stakeholders in the financial sector and regulators.

The commission has just released an approach paper available on its website. The paper outlines its strategy and the recommendations it is thinking of making in its report to be submitted by end March 2013. The approach emphasises the objectives of regulation, the rule-making process, and discusses a change in India’s financial regulatory architecture.

In the 2000s, through a number of government committee reports such as the Raghuram Rajan and the Percy Mistry reports which highlighted problems in the Indian financial sector, a slow consensus was seen to be developing in support of reforms. As India grows, the needs of the economy for finance increases. Households and firms, especially small firms, do not have access to finance. Until now, the approach in Indian finance has been to give permissions for some products or markets. The rest of the financial products and markets for which no explicit permission is given, are banned. This approach has restricted innovation in financial markets.

The modern approach to financial regulation, in many advanced economies such as Australia and Canada, which have undertaken financial sector reform in recent decades and which were resilient during the crisis, is one which allows greater innovation, and yet addresses issues of market failure in finance, emphasises the objectives of regulation. It emphasises that the objective of regulation is to protect consumers. Protecting consumers can be achieved by creating a system in which it is difficult to cheat them, indulge in unfair practices, or sell them unsuitable products. If this is the objective of the regulator, and he is empowered with instruments to ensure it, he does not prevent innovation as long as the financial firm is not engaged in such practices which violate these objectives. This envisages that the regulator’s objectives are clearly defined, his powers are clearly enumerated and that his decisions are appealable.

With the objective of protecting consumers, the financial regulator must reduce the probability of failure of financial firms. Here, the regulator must not prevent failure completely. Weak firms should fail, so that labour and capital is freed up. However, firm failure must be done with a minimum cost to consumers or to the taxpayer. It should be the shareholder who pays since he took the risks. The FSLRC envisages creation of a new resolution agency for smooth firm resolution, before a firm goes bankrupt. Such agencies, in other countries, try to sell off weak firms before they fail.

With a view to protecting consumers and improving microprudential regulation of financial firms, the FSLRC has discussed a consumer protection law and a microprudential law which would outline the basic principles on the basis of which regulators would write regulations. Laws may be separated from agencies that enforce these laws. A law can be administered by one agency or many agencies. The same law, such as a consumer protection law, can be enforced by a number of agencies, each in its field. The question of regulatory architecture—a separate banking regulator, or one banking and one non-banking regulator, or indeed one consumer protection agency (as in Australia) and one unified non-sectoral regulator—can be decided by a separate regulatory architecture law.

A crucial element of the FSLRC approach is an emphasis on the governance of regulation. Regulators will be given independence under the law through the selection process, and mechanisms that determine the relationship between government and regulators. But they will be accountable. Accountability will be ensured through clear, well-defined objectives, avoiding conflicting objectives, a well-structured rule-making process involving a clear reference to the objective of the regulation being in sync with that of the law and to the appeals mechanism (through a newly created non-sectoral Financial Sector Appellate Tribunal that subsumes the present Securities Appellate Tribunal).

Questions of policy such as public sector ownership are left to politicians. But the law will require regulation to be ownership neutral: public, private, cooperative or foreign financial institutions, once registered and regulated in India, will face the same laws and regulation. The path to capital account convertibility is, of course, not a matter of law. It is policy. But law will ensure that regulations made under the capital controls law are subject to the same rule of law, procedures and appeals as all other financial sector law.

The commission has invited comments on its approach paper. These comments will be inputs into further discussions and decisions that are to be made.

Approach paper released by the Financial Sector Legislative Reforms Commission

The Financial Sector Legislative Reforms Commission (FSLRC) is rethinking the legislative foundations of the Indian financial system. FSLRC was setup by a notification on 24 March 2011 and asked to submit its findings on 24 March 2013. FSLRC constitutes the first time in Indian history that a large-scale re-examination of multiple laws in a sector is being undertaken.

FSLRC has released a compact approach paper showing preliminary findings about the strategy that will be adopted. The release of this report is part of the consultative mechanisms that have been followed within the Commission. The Commission has invited feedback from experts and interested parties on this document.

In the mood for reform

Indian Express, 17th September 2012

Now the government must outline path of fiscal correction, put investment back on track

The UPA government announced a number of reform measures last week. The announcements indicate a willingness to take political risks to push the reform process. The measures are signals for investors, domestic as well as foreign, that the Indian government is willing to undertake reform. In all likelihood, India will now avoid a rating downgrade. Yet, the economy is still staring at a deceleration to 5 per cent GDP growth, lack of job growth and inflation. Now that the government has shown its mood for reform, it must push further, to put India back on a healthy growth path. The two priorities of the government today must be fiscal correction and putting investment back on track.

The time till the next general elections in 2014 should not be spent merely managing the political downside of the reform, but in building up an argument for it and promising high growth in the next term as well, if the UPA comes back to power. The UPA government must, first and foremost, outline its path of fiscal correction. Will the diesel price hike be followed up by more hikes, removal of subsidy and eventually a freeing up of diesel prices? The subsidy regime for food, fertiliser and fuel has thrown the Indian fisc into an unsustainable debt path. The present correction, owing to the oil price hike, will only mean a correction of about 0.2 per cent of GDP. The disinvestment announced could bring in another 0.2 per cent of GDP. This does not solve the fiscal problem. The deficit needs to come down by roughly 2.5 per cent of the GDP to be sustainable.

At the same time, large welfare programmes, such as the NREGA, and the proposed health expenditure, will need greater spending. Anyone looking at the rising subsidy bill, at the size of the welfare programmes, and contrasting it with the limited tax base, can only wonder why India will not have a fiscal crisis. A continuation of the present policies cannot but land the country into a huge problem. Either before a crisis or after it, there is little doubt that the current expenditure path has to change.

Will Congress rule push India into a fiscal crisis? If not, can the Congress articulate how that will not happen. Prime Minister Manmohan Singh is reported to have said that good economics is good politics. What is the prime minister's view of what is good economics on the Indian government's expenditure policy? While he has supported a concurrent evaluation of the NREGA programme, is the problem only with leakages, or can India sustain such a welfare programme even if there were no leakages? Even if every scheme works well on its own, will that put the fisc on a sustainable path? What are the projected expenses on the government's welfare schemes if the schemes work without leakages? By what per cent is the expenditure expected to reduce?

When the slogan of inclusive growth, or NREGA, was proposed, it was popularised as a promise that the poor will not be left out of the growth process. In other words, it was implicitly assumed that India would be growing fast and a section of the rural poor would be left out of the growth process. This was why the country needed NREGA. It would help in reducing social tensions caused by high growth in some sectors and slow growth in other sectors such as in rural hinterlands. Implicit was also the argument that NREGA will be paid for by the high tax collection that the fast growing sectors of the economy would yield. Growth was to be made inclusive through a redistribution of incomes. This was the scenario when India was growing at 10 per cent and leaving some people behind. It was a scenario that might stand the test of time if India continued to grow at a long-run steady state of 10 per cent growth. This plan did not appear to evaluate the fiscal path of such a programme when growth halved.

Today India is no longer on the high of a business cycle. What is the sustainability of a large population-wide employment guarantee programme funded out of a small tax base? If production and job growth decline, will the government be able to fund such a programme? The planning commission meeting on September 15 reportedly discussed a low growth scenario of about 5 per cent during the 12th plan period. While the details of the policy logjam have not been reported, it is likely that this relates to a situation of low investment and low growth. What is the path of fiscal expenditure and taxes, debt, deficits, borrowing and interest payments in that scenario?

The other immediate priority of the government is to put investment back on track. Finance Minister P. Chidambaram is reportedly leading an effort on clearing problems caused by three years of government inaction. While one element of the story is to speed up action on the part of ministries and departments, another part of what may be required are small but effective changes in policies.

Data indicates that, one, the announcements of government projects have fallen sharply, and, two, a large number of private infrastructure projects are stuck due to lack of government clearances. The first is reportedly being pushed by the finance minister. On the second, there needs to be more policy change.

Recently, a representation from the infrastructure sector has emphasised the role of the government versus private sector in obtaining clearances. They have argued that future infrastructure projects should be bid with all sovereign clearances packaged in. They have correctly argued that securing sovereign clearances cannot be left to the private sector, and state agencies should play their role as the first partner in the public-private partnership. This would mean that the way bids are structured and awarded would be refashioned. Presently, the concerned ministry, or bid sponsor, sees its role mainly as the licensor or concession awarder. The argument makes perfect sense. This kind of streamlining can be done by the government with immediate effect and can help push investment back on track.

Sovereign warning

Indian Express, 7th September 2012

There are fears that India’s sovereign rating will be downgraded in the near future. This may, however, not happen if the policy environment is better than it was a few months ago. The new finance minister and his team have already raised the hopes of both Indians and foreigners. If the government accepts the GAAR committee recommendations on taxation, and the Kelkar committee recommendations on fiscal consolidation, the policy environment will certainly look better. A diesel price hike, if implemented next week, as reports suggest, would also play a crucial role in preventing a downgrade.

There are two issues related to a downgrade. First, when good governance and fiscal prudence can keep India’s credit rating high, Indian companies are able to compete on an equal footing with the rest of the world. By adopting better policies both for its budget and for economic growth in general, the government can provide Indian companies a better environment. Second, at a time when India has a difficult balance of payments situation, it cannot afford to have lower capital inflows that could put further pressure on the rupee. Not adopting measures that would improve the rating, but simply criticising either the ratings agencies or the ratings mechanism, will be damaging for the economy.

Today, if India does see a ratings downgrade, it will make the cost of borrowing abroad higher. When borrowing is cheaper abroad, it is attractive to borrow in dollars. A ratings downgrade will serve to raise the cost of borrowing, thus imposing a private cost on companies that borrow in dollars. Even if an Indian company is as good as a comparable one, say, from China, if India gets a downgrade then the company has to pay more for its borrowing. In a domestic environment that is already difficult, imprudent fiscal policy imposes further costs on Indian companies.

Balance of payments data for the last two quarters shows a decline in foreign loans, both in external commercial borrowings (ECBs) and in short-term loans. In almost each quarter of 2010 and 2011, companies borrowed more than $6 billion. After the last quarter of 2011, when net foreign loan inflows were $8.5 billion, there has been a sharp decline. In the first quarter of 2012 (January-March), they fell sharply to $1.6 billion. They remained low, at $2.7 billion, in the following quarter.

There has been a decline in both ECBs and short-term loans. In ECBs, we see a sharp change in 2012. There were no net flows in the first quarter. In the second (April-June), they picked up, but were about half of the net flows in the last quarter of 2011. In short-term loans, the story is even more striking. From an average of more than $2.5 billion per quarter, they have fallen to less than $152 million.

The all-in-cost ceiling imposed on ECBs by the RBI allows borrowers to pay only 350 basis points above Libor for three- to five-year loans, and only 500 basis points above Libor for loans with more than a five-year maturity period. Only a handful of Indian companies are considered creditworthy enough in international markets to be able to borrow at such low interest rates. Those with explicit or implicit sovereign borrowing or those with significant international presence may be able to do so, but the bulk of Indian companies may not be able to borrow abroad at these rates.

In earlier years, two factors played a role in Indian companies being able to borrow more abroad. First, the Indian economy was doing well, sovereign ratings were higher and more companies were able to fall within the ceiling. But, equally importantly, a large number of companies borrowed through Foreign Currency Convertible Bonds (FCCBs). The Indian borrower gave the foreign lender two options-— when it was time for loan repayment, the lender could take back his principal and pre-negotiated interest dollars or he could choose to take his repayment in the form of shares of the Indian company at a pre-determined price, often the price prevailing at the time the loan was taken.

Although most companies would have found it hard to borrow at the low all-in-cost ceilings imposed by the RBI, it was possible for them to get foreign loans through FCCBs because it also included a bet on the apparently ever-rising Indian stock market. If the share price of the company was expected to increase, the foreign borrower would be willing to lend to the Indian borrower even when it would not have done so at the interest rate the company was allowed to pay. After the crisis, when stock prices fell, lenders chose the option of asking for the principal and the interest in dollars, rather than in shares. Today, expectations from the stock markets are not looking good enough to attract a lot of money through FCCB. If the RBI leaves the all-in-cost ceiling unchanged, a sovereign credit rating downgrade would make it more difficult for Indian companies to borrow abroad and take less foreign currency risk on their balance sheets.

At present, India is running a large current account deficit, to the tune of more than 4 percent of the GDP. In the April-June quarter of 2012, the current account deficit was $21 billion. Of this, $16 billion was financed by net capital flows. The bulk of capital coming into India in 2012 is portfolio investment. In the April-June quarter, $14 billion came in through portfolio investment. Only $2.7 billion came in through loans. Foreign currency denominated loans may not be the best option for financing the country’s current account deficit but at the moment, India needs to keep up with the flow of loans, given the pressure on its balance of payments. It can ill afford a downgrade.

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