Going on a hike

Indian Express, 13th June 2018

Rate increase by RBI highlights conflict between its role as banking regulator and government’s debt manager.

In its most recent meeting, the Monetary Policy Committee (MPC) of the RBI raised the policy interest rate for the first time since it was constituted. The MPC expects inflation to be higher than its target of 4 per cent and the statement released by the committee indicates that interest rates may be raised again during the year if necessary.
The prime reason for the rate hike appears to be the increase in the Indian crude oil basket. The monetary policy statement does not point to an increase in the fiscal deficit as one of the risks for why it sees higher inflation, or needs to raise rates. On the fisc, the RBI monetary policy statement says that "the adherence to budgetary targets, which seems to be the case so far, will ease upside risks to the inflation outlook".

Many people have been asking whether the pain of rising in global crude oil prices will be made more palatable in India by a reduction in excise duty by the government. The indication from the RBI is that this will not be the case. If crude oil prices are expected to feed into domestic inflation, while the RBI expects the government to adhere to fiscal targets, it evidently does not expect the fiscal deficit to rise. Hence, it seems that the MPC expects that there will be no excise cut by the Central government. This belief is consistent with the statement by Niti Aayog Vice Chairman Rajiv Kumar, who recently said that since states impose ad valorem duties on fuel, they should cut those, thus indicating that the Centre may not cut excise on fuel.

If the government were to cut excise duty, it would have to borrow more. Government of India bonds, through which the government borrows, have seen increasing yields in recent months. Not only does this mean higher borrowing costs at present, but there also seems to be an unwillingness to hold more Government of India bonds by banks.
Many consumers may be disappointed by the lack of excise duty cuts on petrol and diesel as fuel forms a serious proportion of average household expenditure. However, at the moment, with jitters in the bond markets, at home and abroad, fiscal prudence may be the best bet to avoid not just further inflationary pressures that the RBI refers to, but also the risk of a more serious crisis in financial markets. The ability of the government to borrow at reasonable rates depends on the size of the borrowing programme, depth of the bond market and external financial conditions in both emerging markets and advanced economies, among other factors.

In recent weeks, bond markets in emerging markets have been jittery as the prospect of a US rate hike has increased. In addition, the brewing exchange rate and debt crisis in some emerging economies, the possibility of default by Italy, have led to fears of a bigger meltdown in global financial markets. In these circumstances, bond markets in emerging countries have seen an outflow of capital. Foreign investors have pulled out of Indian bonds as well. The Indian financial regulatory regime allows only a limited amount in government of India bonds to be held by foreigners. At present, the limit is not fully utilised. Sixty-eight per cent of the limit was utilised as of May 31, or out of a total available limit of USD 48 billion, USD 32.8 billion was utilised. If foreign investors sell Indian bonds, it puts downward pressure on the rupee. Though data is not available for the most recent period, as it is released with a two-month lag, the data for change in reserves suggests that the RBI has been selling reserves to defend the rupee.

The domestic bond market in India has been witnessing high volatility this year. More than 40 per cent of central government bonds in India are held by banks. When banks hold long dated government bonds, they run interest rate risk. In other words, if interest rates go up, bond prices go down, and banks have to show a loss on their books. A couple of times in the past, the RBI has allowed banks to not “mark to market” their losses, or book them, in the quarter in which the losses are made. However, a speech by RBI Deputy Governor Viral Acharya in January suggested that banks need to learn to manage this risk. Many read this as implying that the interest rate cycle may turn and bond prices may go down, and lost the appetite to hold more government bonds.

To some extent, the RBI already has a captive buyer in banks as they are required to hold a fifth of their assets in government securities under the Statutory Liquidity Ratio requirements. However, once these limits are reached, and banks don’t wish to buy more bonds, the job of the RBI as the debt manager of the government becomes more difficult. It can do “moral suasion”, which is basically telling public sector banks to buy more government bonds. But that is harder after telling banks that they need to manage interest rate risk. In other words, if the government stays with current borrowing targets, the RBI’s job is still not easy. If the government strays from the announced path by excise duty cuts, it could be raising the probability of a crisis in the bond and currency markets.

The most recent decision by the MPC brings out the conflict between the RBI as an inflation targeting central bank, and the RBI as the debt manager of the government whose job it is to keep the cost of government borrowing low. As an inflation targeter, the MPC raised rates, even though that may raise the cost of government borrowing further. This episode also brings out the conflict between the RBI’s role as banking regulator and the government’s debt manager. Because the RBI wants banks to be safe, Acharya asked them to manage their interest rate risk, even though it made it more difficult for the RBI to sell government bonds. It is not surprising that almost all developed economies have seen their central banks hand over the role of public debt management to an independent debt manager, a reform that is taking painfully long in India. Hopefully, for the RBI, the government may stick to its deficit targets despite the pressures of a pre-election year, and not make its job as debt manager even more difficult.

Is India Creating Jobs or Not?

Bloomberg, 18th May 2018

That’s the wrong question to ask.

In recent months, a sharp debate has broken out over whether India is or isn’t creating new jobs. Supporters of the government cite studies, such as those based on Employees Provident Fund data, that show rising job growth. Critics point to household surveys that show jobs being shed in the past year, after the government shocked the economy by suddenly withdrawing most cash from circulation and then introducing a complex goods-and-services tax.

Who's right? Both are - and both are missing the point.

Jobs data in India is notoriously bad and contradictory. The five-year National Sample Survey doesn't tell us about last year, and the Annual Survey of Industries data doesn't capture new industries or services. Given different definitions of employment and different sources of data - many of which are marred by flaws - simply agreeing on how to measure job growth in India is a well-nigh impossible task.

Broad jobs numbers in India aren't especially revealing in any case. Employment rates and rates of participation in the labor force vary significantly between males and females, with India having one of the lowest proportions of working women (28 percent) in the world. The old and the young similarly have low participation rates.

Meanwhile, data from household surveys suggests that men between the ages of 25 and 55 have no choice but to work; unemployment is a luxury they cannot afford. Almost all males participate in the labor force (79 percent). India thus boasts a very low unemployment rate of between 3 to 4 percent.

Yet, anecdotally, many Indians feel they can’t get the jobs they want. The image of thousands of applicants lining up to apply for a low-level government vacancy - which offers benefits and job security - has come to symbolize the desperation of the typical worker.

Any headline jobs numbers thus need to be examined more closely. Pessimists are right when they argue that demonetization and GST caused waves of layoffs in the informal sector, which employs the bulk of Indian workers. Many were fired in the months after demonetization, when employers didn't have the cash to pay them.

This shows up in the household survey data, which records a decline in labor-force participation rates in the past year. There's no point in denying the fact, as some government partisans have tried to do by citing signs of employment growth elsewhere.

At the same time, the optimists are right to argue that formal jobs are being created in India. This also makes sense, given the introduction of GST. The new tax is self-reinforcing: Now, when a manufacturer who pays the tax buys inputs for his products, he's better off buying from companies that are also in the tax net, so that he can get a corresponding credit for his purchases. As a consequence, the system favors GST payers.

Over time, this will shrink the size of India's informal sector and increase the number of formal-sector jobs. Many small firms - plagued by thin margins and low productivity - won't be able to pay the average GST of 12 percent and will have to shut down. In the long run, as more and more companies enter the tax net, production is expected to shift away from such firms almost completely.

This is good news: Companies in the formal sector are subject to inspections and labor laws, and their employees enjoy greater job safety and benefits. The more jobs created there, the better.

The question both critics and supporters of the government should be asking is how to speed up this process. Some state governments have attempted to relax labor laws and the central government has recently sought to liberalize contract labor. Progress is being made on increasing occupational safety and maternity benefits.

But the Industrial Disputes Act, which makes it difficult to shut down factories, remains in place. No doubt upcoming elections will make it even harder to usher in visibly unpopular reforms.

This shouldn't matter too much. In fact, companies already do have the flexibility to hire more workers, as the increase in formal-sector jobs would indicate. Reforms such as a new bankruptcy code should help. While it’s undergoing some birth pangs, the code should pave the way to freeing up capital and entrepreneurship that is stuck in unproductive uses and allow it to be reallocated efficiently.

The focus should be on similar measures that make it easier for companies in the formal sector to invest and expand - and thus to absorb the workers being shed by informal businesses. The process is likely to be slow and painful. But there are no short cuts - and, at least, the right kinds of jobs are finally being created.