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.

When the supervisor slept

Indian Express, 9th April 2018

PNB, ICICI could have averted malpractices if banking system had a mechanism that sounded timely red alerts.

The matter pertaining to the ICICI Bank’s CEO Chanda Kochhar goes beyond the question of propriety. It follows close on the heels of the Punjab National Bank-Nirav Modi fraud case. While the first case occurred in a government-owned bank, the second incident brought focus onto a private bank. In both cases, investigative agencies like the CBI and the ED have stepped in. The common missing factor is the bank supervisor.

Banking is a non-transparent business. Depositors do not know how their money is being invested. Loans are normally given on the basis of the bank management’s judgement. The management assesses the health of a company and its business plans and on the basis of that, decides whether to give the company a loan or not. Bank depositors, the ones whose money is being lent out, do not have information about the company. Regulation and supervision of banks have the objective of protecting bank consumers, reducing the risk of bank failure and limiting the systemic risk arising from the bank’s operations to the financial system as a whole. The supervisor examines the books of a bank with these objectives in mind. The supervisor is not, and should not be, involved in each loan decision. However, the principles based on which loans are given, the integrity of the management, the bank’s audit system, its IT systems and its risk assessment models do come under the bank regulator’s purview.

Speed is critical in ensuring that regulation meets its objectives. The pertinent question is: Does the supervisor catch loans getting stressed and becoming non-performing in time for the top managers or the board to be held responsible for their incompetence or complicity?

Evidence does not seem to suggest that banking supervision in India has, so far, been timely. In an earlier article (‘Extend and pretend,’ IE, October 31, 2017), I argued that the RBI has failed to spot stressed assets in time and created a huge burden for the tax payer. The banking supervisor had allowed banks to hide bad news and permitted them to continue ever-greening loans; this led to rising NPAs. In December 2017, gross NPAs in the Indian banking sector stood at Rs 8.4 lakh crore. This crisis alone brought a recapitalisation bill of Rs 2.11 trillion to the taxpayer. The NPA figures and the recapitalisation needed are likely to grow.

The PNB-Nirav Modi case and the ICICI conflict of interest case suggest further weaknesses in bank supervision. The PNB fraud will cost more than Rs 14,000 crore. If the lack of integration between the CBS (Core Banking Solution) and SWIFT (Society for Worldwide Interbank Financial Telecommunication) allowed PNB officials to cheat, there could be more such such cases hiding in other banks.

The ICICI case revolves around a loan given to Videocon from whose promoter an immediate family member of Kochhar may have benefited. The CEO was part of the committee that made the decision to give the loan. The loan was one in which there could have been a possible conflict of interest. It subsequently turned into a non-performing one. This does raise questions about the people involved and their ethics. But the episode also shows in poor light the systems which are meant to ensure that possible conflicts of interest are brought to the attention of the banking supervisor.

An important element of the story is the speed with which a malpractice is caught by the banking supervisors. Again, there is a parallel between the ICICI and the PNB case. In the PNB (and other public sector banks) there was a lack of integration between the CBS and the SWIFT system through which money was transferred abroad for Nirav Modi. The bank supervisor appeared to have been inadequately apprised of the magnitude of the damage that this lacuna could bring upon the bank. It did not promptly see the problem when it occurred and that allowed the beneficiaries to milk the system for many years before they were brought to book. In the ICICI case, recognition of the Videocon loan as a bad asset took a long time. Both cases appear to have festered for many years before the CBI or the ED stepped in. What steps did the RBI take in the two years since the allegations were made?

In the ICICI case, the bank involved is designated by the RBI as a Systemically Important Bank. This means that if the bank gets into trouble, the entire financial system of the country could be jeopardised. This also means that this bank would have received heightened supervision by the banking regulator. Risk-based supervision implies that the RBI has a special framework for Systemically Important Banks and supervisors watch the bank more carefully. In many jurisdictions, dedicated supervisory teams are assigned to each systemically important financial firm.

The common thread in these cases is banking regulation and supervision. One key question is whether the oversight system for regulation and supervision of banks is adequate. Does the supervisor have red alerts going of when there are possible conflicts of interest? Is there a risk-based system of supervision in place? This is similar to the PNB fraud where the question was: Does the supervisor have red alerts going of for banks where the Core Banking and the SWIFT systems do not talk to each other? The RBI knew that this created risks and officials spoke about it in seminars, but what matters is whether banks in which there is no integration face greater supervisory scrutiny?

The immediate effect of the ICICI case will be to put an end to the demand for privatisation of public sector banks. That is not a bad outcome because to see the problem of the bad performance of Indian banks as one related only to public ownership of banks is a partial view. While ownership is a very important reason for the ills of Indian banking, the lack of adequate regulation and supervision are equally important. We first need to develop our regulatory and supervisory capability before privatising public sector banks or unleashing a large number of small banks onto the system.

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.

The 6.5% warning

Indian Express, 11th January 2018

Almost all steps in the strategy to revive investment are likely to be slow and painful. There are no shortcuts

The GDP forecast for FY 2018 of 6.5 per cent does not come as a surprise. The introduction of a Goods and Services Tax, even in its cleanest and simplest form, would have inevitably led to disruption in any economy. In India's case, multiple rates and a complex structure have made compliance cumbersome and created gaps in the supply chains. As the government simplifies the GST regime in response to the difficulties being faced on the ground, this problem will likely get solved. The bigger challenges for the economy are the problems that have just begun to be solved.

The central puzzle is the decline in investment. Investment did not start declining immediately after the global financial crisis in 2008, but with a lag. For a couple of years, the economy was held up by expansionary fiscal and monetary policy, and the momentum of the previous years. But since 2012, the demand shock seems to have caught up with us. Investment in the Indian economy has declined from 34.3 per cent of the GDP in 2011-12 to 27 per cent of the GDP in 2016-17. The first advance estimates on national income show that investment as a per cent to GDP has further fallen to 26.4 per cent in 2017-18.

During these years, a number of solutions have been tried to revive investment, but with limited effect. First, the decline was understood to be a consequence of the policy paralysis under UPA 2. A large and increasing number of stalled projects was seen to be the reason for the slowdown in investment. There was consequently an attempt to address this issue by reviving stalled projects. Even though the number of stalled projects was reduced with active government intervention and inter-ministerial coordination, the difficulties of private investment did not go away. Stalled projects were perhaps an outcome of underlying problems and not the cause. Therefore, addressing them did not raise the growth of private investment. The outcome to watch for tracking investment is projects under implementation. These started declining in 2011 and have still not picked up after six years.

Next, it was felt that private investment could be increased by raising public investment. Even though the government's ability to raise capital expenditure was limited, there was expected to be a crowding-in effect, and the increase in public investment was expected to lead to an increase in private investment. This strategy had limited effect. Public investment increased but at a much slower pace than expected. The government’s ability to write good contracts and give out projects was limited by bureaucratic hurdles, government contracting systems and procurement rules.

Meanwhile, bank financing had also run into trouble. Banks had lent to companies who were no longer returning their loans or paying interest. Corporate debt restructuring, that gave borrowers additional time to pay back after the crisis, had not helped. Bank money was stuck and they could no longer lend. Credit growth had slowed down. The way out was sought in going after the bad guys or the "wilful defaulters". The others were to be given a longer rope. This strategy did not get money back to banks.

First, it was very hard to identify the bad guys who had run away with the money. Even when the Vijay Mallyas were identified, the banking system did not get the money back and bank lending did not pick up. The good guys who were given time to return the money kept pushing repayment dates further, and they were given new mechanisms to keep kicking the can down the road. Banks failed to recognise poorly performing assets as non-performing and the regulator was lax. The net result was pretty much a bankrupt banking system stuck with bankrupt companies.

The logjam can no longer be ignored. The Bankruptcy Code and the Financial Resolution and Deposit Insurance Bill are a strategy for addressing this problem. They are critical elements of trying to untangle the mess we are in and to address the huge problems being faced today in the banking and corporate sector that have brought investment to a sharp decline. These are not popular measures. Nor are they quick-fixes. The 12 cases that the RBI has sent to the the bankruptcy process could lead to haircuts and losses that cause a number of banks to become unable to meet their capital adequacy requirements in the coming quarter. To prevent this from happening, Rs 2.11 lakh crore is being put into bank recapitalisation. This money could well have been spent on infrastructure or public investment. But until a better plan is ready, the immediate need to allow exising banks to function is the first step.

However, looking forward, as bankrupt companies and bad loans will be resolved by the bankruptcy process, bank losses will rise and putting budgetary resources into loss-making public sector banks will become increasingly infeasible. The creation of a Resolution Corporation will allow banks to be sold to other buyers in an orderly way. The FRDI bill is currently being examined by a Joint Parliamentary Committee and is likely to be passed after taking into account the fears and concerns.

Another critical requirement for investment growth is the availability of non-bank finance. There has been discussion about a corporate bond market that could provide funds to industry, particularly big industry. Yet, no country has been able to develop a liquid and well-functioning corporate bond market without a risk-free benchmarket rate provided by a government bond market. The creation of a well-functioning government bond market with a public debt management agency and integration with equity markets was proposed in the March 2015 Budget. This proposal was rolled back to give the RBI time to work with the Ministry of Finance on a transition plan. As a critical element of facilitating finance for investment, this work needs to be prioritised.

Almost all the steps in the strategy to revive investment are likely to be slow and painful. A sustained pick-up in investment and growth can be expected only once these essential elements are in place.