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.