Crossing the chasm

Indian Express, 9th December 2016

When you wish to influence the behaviour of millions of people, consumers, businesses there has to be a change in the policy framework.

The RBI's Monetary Policy Committee wisely decided not to cut policy rates in its meeting on December 7. Though the economy has witnessed a sharp negative shock with a drop in consumer demand, a rate cut can do little to counter the shock of demonetisation. A policy rate decision is usually expected to have an impact on inflation in one to two years. By then, it is hoped that the impact of this negative demand shock will be over. Moreover, measuring the impact of demonetisation on inflation and the GDP is difficult as the story is still playing out. A bad, but not unlikely, scenario is that demonetisation increases uncertainty in the policy environment, and its effects go beyond the immediate demand reduction due to cash shortages. Consequently, it could lead to a postponement of investment revival by a few years making it difficult to forecast the GDP. Consequently, monetary policy-making too has gone into wait and watch mode.

The decision to keep the rate unchanged is also good as an attempt to improve public perception of the RBI. Demonetisation and its handling, as well as the RBI's insistence that the process was carefully deliberated, adequately prepared for, and that there is ample cash with banks, has undermined the public's confidence in the RBI's capabilities and its commitment to the inflation target. Deputy Governor R. Gandhi's statement after the monetary policy meeting raises, rather than answers, questions about the RBI's competence. Most are unconvinced that the RBI board's recommendation to the government to demonetise was based on independent and technically sound analysis.

As a way out of the shortage of cash, government and the RBI have appealed to the public to adopt electronic payments. Indeed, it increasingly appears as if that, rather than black money held in cash, was the main objective of demonetisation. One point often made in the current debate is the difficulty in doing so as half the Indian population is unbanked. This is an important obstacle in the adoption of electronic payments. The pertinent question, however, is: Why does half of India's population not have bank accounts?

Most of India lacks bank accounts because we have tried to apply a command and control approach to banking policy. The lack of a competitive banking system meant that banks themselves were not inclined to open rural branches and ask customers to open bank accounts. Instead, beginning with the nationalisation of banks, it has been a government initiative for many decades. Banks have been given targets. Pushing public sector banks to open branches, and then pushing them to open accounts for the poor has not been a successful strategy. We did not create a competitive banking system. New commercial bank licences have been rare, barely two per decade. Foreign banks are not allowed to open more than 20 branches a year.

No doubt, in these difficult days without cash, there will be some movement to digital payments. Growth figures, given today's tiny base, will look large. But even some of this may be temporary. Permanent adoption of electronic payment systems will depend on the ease of payments and the charges to be paid for these services. Government has made digital payments free till December end to alleviate the cash situation. At some point beyond that, payment service providers will be allowed to charge for their services otherwise they will shut down the service, killing the whole cashless project. It has been reported that Visa, Mastercard and RuPay will altogether lose Rs 1,000 crore in November-December. Regardless of the accuracy of the amount reported, this is not a sustainable model.

Electronic payments have to be easy to adopt. There are plenty of models around the world to learn from. In some countries today, person to person payments are generally made digitally. Having effectively blocked such payments so far by onerous KYC norms and other restrictions, even the young who had the literacy, the means and the attitude to adopt e-payments, have not done so to the extent desired.

Unless the RBI ensures that all electronic payment systems and e-wallets are inter-operable, we could be creating a monopoly. Today the payments regulator, the RBI, prevents a Paytm customer from paying a MobiKwik customer. This is unlike the TRAI that pushes telecom companies to accept calls that originate from other telecom providers. A telecom company cannot refuse to accept incoming calls and force the customer receiving the call to subscribe to its service. However, a payments provider requires the customer receiving payments to download its app and become a subscriber.

In markets with such network externalities, one of the service providers is likely to emerge as a monopoly, unless the regulator steps in. This is undesirable for a number of reasons. It could leave customers vulnerable to higher charges later, which may again reduce the adoption of digital payments. Second, it would reduce the incentive of the monopolist to constantly innovate as he will not be facing competition. Third, it will create systemic risk as it will make the system vulnerable to the health and electronic infrastructure of one provider. If the provider fails, the whole system can crash and again the economy can come to a standstill.

If the government wishes to push faster for a cashless economy, policy and regulation need to focus on competition and innovation. The RBI has been promoting bank-centric payment systems in an economy where banks don’t even compete to get customer accounts. It is no surprise that neither banking nor payments have spread to the entire population.

When you wish to influence the behaviour of millions of people, consumers, businesses there has to be a change in the policy framework from targets to one that works through incentives. In this case it has to be about incentives of banks, of payment service providers, of the payments regulator etc. Pushing the economy into cashlessness cannot be forced by putting Rs 2,000 notes in the hands of the public so that people use electronic payments from lack of choice, where card companies provide the service at a loss and where some wallets could emerge as monopolies, from sheer neglect or not putting a competitive policy framework in place. If we are moving towards the goal of cashlessness, a focus on technology and neglect of an appropriate competitive regulatory framework will be short-sighted. The policy framework must be based on competition, interconnection and consumer protection. Policy work and committee processes have been working on cashlessness for many years. This work needs to go into the government's next steps.

Show me the money

Indian Express, 11th November 2016

While the ban may address the problem of the stock of black money in cash, the question is will it encourage people to disclose all income and start paying taxes on it? (Source: Reuters)

The sudden and dramatic announcement by the prime minister banning Rs 500 and Rs 1,000 notes issued by the Reserve Bank of India has a number of objectives. Among them are tackling counterfeit notes, curbing black money and restricting finance for subversive activities. While progress will be made by suddenly making the present high denomination currency illegal, we need many more steps before the desired objectives can be fully achieved.

One of the main objectives of replacing old currency notes by printing new notes is to tackle the problem of fake currency notes in circulation. In India, there is fear that counterfeit currency is being used for financing terror as well as other subversive activities. If security features of the present notes are weak and there is rampant counterfeiting, there is a need to replace these with new notes that have better security features. Usually, this is done gradually. So, for instance, the RBI could have started issuing new Rs 500 notes, allowed old notes to be exchanged for new ones and issued a deadline after which the old notes would not have been legal tender.

This is typically the strategy followed by most central banks, who are, in general, in a constant battle with counterfeiters. Curbing counterfeiting of internationally accepted currencies like the US dollar, which is used all over the world for legal and illegal activities is supposed to be a constant challenge.

In India, the problem of fake rupee notes has been noticed for many years. It has been difficult to estimate the size of the fake notes in circulation. It is not known whether the counterfeiting is done in India or across the border. Currency notes with better security features are certainly welcome, though it is not obvious that such a sudden move would make a big difference to this objective. It could have been done slowly with banks not giving out old notes until the last hour.

Then, the objective of curbing black money. Black money is money that has not been declared as income to the income tax authorities. It is not necessarily obtained from crime or corruption. It may be acquired by not showing the output of a factory and not paying excise on it. All black income is not held in cash. For instance, it may be in foreign bank accounts. Similarly, all cash is not black income. Legitimate businesses deal with large amounts of cash. Petrol pumps, white goods dealers, textile merchants and jewelers often have large cash holdings by the end of the day with many consumers paying in cash.

Cash will either have to be exchanged by the holder at a bank himself or through someone. For some days, it will be disruptive for business. It would not be surprising if, in some time, a black market pops up to exchange old notes for new notes, thereby converting black money into white. This could be in the 50-day period in which the old notes can be exchanged with new ones. There would, no doubt, be a discount, if this happens.

But the ban will certainly hit those who are holding black money in cash. Corrupt bureaucrats, politicians and many more with piles of cash must be wondering how to handle the situation and how long to wait before they try to solve it. Since the present high denomination notes are going to be replaced by new notes, it is not that cash will no longer be used for corruption and storing black money - though it is likely that dollars, gold or diamonds could become more popular for such illegal purposes due to the fear of such a ban recurring.

However, while the ban may address the problem of the stock of black money in cash, the question is: Will it encourage people to disclose all income and start paying taxes on it? Or does that require simplification and rationalisation of the tax system? As long as agricultural income can be used as a route to avoid taxes and indirect tax rates have multiple rates and exemptions, the problem of tax evasion is unlikely to go away.

On the negative side, the disruption in transactions could hit the emerging growth of consumer demand. In 1978, India denotified the 1,000 rupee note, and nothing much happened. A black market sprang up, people who had these notes took a loss while selling off these notes to people who could claim these as legitimate income. At the time, those notes were 0.6 per cent of the cash in circulation. Things are more daunting this time as 85 per cent of the cash in circulation is in the old Rs 500 and Rs1,000 notes.

A monetary economics perspective is useful. In India, there is one concept of money supply for the formal economy (the total money in all banks) and another concept of money supply for the informal economy (the cash in circulation). We will have an 85 per cent reduction in money supply for the informal economy for some days. Money is the means of transacting in the informal economy - payments will be held up and purchases will be postponed.

Some see this move as a way of pushing the country forward towards a cashless economy. There are two problems with this perspective. First, it is not that high denomination currency notes will go away. The existing notes will be replaced by new notes. Second, the cashless ecosystem is not ready to support a whole range of new users; this push is premature. Those who move from the denotification of the Rs 500/1,000 notes will not take to electronic payments. Their quest could instead take them to new notes, gold, US dollars and the bitcoin.

Unprepared for bad days

Indian Express, 17th October 2016

India lacks the institutional mechanisms to deal with the death of firms and the failure of banks.

Bank credit to the industrial sector has started shrinking. Its decline has been a serious cause for concern as credit growth is essential to revive investment. However, the logjam is not a short-term problem. The problem's origins lie in the incomplete reforms of the last 25 years. We hoped for the best and did not prepare for the worst. We failed to prepare for the inevitable business cycle downturns that a market economy witnesses.

The inability of banks to lend to industry appears to have pushed them to lend more to retail consumers. This will, to some extent, help industry which has been operating at below capacity. The phenomenon may be helped further by a rise in the salaries of civil servants, a good monsoon and a pick up in public investment.

In a traditional market economy, one might have thought that a pick up in capacity utilisation will mark the beginning of a self-correcting process of bringing about an upswing in the investment cycle. At this point, when investment in the Indian economy has been declining, this would have helped answer the most difficult policy puzzle faced by the Indian economy. But this may not happen soon enough.

If the decline in bank credit had been only due to a lack of demand for credit, then an increase in capacity utilisation would have eventually pushed industry to further increase capacity and led to an upturn in investment. But if the decline in credit growth is due to high NPAs (non-performing assets) this may not happen. The magnitude of stressed and restructured loans suggest that the latter is a serious issue today.

If the reforms of 1991-1992 had clearly envisaged a move to a market economy that inevitably has booms and busts, the government should have, over the years, systematically put in place institutional mechanisms for dealing with the death of firms, exits, bankruptcy and failure of banks. At the same time, courts and contract enforcement would have been made stronger. Instead, a naive version of a market economy led to an institutional framework suitable for capitalism that only witnesses booms.

Now that we have been stuck in a logjam for a few years we are setting up an institutional mechanism to deal with bankruptcy and bank failures. However, it will be a few years before we can build these properly. Unfortunately, this means that the present situation will not be resolved quickly.

A critical reform that should have followed the liberalisation of industry should have been the development of a competitive private banking sector. Our phase of planned industrial growth was over. Why should the government have had a role in deciding which sector and which borrower gets how much credit? Surely, if the government had to genuinely allow industry to grow, it should not have been deciding who gets the money to grow and who does not. But this was not the case. On the one hand, the government continued to own banks; on the other it continued giving directions to all banks, public and private, about which sectors to lend and which were priority sectors.

Instead of moving to a largely private banking system, bank licensing policy seems to have been dominated by a reluctance to allow the share of private banking to increase beyond about a quarter of the banking system. There was an inconsistency between the vision of market-led industrial growth and government controlled resource allocation.

Similarly, banking regulation needed to move away from central planning mechanisms to one more appropriate for a market economy. It should have undergone a philosophical change, moving away from directing banks to invest in certain sectors to regulating and monitoring the risks banks take in the business of banking. Reducing this risk would have prepared the banking system better for the bust. Instead, banks piled on a lot of risk in the boom years. Many of those projects went bad in recent years. The banking regulator has tried to come up with an alphabet soup of schemes like the CDR, SDR and S4A. None of them has been able to solve the problems created by inappropriate regulation in the first place.

An institutional change that should have followed the 1991 reforms should have been setting up of a resolution corporation for banks. In a market economy with booms and busts, banks should be allowed to be set up and to fail. Today, we cannot shut down banks because there is no proper system to shut them down. Weak loss-making banks continue to need more capital. We forcibly merge them with healthier banks, making them weak as well.

What is the way forward? In a privately owned banking system, banks do the business of banking to make profits; they retain earnings and they expand their equity capital and grow their balance sheets. If they make losses and are unable to generate adequate profits and retain capital, they are shut down or taken over by banks who have the capital. In a government owned banking system banks cannot be shut down. The only way out seems to be "recapitalisation", or putting tax payer money into making up for the losses or loans not returned. The situation is fraught with problems. Banks are not willing to either recognise bad loans or sell off weak assets at losses. The regulator is willing to give leeway knowing that government has limited money to recapitalise loss making public sector banks. If banks are forced to recognise losses and government cannot put money in, credit would only decline further.

As long as the economy was small and business cycles were mild, we somehow managed. However, after 2000 we saw a doubling of GDP, very high growth, and then a sharp downswing of the business cycle after 2008. The antiquated pre-market institutional framework is not able to provide the mechanisms the economy needs to get out of the logjam. Policymakers have been looking for short-term answers.

This is the danger of looking for fixes when something is broken. The approach of "don't fix it because it ain't broke" towards India’s banking sector must be fundamentally re-examined.

A note for Dr Patel

Indian Express, 9th September 2016

The newly apponted RBI Governor, Urjit Patel (Express Photo By-Ganesh Shirsekar)

Urjit Patel has taken over as governor at a time when the RBI has, for the first time, been given a clear legal mandate to target inflation. Governor Patel, lead author of the flexible inflation targeting framework, is undoubtedly the most suitable person to give credibility to the new mandate. His biggest challenge now lies in leading the reforms through which the RBI can actually influence inflation.

Raghuram Rajan's key contribution was his firm commitment to inflation targeting as the objective of monetary policy. His term ended with the RBI being given the legal mandate for inflation targeting. Patel faces a much tougher task.

Why is Patel's job much harder? Until now the RBI could talk about price stability and it could respond to the inflation rate by changing the policy rate, but it was not held responsible for the outcome. A rise in CPI inflation could be explained by blaming fiscal expansion, demand for protein, bad measures of inflation, inadequate transmission of monetary policy and so on. What has changed now is that the RBI can no longer merely “explain” high inflation. If CPI inflation is higher than the target, it has to not only provide reasons for its failure to meet the target, but also propose remedial actions.

While today it is a challenge for the RBI to even influence bank lending rates, let alone the CPI, the inflation targeting mandate requires the RBI to ensure that it is able to do so. The amendment to the RBI Act in the Finance Bill 2016 that redefined the objective of monetary policy might have shifted the decision of setting the policy rate from being the sole responsibility of the governor to a committee process, but the Monetary Policy Committee only has the mandate of setting the policy rate. The responsibility of ensuring that changes in the policy rate get transmitted to the financial sector remains with the governor. It is he who will lead the RBI in managing liquidity, undertaking repo transactions, buying and selling government bonds and foreign exchange and ensuring competition in the banking sector so that the MPC's decisions get transmitted to markets.

Improving the transmission of monetary policy is no simple task. There are no easy recipes. For example, one necessary but not sufficient condition for obtaining financial markets that transmit changes made to the policy rate throughout the financial system is a deep and liquid bond market. The bond market in India is seriously limited by the lack of an independent public debt management office and restricted access to bond markets. This is an agenda that needs both legislative change and institution building. It needs cooperation between the RBI and government to make it work. Creating an independent public debt manager and the accompanying bond markets in which the debt office would sell government debt will be a crucial element in improving transmission of monetary policy.

In the next few weeks, a key element of Governor Patel's strategy will have to be communication. Communication to show his commitment to the inflation targeting framework will give it credibility. Rajan's legacy of regularly repeating the RBI's commitment to inflation targeting was in sharp contrast to the flip-flops in the speeches of some of his predecessors. Patel has to continue Rajan's legacy. While markets do assume that he supports the inflation targeting framework, speeches and statements emphasising his commitment to the framework will strengthen and consolidate it. This is particularly important in the present context when questions have been raised about elements of the framework.

Next, Governor Patel has to lay down, whether publicly or internally, a path of the financial market reforms he will undertake to improve the transmission of monetary policy. Some ground work has been done and recommendations are available in the form of the Percy Mistry, Rajan and FSLRC report. However, actual legislative and institutional reform is tricky and involves adept political manoeuvring. It involves negotiating both with the government and with RBI staff. Patel's experience as deputy governor should come in useful in playing this complex role. The task of negotiating the path of reform will be an enormous challenge.

Wearing his academic hat, Patel is known to emphasise fiscal discipline. A profligate government can make the RBI's job of inflation targeting much harder. While the bulk of the responsibility of fiscal discipline lies with the government, in India the RBI plays an important role. A necessary though not sufficient condition for the government to control its borrowing is the pain it should feel when the cost of borrowing goes up. This involves the goverment having to face markets that push up interest rates and punish governments for indiscipline. In India, the RBI, through the Statutory Liquidity Ratio (SLR), mandates that banks hold more than a fifth of their assets as government bonds. This provides the government with a captive market. Rajan laid down a path for reduction in the SLR. With Patel's emphasis on fiscal discipline, he could exercise the option of accelerating this path. This would be the RBI's contribution to pushing the government to show greater discipline.

Governor Patel's second biggest challenge will be how to solve the stress in Indian banking. An alphabet soup of restructuring schemes like the CDR, SDR, S4A has not succeeded. The Bankruptcy Code will not yield results in the next couple of years. It is said that almost any negotiated settlement by banks runs into fear of the 3 Cs — the CAG, CVC and CBI. As a consequence, public sector bank officials are reluctant to sign off on haircuts.

There is no easy way out. Patel, no doubt, understands the enormity of the challenges he faces. As an insider, he would know not just the problems, but also the difficulties that any simple solution poses. This, in itself, is an advantage.

Dengue should be prevented and not merely tackled when the epidemic sets in

Indian Express, 30th July 2016

In India, prevention of dengue is left largely to households, while the government offers a cure. (Source: Illustration by C R Sasikumar)

As hoardings across Delhi indicate, we are waiting for a dengue outbreak. Aedes aegypti, the mosquito that carries dengue, is also the carrier of zika - and chikungunya. Just as in case of dengue, India will offer a fertile ground for zika - the deadly virus that deforms babies when it infects pregnant women.

The eggs of the aedes aegypti survive the Delhi cold, the heat and the dryness for more than a year. When the right temperature and moisture conditions come in late summer and during the monsoons, they hatch. The larvae live in freshwater in tanks, ditches, pots and planters all around us. Eggs laid by an infected female mosquito carry the infection. Soon the Delhi air will be thick with dengue-infected mosquitoes. Dengue cases will be on the rise till October.

It is not as if the problem or the solutions are not known. Countries across the world, including poor ones, have attacked the aedes aegypti. Communication campaigns about cleanliness, insecticide-laced mosquito nets and repellents, while important, are not enough. This is particularly so in the case of dense urban communities. The adult mosquitoes fly up to 400 meters. No single household will bear the cost of cleaning all containers and treating water tanks and coolers in its vicinity. Communication is often inadequate as a strategy. For example, it is advised that all water tanks be emptied, cleaned and refilled every week. How many households, given the water situation in Delhi, will be willing to empty out their tanks every week? If your neighbour does not kill the larvae in her tank, you can be infected with dengue. If you live in a student hostel, there is little that you can do. In other words, the prevention of dengue is a public good; it has externalities.

Experts emphasise government intervention and a multi-pronged attack on the aedes aegypti. Fogging is not enough as it attacks adult mosquitoes and not the larvae. Everyday now, larvae will be turning into pupae and then into adults. You cannot do fogging every day, nor is it safe or economical to do so. One important line of attack is to kill the larvae before they develop into mosquitoes.

Internationally, one of the most important interventions for dengue control has been larvicide or killing the larvae in various water bodies. Even if one imagined that somebody would do all this personally to prevent dengue, it is hard to imagine that people would allow someone to walk into their houses and put chemicals into their overhead tanks. That would not be safe as well. For instance, the dosage of temefos, a WHO-approved larvicide that can be added to potable water, must not exceed certain levels.

Clearly government intervention is required. Community participation is required, but preventing dengue cannot be left to communities. Governments need to have a strategy after studying the pattern of the disease and examining ways of attacking it. The prevention of vector borne diseases has been a clear case of intervention in public health all over the world.

In India, prevention of dengue is left largely to households, while the government offers a cure. It offers tests and hospital beds, a strategy that is not only insensitive when compared with the benefits of a public health prevention strategy, but also costly. A number of studies across the world have shown that intervention by governments through a strategy of prevention is cheaper compared to the government paying for the costs of tests and hospitalisation.

Unfortunately, the Indian health establishment’s prime focus has been on healthcare. There is an attitude of letting people get sick, and then thinking about how to setup healthcare facilities to treat them. From a public finance point of view, however, it is much better to engage in traditional public health interventions which emphasise public goods. In this case, the critical public health interventions are focused on mosquitoes.

We don't need to wait for newspaper stories about people dying of dengue in order to know that the epidemic of October is on its way. We will get a surge in October 2016. The time to act on these is now, and actions should be grounded in public health and not in healthcare. Unsystematic fogging or only cleaning riverbanks is not going to be enough. It is necessary to embark on comprehensive public health initiatives in July, instead of waiting till October and trying to deal with a surge of sick people using a creaking healthcare system.

Public health today barely accounts for 10 to 20 per cent of most state governments' expenditure on health. Healthcare accounts for 80 per cent to 90 per cent of such expenditure. From a financial point of view, however, healthcare is very inefficient when compared with public health. The effectiveness of public expenditure is dramatically superior when money is spent on well managed public health programmes as compared with spending money on well-managed healthcare. But public health requires a different set of skills. In the example of dengue, attacking mosquitoes requires the state to manage hundreds of health workers walking over every square metre of the area. Public health requires management skills to handle large forces of field workers who perform simple actions reliably. As part of the degradation of the India's state capacity in recent decades, we have become pessimistic about our abilities in public health. In despair, we have emphasised healthcare.

There are epidemics that ambush us, and there are epidemics that we can foretell. North India will have an epidemic of dengue fever in October 2016, as it does every year. The question is: Will we able to rouse ourselves, and have public health interventions ahead of time?

(This article first appeared in the print edition under the headline "Public health, not healthcare")

The fall guy

Indian Express, 28th May 2016

Successful inflation targeting calls for more reform. Targeting Governor Raghuram Rajan is all too easy.

Subramanian Swamy's comments, though aimed at RBI governor Raghuram Rajan personally, have significance for the inflation targeting framework of the RBI. In the Budget Session of parliament, the RBI Act, 1934, was amended as part of the finance bill. Inflation targeting has now become law. Soon, the government will notify the level of inflation it wants the RBI to target in the next five years. I argue here that in the present circumstances the target inflation rate should be five per cent. Successful inflation targeting requires reforms that have not been implemented so far. Without a well-functioning bond market, end of financial repression, a competitive banking sector, an independent government debt manager and full understanding and commitment on part of government to low and stable inflation, inflation targeting will be a pipe dream.

In the last 25 years, the RBI has sometimes raised or lowered policy rates in order to control inflation either of its own account, or, since last year, as part of a formal agreement with the government. The Monetary Policy Framework Agreement (MPFA) signed in February 2015, for the first time, put in place an inflation target agreed upon by the RBI and government. As a first step towards making a commitment to low and stable inflation, this was a significant step. Many an expert committee had recommended that India should do what most other countries, including emerging economies, had done, and adopt inflation targeting as the objective of monetary policy. This framework was formalised with the signing of the MPFA.

In the past, the RBI had not systematically used either Consumer Price Index (CPI) or Wholesale Price Index (WPI) as the inflation target. However, the MPFA made CPI the mutually agreed target. Since then it was no longer Rajan's unilateral decision to move from WPI to CPI, as Swamy believes. More so, last week through the amendment to the RBI Act, Parliament made CPI the target. But the main reason for Swamy's unhappiness with the target appears to be the high interest rate regime under Rajan. This, no doubt, is hurting industry and employment.

What should the government do to help ensure that the objective of low and stable inflation as well as economic growth is achieved?

First, the government has the responsibility of notifying the inflation rate that it wishes to achieve. This rate is to be set every five years. The inflation target in the MPFA chosen by government and the RBI was 6 per cent by January 2016 and then 4 per cent for 2016-17 and thereafter (with a band of 2 per cent). This sudden jump down in the inflation rate appears at odds with the stated intent outlined in the Urjit Patel Committee report of setting a glide path to inflation. A glide path in the case of other countries such as Chile and the Czech Republic, cited in the report, was slower and smoother and a lowering of the target was done when the existing target was achieved and stabilised.

For India, a glide path would have meant that the economy reaches a stable 6 per cent, becomes comfortable with it, and then only the target is lowered to 5 per cent. If 4 per cent is the long-run stable target, as argued in the Urjit Patel Committee report, it would be unrealistic to jump straight to it.

Second, the government and the RBI should together review India's first experience with formal inflation targeting. One of the well-known problems with monetary policy in the past one year has been the lack of transmission. It appears that given the lack of other reforms in the financial markets such as the creation of a well-functioning bond market, a competitive and market-oriented banking system, and a bond-currency-derivative nexus, monetary policy transmission does not happen easily. In this set-up, it is unlikely that the three-year path to a low and stable inflation envisaged in the MPFA can be achieved in a hurry.

It is important that we ask whether more reforms are needed before the target is lowered. Even if the government decides to lower the target, it should consider moving it from the present 6 per cent to 5 per cent. After transmission improves, inflation stabilises at 5 per cent and inflationary expectations come down, in the next setting of the inflation target five years later, the target could be brought down to the long-run target of 4 per cent.

Third, if the government wants to give the country low and stable inflation by adopting an independent monetary policy, it should clearly signal that it does not want the RBI to peg the exchange rate. One reason for the high interest rate regime has been the reluctance to ease liquidity after the shock to the rupee following the taper talk in May 2013. The unstated mandate of the RBI seems to be that it has to manage the exchange rate and prevent it from depreciation.

Fourth, the government needs to put an end to the foolish notion that the RBI can target WPI. The bulk of the items in WPI are tradables. Their prices are determined in international markets. WPI inflation closely follows the US producer price index based inflation rate. Inflation in WPI is determined by global commodity prices and not by domestic monetary policy. In other words, targeting WPI would be akin to targeting global commodity prices, something no central bank has control over. It is not surprising that no country ever tries to target it.

From the point of view of the domestic mandate, inflation measures based on CPI are the most common target for inflation-targeting countries. A couple of countries strip CPI of volatile food prices, but most central banks mainly use such a concept of “core inflation” in their internal models. CPI is the measure consumers relate to. WPI does not represent anyone’s basket, and at best, represents the price of inputs and outputs for producers. The choice of CPI is superior to the WPI because it measures the cost of living for consumers. Even though food is volatile, but because it matters to households, it is the rise in cost of living they care about. After all, governments adopt inflation targeting as the mandate they give to central banks because they want voters to have low and stable inflation. Incidentally, they also hand over this task to central banks so that if people get unhappy, such as with rate hikes, it is the central bank that gets blamed. Swamy seems to be doing pretty much that.

Sort out the tax maze

Indian Express, 9th April 2016

The government has ordered a probe into the leaks. But there are thin lines between the legal and the illegal.

The Panama Papers reveal that countries with much simpler tax laws, lower costs of compliance and a stronger administrative capacity to enforce laws than India have not been able to prevent the use of tax havens. In India, tax rates are higher, the system is complicated and capital controls restrict foreign financial transactions. Tax havens are more likely to be used not just for illegal activity but even for legitimate businesses.

The government has ordered a probe into the leaks. But there are thin lines between the legal and the illegal. The difference between tax evasion and tax avoidance is one such line. Tax evasion involves not paying taxes on your income and is illegal. Tax avoidance, on the other hand, is about managing your taxes across different tax jurisdictions to take advantage of differences in tax rates, such as corporate tax rates, in tax treatment of different kinds of income, such as capital gains, and in tax treaties among countries. Tax havens such as Panama, the British Virgin Islands and the Bahamas try to attract business by offering low tax rates and easy compliance.

Officials from OECD countries on the Panama list are under public pressure because they have been advocating that tax avoidance, though legal, is cheating. A number of OECD initiatives have been taken to reduce tax avoidance: An agreement on Base Erosion and Profit Shifting (Beps) aims to prevent companies from choosing low-tax jurisdictions to book profits in. The Automatic Exchange of Information (AEOI) framework will facilitate information flows among signatories. The Foreign Account Tax Compliance Act (Fatca) targets non-compliance by US taxpayers and compliant countries have to provide customer information to the US government.

In addition to tax avoidance, as tax havens have laws to ensure greater confidentiality of companies and banking secrecy legislation, the companies may be used for money laundering. In general, there is a widespread perception that offshore companies are conduits for money laundering, illegal transactions, tax evasion or parking unexplained wealth. While offshore companies may be used for illegal purposes, law-abiding citizens may hold them for making investments in other countries to help navigate the complex maze of tax treaties and multiple jurisdictions involved in managing tax liabilities. Hedge funds that manage money in multiple countries often use tax havens to reduce compliance costs arising from different tax treaties among jurisdictions.

The Indian case is more confusing than those of OECD countries. It has been made complicated by a set of tax laws that makes compliance more costly than in the OECD. We rank 157 in the ease of paying taxes. Further, the effective tax on profit is higher: The corporate tax rate and the dividend distribution tax put together make the tax rate on profits nearly 50 per cent. The capital gains tax makes financial transactions even more unattractive. This regime is made more tortuous by an onerous set of capital controls.
As a consequence, companies operating globally have every incentive to set up companies in such jurisdictions.

There are some cases in which the actions are clearly illegal. The first, for example, is when the underlying activity is criminal,
say, drug or arms trade. These activities are covered under the Prevention of Money Laundering Act. As a member of the Financial Action Task Force, India works with other member countries to prevent the use of the proceeds of crime.

The second is when there are cases of tax evasion: A person does not declare to the tax authorities in her home country her income, which is paid into a bank account of her company in Panama, and no taxes are paid. Here, a distinction between tax evasion and avoidance is relevant. If taxes have been paid in the tax haven at its lower tax rate, then there may be no illegality. When India introduces the General Anti-Avoidance Rule (Gaar), some of these activities may become illegal.
The third case is if there is a violation of capital controls. This is an India-specific issue. Under the Liberalised Remittance Scheme (LRS), every Indian resident is allowed to invest $2,50,000 abroad every year. In 2004, the limit was one-tenth of this. Money remitted abroad is from income on which tax has already been paid. If the amount invested abroad exceeds the amount allowed by the RBI, it is a violation of the law.
Fourth, the illegality may be the non-declaration of assets held abroad. A provision in the Finance Bill introduced in 2015 made it criminal not to declare foreign assets in annual tax returns. If the assets held in tax havens have been declared, then it is not illegal to hold them.
OECD countries have simpler tax laws with lower tax rates and lower compliance costs than India and no capital controls. The focus of the authorities is to broadly keep business in the country and to tax the income of its residents. Yet, the Panama Papers show that even with much simpler systems and more effective enforcement, it is a challenge to prevent illegitimate cross-border flows.

In India, it is not just entities engaging in crime and tax evasion that have offshore companies. Reports suggest, for example,
that many Indian technology start-ups are moving their headquarters to offshore locations due to our complexities. These muddy the waters as both legal and illegal activities move abroad.

Looking forward, first, rationalisation of capital controls should be a top priority. Many government reports have laid out the path forward. Second, India must move to a simple tax regime with lower compliance costs. The blueprint is ready in the Direct Taxes Code. When countries with simpler laws and better enforcement are not able to prevent violations of the law, we cannot hope to do so with our labyrinth of capital controls, maze of tax laws and much weaker tax administration.

La-la land budget

Indian Express, 2nd March 2016

Official GDP data is embedded in its vision and strategy. But the numbers seem wrong.

Finance Minister Arun Jaitley presented his first two budgets amid high expectations. He was supposed to usher in bold reforms, push up investment, revive India's engines of growth and create an environment in which domestic and foreign capital felt confident of investing. The budget speech was expected to outline a roadmap for liberalising the economy. It was hoped to be more reformist than the budget speech of 1991.

Budget 2016 was presented under completely different expectations. Fingers were crossed that Jaitley would not deviate again from the path of fiscal consolidation. It was hoped that the strategy of borrowing more for public investment would not be tried again. Markets prayed that an impending rejig of the long-term capital gains tax was just a rumour.

When the budget was announced, most heaved a sigh of relief. Many bad ideas had been kept out. A few good ideas had crept in. Jaitley decided that it was more important to stick to deficit numbers. There was no mention of the long-term capital gains tax. Public spending was more or less budgeted to be under control. Whether this was done to persuade RBI Governor Raghuram Rajan to cut rates, to protect India's credit rating, or out of genuine concern about the debt-to-GDP ratio, it was a relief.

Some worry that the budget numbers are based on unrealistic assumptions, that these numbers can never be achieved. Others feel that there has been a shifting of budgetary allocation from mundane-sounding heads to more politically correct heads. Still others find that investment in roads and railways will now be done by off-balance sheet borrowing. Yet, on the whole, there is cheer.

The need of the hour is a rate cut. And for that, we needed an announcement of sticking to the path of fiscal consolidation.

It is now hoped that Rajan will cut interest rates, will cut them soon and will cut them by a significant amount. Further, it is hoped that he will ease liquidity in the banking system so that the policy rate cut is transmitted to other interest rates. Lower rates would ease the interest burden on industry and prevent further damage to balance sheets. Hopefully, it will also eventually help spur investment.

Given the poor transmission mechanism of monetary policy and the weak balance sheets of banks, hopefully Rajan will also allow the rupee to weaken. A depreciated rupee would help make imports more expensive and exports cheaper, thus giving a boost to demand for industry.

Other than the impact of the budget on boosting growth through the easing of monetary policy and a more competitive currency, there is little else in the budget that will help push investment. For example, the retrospective tax was not repealed. Only assurances about the good behaviour of the income tax department were given. Similar assurances have been made in the past. The reduction in the corporate tax rate did not take place as promised. There was little progress on disinvestment or privatisation. There was no serious cut in food or fertiliser subsidy. Rural distress and low income growth in the farm sector received significant attention in the budget speech, though, fortunately, not that much in terms of budgeted expenditure.

One explanation for why the economy does not need more reforms could lie in the GDP numbers. The logic seems to be as follows: We've already achieved high growth. GDP growth has now accelerated to 7.6 per cent. The increase in Central government capital expenditure has revived investment. The government converted the difficulties and challenges it faced when it came to power into opportunities. Make in India, Skill India, Digital India and a host of other initiatives have yielded results. We are growing faster than China or anyone else.

Mission accomplished! Now we can turn our focus away from growth to redistribution. The redistribution should be done better, with lower leakages and improved targeting. Money should go to the poor and to farmers. More taxes and more transfers can reduce distress. That is why the focus of the budget is not on reviving investment and growth.

While it is all very good if the GDP numbers could be relied upon to tell us the state of the economy, few today have faith in these numbers. Most of us, including macroeconomists like me who have spent most of their lives studying GDP numbers, no longer understand what GDP in India means. This is not to doubt the CSO's methodology in correctly measuring value-added or its sincerity in deflating it with what it believes is the correct deflator; this is more a case of complete bewilderment.

In the past, when production, profits, wages and jobs grew, GDP growth would be healthy. If production was falling, the GDP would fall. Perhaps it was all a play of a healthy inflation rate in which simple calculations made in our heads would make sense. Today, when the volume index for manufacturing is showing tepid growth, we learn that manufacturing GDP is growing very fast. When the net sales of companies are flat, we learn that wages and profits are growing. When bank credit growth is slow and banks are not lending, we are told we need to deflate them correctly and that will turn bank credit growth upside down.

Regardless of what the GDP numbers say, however much they point upwards, almost everything tells us that the economy is looking down. Focusing on GDP numbers hides the danger that we may be living in la-la land. Unless we acknowledge that there is a problem of slow growth and low investment, we do not worry about how to solve it. Perhaps that is why the budget did not focus on investment revival.

There are a few good initiatives in the budget but none that reflects the urgency of the situation. In other words, official GDP data is embedded in Jaitley's vision and strategy. If the GDP does not reflect the true state of the Indian economy today, these may need a reassessment.

Lecture series on the Public Economics of Health Policy in Developing Countries

Jeff Hammer will deliver five lectures at NIPFP in the coming week. All are welcome.

Let the rupee slide

Indian Express, 3rd February 2016

The economy is best served by lowering interest rates and blocking protectionism.

In its monetary policy announcement on Tuesday, the Reserve Bank of India (RBI) decided to keep the policy interest rate unchanged. One of the implications of this decision is for the rupee. High interest rates have helped in keeping the rupee strong in recent years. It appears policymakers wish this to continue.

But the recent slowdown in China and the depreciation of the yuan means India's external environment has changed significantly. While two years ago it might have seemed like a good idea to prevent the rupee from weakening, a rethink is now warranted.

In recent months, Indian industry has been facing sharp competition from falling international prices. As the budget-making process starts, demands for tariff hikes will get stronger. Accepting protectionist demands could impact downstream industries and have implications for India's international treaty obligations. Favouring certain sectors, especially those with a few large companies, can make the protection politically difficult.

One example of this is the steel industry where the world's largest producer of steel, China' has seen a slump in demand and has an industry suffering from overcapacity. The Indian steel industry is faced with an onslaught of cheap imports. It has, in response, been pressing for hikes in import duty on steel, imposition of a minimum import price and anti-dumping duties.

It can be argued that the government should do nothing, and allow the Indian consumer to benefit from lower Chinese steel prices. However, it is difficult for the government to ignore the state of the steel industry and job losses. The consequent higher probability of defaults on bank loans by steel companies may also push banks into further trouble.

Already, India is ranked No 1 in imposing the most protectionist measures since 2008. In 2015, India imposed the second highest number of protectionist measures, after Russia. For the fastest growing economy in the world, the policy of greater protectionism is becoming untenable.

We expect that in 2016 the pressure for protectionist measures may increase. Global trade has slowed down to nearly zero per cent growth. As the Chinese economy and Chinese exports slow down, Chinese authorities may to try to help push exports.

For one, the Chinese renminbi was devalued. For years, the Chinese currency had seen pressure to appreciate. The slowdown, the pressure on exports and China's decision to depreciate seem to have set off an outflow of dollars from China. Today, the pressure is for greater depreciation. The pace of depreciation has been slowed by foreign exchange intervention. China has been selling dollars. We have seen a decline in its foreign exchange reserves by $513 billion in 2015. In the month of December 2015 alone, China's reserves fell by $108bn. With higher pressure to increase exports, China may allow the yuan to depreciate more.

The most likely direction of the yuan is downwards. In response, other emerging economies are also weakening their currencies. It is not difficult for an emerging market (EM) to do a currency depreciation in today's environment. It does not require cutting interest rates, out of line with macroeconomic conditions. Global growth has slowed down and commodity deflation is putting downward pressure on prices. Following the increase in US interest rates by the Federal Reserve, emerging economies have been witnessing outflows of capital. This is putting pressure on EM currencies to weaken. Indeed, today it is harder for an EM central bank to prevent a depreciation than to allow it.

If other currencies depreciate, it will further make India's imports cheaper and increase the demand for trade protection. However, tariffs are not the only way to protect domestic industry. As is being seen globally, an alternative approach to raising tariffs to tackle the loss of competitiveness of domestic industry is currency depreciation. In the above example, the impact of a 10 per cent depreciation is equivalent to a 10 per cent tariff on all steel imports. Depreciation increases the price of imported goods.

Last week, when Japan adopted a negative interest rate strategy, currency considerations are understood to have played a significant role. While deflation has been around in Japan for a while, the challenge from the yuan and the decline in commodity prices is new. The cut in Japanese policy rates will, it is hoped, depreciate the Japanese yen and increase import prices.

Today, when other countries are protecting themselves by allowing currency depreciation, should India lean against the wind? Should we combine a strong rupee policy with protectionism?

Allowing the rupee to depreciate has further benefits: It makes all imports more expensive. The government does not have the politically difficult job of increasing tariffs case by case. A weaker rupee would also help push Indian exports.

From 2009 to 2013, in the period of high volatility in the global economy, India had a largely flexible exchange rate policy. Since May 2013, India's exchange rate policy has been to prevent significant appreciation or depreciation. Since the taper talk and expectation of rupee depreciation in May 2013, an increase in interest rates and liquidity tightening have prevented any significant weakening of the rupee. Debt flows have been large as the differential between domestic and international interest rates remains high.

Everyone does not want a weak rupee. Foreign investors applaud the strong rupee policy as it protects their returns. Rich Indians like cheap foreign holidays and imported goods. For some people, a strong rupee is a matter of pride. However, the policy of keeping the rupee strong and combining it with protectionist trade measures is unsustainable. Exchange rate policy and strategy for 2016 cannot be the same as it was before the Chinese story started unfolding. The RBI and the commerce ministry need to be on the same page. The government must take a holistic view of the policy strategy on protectionism, the exchange rate and interest rates. The Indian economy would be better served by lower interest rates, blocking protectionism and letting the market determine the price of the rupee.

Be tight-fisted

Indian Express, 18th January 2016

The 'tight fiscal, easy monetary' policy mix can better address problems that plague private investment.

The finance ministry has stressed that it will stick to the path of fiscal consolidation. This is good news. While a move away from the announced targets to give the economy a stimulus may have seemed attractive in light of the signs of slower growth, the policy would not have been the most suitable for reviving investment, the biggest challenge facing the economy.

After the mid-year review suggested that fiscal targets may need to be revised, many economists emphasised the benefits of staying put on the announced path of fiscal consolidation. First, the debt to GDP ratio would remain under control. Equally important, the finance minister would maintain his credibility, particularly since he has already deviated once from the path. The decision of the government to stick to the path of the announced fiscal targets is good not just in the long run. It is also more likely to help in the short term.

One immediate gain of sticking to the path of consolidation will be to create space for monetary policy easing. The sharp decline in global commodity prices and the slowdown in demand in the domestic economy have reduced inflationary pressures. The policy interest rate - that is, the repo rate - stands at 6.75 per cent. Unlike, say, in Europe, where there is no scope for cutting the policy rate that is near zero, in India, there is ample scope to cut it. But while in principle the policy rate can be reduced significantly, the question is how to give monetary policy the space to do so.

A fiscal stimulus would increase the likelihood of demand rising and pushing up the inflation forecast. While deciding the policy interest rate, monetary policymakers target the forecast of inflation and analyse the pressures of demand on core inflation. With a slowdown in global demand, investment and domestic deman, a greater easing of the stance of monetary policy may be more possible today than perhaps even a year ago. This opportunity could be lost if the government had chosen to pursue a policy of fiscal expansion.

Monetary easing in the last one year has been cautious. A number of factors were responsible for this. One, the United States Federal Reserve was expected to raise interest rates in 2015, which could impact volatility in financial markets, especially currency markets. Two, there was a sharp increase in the prices of food items like onions and pulses, feeding into higher food inflation. Three, right at the beginning of the year, the government moved away from the path of fiscal consolidation. The fact that the policy rate was eased by only 125 basis points over the year, though inflation fell by about 500 basis points, can partly be explained by fears of rising inflationary pressures later. Today, when the Fed has finally raised rates and food inflation is expected to remain within control, deviating from the path of fiscal consolidation could keep fears of inflationary pressure alive and keep monetary easing cautious.

A loose fiscal policy would, therefore, have effectively meant that policymakers would be choosing the "loose fiscal, tight money" policy mix. This is sometimes justified by arguing that, given the poor transmission of monetary policy in India, its impact is limited compared to that of public investment, which involves direct spending by the government and raises demand instantly. While, in theory, this may hold, there are two reasons this may not be true in India today.

First, the capacity of the government to spend is limited. A large share of the capital expenditure allocated in Budget 2015 is yet to be spent. Many good plans have been approved and money allocated, but the shovel is yet to hit the ground. While, in theory, public investment can spur private investment' limited state capacity may be one reason why the magnitude and lags involved may make this strategy less optimal than theory suggests.

Second, private companies are unable to repay the interest on their debt. Banks are increasingly seeing loans get in trouble. High interest rates hurt not just the companies whose revenue growth has fallen sharply but also banks whose stressed assets have been on the rise. For private investment to pick up, companies need to have the ability to borrow, and banks the ability to lend. Raising demand through a fiscal stimulus does not address the balance-sheet stress of companies and banks, while a reduction in interest rates would.

Early in 2015, the government and the RBI adopted inflation targeting as an objective of monetary policy. Inflation targeting is adopted by governments and central banks to tie down their own hands. The benefit of low inflation goes to the elected government that gains by way of providing a low-inflation environment to citizens. While endless arguments can be made about the effectiveness of monetary policy in India, the efficiency of the transmission mechanism, the role of food inflation, and so on, there is little doubt that the objective of low inflation is consistent with the preferences of the bulk of the population. The suggestion made by some economists that the government should rethink and review its commitment to inflation targeting, instead of finding ways to meet it, is unwise.

The best strategy for the government, therefore, lies not in giving up the inflation target, or in changing the measure of inflation adopted, the consumer price index, because it is higher than the wholesale price index, or in changing the glide path towards the target, but in creating the conditions that would keep inflationary pressures down.

In the present context, adhering to the announced path of fiscal consolidation would allow the "tight fiscal, easy monetary" policy mix that is more suited to addressing the troubles that plague private investment. The RBI should respond to this commitment by cutting interest rates. There is clearly no magic bullet for reviving investment. However, a reduction in the interest burden could possibly prevent more companies from going towards bankruptcy. This is a greater need of the hour than higher demand.