By Ajay Shah, on March 21st, 2013
Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.
Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.
In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.
Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.
A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don’t, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.
For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it’s easy for us to overdo this message. In many situations, I feel it’s better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.
These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay.
This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.
One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.
A prominent example of this debate has been `financial market infrastructure institutions’ (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.
Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.
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By Ajay Shah, on March 12th, 2013
by Bindu Ananth and Kshama Fernandes
Over 2006-12, RBI and SEBI have created a strong and conducive regulatory environment for securitisation, listing of securitised debt instruments, and standards of transparency and reporting. Securitisation volumes have picked up and we recently witnessed the first listed transaction.
In October 2011, the income tax authorities issued a claim on certain securitisation special purpose vehicles (SPVs), stating that the gross income of such SPVs was liable to tax. The matter is presently under sub judice with the Bombay High Court. Several industry participants approached the Ministry of Finance (MoF) to seek clarity and reinforce the “pass through” status of a securitisation SPV.
The Finance Bill, 2013, has sought to clarify the tax position by stating that securitisation SPVs are not liable to pay income tax. However, the Bill also states that trustees of such SPVs must pay tax on distributed income.
The above amendment has an unintentional and significantly negative implication, on account of which taxable investors would be disincentivised from participating in securitisations.
This memo explains the issues and the unintended implications caused by the present draft of the Finance Bill in relation to securitisation SPVs, and provides a possible solution for addressing these issues.
Objectives of the MoF with respect to taxation of Securitisation SPVs
The Finance Minister (FM) in his speech presenting the Budget for the year 2013-14, set out his intent in presenting the proposed changes to the taxation of Securitisation SPVs: “In order to facilitate financial institutions to securitise their assets through a special purpose vehicle”.
The depth and vibrancy of the asset securitisation market is an essential building block in transfer of risk and transmission of capital from well capitalised investors to high quality originators. The framework for a well-functioning securitisation market has been laid down in considerable detail by the Reserve Bank of India (in 2006, further strengthened in 2012) and the Securities and Exchange Board of India (detailed guidelines in 2008 and listing guidelines in 2011).
It is our understanding that the objective of the Ministry of Finance in providing the basis of taxation of securitisation SPVs, is to clarify and establish the pass-through status of securitisation.
Changes proposed by the Finance Bill, 2013
Given below is the text proposed to be introduced into the Income Tax Act, 1961 by the Finance Bill, 2013:
CHAPTER XII-EA
SPECIAL PROVISIONS RELATING TO TAX ON DISTRIBUTED INCOME BY SECURITISATION TRUSTS
115TA
- Notwithstanding anything contained in any other provisions of the Act, any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income at the rate of–
- twenty-five per cent. on income distributed to any person being an individual or a Hindu undivided family;
- thirty per cent. on income distributed to any other person:
Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.
- The person responsible for making payment of the income distributed by the securitisation trust shall be liable to pay tax to the credit of the Central Government within fourteen days from the date of distribution or payment of such income, whichever is earlier.
- The person responsible for making payment of the income distributed by the securitisation trust shall, on or before the 15th day of September in each year, furnish to the prescribed income-tax authority, a statement in the prescribed form and verified in the prescribed manner, giving the details of the amount of income distributed to investors during the previous year, the tax paid thereon and such other relevant details, as may be prescribed.
- No deduction under any other provisions of this Act shall be allowed to the securitisation trust in respect of the income which has been charged to tax under sub-section (1).
115TB.
Where the person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust fails to pay the whole or any part of the tax referred to in sub-section (1) of section 115TA, within the time allowed under sub-section (2) of that section, he or it shall be liable to pay simple interest at the rate of one per cent. every month or part thereof on the amount of such tax for the period beginning on the date immediately after the last date on which such tax was payable and ending with the date on which the tax is actually paid.
115TC.
If any person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust does not pay tax, as referred to in sub-section (1) of section 115TA, then, he or it shall be deemed to be an assessee in default in respect of the amount of tax payable by him or it and all the provisions of this Act for the collection and recovery of income-tax shall apply.
Explanation. — For the purposes of this Chapter,–
- “investor” means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
- “securities” means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
- “securitised debt instrument” shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
- “securitisation trust” means a trust, being a-
- “special purpose distinct entity” as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
- “Special Purpose Vehicle” as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed.”
The following additions of Section 10 (23DA) and Section 10(35A) are also proposed to exempt from income tax certain income related to Securitisation SPVs:
(23DA) any income of a securitisation trust from the activity of securitisation.
Explanation.”For the purposes of this clause,”
- “securitisation” shall have the same meaning as assigned to it -
- in clause (r) of sub-regulation (1) of regulation 2 of the Securities an<>d Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956; or
- under the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
- “securitisation trust” shall have the meaning assigned to it in the Explanation below section 115TC;”
And
“(35A) any income by way of distributed income referred to in section 115TA received from a securitisation trust by any person being an investor of the said trust”
Unanticipated implications of the proposed text
Securitisation of assets by financial institutions requires the existence of a wide range of investors for whom investment in Securitisation SPVs is a viable option. Currently, predominant investors in the securitisation market in India (particularly in the securitisation related to financial inclusion) are banks. Banks are sophisticated investors and sit on large pools of capital that they must deploy appropriately. Securitisation has been an important way for banks to efficiently and effectively deploy capital where it is needed.
Other investors in securitisation, such as Mutual Funds and private investors currently provide significant but far less capital through securitisation. Yet other investors, such as insurance companies and pension funds, are yet to join the market.
However, it appears that the proposed changes would make the investment in Securitisation SPVs unviable for all but a certain class of income tax exempt investors (such as Mutual Funds). To elaborate on this, given below is a brief synopsis of the tax position of an investor in such SPVs, along with that of the SPVs themselves, as well as the issues arising out of the proposed amendments in the Finance Bill:
- The current language of the proposed provision states that “any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income” but as SPVs are designed to be mere mechanisms to route payments. It is not clear how its “income distributed” will be determined for the purpose of Section 115TA.
- The language used in Section 115TA clearly indicates that the liability to pay “additional” income tax is placed upon the SPVs. It is not clear what this tax is in addition to.
- Howsoever its income may be determined, as a result of Section 14A, no deduction will be permitted for expenses out of its total income.
- Income under Section 10 (23DA) or under Section 10 (35A) is income not includable in total income.
- In terms of Section 14A, no deduction is permitted with respect of income described in Section 10 (23DA) or Section 10 (35A).
- Investors, other than “any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act”, however, often do have incomes and incur expenses in raising money to invest in securitisation transactions.
Illustration:
- A bank uses Rs. 1,000 of money it has accepted as deposits at the rate of 7.5% to invest in PTCs with a principal amount of Rs. 1,000 with a term of one year.
- The PTC offers a yield of 13%, translating into a sum of Rs. 1,130 of which (assuming the taxable “income distributed” is Rs. 130) Rs. 39 will be deducted as tax in terms of Section 115TA leaving Rs. 1,091
- But the bank has to return INR 1,075 to the depositors. Under Section 14A, the interest cost of Rs 75 is not deductible
- For a pre-tax profit of Rs 55, the post-tax profit of the bank is Rs. 16 i.e. a profit of 1.6 percent. The tax paid in this transaction is Rs. 39. Effectively, the rate of taxation relative to income in the hands of the investor is over 70%.
For the investor, Section 10(23DA), Section 10 (35A) and Section 14A have an effect similar to the taxation of revenue rather than taxation of income.
On the other hand, if the investment in the SPVs was treated, as it was traditionally, as pass-through, the bank would treat the income from investment as any other income and pay tax on its net income (in the example above: Rs 130 – Rs 75 = Rs 55), with an effective rate determined by the net income of the bank, which would be far less than the 70 percent indicated by the proposed language of the Finance Bill, 2013.
Therefore, the unanticipated consequences of the present draft of the Finance Bill are:
Higher effective rate of taxation of income from securitisation, when compared to other sources of income of an investor
Tax paying investors will stay away. Banks, NBFCs etc. may not be willing to invest in securitised debt instruments, unless compensated for the higher tax payable
Severe impact on market depth and liquidity. Banks are presently the largest investors in securitisations and their absence would severely inhibit the growth of the market
No incentive for new investor classes to participate. Investors such as private wealth, corporate treasuries, AIFs etc. may find securitisation an unviable investment option
An alternative draft
It may be noted that the taxation of private trusts is well understood and has been relatively stable for a significant period of time. If we wish to avoid the unanticipated consequences as outlined above, we would require reinforcement and restatement the existing position of law.
Attention may also be drawn to the provisions of Section 160, relating to representative assessees, which would also apply to trustees of private trusts, including Securitisation SPVs. The proposed addition of Section 10 (23DA) and Section 10 (35A) should be removed and no changes must be made to Section 10 in this regard.
It may be beneficial if the proposed Section 115TA read (in a restatement of the existing law) as follows:
CHAPTER XII-EA
PROVISIONS RELATING TO INCOME FROM INVESTMENT IN SECURITISATION TRUSTS
115TA.
(1) Any amount of income received by an investor from a securitisation trust shall be chargeable to tax as part of the total income of such investor.
Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.
Explanation.–For the purposes of this Chapter, –
- “investor” means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
- “securities” means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
- “securitised debt instrument” shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
- “securitisation trust” means a trust, being a-
- “special purpose distinct entity” as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
- “Special Purpose Vehicle” as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed.”
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By Ajay Shah, on August 21st, 2012
Ila Patnaik in the Indian Express on the role of the Ministry of Finance in India’s growth. Pratap Bhanu Mehta in the Indian Express on India’s cabinet reshuffle. Anil Padmanabhan in the Mint about how things have changed at MoF after Chidambaram got back.
Bibek Debroy on a major problem that afflicts India today: Human capital obsolescence. Now that I’m safely past that age, I know the right answer for leadership positions: the right age is 40.
Theodore Dalrymple in the Wall Street Journal likes India’s Olympian detachment from the Olympics.
Trampling on the individual in India: Jayalalithaa vs. India Today. Also see Gopu Mohan in the Indian Express who shines the light on the systematic use of litigation.
Russell Green in Mint on the problems of priority sector lending.
Pramit Bhattacharya in Mint on Kaushik Basu’s tenure as CEA.
Mythili Bhusnurmath in the Economic Times on the difficulties of bank solvency that India now faces. The article refers to this RBI report on restructuring of bad debt.
The ghost of Abraham’s letter by N. Sundaresha Subramanian in the Business Standard.
Amol Sharma and Megha Bahree in the Wall Street Journal about Mukesh Ambani’s 4G plans. In it: “On one page there was a complex mathematical calculation of how fast each cell tower could carry data.”
Odd SDP data for Maharashtra, by Dilasha Seth in the Business Standard. Also see.
The man who saved capitalism by Stephen Moore in the Wall Street Journal.
By Ajay Shah, on August 6th, 2012
by Harsh Vardhan.
On 20 June, RBI issued guidelines that permitted White Label ATMs (WLA) to be operated in India. These guidelines could make a very significant change in the banking business – one that would go a long way in improving penetration of banking. This was a move that was long overdue. We can now look forward to very rapid expansion of the ATM networks along with many new services being offered at them.
ATMs arrived in the US in the late 1970s and in India somewhere in the 1990s, when some foreign banks set up a few in Mumbai and other metros. It was not until the late 1990’s and early 2000’s that ATMs became an important channel and there was a rapid growth. This growth can be attributed to the new generation private banks who used ATM’s cleverly to expand the reach of their (then) limited branch networks to attract customers. These banks realized that it will take them a long time to match the branch reach of public sector banks, and hence adopted a model where a branch surrounded by a slew of ATM’s became the means of attracting customer. The proposition to the customer was – “Open an account in the branch which may be far away from your home or place of work but transact on an ATM which is very close to you”. A new generation of customers, more amenable to the use of this channel also helped. Slowly, most of the new generation banks managed to transfer a sizeable part (in some cases over 80%) of basic transactions — cash withdrawal, balance enquiry, etc. — to ATMs. The cost advantage was compelling. Doing transactions on ATM’s can be 50% to 80% cheaper than using branches. We also saw some small “value added services” emerge at the ATM, such as bill payments.
Despite the rapid growth of the ATM network, their density is still low compared to other countries. India has ~ 77 ATMs per million population which is much lower than even countries like Thailand and Malaysia which have ~200 ATMs per million and significantly lower than the US which has over 1200 ATMs per million people. Clearly, ATM density will have to grow which means a large number of ATM’s will have to be rolled out. For this to happen, appropriate incentives have to come into play in this field.
How do ATMs work?
It is important to first understand the mechanics of ATMs, to fully appreciate the roles played by different entities and how the new regulations change these roles and thus the incentives.
ATMs are essentially electronic contact points between a bank and its customers. The jargon of the field involves three kinds of entities:
- Issuing banks – those that issue ATM cards (or debit and credit cards) to their customers
- Acquiring banks that operate ATMs and dispense cash (similar process also is followed in case of the so called Point of Sales (PoS) terminals that are used at merchant establishments for payments)
- Payment associations (also called Network Providers) – the intermediaries that facilitate the flow of information (payment instructions) and funds between issuing and acquiring banks
The process flow of cash dispensation by ATMs (which is 95% of what they do) works like this:
- A customer approaches an ATM and inserts his card.
- The ATM “reads” his card and passes the information to the bank which has set up the ATM. This bank is conventionally called the “acquiring” bank.
- Computers of the acquiring bank read the information and determine if the customer is its own or of some other bank.
- In case of its own customers the bank invokes his account, checks if there is enough money, and if the password is correct, sends instruction to the ATM to dispense cash. Such transactions, where the acquiring bank and the card issuing bank is the same, are called “On Us” transactions.
- Sometimes the customer has a card issued by another bank (”the issuing bank”). The acquiring bank (i.e. the one which setup the ATM) sends a message to Visa, MasterCard or “NFS” the National Financial Switch (a system set up by National Payment Corporation of India) depending on the arrangements between the acquiring banks, the issuing bank and these entities. These entities are called “Payment Associations” and they perform the role of connecting card issuing banks with the acquiring banks
- Upon receiving the information from the payment association, the issuing bank checks up the availability of a balance in the bank account, and sends the payment instruction to the ATM which dispenses cash. In this situation the acquiring bank is making the cash payment to the customer on behalf of the issuing bank. Such transactions are usually referred to as “Off Us” transactions
- The payment associations keep records of all “Off Us” transactions. At the end of each day, they do clearing and settlement of funds whereby all banks pay or receive funds depending on the net Off Us transactions made through their customers and possibly their ATMs.
- The issuing bank pays some fees to the acquiring bank and to the network providers for every transaction that their customers carry out on ATMs (i.e. for all “off us” transactions). These fees are a revenue for the acquiring banks which spends money in building and running the ATM network./li>
It is useful to think that there are 2 distinct flows in this process: a flow of information (or instructions), and a flow of money. Information flow takes place on communication lines between the entities involved and funds flow is mediated by the payment association through its own clearing and settlement processes. The two flows are linked but distinct.
The new guidelines
Historically, RBI regulations prevented non bank players from competing in this space. Regulations allowed only commercial banks to own and operate ATMs. This means that each ATM, in the view of the regulator, belonged to the acquiring bank. And no entity other than a commercial bank could do the acquiring part of this process.
Building and running ATMs is more of an IT/telecom business and many banks were not keen to create these capabilities. A significant amount of outsourcing was done by banks, whereby the maintenance and in many cases even the rollout of ATM’s was done by independent companies for banks. But regulations dictated that all the crucial aspects of running the ATM network remained squarely with banks. Even the locations of ATMs – which banks needed to inform the RBI – were pegged to a bank.
The new guidelines effectively open up most of the acquiring part of the process to non bank independent players. They clearly recognize that the information and the funds flow are distinct and while there may be some logic in keeping the funds flow within the ambit of commercial banks, the information flows can be performed by non banking entities. The new guidelines make some profound changes, including allowing:
- Independent white label ATM providers to set up and operate ATM networks (without being a bank); these companies can apply for and get approvals for the locations of ATMs – the locations will be assigned to these companies and not to banks
- Independent ATM networks to connect directly with network providers such as Visa Mastercard, and NFS – thus allowing them to pass on the payment instructions emanating from the ATM without having to go through the acquiring bank, While the cash settlement will continue to be via the acquiring banks (called sponsor banks under the new guidelines), an independent ATM operator can do such settlement through multiple sponsor banks
- Allowing companies to tie up with multiple banks as acquiring (sponsor) banks; this will meant that even if the arrangement between a particular bank and an ATM operator is discontinued, the operator can tie up with another bank and continue to operate ATMs
- ATM operators the freedom to offer value added services
Effectively, these changes imply that running the ATM network has now been recognized as an independent activity, but at the same time seeing that it is a business that needs the support by banks for activities such as managing cash and for settlement. Thus the RBI has taken significant part of running ATM networks out of the ambit of commercial banking.
Why is this a good idea? Building out the ATM network is not a core activity for banks. For banks, an ATM is a transaction point for customers. Setting up and running a large number of ATMs is an activity that adds little to the profitability and performance of banks but does add a significant amount of operational burden. This is the reason why many Indian banks started outsourcing ATM rollout and management once they reached a critical mass on ATMs. This is not the business of banking. At first blush, it is an IT or telecom business. But at a deeper level, it is closer to the retail business, with issues like location, branding, efficiency, multiple services, etc.
For independent white label operators, building out a large ATM network and squeezing operational efficiencies out of it would be the core business. They are expected to focus on much faster rollout of network, strategically thinking about locations, squeezing efficiencies in the management of the network, adding value added services, etc. An analog would be the case of money-changing business – what is popularly known as “Exchange Bureaus”. For a long time only banks were allowed to run these and so we saw very few outlets even at airports and so on. This business was opened up for private independent players about a decade or so ago, which resulted in a dramatic increase in the number of outlets as well as the quality of their service.
There are several classes of players that are likely to enter this business. Large established international players (eg Star, Pulse, NYCE from the US) should be interested as they would see India as a major growth market. Local players currently providing oursourcing services for ATM rollout and management would be another class of players that are likely to enter. ATM manufacturers (eg NCR, Diebold) also could look at this as an extension of their business. Other firms in related business such as telcos that provide the network connectivity could also consider entry. Each of these different classes of players have their own strengths and weaknesses. Time will tell which is the ideal business model. The competitive dynamics between these various kinds of players will give customers in India better ATM services in all respects: more locations, better locations, more services, and superior customer experience.
Many aspects of the white label ATM business will only become clear as the story unfolds. The most critical is the long term sustainable economics of the business which will determine the capital that is deployed into the business. While the RBI guidelines prescribe overall restrictions on the fees charged by the ATM operator to the bank, they stay away from prescribing the exact charges, which is the right approach. At first, there will be a bit of a competitive frenzy; some players will set some charges to very low or very high levels. It will be some time before stable pricing structures and levels emerge. The guidelines are not absolutely clear if these companies can develop independent brands for their networks (such as Most and Cirrus in the US). Such branding will be a crucial part of making white label ATM an independent business. My interpretation is that independent branding is not explicitly prohibited but it is not explicitly permitted either and clarity on this count would be very useful.
Overall these guidelines are a move in the right direction. There is a lot in the payment space that is currently tied to commercial banking due to regulatory reasons. The evolution of technology and consumer behavior suggests that many aspects of payment business need not remain confined to banking and in fact taking them out could unleash innovation that would drive significant efficiency gain and consumer value. We can hope that the deregulation of ATMs is the first of several similar steps that the RBI takes to allow the emergence of a payments industry in India, distinct from the business of banking.
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By Ajay Shah, on July 9th, 2012
by Madhavi Pundit and Suyash Rai
On June 27, RBI published its Payment System Vision Document (2012-15). The document shows RBI’s vision and mission for the payment system, and specifies the objectives, approaches and courses of action emanating from the same. It is a laudable step taken by RBI to discuss its plans for payments in India. All regulatory activities, such as banking and capital account liberalisation should have vision documents to similarly show the road map. They bring clarity to market participants, and helps everyone plan better.
A vision document is an opportunity to think from first principles, and to dream about the payments landscape. The document does not do this sufficiently.
Going by the ideas of the vision document, it is difficult to hold RBI accountable to it or to evaluate its role as a regulator, because it is not clear what we should expect the payment system to achieve, say, five years from now. Though the vision itself may be a general, aspirational statement, it should be accompanied by quantifiable goals that can be achieved by Indian payments system (regulator + industry). For example, the regulator can set objectives that by 2015, cash will be x% of transactions, or that cheques will be phased out by 2020. RBI can then, as a regulator, take steps to facilitate the achievement of such goals, with the expectation that other participants will play their part. Such sharp statements are absent in the document.
Once a suitably ambitious, but quantifiable, vision for payments has been stated, achieving it requires looking beyond incremental modifications. This brings us to the kind of steps RBI has proposed in the document; the things that it will do to achieve the vision over the next three years. For a vision document, the proposed steps are rather tactical and operational. From this document, it seems RBI is running all payment systems, with incidental cooperation from the private sector. It is difficult to imagine how industry participants should work towards the vision. For an example of how this can be done, contrast the RBI document with the Strategic Review of Innovation in the Payments System, recently released by the Reserve Bank of Australia. Unlike RBI’s document, the focus of this document is purely strategic, and on removing barriers that prevent market participants from innovating.
The document should clearly state what RBI sees as its role in payment systems – which is above all, that of a regulator – and what it sees as the role of market participants. While the document focuses on the development of certain types of electronic payment systems, certain standards, authorisation methods etc., there are a host of other ways the market could innovate. The document’s approach precludes other means by which the same goal of higher electronic payments can be achieved.
All regulation must be rooted in market failures that damage the interests of consumers or threaten systemic crises. A specific regulation must address a specific market failure and thus tangibly further consumer protection or systemic stability:
- In payment systems, consumer protection would entail measures that ensure transparency and disclosure by payment providers, so that consumers receive what they are promised.
- In addition, providers must be subjected to micro-prudential regulations, such as capital requirements, risk management and investment restrictions that ensure their safety and soundness, based on the risks they take. The risk based approach means that small value systems with real-time payments need less regulation than large value systems that hold clients’ funds for a certain amount of time.
- For systemic stability, enhanced regulation and supervision of systemically important payment systems, especially back-end infrastructure, such as RTGS, is required.
RBI ought to focus on these regulatory objectives, where it would deliver public goods, rather than take on `private goods’ functions that can be handled ably by the market. Systems such as NEFT and ECS, which essentially require capabilities that go beyond a regulator’s core competence, can be run well by the private sector, under RBI’s regulations. In such systems, competition is of essence.
From this perspective, the vision document starts looking less impressive. It is tied to the existing ways of doing things, and intent on incrementally improving them, rather than questioning the existing paradigm. This is unsatisfactory, for a paradigm shift is what India most requires.
Perhaps that is why there seems to be a lack of clarity of purpose. For example, RBI talks about investing in cheque systems and electronic systems at the same time. Developing a grid system to replace clearing houses as suggested is expensive. If the objective is to phase out cheques and promote electronic payments, the revamp of the cheque clearing system has no place in the vision document for electronic payments.
The emphasis on electronic payments is welcome. It is time for India to become a less-cash society, and ultimately a cash-less society. Myriad inexpensive, safe and useful electronic technologies are available, and more are being developed as we write. Hence the extensive use of cash and other paper-based instruments is not acceptable. They are expensive and inconvenient, and cost the most to those with the least – who pay for using these instruments and also face value erosion due to inflation. More needs to be done to move to electronic payments, and soon.
Competition and innovation are both important for this goal. The document talks about the dilemma the regulator faces with regard to pricing. To us, there is no such dilemma. To a large extent, the regulator should not intervene in business decisions such as pricing. In terms of market structure, there are two types of charges in payments – by retail payment providers and by infrastructure providers in the system. At the front end, innovative and cost effective payments products and gateways can develop if there is competition and there is no case for regulatory intervention here. It is a serious issue, and as experience from credit markets would suggest, a cap on pricing usually leads to more exclusion than inclusion.
Anti-competitive actions by players can be taken up to the Competition Commission. At the same time, it is important to note that in industries that are network based, there may be a need for monopolies or duopolies in infrastructure provision which require modification of the standard approaches of competition law (example).
Under these circumstances, if there is evidence of supernormal profits, there may be role for regulating prices. But even here, price determination should be done transparently, based on a full analysis of costs and reasonable returns, and in consultation with industry participants. For example, in the recent announcement of a cap on merchant discount rate on debit cards, there is no explanation from the regulator for how the amount 0.75 per cent was decided, and what are its costs and benefits to the system.
The role for non-banks is conspicuous by its absence in the vision statement. Currently, regulations tie the hands of non-bank payment providers. Take the example of Airtel money, which is a semi-closed mobile wallet. This means money can be transferred to other Airtel customers and transactions can take place with certain merchants, but there is no possibility for cashing out. Vodafone has partnered with a bank, and hence allows cash out from retail points; but these registered points have to be within 30 km of the bank partner.
A key insight that should guide the way forward is that payments is a separate business from banking, and should have its own regulation. Decoupling them could help achieve the twin goals of innovation and inclusion. An electronic payments revolution can take place when small value transactions are done electronically, i.e., customers in every nook and corner of the country can access secure, efficient and low cost retail payments services that can be considered cash substitutes. E-money in many countries has exploded on the backs of non-bank led payments systems such as telecom companies and retail chains, and their reach has been impressive. Easing restrictions on non-bank payments systems in India is required to really take advantage of their vast networks that have already penetrated unbanked areas. There are risks, but nothing that a forward thinking regulator who recognises the immense potential cannot creatively address. (See How to achieve safety in payments for an example.)
Finally, for large value electronic payments systems, RBI’s vision should be to bring them up to world standards and integrated with global systems. Cross-border payments are an important facet of international trade and integration, and this can lead to settlement/ Herstatt risks. RBI should address operational and regulatory issues to minimise these risks. For example, RTGS should be brought as close as possible to a 24 by 7 settlement system to ensure overlaps with corresponding systems in other countries and time zones. Additionally, in light of recent data that shows that the INR is the third most traded emerging market currency, these and other steps should be taken so that the INR becomes an eligible currency for settlement in the Continuous Linked Settlement (CLS) system, alongside the other international currencies already on CLS.
In conclusion, it is commendable that RBI has released a payments vision document. Such a document gives an opportunity for us to understand the mind of a government agency, and discuss and debate its priorities and actions. But writing a vision statement is a chance to step away from the familiarity of set ways and ask the big questions. RBI should not squander this opportunity.
By Ajay Shah, on June 26th, 2012
All of us are aware of India’s inflation crisis. It is very disappointing, how we lost our grip on stable 4-to-5 per cent inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5 per cent.
All of us agree that there is something insiduous when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument “Yes, this is bad, but if high inflation is the way to get to high GDP growth, let’s get on with it”. It is, then, important to ask: Why is low inflation valuable?
Nominal contracting is very important
Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.
Every society needs to adjust all the time, in response to changes in tastes and technology. When tastes or technology change, the structure of production needs to change, which involves renegotiation of (written or unwritten) contracts. These adjustments are costly. Contracting is costly, and renegotiating contracts is costly.
It is useful to think of a finite supply of adjustment as being available in the country. We should devote that full power of adjustment to the beneficial adjustments associated with changes in tastes and technology. In a place like India, where GDP doubles every decade, the requirement for adjustment is (in any case) large.
Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.
Contracting is costly. Almost everything that senior managers do is to arrive at complex deals that create and sustain complex structures of production. This work is continually torn down by high inflation which makes the deals of last year break down today. Managers are able to build sophisticated edifices of contractual arrangements under low and stable inflation. These webs of contracting are harder to build and hold up when the acid rain of inflation is continually tearing these down.
Inflation messes up information processing
To continue on the theme of adjustment, the essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise’ by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.
Building a sophisticated market economy is all about making long-term plans. When a firm decides to build an airport or a highway, this involves making NPVs over the next 20-40 years. This requires having a fair idea about future inflation. If inflation will fluctuate in the future, then firms will err on the side of caution when making plans about the future, i.e. investment will be reduced. I will stress that long-term investment, in projects such as infrastructure or heavy industry, relies critically not just on a long-term bond market (which, in turn, critically requires low and stable inflation) but also on the calculations happening in a spreadsheet about the NPV of the investment project, which involves projecting all revenues and all expenses for the next 20-40 years (which also critically requires low and stable inflation).
Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.
A civilised society is one in which people can make plans for the deep future, and trust in financial instruments. It is simply cruel on the elderly to inflate away their nominal assets. The possibility of even one bout of high inflation over the coming 25-35 years forces people to drop back to other mechanisms of protecting themselves in old age. What is needed is not just inflation control right now. What is needed is the environment of mature market economies, where outbursts of inflation are fully ruled out for decades to come.
Impact upon relationship with banks
In India, banks pay very low interest rates. While many interest rates have been deregulated, the interest rates paid by banks are held back by factors such as low competition and financial repression (i.e. forced purchases of government bonds).
When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, households tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.
If the financial system were regulated sensibly, then with high inflation we would immediately get higher nominal interest rates since buyers of 90 day treasury bills would demand higher interest rates to pay for inflation. This would reduce the damage caused by high inflation. In India, we suffer from bigger negative effects because of a faulty financial system.
These may seem to be small things but they actually are fairly large effects. Towards an understanding of the costs of inflation — II, by Stan Fischer, 1981, argues that perfectly anticipated 10% inflation induces a cost of 0.3% of GDP on account of only one factor : excessive efforts by households and firms to hold less cash.
The rising prominence of gold
Gold is a barbarous relic; it is the investment strategy of choice for uneducated people. It is also a vote of no confidence in fiat money. Our failures in creating a capable central bank, which delivers sound fiat money, are taking Indian households back to their old ways. Many decades of progress in getting households to engage with the modern financial system is being undone in this inflation crisis.
A classic quotation
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become `profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.
From Chapter 6 of The Economic Consequences of the Peace, by John Maynard Keynes. Source: Who said “Debauch the Currency”: Keynes or Lenin? by Michael V. White and Kurt Schuler, Journal of Economic Perspectives, Spring 2009.
But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here’s the classic picture, for the 1960s in the US:
which shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.
A look at the same evidence for the US, over a longer time period, shows no such tradeoff:
The idea that there is a tradeoff between inflation and unemployment is thus an artifact found in the minds of people who studied economics in the 1970s. This proposition was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.
In the empirical literature, it is quite clear that by the time we get to double digit inflation, this has a discernable and negative impact on growth. This generally means that at a 95 per cent level of significance, you can reject the null of no effect, in conventional datasets. The conceptual reasoning above gives no reason for believing that there should be a threshold effect, that inflation above 10% should hurt growth but below 10% things should be fine. It could well be the case that when you get to smaller values for inflation (e.g. 9%) this effect size is not detected with conventional datasets at the 95 per cent level of significance.
It is interesting to look at the target inflation rate set in the numerous countries which have setup either de facto or de jure inflation targeting. The median value chosen has been: 2%. If people were convinced that inflation below 10% is not damaging to growth, inflation targets may have been higher. But instead, the typical inflation target in the world is 2%. This underlines the universal consensus in favour of targeting low inflation — more like 2% and far below the 10% that we’ve got stuck with in India.
In the West, some people with a weak grip of economics, and strong sympathy for the unemployed, have argued that high inflation is a good thing because it helps reduce unemployment. In contrast, in India, economists have consistently found that the poor are adversely affected by inflation. There has not been a left-of-centre lobby that is soft on inflation, here.
Conclusion
There is no tradeoff between inflation and growth.
High inflation damages growth.
One element of India’s growth crisis is India’s inflation crisis.
It is important to think carefully about the accountability of the central bank. RBI is not in charge of India’s welfare. RBI is in charge of India’s fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4 to 5 per cent range.
Low and stable inflation is an essential ingredient of the foundations of high economic growth in India. RBI can lay that platform. They can do no more. If they try to reach into other objectives, they damage this core.
By Ajay Shah, on June 1st, 2012
Business as usual, in India, is taking us to a destination where RBI & SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance will take place overseas, and the overseas market will dominate price formation for India-related financial products.
Why might this happen?
Finance is the business of bits and bytes. Orders being sent to India can be easily switched to other venues. An array of other venues are now springing up:
- Nifty futures trade in Singapore on the SGX
- An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market’).
- Derivatives on the rupee trade overseas on the OTC market (linear contracts are termed `the NDF market’).
- Trading in individual stocks is taking place on the ADR and the GDR market.
Let’s focus on Nifty – the most important financial product in India. (The arguments pretty much identically apply to everything else).
The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy ( example, example, example, example, etc). The overseas market faces no such problems. The CEO of SGX wakes up in the morning and thinks about competing with NSE. The CEO of NSE wakes up in the morning and thinks of an array of weird things. And then, there is taxation. The fundamental principle worth using in this field is residence based taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and could get worse tomorrow (if GAAR is used to abrogate the Mauritius treaty). We think we are comfortable, because India has capital controls, and residents don’t have much of a choice on taking their custom elsewhere. Things aren’t that simple. First, non-residents can pioneer sending order flow to overseas venues, and make them liquid. The next stage will be about Indian MNCs, who run global treasuries, who can easily patronise the overseas venues. The third stage will be HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul [ example].
As on date, the SGX Nifty OI is 27 per cent higher than that for Nifty futures on the National Stock Exchange (NSE). The figures are more alarming if one considers the OI in a single month in May as the built-up positions on the SGX are 70 per cent higher than on the NSE. In May, the SGX Nifty OI was worth over Rs 16,200 crore while that on the NSE stood at over Rs 9,250 crore. As far as three-month contracts go, the Nifty futures OI on the NSE is over Rs 12,750 crore.
In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE’s. It is astonishing to see that for the biggest Indian product – Nifty – an overseas exchange has got superior open interest.
In the baseline scenario, Indian policy-making will meander on clueless and unconcerned. NSE will continue to lose ground. Why do we care? Is this mere protectionism – what is wrong if the entire India-linked equity index derivatives business takes place overseas?
- A rich and complex ecosystem of finance has developed surrounding the Nifty contracts. Hundreds of thousands of high skill workers are in this industry. A decisive loss of market share for India would endanger their livelihood.
- The tax revenues associated with all these activities, at present, come to the Indian authorities. The Indian tax man earns income tax (on wages and on corporate profit) and VAT (on an array of activities of the firms). All this will go away if the business shifts to Singapore.
- A sophisticated Indian financial system is required if monetary policy is to be effective. The demise of the onshore financial system will damage the onshore monetary policy transmission. It will further take us back towards a world where government is unable to play a role in business cycle stabilisation.
- Prospects of Bombay emerging as an international financial centre will subside. If we can’t even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren’t India-linked?
- Access to finance for firms will tend to split into a two-tier world: the big firms will go abroad to get their corporate finance done. The small firms will face greater constraints since they will not easily access finance abroad (there is a greater information distance between the typical Singapore investor and the typical Rs.1000 crore or Rs.100 crore Indian company), and the local financial system would be weak.
When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change, and to maintain high ethical standards.
It now seems that those hopes were premature. The more likely scenario is one where India-linked finance will happen offshore, while RBI/SEBI/CBDT/CCI/FMC/IRDA squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance will suffer from one setback after another.
We are likely to go back to the conflicted arrangements that gave us the Harshad Mehta scandals of the early 1990s and the Ketan Parekh scandals one decade later. I used to think we were finished with those problems. But we are about to restart on that entire story; there is little institutional memory about how those things came about and how dangerous our present path is. Each future scandal, of this nature, will be greeted with joy by overseas financial providers, who will scoop up market share every time India falls into turmoil.
Many years from now, we may one day get to fundamentally superior governance arrangements in finance, and achieve high ethical standards in public life and securities infrastructure. If this happens, we would be able to come back to these questions. As an example, Japan lost the Nikkei 225 contract to Singapore in the mid-1980s and got back into this to a significant extent 15 years later. In the years or decades that will go by until domestic financial governance structures are corrected, a great deal of organisational capital in the onshore financial system will have been lost.
The revolution in the stock market used to be one of the best success stories of economic reforms in India [ link, link]. It may well fall apart in coming months and years.
By Ajay Shah, on May 29th, 2012
by Shubho Roy and Ajay Shah.
The macroeconomic setting
India’s macroeconomic woes consist of a high inflation, low GDP growth and a drop in asset prices. The loss of momentum is visible in the seasonally adjusted data:
| Indicator |
Early 2009 |
Latest |
| GDP growth (QoQ, saar) |
9.83
Q2-2009 |
4.25
Q4-2011 |
| Inflation (CPI-IW, pop, saar, 3mma) |
7.5
Feb
2009 |
12.9
Mar 2012 |
| INR/USD |
48
Jan 2009 |
56
May 2012 |
The picture is not uniformly bleak. The most important asset price of the economy, Nifty, has not dropped across this period. On 1
January 2009, Nifty was at 3033. Today, it is at 4920, which is a good 62% higher. More generally, stock prices have held up rather
well so far. The trailing P/E of the broad market index, the CMIE Cospi, stands at 17.3, while the median value across its full history (from 6/1990 to 4/2012) is 17.83. We may think that conditions in India are difficult, but the stock market is saying that they’re roughly median conditions in terms of the outlook for earnings growth.
The current account deficit
In recent years, the fiscal condition of the government + PSUs has worsened. This has led to a large gap between savings and investment (the worsening in public finance has diminished savings). There is an accounting identity: The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital.
It is likely that in the coming year, we will have a current account deficit of 4% of GDP, or $80 billion a year, or Rs.1700 crore
a day. This means that we have to worry about how foreign capital views India. Under these conditions, if there is even a short hiccup
in capital inflows (as appears to have come about after the government proposed to modify the Mauritius route, and more generally with the problems of governance in India), it yields sharp rupee depreciation.
We import a lot of capital; government policy actions interrupt that flow of capital; the rupee depreciates. This is not
mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.
What should the responses be?
There are five sensible paths for government to take, in this situation:
- We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the
fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
- To ensure the smooth flow of Rs.1700 crore a day into the country, we should not spook foreign. We should not interfere with the de facto residence-based taxation framework which India is giving foreign investors, as long as they come through
Mauritius. This policy framework is, in fact, in India’s best interests.
- Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance.
- In the face of these difficulties, it would make little sense for RBI to trade in the currency market, to try to block the rupee
depreciation. There is good reason for rupee depreciation; the currency market is doing a pretty good job of translating the
fundamentals into a price. And, in any case, even if RBI desired to do something about it, its weapons are puny when compared with the size of the currency market and the Indian economy.
- It is an opportune time to continue with the liberalisation of the capital account. However, it is useful to think deeply about how to proceed with this. Some kinds of liberalisation can be dangerous. It is important to think about sequencing, and at all
times, to worry about unhedged currency exposure. A good deal of expertise has built up on the subject, through the Raghuram Rajan Committee and the UK Sinha Working Group.
An evaluation of what has been done
There are three features of recent policy responses which appear to be on track:
- By and large, RBI’s trading on the currency market appears to be at a low scale, nearing zero in many recent months. This is
wise. It increases respect for the brainpower at RBI.
- The government raised the price of petrol, so as to cut the fiscal deficit. This increases respect for the brainpower and
political capabilities of the government.
- The government decided to defer the attack on the Mauritius treaty by a year (though not to shelve it altogether). In the
absence of clear policy statements about the importance of residence-based taxation, this shelving does not increase respect
for the government.
Apart from these three good moves, a slew of dubious ideas have been afoot.
- A. Enlarging the scope for dollar-denominated borrowing by Indian firms
- On 20th April, 2012: external Commercial Borrowings regulations were amended to:
- Increase the limit on power companies to refinance their borrowings in Rupees with foreign currency loans (also called External Commercial Borrowings or ECBs).
- Allow companies to borrow in foreign exchange to make capital expenditure for maintenance and operations of toll systems (See here)
- Companies were allowed to refinance their ECBs with subsequent ECBs at higher interest rates (See here).
Evaluation: Do we really want Indian firms to hold dollar denominated debt? In particular, firms in the field of infrastructure who have cashflows in rupees? Sensible firm should see the high ex ante currency volatility and stay away from borrowing in dollars without hedging; so the impact upon capital flows will be small at best. And firms that do borrow in dollars and keep it unhedged are probably not going to fare well.
- B. Enlarging the scope for dollar-denominated borrowing by banks
- On 4th May, 2012: The maximum interest payable on forex deposits by NRIs in Indian banks was increased (See here):
- For deposits between 1 to 3 years the increase was 75 basis points.
- For deposits between 3 to 5 years the increase was 175 basis points.
Evaluation: Banks are disaster-prone 19th century institutions. Do we really want them to hold more unhedged foreign
currency exposure? Of all places in the economy, this is the worst place to keep unhedged currency exposure. The wise ones will not borrow in this fashion, so the impact upon capital flows will be small at best. And the unwise ones, that borrow in dollars and keep it unhedged, are probably not going to fare well.
- C. Reducing the economic freedom of exporters
- On 10th May, 2012: the right of exporters to hold foreign exchange was reduced by 50% (See here):
- Exporters were allowed to keep their forex earnings in special accounts called EEFC accounts. They were not mandated to convert it into Rupees. This allowed them the ability to fund imports for their business without going through costly conversions.
- Now only 50% of their export earning will be allowed to be kept in forex. The rest will be converted into Rupees against their wishes.
Evaluation: In the old India, FERA made ownership of foreign exchange an exotic and rare thing. Many businessmen in
India engaged in import/export misinvoicing and tried to hold assets outside the country. In the early 1990s, C. Rangarajan’s RBI embarked on a modern arrangement. Exporters were given greater economic freedom. We are now rolling the clock back by 20 years; we are tampering with current account liberalisation.
The number “50%” has not been justified in the RBI notification. Any exporter, with significant raw material import cost will now pay unnecessary transaction charges. In global trade, where every country takes the utmost effort to keep their exports competitive, any small distortion impacts on export competitiveness; this is pushing in the other direction – it is an attempt to reduce India’s export competitiveness.
This is a new low in Indian economic policy. Every internationally oriented household in India will now be more keen to hold assets and liquid balances outside India, safe from the clutches of Indian capital controls. This measure will thus exacerbate capital flight and worsen the problems of the rupee. Success in the marketplace will tend to accrue to businessmen who break laws as opposed to the law-abiding ones.
- D. Damaging the currency futures market
- On 21at May, 2012: restrictions were put on exchange-traded derivatives (See here):
- The net overnight open positions that the banks hold shall not include positions in the exchanges.
- The positions in exchanges cannot be used to offset positions in the OTC market for
- The position of banks in currency exchanges shall be limited to $100 million or 15% of the market (whichever is lower)
Evaluation: The world over, there is a clear understanding that the exchange is a superior way to organise financial trading. When compared with the OTC market, the exchange has superior transparency and risk management. Policy makers need to continually modify policies so as to favour a migration of all standardised products away from the OTC market to the exchange-traded contracts. RBI’s moves go in the wrong direction.
How do we ensure that the price on a financial market is driven by fundamentals? The answer : We must have a deep and liquid market, and a broad array of sophisticated speculators. RBI’s actions are going in the exact opposite direction. They are trying to make the market illiquid. But it is in an illiquid market that we will get market inefficiencies and weird behaviour of the price. They are increasing the chance that something nutty happens on the rupee.
This circular is also a reminder about poor legal process at RBI. Every action by a regulator must articulate a rationale. Financial regulations are motivated by exactly two possibilities – consumer protection or micro-prudential regulation. The government agency that wields the power of financial regulation must show the clear rationale, describing what is the market failure that this regulation is seeking to address. The government agency must show the cost-benefit analysis, explaining why the costs of this action outweigh the benefits. As is typical of financial regulators in India today, RBI’s documents show no rationale.
It is possible to conjure one conspiracy theory. The attempts at damaging the liquidity of the currency futures market should be seen in connection with previous work on damaging the liquidity of the OTC market. Perhaps there is a grand plan here. The scale of RBI’s trading on the currency market is implausibly small when faced with the size of the Indian economy, with the size of India’s cross-border interactions and the size of the currency market (both onshore and offshore). Perhaps these recent moves are designed to damage the liquidity of the market, so as to get to a point where RBI intervention can make an appreciable dent on the price. Perhaps the game plan is to gnaw away at the capability of the currency market through a series of moves, and then take off doing large scale manipulation of the market. If this is the game plan, it reflects very poorly on the economic policy capability at RBI. It would also generate massive profit opportunities for the speculators of the world, who would short the rupee when the large scale manipulation commences.
Rumours about other bad ideas abound. E.g. it is suggested that RBI will sell dollars to exporters directly. How is this different from selling dollars on the market?? It is suggested that the currency futures and the OTC markets should be completely cutoff by banning the arbitrage. How would this solve the macroeconomic problems which bedevil the rupee?
Microeconomic distortions are not a good way to address macroeconomic problems
What does one make of this spectacle? A simple principle worth reiterating is:
Problems rooted in macroeconomics must be addressed using macroeconomic instruments.
We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these — monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation (i.e. CPI-IW inflation) going to the 4-to-5 per cent range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.
A big element in the picture is the loss of confidence, in the eyes of the private sector, on an array of issues ranging from ethical standards to the sophistication of fiscal, financial and monetary policy. This is an important problem and it needs to be addressed. The spectacle of a government flailing at the macro problems using micro instruments is worsening matters. Perhaps there is constant pressure to announce `new measures’ to solve the problem. Deeper solutions are hard, and there is enthusiasm for `doing something’ (large or small) [example].
We’ve seen this movie before. In the last decade, again and again, RBI tried to wield capital controls as a tool for macroeconomic policy. They failed. It is disappointing to see the lack of learning.
Some of the moves above have come out of the reflexive socialism that lurks within the Indian bureacracy. Perhaps, in a crisis environment, the ordinary immune system within each government agency, which keeps the sub-clinical socialism under check, is not working as well. This hurts from two points of view. It betrays the lack of capability of these government organisations; it reminds us that the Indian State is strewn with people who have a low knowledge of economics and a taste for dirigiste. It also reminds us of the policy risk: Precisely when the best capabilities are required (in a crisis), we seem to be slipping into the lowest quality policy initiatives.
Everyone who sees the government / RBI engaged in one ill thought out measure after another gets worried about India’s future. How can a $2 trillion economy flourish while such immense powers are placed with individuals and institutions with such weak capabilities? This further damages confidence, which deepens the macroeconomic crisis.
Acknowledgements: We are grateful to Apoorva Ankur, Sumathi Chandrashekaran, Pratik Datta and Kaushalya Venkataraman for useful suggestions.
By Ajay Shah, on April 12th, 2012
The most important measure of inflation in India is the year-on-year change of the CPI-IW index. This time series, for 120 months, is shown above. From 2006 onwards, India slipped into a new phase of macroeconomic instability, where inflation has strayed far outside the informal target zone of inflation at four-to-five per cent.
Has inflation subsided?
In recent months, there has been a surge of optimism that the inflation crisis is coming to an end. However, a careful look at the seasonally adjusted data reveals that there is cause for concern.
| Month |
P-o-p SA |
Y-o-y |
| Sep 2011 |
17.49 |
10.06 |
| Oct 2011 |
2.01 |
9.39 |
| Nov 2011 |
3.11 |
9.34 |
| Dec 2011 |
-2.14 |
6.49 |
| Jan 2012 |
8.22 |
5.32 |
| Feb 2012 |
12.01 |
7.57 |
In September 2011, point-on-point seasonally adjusted (annualised) inflation was at 17.49 per cent. The year-on-year inflation was running at 10.06%.
We then had three good months: October, November and December, where the point-on-point seasonally adjusted (annualised) inflation dropped to 2.01, 3.11 and -2.14 per cent. This yielded a sharp decline in the year-on-year inflation to 6.49 per cent in December 2011 and further to 5.32 per cent in January 2012.
But after that, things haven’t gone well. Point-on-point seasonally adjusted inflation, which is the thing to watch for in understanding what is happening every month, is back up to 8.22 per cent in January 2012 and 12.01 per cent in February 2012. Year-on-year inflation is back up to 7.57 per cent in February 2012.
A casual examination of the key graph (shown above) shows that the worst of double digit inflation seems to have ended. But we are not inside the target zone of 4 to 5 per cent, and neither are we likely to achieve this in the rest of this year. It would be unwise to declare victory over the inflation crisis, with this information set in hand.
Looking forward
Looking forward, there are two main problems worth worrying about. The first is the expectations of households. At the heart of India’s inflation spiral is the problem that the man in the street has lost confidence that inflation will stay in the four-to-five per cent target zone. Survey evidence about household expectations has shown double digit values. This generates persistence of inflation; idiosyncratic shocks tend to not quickly die away. The mistrust of households is rooted in the lack of commitment to low and stable inflation at RBI, and this problem is not going to go away quickly. Despite all the problems faced in fighting inflation, RBI continues to communicate, through speeches and official documents, its lack of focus upon inflation.
The second problem is that of the exchange rate. Exchange rate depreciation feeds into tradeables inflation. With a large current account deficit, with policy impediments putting a cloud on capital inflows, rupee depreciation has taken place and may continue to take place. This would be inflationary. Indeed, if RBI chooses to cut rates on the 17th, there will be further weakening of the rupee (since the interest rate differential will go down thus deterring debt flows), which will further exacerbate tradeables inflation.
The media and financial commentators treat it as a given that on 17th, RBI will cut rates. However, the outlook on inflation is worrisome. India’s inflation crisis, which began in 2006, has not ended. Year-on-year CPI-IW inflation has not yet got into the target zone of four-to-five per cent, nor is this likely to happen anytime soon.
Our thinking on this needs to factor in the general elections, which are looming at the horizon in May 2014. Given the salience of inflation in India for the poor, the ruling UPA coalition is likely to be quite concerned about getting inflation back to the informal target zone of four-to-five per cent, well ahead of elections. This also suggests that the time for hawkish monetary policy is now, so as to get inflation under control by mid-2013, well in time for elections in mid-2014.
A historical perspective
Inflation went out of control in 2006/2007 because RBI’s pursuit of the exchange rate peg required very low interest rates at a time when the domestic economy was booming. (The capital controls that were then prevalent failed to deliver monetary policy autonomy; the only way to get towards exchange rate goals was through distortions of monetary policy). Given the lack of anchoring of household expectations, that inflation crisis has not yet gone away. Today, RBI is substantially finished with exchange rate pegging; we are mostly a floating exchange rate. In the future, inflationary expectations will not get unhinged owing to a pursuit of exchange rate policy by RBI. But while a pegged exchange rate pins down monetary policy, a floating exchange rate does not define monetary policy. RBI has yet to articulate what it wants to do with the lever of monetary policy. The first task for the lever of monetary policy should be the conquest of the inflation that is in our midst, owing to the monetary policy stance of 2006/2007.
In the early 1990s, unsterilised intervention in the pursuit of Rs.31.37 a dollar gave an inappropriate stance of monetary policy, which kicked off an inflation. Dr. Rangarajan wrestled it to the ground, even though the monetary policy transmission was weak then. In 2006, we ignited another inflation, once again owing to exceedingly low policy rates in the pursuit of exchange rate policy. Dr. Subbarao’s challenge lies in wrestling this to the ground. His job is easier when compared with what Dr. Rangarajan faced, thanks to the progress which has taken place on financial reforms and capital account decontrol.
By Ajay Shah, on January 27th, 2012
Reportage by Robin Harding and Michael Mackenzie in the Financial Times:
The rate-setting Federal Open Market Committee predicted low interest rates until late 2014 and set a formal inflation objective of 2 per cent, reflecting chairman Ben Bernanke’s long-held goal of providing greater transparency.
The FOMC downgraded its estimate of growth in the coming quarters from “moderate” to “modest” and Mr Bernanke indicated that another monetary boost for the economy – most likely another round of quantitative easing, or QE3 – remained an option.
“We are prepared to take further steps in that direction if we see that the recovery is faltering or if inflation is not moving toward target,” Mr Bernanke said.
The Fed also published its first detailed forecasts of future interest rates.
…
Adopting the 2 per cent objective is a historic move that binds the whole FOMC to a defined goal that will endure after Mr Bernanke leaves. It means the FOMC can easily justify more easing if it wants to because its inflation forecast for 2014, of between 1.6 and 2 per cent, is below target.
The FOMC voted for Wednesday’s decision by 9-1. The only dissenter was Jeffrey Lacker, president of the Richmond Fed, who wanted to leave the late 2014 date out of the policy statement.
The US suffers from legacy legislation, which predates modern monetary economics, which places the burden upon the Fed of pursuing both price stability and low unemployment. The evolution of the US Fed has been led by human energy within the Fed. Starting from Paul Volcker, who took charge in August 1979, the US Fed has run a Taylor rule with a nice strong above-1 inflation coefficient. In a recent column in the Indian Express, Ila Patnaik tells us about Paul Volcker’s story and how it matters to us. In effect, from Volcker’s chairmanship onwards, the behaviour of the US Fed has been that of an inflation targeting central bank. This was the de facto reality. Everyone knew that the US Fed targets inflation at 2%. What is new now is that the Fed has put greater credibility behind this, by going closer to de jure inflation targeting.
A key dharma of good central banking is to say what you will do, and then do what you just said. By saying that there is an inflation target, there is now full alignment between the words and deeds of the US Fed.
The day will come when India will enact high quality legislation which puts monetary policy on a sound institutional foundation. But we should not accept mal-performance by RBI until that day. It is possible for RBI to do much better, when compared with the present, even though the present legislation is really badly written. The US Fed is a good example of how technical capabilities within the Fed, and not an external legislative mandate, have driven improvements in the functioning of the Fed. This sort of progression is what RBI can and should aspire to, and this does not require waiting for a high quality RBI Act.
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