Friday, 3 February 2017

Not with a bang

Indian Express, 2nd February 2017

FM springs no surprises. Nor responds adequately to slowdown in private investment.

Budget 2017 took place under the shadow of demonetisation. What would the follow-up actions be, especially as the outcomes from demonetisation have been disappointing compared to its stated objectives? The budget has proved to be a quiet affair. We are left with relief that erratic actions have not been taken. At the same time, there were few steps that would address the biggest concern about the economy - the slowdown in private investment.

Before the budget speech, there were several scenarios which were being talked about. Would the budget propose other radical measures like a banking transaction tax or the removal of income tax proposed by Artha Kranti? Would the budget try to soothe demonetisation’s pain by sending transfers and tax breaks to the affected? Would the fiscal deficit be increased to alleviate its contractionary impact?

The demonetisation experiment was a negative shock to the economy. Some people were proposing that this should be offset by a fiscal expansion. The finance minister (FM), however, stuck to a modest fiscal deficit. This makes sense for many reasons. First, a larger fiscal deficit could have hurt India's credit rating. A fall in ratings could have lead to a flight of capital and a rupee crisis. Second, providing a fiscal stimulus would be tantamount to accepting that the negative demonetisation shock has consequences beyond the present quarter. This may not be something the government is ready to admit. In terms of providing a positive shock by expanding expenditure, the capacity of the state to spend funds effectively is limited. The budget speech did well in not announcing big subsidy programmes. There was a sharp increase in the expenditure of MNREGS. This may be consistent with the increased utilisation of MNREGS owing to demonetisation that appears in the initial data. It has to be kept in mind, however, that the prime minister’s speech on December 31 announced many traditional subsidy programmes.

The overall emphasis on subsidies is larger than meets the eye.

At a conceptual level, perhaps demonetisation and the associated political strategy is more about being anti-rich than being pro-poor. In the past, populism in India has involved inventing subsidy programmes that help the poor. This government has tried to make poor people happy by pointing to the distress of the rich. Perhaps this would imply that the budget would also take actions which could be positioned as being anti-rich, such as raising tax rates or avoiding reforms. There could have been a number of measures that fitted the bill, such as a wealth or inheritance tax. It is not clear what the impact of these would have been. The FM proposed a surcharge on income between Rs 50 lakh and Rs 1 crore.

When faced with economic difficulties, another way through which fiscal policy can be expansionary is to cut taxes. One long-standing area for Indian fiscal reform is bringing down the corporate tax rate. In Union budget 2015, the FM promised that the Indian corporate tax rate will be brought down to 25 per cent. One concern for not doing this for the corporate sector may have been the risk of being called pro-rich. Another may have been the uncertainty that removing exemptions could have introduced at this time. The rate could not have been cut for large corporates that contribute to most of the corporate tax collections, without removing exemptions, or it would have led to a dip in revenues, something the government cannot afford at this point.

A compromise has been achieved by proposing a lower, 25 per cent tax rate for small companies whose income is under Rs 50 crore per year. At a political level, this can be seen as reaching out to small businesses. One can also hope that they would help to improve compliance by smaller companies.

Similar moves are visible in personal income tax, where tax rates were cut at low incomes and increased at higher incomes. These moves are consistent with the populist, anti-rich stance. Respect for Indian policymaking capacity was at a low after demonetisation. Expectations for the budget speech were low. The pessimists expected an escalation of erratic measures crafted by non-experts. The prevailing mood seemed to support doing things that were bold and that no reasonable country had tried before. Fortunately, the budget did not propose a universal basic income, a banking transaction tax, a cash transaction tax or any other untested idea.

In terms of institutional reform, the budget speech was necessarily silent on the big story: The Goods and Services Tax.

A sound GST is one with a low single rate, comprehensive coverage and a single administration. Many compromises have already been made which ensure this will not come about. The extent to which a sound GST is delivered will have a major impact on the coming years.

On financial sector reform, some old policy initiatives are gradually going towards execution. The abolition of FIPB was long overdue and is a welcome step. The Resolution Corporation will deal with the failure of financial firms.

In summary, while the FM should be given brownie points for staying on the conventional path and not giving any big surprises, he also did not respond adequately to the serious slowdown in private sector investment India has seen in recent decades.

Monday, 16 January 2017

Reserved Bank of India

Indian Express, 14th January 2017

Demonetisation showed India's central bank is too opaque. Its decision-making must be open to scrutiny.

The RBI board's decision to recommend withdrawal of legal tender of high denomination notes after a short board meeting is seen as a loss of independence of the RBI. The recommendation was based on advice by the government that the RBI Central Board should consider such a decision. The RBI board was within its powers to turn it down. It could have directed the management to give it a report on the costs and benefits involved and taken a considered decision in its next meeting. Why did it not do so? Why could the government take the RBI board for granted?

To figure this out, we need to look at how the RBI Central Board normally makes decisions. As an example, we consider how the RBI Central Board decides the annual expenses of the RBI; a relatively important decision about spending public money. The RBI annual report shows the RBI’s annual expenses in 2014-15 were Rs 13,356 crore. These are comparable to the annual expenditure of many states in India, and many times bigger than that of most central banks and regulators in India and abroad. Nearly a third, or more than Rs 4,000 crore, is spent on RBI staff salaries, superannuation, housing, maintenance, directors’ fee and board meeting expenses. Such a large use of public money requires adequate scrutiny.

The board would discuss and approve the expenses and fulfill its role of controlling excessive expenditure by the management. However, there is no evidence available that the board even discusses this enormous annual spend of the RBI. Further, there is no evidence that the board looks after the public's interest in the event that there may be a conflict with the interests of the management. This is something the Board would have been expected to do. The decision seems to be taken mainly by the management - without the scrutiny of the Board.

How could such an arrangement be possible in today's India? The answer lies in the text of the RBI Act. In 1934, India's British rulers did not see a role for defending public interest which could be in conflict with the interests of the RBI management - the sections of the Act relating to the functioning of the Board have not been amended even after Independence. Through regulations made by the Board (Regulation 15 of the RBI General Regulations), the board created a "Committee of the Central Board" to which it delegated all its powers. The management may invite a couple of directors to meetings of the Committee, based on whichever directors happen to be in Mumbai at the time. This Committee can meet often and take all decisions that are then approved by the Board - in effect, the RBI Central Board has abdicated its responsibilities to the people they were supposed to have oversight over, that is, the management.

A normal governance practice is to create committees of a board with specific mandates and come back to the board for decisions, rather than take decisions. All decisions are taken by the board. In the case of the RBI, all the general powers of the Central Board have been delegated to the Committee of the Central Board - the Committee of the Central Board virtually can do everything that the Central Board can, under the RBI Act. This defeats the spirit of collective decision-making at the Central Board-level and circumvents the necessity of obtaining votes of the majority of members of the Central Board. The minutes of the Committee are placed before the Central Board; this serves little purpose as decisions are already taken and members did not participate in them. The Central Board effectively becomes responsible for all decisions of the Committee without deliberations - while the Committee has no accountability on how it discharges its duties.

The regulation that empowered this Committee to transact all the business of the Central Board was made in 1949. For decades, the RBI board has functioned in a manner in which it did not deliberate on the most important decisions of the functioning of the RBI. This suited the management, which did not have public accountability in this unusual set-up. The management's functioning has consequently become a black box with no scrutiny. The Board functions in a manner that would not be acceptable even for a private company as it would violate company law. Today, Parliament may find fault with the demonetisation decision and blame the RBI for not asserting its powers or the governor for not doing his job properly. But if the Board continues to function in this manner, the problem will remain.

A related issue is that of transparency. The RBI does not make the Board agenda or minutes public. This lack of transparency is not just about this episode, when an RTI enquiry about Board minutes was turned down. Even the minutes of Board meetings held five years ago are not made public. If the Board was required to make its proceedings public, would it have continued to behave in this manner or would public scrutiny have prevented such functioning?

This takes us to the question of what is gained by transparency. Why are the agenda and minutes for board meetings of regulators or central banks in India and abroad made public? In the minutes, only a few specific decisions, such as those related to specific companies or trade secrets that the law prevents regulators from revealing, are held back. The answer lies in the understanding that along with transparency comes autonomy. When participants know that discussions of the meeting will be made public, they, as well as those who may be sending letters or advice to the Board, behave more responsibly. This reduces the chances of the Board being pressured or taking hasty or irresponsible decisions.

Parliament must examine in detail the functioning of the RBI Central Board. The RBI must be required to make public minutes of all past meetings of the Central Board. The agenda of every meeting should henceforth be public. If there are to be any exceptions based on national security, it is Parliament that should decide. The Board must not be allowed to abdicate its responsibility. Unless Parliament amends the law and enforces a well-functioning Board, the RBI will continue to be a weak institution and fertile ground for further mistakes.