How to cap the CAD

Financial Express, 28th June 2013

The deficit in India's balance of payments in 2012-13 remained just below 5% of GDP. At 4.8% of GDP, though extremely high by historical standards, it brought a sigh of relief to those watching the external sector. Today, the pressure on the rupee to depreciate is largely a phenomenon caused by an appreciation of the dollar against its major trading partner currencies. If the balance of payments had turned out to be even worse than 5%, which has pretty much already been factored into currency markets, there could have been an additional worry about the country-specific pressure on the rupee that might be around the corner.

Indeed, the good news is that in the January-March 2013 quarter the balance of payments situation for India improved. In the third quarter of 2012-13, the balance of payments deficit had risen to 6.7% of GDP. In the fourth quarter it fell to 3.6%. Again, though this appears very large by historical standards, the improvement is welcome.

The improvement came about primarily because of higher exports, though there was also a small decline in imports. The recent rupee depreciation is good news, as it would help to keep exports competitive. Most other currencies have depreciated and if the rupee had not depreciated then this increase in exports could be threatened. However, service exports are down and hopefully a weaker rupee would help.

The balance of payments statistics shows that the net invisibles have recorded a sharp decline. In the corresponding quarter a year ago they grew at 27.5%. In Q4 of 2012-13 they declined by 7.7%. This behaviour is consistent with the increase in import of gold. Low real interest rates make it unattractive for households to send money to India in the same way that it encourages them to buy gold. When growth crashes and investment opportunities within a country are weak, the attractiveness of the domestic currency declines. This, along with a high inflation rate that has persisted for many years now, is responsible for weakening the attractiveness of the rupee.

The consolidation of the central fisc would also have played a role in keeping the current account deficit (CAD) under control. After P Chidambaram took over as finance minister there has been a drive to control expenditure. This drive has resulted in fiscal deficit below targeted, and in controlling aggregate demand in the economy. This would help in preventing a spillover of demand.

While the news that the CAD is below 5% is good, it still remains a matter of concern. India is financing the CAD by attracting foreign portfolio investment. With the withdrawal of the quantitative easing (QE) programme by the US Fed, these flows may recede. The SEBI board has moved forward to implement the simplification of the foreign institutional investor framework that was proposed by the UK Sinha committee report. This is a positive development. However, the task is not over yet.

First, there are problems in the know-your-client norms, which are proposed to be different for different categories, and it remains to be seen if individuals are easily able to access Indian equity markets as the framework aims to do. Second, the debt market still remains riddled with bad design and quantitative restrictions. Unless these are removed, we are actually blocking off one channel for which India can be an attractive investment destination-rupee-denominated sovereign debt. Third, India will need to move to residence-based taxation if it wants to attract flows as effortlessly as the OECD countries do. Every few months an enthusiastic tax officer or a minister of state wanting to increase revenue collection starts talking about scrapping the Mauritius treaty. This creates uncertainty in the market. This problem cannot be solved by signing a new treaty as that too could come under such cloud; it can be solved only by the country moving to a tax regime where foreigners are not given such tax uncertainly. The move to reduce the withholding tax on foreign debt to 5% is a good one. But the next move will have to be to remove it altogether.

Is the large CAD a temporary phenomenon, or is it here to stay? In 2011-12, the deficit was 4.2% of GDP. In 2013-14, it is 4.8% of GDP. The coming year could do well if exports pick up further. So, for example, if the US economy does well then it should reflect on the demand for exports from India. In that case, our CAD could be lower. However, we should not merely depend on this. Reform in fuel and fertiliser price policies and fiscal consolidation will help control demand. On the other hand, better growth and investment opportunities and lower inflation will make India a more attractive investment destination. At the same time, India needs to get rid of the maze of capital controls that it has created so that the country becomes a more attractive destination for foreign capital.

Don’t try to control the rupee

Financial Express, 21st June 2013

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Quantitative easing by the US Federal Reserve has been accompanied by high volatility in global financial markets. Most emerging market currencies have witnessed volatility since 2010. The rupee has been among them. In recent days the rupee has moved towards the level of 60 to a dollar. Figure 1 shows that while the Chinese renminbi has remained strong, other emerging economy currencies like those of Turkey, Brazil, South Africa and India have all depreciated in recent times, with most of them seeing a similar amount of depreciation. The South African rand has depreciated more, but the Indian rupee has moved as much as most of the other large emerging economies seen in the graph.

Given the scale of the phenomenon, the first point to note is that this is a global phenomenon. So, while India has its problems of policy paralysis and stalled investment projects, the rupee has not depreciated solely because of domestic issues. This is not to say that we should not have better economic policies, but to argue that on its foreign exchange policy what India needs is not to try to control the value of the rupee or its volatility in the foreign exchange market, as much as to understand what is the impact of these policies on growth and how can we make the economy resilient to sharp movements in the rupee.

When the rupee moves, there are gainers and losers. Among the gainers are those who export to the world. Figure 2 shows the real effective exchange rate of the rupee. This shows that the rupee has not appreciated like the Chinese renminbi has, or depreciated like the South African rand has, but roughly remained stable. The real effective exchange rate is what determines export competitiveness. There has been domestic inflation in India, and what has kept Indian exports competitive is the rupee depreciation. If like the Chinese currency, the rupee had also not depreciated, today Indian exports would have been even less competitive. From the point of view of the exporters the depreciation has merely compensated for the higher domestic inflation in India. Exports have a positive impact on growth.

However, when we turn to the losers, there are two major categories of losers. First are importers, whose prices go up. To the extent that some of these importers are exporters, they get compensated. Others may pass on their higher costs and the consumer is the one who ultimately pays.

The second are companies who may have borrowed in dollars. If companies were mindful of which currency their revenues are primarily going to be in, then in the high volatility environment, companies with export revenue borrowing in dollars would not be in trouble as they would have a natural hedge. But if companies that were earning in rupees such as infrastructure companies saw an opportunity to borrow cheaply, and chose to take the currency risk on their balance sheets, they will be in trouble.

In this respect, the liberalisation of the external commercial borrowing regulations to allow infrastructure companies to borrow abroad was not sensible. Infrastructure companies facing difficult domestic conditions, stalled investment projects, difficulties in clearances, with balance sheets that are already troubled should have been discouraged from taking on foreign debt. Anyway, if companies chose to take the currency risk they will have to pay back more in rupees. Considering the high volatility in the market, the large current account deficit, the poor growth rate of the Indian economy, it is not obvious that many companies would choose to bet on a currency that could easily depreciate when capital flows out. The reduced confidence in the Indian rupee both on account of domestic policies and on the macro environment of low growth and high inflation was pointing to a possible depreciation of the rupee.

The economy performed poorly last year. While some estimates point to an increase in growth in the coming year, the high volatility in the rupee and the impact this will have on corporate balance sheets may indicate a performance weaker than what one might expect.

What should the policymakers do? At present, the only thing possible is to push through the long-promised reform measures on financial markets so that companies are able to hedge their risks and become resilient to shocks to the currency market.

Modi's food security test

Indian Express, 14th June 2013

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

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

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

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

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

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

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

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

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

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

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

Can't bank on it

Indian Express, 04th June 2013

The RBI board makes no attempt to review its regulatory failures

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

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

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

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

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

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

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

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

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

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

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

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

(Co-authored with Shubho Roy of NIPFP)