Lessons from a fraud

Indian Express, 17th February 2018

PNB scandal points to unreformed financial sector, failure of risk management and auditing systems

The Punjab National Bank-Nirav Modi scandal has, once again, given rise to questions about public sector banking in India. The mixing of the business of banking with government is fraught with difficulties. Public ownership effectively reduces the RBI’s powers to punish managements and boards of banks when they fail to perform their key role of managing risk. Rules of hiring and salary, political pressures, lack of accountability and the implicit sovereign guarantee of PSBs create the wrong incentives.

While the blame-game is on for l’affaire Nirav Modi, India needs to address fundamental questions about ownership of banks and the difficulties it creates. This is not surprising given the public support for PSU banks. Public sector ownership comes with an implicit sovereign guarantee.

For instance, depositor angst about the Financial Resolution and Deposit Insurance (FRDI) bill has been mainly because it has brought into the public debate the fact that all deposits are not guaranteed. Most depositors are not aware of the Rs 1 lakh limit of deposit insurance. The realisation that deposits above one lakh may not be safe if a bank fails, even if the bank is owned by government, is creating huge discomfort. Whether a bank is involved in fraud, as allegedly in the case of the PNB, or whether it has made bad judgements about business loans, depositors have been looking towards public ownership rather than the competence of the bank management for keeping their savings safe.

Given that there are few avenues for safe financial savings, this is to be expected. On the one hand, India forces banks to hold government bonds through the Statutory Liquidity Ratio. On the other, it does not allow households to lend to the government through small savings schemes like the Public Provident Fund and National Savings Schemes beyond income tax rebates. Nor can households purchase risk-free government bonds through the stock market. Households which have low-risk appetite go through the public sector banking system to find avenues for their financial savings. The lack of other instruments in the financial sector, therefore, creates political pressure for public ownership of banks.

The PNB-Nirav Modi fraud highlights the failure of operational risk management and auditing systems. Regardless of whether it was inefficiency or fraud, what is the accountability of the management and the board of the bank? If the PNB was privately owned, would the impact of such a fraud have been only on the two officials arrested or directly involved?

It is reported that the RBI has asked the PNB to pay other banks who gave credit based on the PNB’s guarantee. If the PNB pays up and suffers losses, would it be the taxpayer who will fill in for these losses through further re-capitalisation of the bank?

How many times in the past have taxpayers paid the PNB and other public sector banks that were falling short? CAG Report No. 28 of 2017 titled “Performance Audit Union Government Recapitalisation of Public Sector Banks” says that GOI, as the majority shareholder, has infused capital of Rs 1,18,724 crore from 2008-09 to 2016-17 in PSBs for meeting their capital adequacy requirements. The government has announced that it is infusing another Rs 2.11 lakh crore into PSU banks. At the same time, bad loans in the banking sector are above 10 per cent of outstanding loans. According to the RBI’s Financial Stability Report, while NPAs are rising for both public and private sector banks, those for public sector banks could rise to as much as 14.6 per cent by March 2018.

What is the way forward? The answer may not lie in the over-simplified solution that public sector banks should be privatised. That would be part of the solution, but along with that, other reforms are needed.

First, there is a need to address the requirements of a large and increasing number of investors who should get greater access to mechanisms to lend to government. This may not even mean lower returns. Considering that today the government 10-year bond yield at above 7 per cent is higher than the fixed deposit rate offered by most banks, some could choose to invest in bonds directly through the stock market. This needs a reform of the bonds market.

Second, small savings schemes should be reformed. Direct lending to small savings schemes can be expanded beyond the tax rebate caps. Interest rates can be linked to government bond yields. Third, to address concerns about private banks the deposit insurance cap could be raised; Rs 5 lakh would cover 98 per cent deposits.

Fourth, if the government decides that PSBs should offer risk-free deposits above the cap on deposit insurance they should be allowed to invest only in government bonds, or, do “narrow banking”. Then the implicit sovereign guarantee could effectively turn into explicit sovereign guarantee. The business of giving loans, making decisions, figuring out risk management systems, hiring competent staff, provisioning for bad loans, creating mechanisms for accountability and punishing management when systems fail can be left to private banks. Today the taxpayer pays when PSBs fail to perform these functions properly. Narrow banking by PSBs can take this burden away from the taxpayer.

The reforms of 1991 changed the way business works in India. They allowed the private sector to set up production and import without needing licences. They fundamentally took government out of the role of determining how and what should be produced. However, what they failed to do was to take the government out of the role of financing production and trade. By maintaining a largely bank dominated financial system and keeping it public sector dominated, India tried to run a market economy on one leg. The other leg, of finance, that should have supported the market economy, has been dragging the economy down. More than 25 years after liberalisation, finance is increasingly emerging as the binding constraint which emphasises the pressing need for fundamental reform.

Union budget: Not as expansionary as it seems

livemint, 6th February 2018

Big announcements notwithstanding, the fine print suggests that fiscal deficit targets are likely to be met

The Union budget has raised concerns about macroeconomic stability, as reflected in some key budget announcements. An examination of the fine print suggests that while there may be some upside risks to inflation, fiscal deficit targets look likely to be met.

First, the full cost of the health protection scheme that promises Rs5 lakh per household per year appears to be more than what has been budgeted. Second, oil prices may rise while budget estimates seem to assume a scenario of benign oil prices and this may have fiscal implications. Third, the government has announced a 50% increase in minimum support prices (MSP) for the coming kharif crop that could lead to a higher deficit. In addition, the corporate tax rate for small enterprises has been cut to 25%.

On the first count, rolling out an all-India health insurance scheme is a challenging task. State capacity to deliver is limited. From the private sector side, good quality tertiary healthcare is still not available all across the country as would be required for this scheme. The supply response of the private sector to the incentives created by this scheme may take some time to realize.

In addition, regulatory capacity of, one, the health sector to regulate the private providers, and, two, the health insurance sector to make sure fraud does not become rampant will take time to develop.

Further, states need to come on board as well for this scheme. Many of them already have their own insurance schemes and will need to replace old schemes. The transition from old to new schemes may require time. This may mean that the new scheme will have limited expenditure in the current year. The allocation of only Rs2,000 crore suggests that this may indeed be the expectation of the government as well. This may mean that the impact on the deficit of the health insurance scheme may be limited.

Oil prices have been rising in recent days. This could put an upward pressure on fuel prices. When global oil prices were falling, the decline in price was not passed on to the consumer as the government increased excise duties. It remains to be seen whether the government will try to keep the price of oil stable. If oil prices rise, would excise be cut to cushion the consumer from the price rise? If so, how would this impact excise collections?

Further, the impact of the oil price hike on fertilizer subsidy will be another issue to contend with. The oil price hike would also mean a larger import bill and a higher current account deficit. This could possibly put downward pressure on the rupee.

In the past, it has been seen that increase in MSP has led to food inflation. Another channel through which the impact of the MSP hike could be inflationary is through a larger fiscal deficit. There are two possible models through which higher MSP is paid to farmers. One is via actual procurement of foodgrains by the Food Corporation of India (FCI) from farmers, which pays MSP to farmers.

However, given that the capacity of FCI to procure all the foodgrains listed across the country is limited, the alternative is to directly pay farmers the difference between market price and MSP. Anecdotal evidence suggests that the scheme benefits traders. In places where this scheme has been tried, it has been found that the difference goes to a large extent into the hands of traders who pay farmers low prices and collude with them to pass on the additional payment to them.

This could mean a big payout by the government but not an equal increase in the income of farmers. If “leakage” arising from this flaw in the scheme could be limited, the deficit could remain under control

In the budget speech of March 2015, the finance minister had promised to bring down the corporate tax rate to 25% over a period of four years. This promise was made on the grounds that the regime of corporate taxes in India needed to be rationalized, exemptions to be removed, and tax rates to be brought down to globally competitive levels. By the end of four years, the corporate tax rate has been cut only for smaller enterprises, which account for roughly less than 10% of corporate tax payments. The remaining corporates will still pay higher taxes.

One reason for not going ahead with the reform has been the difficulties in removing exemptions. If the finance minister had gone ahead with reducing the corporate tax rate for all enterprises without removing exemptions, collections would have suffered. While it is a pity that the reform has not been attempted, the effect of the rate cut on the deficit would be limited since only a small share of tax collections will be affected.

One clear impact of the budget will be higher personal income tax collections on account of the long-term capital gains tax, dividend distribution tax for mutual funds and the increase in education cess. As the GST (goods and services tax) regime is simplified, we may also see a pickup in GST collections.

What does all this mean for inflationary expectations and monetary policy?

Over the past one year, the monetary policy committee (MPC) has repeatedly raised concerns about the fiscal deficit. Whenever rates have not been cut despite inflation being around or even below the target of 4%, the MPC has pointed to fiscal slippages and possible higher borrowing due to the Seventh Pay Commission, and higher house rent allowance. Though the MPC may have concerns about the fiscal deficit, if the limited capacity of the government’s delivery mechanisms is taken into account, the MPC should not be overly concerned. This can create space for an accommodative stance of monetary policy.

Behind the plunge

Indian Express, 8th February 2018

High volatility of stock markets is a response to global movements, domestic concerns over disruptions

The last few days have seen stock markets witness a sharp fall and high volatility. Developments in the Indian markets are related both to global financial markets as well as to domestic policy. Markets also factored in the effect the budget would likely have on the RBI’s monetary policy decision.

One important perception in recent months has been that the market was perhaps overvalued. The last 10 years of data show that the “trailing” price-to-earnings ratio of a broad measure of companies was historically high. In other words, earning growth has been stagnating, but markets have continued to expect that earnings would pick up. This expectation kept stock prices high. The feeling that there may be an asset price bubble appears to be part of the rationale for bringing back the long-term capital gains tax in the budget. If the intent was indeed to bring about a correction in equity prices, by putting tax and additional compliance costs for households, then the process appears to have started. A dividend distribution tax on dividend paid by mutual funds is similarly expected to make equity mutual funds less attractive. The process of correction has been more than helped by global market movements.

Global markets moved sharply after there was a surprise increase in US pay-roll data. The US job market numbers showed an addition of 2,00,000 jobs in January 2018. Along with the increase in jobs, primarily in the private sector, wages witnessed a more than expected increase. This led to the expectation that the US economy may be picking up faster than expected. Inflationary pressures due to higher economic activity and the increase in wages may lead the Federal Reserve Bank monetary policy to be tightened faster than previously expected. As a consequence, interest rate increases could be more than what the markets were expecting. This change in the perception about future liquidity conditions appears to have hit US financial markets and with them, markets across the world. Indian markets, too, moved down.

At the same time, there were concerns that the RBI would adopt a tighter stance of monetary policy. In the policy announcement on Wednesday, February 7, the RBI has kept the policy rate unchanged. However, the Monetary Policy Committee has raised concerns about inflation. Its projection of inflation is higher than the target rate of 4 per cent, suggesting that it may think about raising interest rates at some point to bring it down. Any perception that interest rates would rise and liquidity will tighten tends to make the stock market less attractive.

According to the Monetary Policy Committee, risks to inflation arise from the effects of higher house rent allowance, higher custom duties, higher minimum support prices for kharif crops, higher oil prices and global commodity and financial markets.

A key concern is the fiscal deficit. The RBI notes that the fiscal slippage as indicated in the Union budget could impinge on the inflation outlook. It adds that apart from the direct impact on inflation, fiscal slippage has broader macro-financial implications, notably on the economy-wide costs of borrowing which have already started to rise.

The RBI has pointed to commodity prices, which have been rising in recent days. There could be an upward pressure on fuel prices. This could have a direct impact on the subsidy bill. Further, when global oil prices were low and declining, the benefit was not passed on to the consumer. The government increased excise duties. If the government tries to keep excise the same, to maintain its revenue, there may be inflation. If, on the other hand, it cuts excise, the fiscal deficit may rise. Both are reasons why the RBI may raise interest rates. Only if global oil prices do not rise will neither of these happen.

The other key concern is the increase in MSPs of crops in the budget. In the past, it has been seen that an increase in miniumum support prices has been correlated with high food inflation. This was in a system in which the key foodgrains procured were wheat and rice, both of which were important elements of the consumption basket. Now almost all crops are part of the list of crops to be procured. Higher procurement prices could feed into higher food prices. Alternatively, if they are sold to consumers through the Public Distribution System at below the cost of procurement, there will be an increase in the subsidy bill. This could push up the fiscal deficit and again be inflationary.

The huge increase in the coverage of the health insurance scheme in terms of both the population covered and the amount of payout means that health insurance premiums paid by the governent could rise if the scheme is implemented as promised. The fiscal impact of this in the coming year may be small due to the lack of the government’s capacity to deliver, but as the system is put in place and people start using the scheme, there may be a significant expenditure increase.

At the same time, it is not clear that the impact of the GST on additional revenue will happen immediately. It is not just that compliance takes time, it is also hard for producers in the informal sector to suddenly become 12 per cent or 18 per cent more productive so as to be able to pay higher taxes and survive in the formal sector. These disruptions, which will have long-term gains for the economy, may lead to difficulties in the short run. This again mean risks to the fisc.

Even if this year’s fiscal targets are met, thanks to the government’s limited ability to spend and some good luck on global prices, it is only for the official fiscal deficit targets. Items like bank re-capitalisation bonds that do not show up as additional borrowing in the budget, and are not part of the fiscal deficit, nonetheless impact bond market conditions. Rising long-term interest rates and failed bond auctions by the RBI indicate that bond markets are already seeing a tighening even without a monetary policy announcement.